Transcript for:
Market Failures Overview

hello econ students this is principles of macroeconomics with Dr Molton today we're going to be studying uh chapter 4 which is market failures the topics we're going to cover today include efficiently function in markets externalities and efficiency losses society's optimal amount of externality reduction and asymmetric information let's get into it um but first what is a market failure market failure is when markets fail to produce the right amount of a product uh so um why would a market not produce the right amount uh generally this happens when there's an externality of some sort so an efficient outcome requires that the market demand curve has to reflect the full willingness to pay of every in the market and the market supply curve has to reflect all costs of production um so uh if the market demand curve does not reflect the full willingness to pay of every person um then you have a a positive externality if the market supply curve does not reflect all costs of production then you have a negative externality so um resources can be overallocated or under allocated um so Goods can be overallocated or uh sorry resources can be either overallocated uh or under allocated to the uh production of a good uh if you have these externalities um we're going to study the meaning of surplus uh Surplus is going to be the sum of consumer surplus and producer Surplus um but so first we're going to look at what a consumer surplus is then what a producer Surplus is then we're going to get into more details and externalities and uh we're going to discuss positive and negative externalities so consumer surplus is the difference between what a consumer is willing to pay for a good and what the consumer actually pays uh so it's the extra benefit from paying less than the maximum price so we saw in chapter 3 when we looked at the law of demand that demand curves are downward sloping uh demand curve is also going to reflect the marginal benefit to Consumers uh and the willingness to pay of consumers um but every consumer is going to pay the same price uh even though some consumers are willing to pay a much higher price uh so because we have our downward slip and demand curve we know that uh if the quantity uh equilibrium quantity were less then the price people would pay would be higher so there's some people willing to pay that higher price but everyone pays the same price in the market uh and they pay the equilibrium price there's going to be some people who are go going to need to pay significantly less than the satisfaction that they receive from the item um so willingness to pay reflects the utility or the satisfaction that consumers uh get uh from uh or the benefit that they get from consuming a product uh so think about if you went to buy a new car um and if you walk in the dealership willing to pay 50,000 for a car and you end up only paying 40,000 um you have gotten $110,000 of consumer surplus then um because is that represents the amount uh that uh so you paid less than your willingness to pay by $110,000 so here we have a uh numerical example on the left we have a table or schedule and on the right we have a graphical representation so this table shows a number of uh people we have Bob Barb Bill EA Brent and blesson they have different willingness to pay um so Bob is willing to pay $13 Barb is willing to pay $12 bill is willing to pay $11 e is willing to pay $10 Brent is willing to pay $9 and blesson is willing to pay $8 their willingness to pay here uh is reflective of their marginal benefit so this is the benefit that they receive uh from consuming the item meaning the satisfaction or utility that they get from consuming the item uh but do they actually have to pay this amount um no they don't uh they all are going to pay the same price for the product and they are going to pay the equilibrium price here we're given an equilibrium price in column three of $8 so we can calculate consumer surplus as what they're willing to pay minus the equilibrium price so Bob's consumer surplus is going to be $13 - $8 or $5 Barb is going to be $12 - $8 or $4 bills is going to be $11 - $8 or $3 and if we go down to blessing here he is willing to pay $8 that's the satisfaction he gets from consuming this uh and he actually pays $8 so his consumer surplus is zero he doesn't get anything extra he pays exactly the amount of his utility or satisfaction on the right we see this represented graphically so uh on the vertical axis we have price on the horizontal axis we have quantity we have the green demand curve which is downward slope pin uh and it's labeled uh D for demand which is equal to marginal benefit which is equal to maximum willingness to pay and what price do they actually pay uh equilibrium price is marked here at $8 so every single one of these people is going to pay $8 consumer surplus is going to be represented by this triangle here that is below the demand curve but above the horizontal line at the price uh at equilibrium price so this green triangle consumer surplus we're going to Define similarly a concept called producer Surplus producer Surplus is the difference between the actual price a producer or a seller receives um and the minimum price they would accept so this is extra benefit from receiving a higher price um so just to backup consumers of course would like to pay as low a price as possible um but the price they're going to pay is the equilibrium price producers would like to receive as high a price as possible but the price that they're going to receive is going to be the equilibrium price so here we're going to represent our data in two different ways on the left we have a table or schedule and we have six people we have Chandler Chia Chuck chasen uh chuma and Chad um column two shows their minimum acceptable price uh Chandler willing to accept $3 sha willing to accept $4 I'm willing to accept $5 Jason is willing to accept $6 schuma willing to accept $7 and Chad is willing to accept $8 the actual price they pay is going to be the equilibrium price of $8 we can calculate producer Surplus as the price that they all pay minus their minimum acceptable price so Chandler has a producer surplus of $8 minus $3 is $5 Chaya has a producer surplus of $8 - $4 is $4 I have a producer surplus of $8 minus $5 is $3 Etc down the line Chad as a producer surplus of $0 cuz 8 - 8 is 0 we can also see this represented graphic Al so price is on the vertical axis quantity is on the horizontal axis we have our supply curve which is this red line that is upward sloping um and uh we are given equilibrium price uh which is this uh dot here uh at $8 and uh it's represented by P1 so our producer Surplus is the blue triangle that is below the horizont on the line of equilibrium price and above the supply curve uh and here our supply curve uh equals marginal cost of production which also equals minimum acceptable price so Supply equals marginal cost equals minimum acceptable price now graphically we're going to put them both on the same graph uh so here we have our supply curve we just looked at is upward slop in Supply equals marginal cost equals minimum acceptable price um our demand curve is downward sloping demand equals marginal benefit equals maximum willingness to pay H our consumer surplus is going to be the green triangle that is below the demand curve but above equilibrium price um producer Surplus is going to be the blue triangle that is below equilibrium price but but above the supply curve um and our equilibrium price of course is where the supply curve intersects the demand curve um which is also where marginal cost equals marginal benefit um if we add together consumer surplus with producer Surplus we get total Surplus uh so uh our supply curve which reflects minimum acceptable price and marginal cost here we're assuming that this reflects all costs of production um and in order for this to work and for us to get to efficiency we're going to assume that there are no externalities so Supply equals the marginal cost to everyone um not just to the producer and um the demand curve is going to represent the marginal benefit uh to everyone uh not just uh those uh who are buyers um because we're going to assume no positive or negative externalities um so another way to think of this Surplus is uh so willingness to pay uh for for each unit it sold you can subtract from willingness to pay you can sub I'm sorry you can subtract willingness to pay maximum willness to pay um you can subtract out minimum acceptable price and that shows the benefit to society from selling that unit there's a benefit to the consumer where he uh where he gets utility beyond the price that he pays and there's a benefit to the producer or the seller um where he uh picks up money uh above his costs of production so so he makes profit um so uh so basically for each unit we are going to uh make Society better off by uh selling this unit and we're going to keep making Society better off until we get to this equilibrium point after equilibrium point we no longer make Society better off um because beyond that point additional units that are produced and sold um would result in marginal costs that are above marginal benefits or um minimum acceptable price that is above maximum willingness to pay so every additional unit produced after this would make Society worse off uh is possible for a society to have an efficiency loss or a dead weight loss here we see a dead weight loss from under production where we are not producing all the units we should be producing here it's assumed we are producing quantity 2 uh instead of quantity one quantity one would be at equilibrium and at our equilibrium point then we would get the maximum total amount of consumer surplus and producer Surplus by producing a quantity 2 we have this gray triangle here which is a dead weight loss this is an efficiency loss from under production because there are units that are not produced that should be produced so uh between Q2 and q1 each of these units the um willingness to pay exceeds willingness to accept um you could also look at it as the marginal benefit exceeds the marginal cost for each of these units so each of these units would make Society better off if they were produced uh and sold uh and bought uh but because they are not produced and sold and bought uh Society has not made better off by this amount so this is an efficiency loss we can also have a efficiency loss from over production so uh here if we produced quantity one at point B here we would be producing efficiently we would be maximizing consumer plus producer Surplus or total Surplus um and we'd be producing every unit where the marginal benefit exceeds the marginal cost um here instead we're producing at Q3 so we're producing extra units and these extra units the marginal cost exceeds the marginal benefit uh or you could think of it as the willingness to accept uh is higher than the willingness to pay so for each of these extra units that is produced Society is made worse off um so it costs more than Society benefits uh so this gray triangle here is a dead weight loss or an efficiency loss from over production from producing too much okay so now that we've talked about uh underproduction and over production we're going to discuss how we can actually get to underproduction or over production how we get to these market failures uh this happens in society when we have an externality an externality is a cost or benefit that acres to a third party external to the market transaction so so when we have a negative externality uh too much is going to be produced uh so we're going to have over production when we have a positive externality too little is going to be produced um we are going to have uh under production uh and the reason is that when we got efficient production here we made some assumptions that there were no externalities that our demand curve reflected societies marginal benefit and maximum Wellness to pay and the supply curve uh had no uh negative externalities and reflected society's marginal cost or minimum acceptable price um but if there is an externality then there is uh then there is either a cost imposed to people that is not reflected in the supply curve or there is a benefit uh to society that's not reflected in the demand curve so an example of an externality uh would be something like pollution uh if a business produces um and when it produces something it also uh gives off pollution whether that be air pollution water pollution um or just trash Etc um this is going to be a negative externality um that is imposed on society so if that externality had been internalized uh then that cost would have been reflected in the supply curve and as a result less would have been produced but because it's not reflected in the supply curve um too much is going to be produced this is a supply side market failure here um the opposite of this is a positive externality so a positive externality is when the demand curve doesn't reflect all of the benefits to society there's a positive externality which is an externality a benefit that occurs to someone other than the buyers um so uh for example um if I purchase a fireworks show um or a or a park or things like that uh they confer benefits on people who don't pay for them because you can just look up and see the fireworks show um you may be able to walk through the park or observe the beauty of the park from afar without paying for it so that is a extra benefit uh that URS to people other than the the buyers so it's not reflected in the buyers willing this to pay so too little is going to be uh demanded therefore too little is going to be produced so we have a demand side market failure so here we're going to look at a graphical representation of this on the left we have a negative externality so um we just have one demand curve uh which is downward slop in here we have two Supply curves uh the first supply curve the bottom supply curve uh s or the one that to the right um is going to be the private supply curve um s subt uh is going to be uh society's supply curve um so um the private supply curve does not reflect some negative externalities that are imposed on society the societal supply curve reflects um the full cost uh include in these externalities so we see from society supply curve that the equilibrium point should be at a and if the equilibrium point were at a then uh this whole big triangle would be our consumer surplus and producer Surplus um but instead we are going to produce where the private supply curve intersects uh the private demand curve so our equilibrium point is going to be Point C at Point C we are going to produce too much uh from the perspective of society's supply curve so we have extra units produced uh where uh the uh marginal cost to all of society exceeds the marginal benefit to all of society and because of this overproduction we have this gray triangle is a dead weight loss so there's too much produced uh we have an over allocation of resources um the vertical distance between the private supply curve and Society supply curve is the amount of the negative externality on the right uh we have a graph that shows a positive externality so um so here um Point Z reflects where so okay let me back up first of all we have uh s is going to be our supply curve we just have one supply curve here uh really this should be labeled just s not s of T um we have two demand curves uh the bottom demand curve or the one to the left is the private demand curve and the top demand curve or the one to the right is society's demand curve uh and so where should we produce to provide the most efficient production for all of society we should be producing at Point Z equilibrium point where uh the supply curve intersects with society's demand curve where we are actually going to produce is where the supply curve intersects the private demand curve which is at point x so we are producing uh less than we should so this represents an underallocation we produce that QE when we should have produced here at qo uh really this Q should be moved over here um so uh as a result we have this triangle here that is going to be a dead weight loss uh which is an under efficiency loss from underallocation so these are all units that where the society's marginal benefit uh is greater than the marginal cost uh or where society's uh willingness to pay uh is greater than the willingness to accept uh so each of these units would make Society better off if they were produced but they are not produced uh because the demand curve the private demand curve does not reflect the benefits to all of society uh it just reflects the benefits to these private buyers so it does not include these externalities uh the vertical distance between the private demand curve and society's demand curve represents the positive externality so how do we solve for uh negative how do we correct for negative or positive externalities there are a number of ways that we can deal with this um so first we're going to look at government intervention and we're going to look at the simplest cases and then we're going to look at some more complicated ways of dealing with the problems um so the first way to correct a negative externality and the best way to think of a negative externality is something like pollution um so when we have pollution uh that is an externality that is imposed on society that is not taken into account as a cost of production if it were taken into account as a cost of production we would produce less um so how do we correct for that negative externality what we want to do is instead of producing at Point C we want to produce at Point a so how do we do that so one way of doing that is for government to impose direct controls and what direct controls means is government will set limits on the quantity that can be produced so they'll say the maximum you can produce here is q0 um you're not allowed to produce uh this over allocation here um so hopefully that will cause production to be reduced till you get to point a here uh a second way of dealing this with this is a paguan tax uh so this was paguan tax was invented by The Economist Arthur pagu in I think around 1890 late 1800s and the basic idea is to put a tax on uh producers or suppliers or sellers um by exactly the same amount as this negative externality and so what this tax would do is it would push this supply curve up until the private supply curve is the same as society's supply curve or the the social supply curve um so if the tax amount uh the per unit tax is exactly the same as the negative externality then this supply curve is going to shift up by exactly that amount because it's going to increase costs increase the marginal costs again the supply curve is the same as the marginal cost curve so if we tax each unit by uh the amount of this negative externality the marginal cost curve is going to shift up by the amount of the tax until the private Supply curve is the same as the supply curve and then we get the point a uh okay so we have this all sounds good in theory uh in practice though uh neither of these things work very well uh so first of all uh direct controls are very distortionary on the economy so when we have direct controls and we just say you can only produce up to a certain amount um or you can't produce stuff that you want to produce um that we we still have efficiency losses there um the so the problem there is that what is produced is not necessarily produced in the most efficient way um and is very coercive to uh the business owners the industry Etc up a paguan tax uh while it sounds good in theory uh the problem with one problem with both a paguan tax and a direct controls is it relies on the assumption that government knows what the problem is government knows that there's a negative externality and government knows how much the the negative externality is and the reality is government does not have these uh neat looking graphs in front of them so they have to come up with their best estimates and their estimates are not only usually wrong but pretty much always wrong so a pagui and tax we're trying to get this private supply curve uh up to the same amount as the social or Society supply curve that relies on this the tax being the same amount as a negative externality but if we don't actually know how big the negative externality is the tax we uh impose could either be too little where we don't get up to this uh society's supply curve or it could be too much we can oversuit uh society's supply curve uh and in reality often we don't know the actual amount of the negative externality and there are a whole bunch of political problems uh we're going to discuss more government problems in chapter 5 but the incentives are often very wrong so government number one is not omnicient it doesn't necessarily actually know the problems and it doesn't necessarily actually know the solutions even when it does know the problems and it does know know the solutions uh very often government's incentives are not necessarily to correct the problem uh because government may be politicians may be lobbied by companies who uh either don't want a paguan tax don't want direct controls or sometimes they want direct controls that are imposed uh on their competitors as a barrier of Entry to the industry both of these can have negative consequences even though we're trying to solve a problem okay how do we correct positive externalities uh Here Again The Government Can intervene in two different ways so remember our positive externality was that we were not producing enough of this stuff our private demand curve was to the left of society's demand curve and the vertical distance between our private demand curve and society's demand curve was the amount of this positive externality so one example used in the book uh was vaccinations so when you get vaccinated it not only helps you but also helps other people who are around you your friends your co-workers your family members and that positive externality uh is not reflected in the amount you're willing to pay uh by the way if an externality is integrated into the amount you're willing to pay or integrated into the amount that uh into into producers marginal costs then that's called internalizing and externality um but here that positive externality is not internalized so what do we do well we're going to try to shift our private demand curve until it matches society's demand curve and uh we're going to do it just like we would with the paguan tax except here we want the opposite of a tax so uh here we are going to give a subsidy there are a bunch of there are two ways to Subs subsidize either you can subsidize buyers if you subsidize buyers you're going to move this demand curve up until it matches society's demand curve so a buyer subsidy you can also subsidize uh suppliers uh so subsidize producers if you subsidize producers then instead of moving the demand curve you're going to move the supply curve and if you want to move the supply curve then we would shift this supply curve up until it intersects at point Y here with a subsidy to producers so we get subsidized either consumers or producers in the example of vaccinations uh we could uh offer uh every citizen a voucher for uh $50 worth of vaccinations that would be a subsidy to the buyer or we could offer uh subsidies to hospitals uh to cover their costs of covering vaccines that would be a subsidy to producers which would shift the supply curve uh a final way that the government can step in here is government provision so government can become part of the market or the entire market so so remember we said before that our market demand curve is the aggregation of individual demand curves um and our market supply curve uh is the aggregation of individual firms or sellers or producers uh so here we're going to add one more producer and that extra producer is going to be the government uh government is going to to produce more of this item so if Government produces either part of a good or service or all of a good service then we can push up uh or we can push up our supply curve uh until we get it up to point Y here um where um no um let me see I guess no I'm sorry we don't want to go for point Y um we want to get to this quantity here so what we really want is there's there isn't a point labeled but we want to uh if we shift this supply curve we want to shift it out until there is a line here and if there's a line here then it's going to inter at this point here uh new supply curve is going to intersect the private demand curve uh such that we will produce the amount that we want to produce uh which is going to be q0 which before was at Point Z and uh and uh and I'm sorry when I mentioned subsidizing producers before subsidizing producers would shift the supply curve to the right if we subsidize producers then that's going to uh increase Supply meaning shift it to the right until we intersect here so these are government interventions uh so positive externalities correcting positive externalities has similar problems to correcting negative externalities so if government is subsidizing then we are assuming we know the amount of the positive externality we're assuming that government even realizes there is underallocation so government might be wrong about the underallocation uh government May uh estimate the positive externality incorrectly and if they don't know the amount of the positive exality in a per unit basis then their subsidy may end up either not being enough uh to get us to the socially optimal level or it may overshoot it might end up being too much of a subsidy where we can end up having over allocation if we overshoot it um okay okay yeah so if we're correcting for negative externalities um then we are going to uh have a paguan tax here that is going to shift our private supply curve to the left until it matches our social supply curve uh I think I I think I went into how that worked not realizing there were slides that just graphically showed that so so T this vertical distance is the amount of the paguan tax which is the same as the amount of the negative externality so this is a Global Perspective uh one uh bit of pollution or negative externality that we are trying to deal with Worldwide is climate change and climate change is uh in large part driven by carbon dioxide emissions so uh one way of dealing with too much carbon dioxide being emitted is to have a paguan tax and there are many countries that have a paguan tax which is a a carbon tax on carbon dioxide emissions so this shows um what percentage of CO2 emissions in a country are taxed at a rate of7 per ton or higher so in Switzerland about 70% in Norway 70% of their CO2 emissions are taxed with the paguan tax at uh this High rate uh in France about 55% South Korea about half 50% Germany about 40% uh we see here the United States uh only taxes about 22% um of its CO2 emissions uh China taxes less than 10% Brazil taxes practically nothing um so as you might expect if you see uh this chart uh where does most of the pollution comes from uh a lot of the CO2 emissions comes from China uh a lot comes from the United States uh much less comes from these other countries with very high taxes uh paguan taxes on co2 emissions this is how we would correct for a positive externality um so we have this positive externality which we mentioned before which is the private demand curve is to the left of the social demand curve so because of this we have underallocation of resources we're producing less than we should at the socially optimal level um and this triangle here is uh dead weight loss or efficiency loss from underallocation uh so how do we correct for it uh we can try to shift our private demand curve to the right until it matches society's demand curve and we can do that with the subsidy and this shows a subsidy of consumers which shift our demand curve to the right uh we can also subsidize producers and subsidizing producers shifts our supply curve to the right uh so in both cases we can in theory uh get to our efficient point where there is no longer an underallocation and we've corrected for the positive externality uh by internalizing it uh again the problem here is it's very hard to actually estimate the amount of the positive externality and therefore it's hard to know the correct amount to subsidize so you can have overshoot in or unders shooted uh another thing that can be done is the government can provide uh part of the uh production so uh government would step in and provide some or all of the supply curve which would shift the supply curve to the right uh in a way similar to a subsidy uh so this chart emphasizes sorry summarizes some ways to correct positive and negative externalities uh a negative externality something like pollution it's a spill over cost it is an extra cost of production that is borne by people other than the suppliers um that suppliers do not take into account when they make their production decisions uh so what happens as a result of this negative externality we have over production of output we produce too much and therefore over allocation of resources so resources are used which are not available to produce other things ways to correct so uh we talked about liability rules and lawsuits so this is direct controls where the government would say you're not allowed to produce above a certain amount uh so for example with pollution government can say that you cannot pollute Beyond a certain number of parts per million of air pollution or water pollution uh number three was a tax on producers this is a bagian tax um actually at I think I misstated so uh number four would really be direct controls is when we say government is saying um that you can't uh produce uh above a certain amount uh so now we're going to talk about some of the other things here that we haven't talked about yet uh liability rules and lawsuits um are a bit different from direct controls so direct controls would be hard caps on production where government would step into producers and say uh you can't produce more than this quantity period uh liability rules and lawsuits uh would say uh that you are not allowed to produce above a certain amount and if you do produce above a certain amount then you will be fined as a result and that fine is supposed to be like a very high amount um but if you are a producer then you are going to look at that fine and you're going to figure out uh is it more profitable to produce and eat the fine uh or is it more profitable to not produce and avoid running over and avoid running into the fine so liabilities and lawsuits is a bit less restrictive than Direct controls uh because there can be an efficient breach uh where with liability rules and lawsuits um companies can decide that that they want to violate the law and pay the fine uh so private bargaining uh this is was pioneered by The Economist Ronald Coast known as Kum bargaining uh what Ronald Co realized uh is it's not really correct that when a uh company has a negative externality that they are imposing a cost on society uh because in reality uh there are several different economic actors that are imposing costs on each other so uh for example uh if we think about air pollution uh you can have a factory that is spewing out air pollution and you can have people who live next to the factory that have to endure the air pollution um and may get sick as a result um so normally you would think that the factory is imposing a cost on the people who live near it the pollution being that cost but it's also the case that the people people who live near the factory are imposing a cost on the factory as the people living near the factory they could just move further away from the factory and then be further away from the pollution and then the pollution wouldn't affect them and what C observed was that it's not necessarily true that the most efficient um outcome for society is to curtail production and thus to uh curtail pollution it may be more efficient for Society for those people who are breathing the pollution to move further away so the way Coast looked at um these externalities was you would establish a a rule as to who by default needed to bear the cost so your default rule might be the factory Bears the cost but then you allow the economic actors to negotiate with one another so the factory may choose to negotiate with those who live around the factory and pay them to move further away and that may be less costly than the factory not polluting in the first place so private bargaining is another way to resolve a negative externality uh by compensating those who suffer due to the negative externality um number five is an interesting um extension of private bargaining uh which is a market for externality rights so market for externality rights is um in the US we use this for air pollution and water pollution and this is a concept called CAP in trade uh and the basic idea is instead of imposing direct controls on factories and saying uh you have to limit your production to a certain amount um the problem if you tell factors that you have to limit a production to a certain amount is the government doesn't necessarily know what the most efficient way is of curalin um pollution the factories themselves know the most efficient way of Cil and pollution so you may have multiple factories there may be some factories where it is very expensive to curtail pollution and other factories where it's is very cheap to curtail pollution so you would prefer the factories where is very cheap to curtail pollution to have them um uh either produce less stuff or uh modify their smoke stacks for example so that they pollute less you you would prefer to uh to remedy the pollution in the least cost way so what a market for externality rights does uh with cap and trade is government sets the total amount of pollution and then gives the factories basically licenses to pollute uh where they say that you can pollute but only up to a certain amount so for example uh there might be five factories uh and there might be pollution currently of 10 tons of something like carbon dioxide and the government May step in and say we want there only to be five tons of carbon dioxide instead of 10 tons so they would capit at uh 5 tons of carbon dioxide they would issue pollution credits if there's five factories they might give each five Factory a credit for one ton of carbon dioxide pollution but then they let the factories trade those credits with one another so uh a factory where it is uh very expensive to remedy pollution might buy uh a credit from another Factory where it's very cheap to curtail pollution and so when it has the credit to pollute more then the more expensive Factory will just go along polluted and then the cheaper Factory will take those uh take those actions uh at less cost to curtail the pollution in that particular Factory and what so this was basically a theory that economists put out there that cap in trade could result in uh pollution being Abad or remedied uh cheaper than other methods and it was tested and it wildly exceeded everyone's expectations so uh pollution abatement was basically double as cheap as they expected when they use cap and trade and it's been used for air pollution water pollution Etc okay so our next category is positive externalities this are these is this is spill over benefits so this is when the market demand uh does not reflect the full Society demand uh because there are externalities which are positive so there are people who are benefited who are not the buyers um this results in under production of output and therefore underallocation of resources so we're not producing enough so how do we deal with this uh turns out private bargaining works as well uh cian bargaining for positive externalities so an example of private bargaining for uh positive externalities and the the book has uh I forget what you call it like a little uh basically half a page talks about uh honeybees who do pollination and when the bees pollinate it benefits farms in the area so uh what has been observed is that beekeepers will negotiate with farms in the area where the farmers will pay them to bring their bees in uh which then benefit all the farmers so this is an example of private bargaining where the farmers will get together and collectively pay to have honeybees uh that help all their Farms um another possibility is subsidies to Consumers um and we talked about subsidies to Consumers subsidies to producers and government provision example I'll give here uh subsidies to consumers or producers we could look at vaccinations so subsidy to Consumers would be like a voucher for uh $50 discount on vaccines to the consumer subsidy to producer would be uh money that is sent to hospitals in order to fund vaccinations or to doctors or to vaccine companies that produce that vaccines there are a number of ways to do the subsidy to producers and uh lastly we have government provision so in our vaccine example we could have government governs uh step in and produce vaccines we could have governments step in and uh build hospitals or pay doctors uh to give vaccines to people uh another example of government Provisions is this is example you see everywhere is public parks so uh a park uh imposes a positive externality on all of society so people get to enjoy public parks they get to enjoy Fireworks shows on July 4th uh things like that the government will often uh step in and provide those for the benefits of others so this graph is intended to show an important concept which is uh how much should we uh Abate po ution um and if I asked you what is the optimal amount of air pollution or what is the optimal amount of water pollution um most people if they ask that their immediate knee-jerk response would be zero uh I would like zero air pollution I would like zero water pollution or or if I asked how much litter do you want um on the streets how much litter do you want uh on Parks or on people's Lawns um you might say the answer is zero lit um but the reality is that's not actually true um because much like all other goods and services um we have um we have a uh diminish in returns so the it is much easier to Abate the first 10% of pollution then the next 10% then the next 10% then the next 10% and the most expensive abatement of all will be that final 10% uh so for example uh let's look at uh litter that is on uh roads or litter in Parks um so do we want to have zero litter uh well we need to look at the cost of avoiding that litter and so what are possible ways of dealing with litter so one way is you can have substantial enforcement costs so you can have police everywhere that are looking around to try to see people who are litterin uh you can install cameras everywhere to try to catch every case of litterin you can pay people or have machines that go uh every hour and and look for litter and pick it up but all of these things cost money and cost resources and cost time so the more effort you put into a bait in pollution the more it's going to cost and what we really want to do is we don't want to pay as much as possible to get us to zero pollution we only want to um Abate pollution or avoid pollution when the benefits exceed the costs and as we can see in this graph the cost of pollution abatement marginal cost is going to go up and up and up marginal benefit is going to go down and down and down um so there reaches a socially optimal point which is not zero pollution um so the optimal amount of pollution abatement is this equilibrium point q1 um and that results in a certain amount of dollars spent and that dollar spent is not just this infinite amount where we try to get to uh where we try to get to zero pollution um the same uh concept is also true if you think about air pollution or water pollution how do we get to zero air pollution uh well if you want to get to zero air pollution number one uh a lot of goods and services that we enjoy will have to be either made overseas or not made at all because producing a lot of things requires some amount of air pollution um or if you really try to avoid all air pollution then you're going to have to change technology change the way things are produced where goods and services are going to get a whole lot more expensive um and next we can think about air pollution from Cars how do you get down to zero air pollution from Cars you cannot do that with gasoline powered vehicles or with um Diesel power powered vehicles um even with like hydrogen powered vehicles that you're always going to have some amount of pollution uh so in order to get air pollution to to zero you might have to go to an all El electric Fleet or people might need to stop driving Al together and even with electric vehicles uh right now um if we if we want to run electric vehicles they need to be powered somehow our power grid currently cannot support an all electric Fleet we basically have to double our power grid to make that happen uh and right now a lot of our power grid is on coal plants which have their own pollution if we went to all electric vehicles we would also have to go all nuclear or all solar with our electric grid which would be uh a lot of extra building out so do we really want to get to zero air pollution probably not because it's just too expensive the optimal amount of pollution abatement is this amount here where the marginal benefit equals the marginal cost that gets us the equilibrium point uh so I already talked a bit about um Co and bargaining um so private sector bargaining uh can resolve an externality problem uh so uh Coast theem uh that was pioneered by The Economist Ronald Coast suggests under the right conditions private bargaining can solve externality problems so government intervention may not always be necessary uh and really often it is not necessary uh uh so the role that government would generally have under a Coan bargaining Theory uh is set in those initial conditions because Co Coan bargaining AR uh relies on property rights so it doesn't really matter what the initial property rights are but you have to come up with some initial initial property rights so in the example of uh a factory in and people live in houses near the pollution that breathe the pollution the question is initially who's responsible are the factories responsible um or are the people living in the houses responsible and either one is fine but whichever is the default then they can bargain with the other or they can pay the other uh to take on that role instead so uh government has a role to the extent they assign these initial property rights um the so the optimal uh reduction of an externality um in order to receive this optimal abatement officials need to correctly identify both the existence of a negative or positive externality the cause of the externality and also by what an by what amount it needs to be uh adjusted and all those three things are very hard to do in addition you can have government failure so government failure would occur uh we're going to discuss this a lot more in chapter 5 uh but this gets into a a field of Economics that is called public Choice Theory and the basic idea of public Choice theory is government officials are also economic actors so uh very often uh people try to model the government as some sort of Utopia where government officials are uh omnipotent so they they know everything they make the best decisions and it's also assumed that government is always working for society's best interests uh in reality government is not omnipotent um government officials do not know everything government officials often make a lot of mistakes so they can't correctly identify the existence and cause of a problem or the amount of a problem even if they could identify the existence and cause um but more importantly government may not have society's best interest at heart um so individual government officials instead of uh seeking the best interest of society are often seeking their own best interest so bureaucrats um are self-interested to increase their salary to increase their power uh to uh to not get fired to keep their jobs to increase the budget to their departments uh politicians are self-interested uh to increase their salaries uh to increase campaign contributions to get reelected uh voters are often interested in in uh get in a government sub subsidy or get in a government tax reduction for their own benefit rather than looking for the benefit of all of society so there are economic actors throughout government were not in reality acting in the social interest and in reality are acting to their own interest which may conflict with the social interest so for example um if we're looking at pollution a b statement and we're looking at something like a paguan tax or Direct Control uh or whatever and you have a politician the politician may want to Abate pollution outside of their congressional district but inside of their congressional district uh they do not want to impose extra taxes or extra regulations uh on companies in their District because those companies in their District uh are going to be funnel in campaign money uh and votes to those politicians so before I move on um I do want to tell uh a quick story that's relevant both to this chapter and also to chapter 5 um the the whole point of this chapter uh seems to be that uh markets don't always produce the best results and therefore government should intervene to get better results um that may sound nice in theory in reality it doesn't work out that way um because of what I just talked about that government officials um are often self-interested rather than working for the best interest of society and uh because uh well these grass that we've looked at before like this graph here or these graphs here might look simple and straightforward the reality is government officials do not have these graphs in front of them so they don't know actually when there's underallocation or over allocation they don't know when there is a positive externality or a negative externality even if there is they don't know whose fault it is uh they don't know the amount they don't know this vertical distance which means they don't know the correct amount of a subsidy or bagian tax uh or so forth um so uh and the other problem is there are solutions outside of government so we looked at uh Co and bargaining uh private bargaining as a private solution to negative externalities and positive externalities in other words we have what looks like a market failure but this market failure can be solved in the market itself without the need for government um so more fundamentally there's a story I heard at a conference that is uh relevant to what's going on here and it's an analogy so imagine you're at a singing contest um and you're the judge of the singing contest uh and there is a line of uh a line of singers in front of you and the first singer gets to the podium starts singing and it's the most awful thing you've ever heard um so uh the singer seems completely toned deaf uh it's very cacophonous um your ears are just cringing from hearing the uh the song so uh then you turn to the second contestant and say say okay you win um that's essentially the way that a lot of economists look at market failures so in this sense the first contestant contestant number one that's the market failure so we see the market doesn't work and then uh the judge turns to contestant number two and says okay you win the second contestant that is government um uh intervene in the market supposedly to correct that market failure so what's the problem with that as a solution number one we haven't heard the second contestant sing so it may be that the second contestant sings even worse than the first contestant and that's often the case where we assume that when there's a market failure the solution is for government to intervene but the government solution is often worse than the market failure is trying to correct the second problem is there are not just two contestants there may be three or four or five or 10 contestants and so we've seen the first contestant is a very bad singer now we've turned to the second contestant and said you win not only did we not hear from the second contestant to see whether the second contestant was actually better than the first contestant but we also didn't look to the third the fourth the fifth or the sixth contestant to hear them sing and hear well whether they were better than the first contestant and whether they were better than the second contestant and in this analogy the uh the 3D fourth fifth six contestant those may be other ways that government can intervene so for example instead of a paguan tax uh maybe it's a good idea uh to try cap and trade um instead of uh government subsidies uh maybe it's a good idea uh to uh instead of government subsidies uh maybe it's a good idea to try private bargain in or Coan bargain in so there are other possible solutions so just keep this in mind that uh it's not as simple as it sounds and this chapter tries to present things as oh the market doesn't always work there's market failures therefore government um in real that doesn't always make a lot of sense because we have government failures which we're going to discuss in chapter 5 and because we have private solutions that can correct for market failures okay uh next we're going to move into asymmetric information asymmetric information occurs when one party to a transaction uh possesses private information not readily available to the other party uh at a reasonable cost um so uh this causes scarce resources to be allocated inefficiently um and often uh the argument is government should intervene when you have these failures due to asymmetric information uh so th this is another type of market failure so um positive and negative externalities are one type of market failure but not the only possible market failure uh so this happens when one party to a transaction has substantially more information than another party uh this can make it difficult to distinguish between a trustworthy buyer or a trustworthy seller uh so the best way uh the best initial example to think about is the used car market uh suppose that uh you were going to buy a used car and use by a use car which now they call like pre-owned vehicles but these are cars that are 3 four years old and have tens of thousands of miles on that um the seller knows a lot about the vehicle so knows whether the car is in good working order knows what problems the car has had to deal with um you as a buyer don't have that information um so to a certain extent you rely on what the seller tells you about how good the car is uh the problem is the seller may lie about the car um so when the seller sets a price for a car um you don't know whether this is a good car or a bad car um and an asymmetric information problem which we're going to talk about uh in more detail later uh is confronted with that situation you may assume it's a bad car uh and assume it's overpriced and not be willing to pay that much which can cause the whole Market to unravel this is an asymmetric information problem um a more simplistic example is suppose you are driving your car you get to a gas pump and go to fill up your car with gas um how do you know uh when the uh when the gasoline pump says that each gallon costs $3 and you put uh 10 gallons in your car um and it charges you $30 how do you know it's actually put 10 gallons in your car how do you know it hasn't put five gallons in your car how do you know it's put uh the correct octane whether that be uh 87 89 uh 91 Etc how do you know that that is the octane put in your car uh maybe it's a different octane how do you know that it's even gasoline that went in your car uh maybe they put water in your car maybe they put vegetable oil uh maybe they put um water LA with sugar um you don't actually know what's going in your car um this is the asymmetric information problem that uh the seller has a lot more information as what he's putting in your car than you as a buyer know um the one way that we resolve this in the US is government intervenes and government has set standard weights and measures um where they say how much a gallon is um how much uh a certain amount ways uh and then government will um periodically go around and test gasoline pumps not only to make sure that gas is coming out not not only to make sure gas have certain o is going out but also to make sure that its measurement of how much gasoline is going out matches how much actually does come out um so this is the government intervention that is argued for by the book now I'm going to make the case that this doesn't really make any sense so you're going to need to understand the books argument and you're going to have to rely on the book when the textbook when you do your homework assignments and your quizzes and exams but the reality is they're just wrong so let's get into it so when sellers possess private information so our first example was the gasoline Market you go to a gas station start filling your car's tank how do you know you're actually getting gasoline how do you know you're getting that much gasoline um this is an asymmetric information problem the solution that um is generally implemented here in the US is government goes around and tests gas pumps uh basically once a month or something like that to make sure that it is actually putting out the amount of gas the number of gallons that they say they are um does that actually need to be the case uh I would argue no um there are many other countries where government does not regulate gas pumps like that um and the market does not unravel um not only that but there are many goods and services that are far less regulated than gas bumps um because that same argument can apply to every good and service that is sold it can apply to haircuts you get from a barber shop it can apply to um the food you buy at a grocery store uh it can apply to if you if you buy anything if you buy music music on the internet uh whatever um the seller is always going to have have more information than you um and it's always possible for the seller to cheat you uh the reality is that is a very rare occurrence and the reason that that's a rare occurrence is because sellers establish reputations um so if you go into a restaurant um I would argue that you are getting a meal that tastes good a meal that doesn't make you sick um not because the restaurant is afraid of the government uh regulating them uh but because they are afraid of losing business and they know not only if they give you a bad meal that you won't go back but that their reputation will suffer because you will go and tell your friends um you will go leave a bad review on something like Yelp um you may if you get mad enough you may even go and uh March in front of the restaurant with a sign and tell people that their food is bad um so there are private ways of dealing with this problem without government intervention but again the book argues that the only way to deal with this problem is government intervention um our second example is the licensing of Surgeons so if you get uh if you get open heart surgery or you get your appendix removed uh Etc uh you probably want the person who does that to be competent um you want them to know what you're doing to know what they're doing um because that is a procedure that can have long-term consequences it could lead to death if they bot um or it could lead to a uh permanent disability uh so you want to make sure the person who's doing that knows what they're doing um the way that we resolve that generally in America is through licensing so occupational licensing uh in order to be a surgeon uh you have to go to medical school for three years and then you need to do an internship for something like a year then you need to do a residency I forget how long residency is but maybe like two or 3 years um so you get all this education you get uh training uh basically apprenticeship um so you know that uh and after all of that they need to take a test they need to be board certified um which demonstrates that they have a certain requisite knowledge so uh and there are laws that forbid people from holding themselves out to be surgeons when they don't have the required education when they haven't passed their boards so because of that uh you generally have a pretty good idea that that uh that a surgeon uh is going to have this level of Competency due to government licens in um again the argument of the textbook is that this is a problem that can only be solved by government government needs to license surgeons or uh a lot of people will uh die uh because they will be operated on by people who don't know what they're doing uh the reality is this just doesn't make any sense um the reality is we see occupational licensing of a lot of occupations and what that often does is it raises the cost so surgeons in particular um is a good example because in something like a 30-year period uh the number of law schools in the US doubled the number of medical schools went up by just a quantity of two um so there's an artificial restriction on the number of Surgeons uh in the country um and that uh artificial restriction on the labor pool uh for surgeons uh results in many less surgeons available uh which makes procedures more and more expensive to patients um when in reality we could be training a lot more people uh not only that but many medical procedures uh are done by people who do not need that amount of education so if you go in for a doctor's office visit what normally happens for most people is you're going to wait in the waiting room for 30 minutes or an hour uh you're going to go in uh they're going to make you then wait in the patients room you're going to be seen by a nurse Maybe for 15 20 minutes to test various things ask you a lot of questions then the doctor's going to come in and talk to you for 2 minutes um so a lot of what's done in a doctor's office is actually done by nurses and a lot of what is supposedly done by doctors could be done by physicians assistants who are specialized in certain areas and do not need um education of uh like eight years uh in order to diagnose and treat something simple um we see this with uh electricians plumbers Etc uh there are uh there are different uh levels of certifications required for uh electricians in different states states with more uh onerous hurdles for electricians um do not have um a lower incidence of um electrocutions um in fact they have higher uh executions and why is that uh number one uh electricians receiving more training uh generally uh as a matter of data does not make it less likely that they're going to make a mistake and not do things according to code uh and not hurt themselves um there really is no correlation between the amount of training and that uh number two um it artificially makes uh electrical work more expensive so people are more likely to go and try to do it on their own and then there are substantially more fatalities as a result so occupational licensing raises the cost um and makes us Society worse off as a result um also there's a lot of Occupational licensing that just makes no sense whatsoever so for example there are a lot of areas where in order to braid hair you need to get a beautician's license but to get a beautician's license none of the training involves braid and hair the people are prohibited from braid and hair until they get this very long uh training that has nothing to do with what they actually want to do as an occupation um so this just raises the cost uh significantly so a lot of Occupational licensing is actually complete nonsense um but most importantly uh getting back to our surgeons example uh it's not the case that the market can't deal with this problem without government um so uh we've seen in most other areas we can think about uh that the private Market has stepped in and provided ways of uh conveying information about the quality of various workers so we see this with Yelp reviews with Google reviews uh Etc um we see it with um with products there is uh like under rers laboratory there are uh product reviews all over the Internet so it it's possible to get information out there about the quality of various Services um I saw an article just recently as in today um it was a big controversy about uh a doctor's office in Nashville that uh it turned out that the doctor wasn't actually a doctor and everyone was up in arms because he'd been in business for uh a year treated thousands of patients and then patients found out he's not a real medical doctor um and they they talked about suing him and so forth but I came with a different takeaway for that um and my takeaway was treated a thousand patients and it took them a year to realiz that he's not a licensed doctor so he must have been doing a pretty good job in general um if he didn't know what he was doing and was doing a terrible job then he would have been uh sued um for uh for malpractice uh you know a year ago or nine months ago it wouldn't have taken them a year to figure out he's not a real doctor um secondly uh when I dove into the story a bit more it turned out when they said he's not a real doctor he actually was a real doctor but he just wasn't licensed in the United States so he was an immigrant from overseas uh he was a board certified Phi physician in his home country uh but had not recertified in the United States uh because the United States does not cross recognize doctors from most other countries and we're not just talking third world countries um I a friend who was a doctor in Australia and when she came to the United States she had to redo her residency um and take her boards again um so we don't trust doctors from overseas even if the doctors from overseas have been in practice for 20 years treating thousands and thousands of patients so uh the so basically people were up in arms uh because this doctor in Nashville it turns out was not a board-certified physician in the US but the reality is he was a board certified physician in another country and he operated on patients for I think operated is the wrong word he treated patients for a year I think he was a dermatologist he treated patients for a year uh without any problems okay uh the next thing we're going to cover is moral hazard and adverse election so our previous example is when the sellers possess private information that the buyers did not uh this next category is when the buyers possess private information uh that the sellers do not um and this can lead to two types of problems a moral hazard problem and an adverse selection problem um so the difference between moral hazard and adverse selection um is are we looking uh after the sale or before the sale so moral hazard is expost meaning after the sale adverse selection is ex anti meaning before the sale so uh let's look at moral hazard first uh the problem with moral hazard uh is uh so the quintal example of moral hazard is Insurance uh the idea of insurance um is we are going to spread out the risk over a lot of people so I'm going to pay uh a premium um a monthly or yearly premium um and then if some rare catastrophic event happens uh and triggers then uh I'm going to encounter a lot of costs and my insurance company is going to cover those costs um and you can get insurance for all sorts of things so for example you can get uh fire insurance for your home um you could get um uh accident insurance for your car um you could get um uh you can get uh medical insurance or health insurance uh for your own health uh Etc um all of these have moral hazards associated with them and the problem is uh once I buy insurance uh now the risk is being taken not by me but by the insurance company uh and that gives me an incentive to engage in riskier Behavior so for example uh suppose I have car insurance um if I have car insurance then I don't need to worry as much about total in my car uh because that's going to be paid by the insurance company so on the margin I can drive faster um I can not pay as much attention I can text well driveing Etc um because I'm not going to be bearing the cost my insurance company will be bearing the cost uh let's look at fire insurance for your house if I buy fire insurance for my house uh I am not going to be nearly as worried about my house burning down if my house burns down then I don't have to pay out of pocket to rebuild my house the insurance company has to pay for that uh they have to cover the cost of a new house um so um if I'm not paying for the cost of the new house maybe I don't uh pay as much attention to put in smoke alarms in every room making sure that the batteries are up to date um having a fire extinguisher everywhere um uh not uh having uh grease fires uh when I cook various things uh so I'm going to be a little bit less careful because I'm not bearing the risk now my insurance company is bearing the risk so from the perspective of insurance companies this is a problem so insurance companies uh want you to be careful um so how do insurance companies deal with this how do they account for moral hazard problems well often in insurance insurance policies they will require you to take certain precautions so if I get fire Insurance my fire insurance policy may require me to have smoke detectors and every room um if I get auto insurance then I may be required to have a uh to take a safe driving course uh for example uh or I may be required to have uh safety devices in my car I could be in theory required to have like an airbag or a seat belt or so forth nowadays A lot of that is required by the government anyway but uh even if the government didn't require that insurance companies would require that um a second thing that insurance companies can do is they can give you more skin in the game so instead of if my house burns down uh instead of uh the insurance company providing the entire new house they can have either a deductible um they can require a deductible where I would have to pay part of it um or co- Insurance where I would have to pay part of it so the way a deductible would work is I would pay the first amount up until a certain level so I might have a deductible of something like $20,000 where if my house burns down and I have a house that's worth $300,000 then I have to pay the first 20,000 and the insurance company pays the rest or we could have co- Insurance where uh where I would pay 20% of the cost and the insurance company would pay 8 % of the cost so for a $300 house I would end up paying uh uh $60,000 and the insurance company would pay $240,000 um what this does is it creates incentives for you to uh protect uh your house from burning down it creates more incentives for you to protect your car from uh from crashing or from hered others with your car Etc uh so those are possible ways to solve the moral hazard problem and again moral hazard is expost so it happens after you already bought something adverse selection problem happens before you buy something um so uh the one example of an adverse selection problem is health insurance so uh I know more about um how how sick I am am or uh basically my medical conditions than does my insurance company um so nowadays by law the insurance company is not allowed to charge more for pre-existing conditions but in a free market insurance companies uh basically would charge you uh a higher rate if you were sicker if they knew about conditions um and you would be insuring against unknown conditions um so the problem with adverse selection uh is the seller doesn't know whether the person who wants to buy insurance is someone who's really sick and would require uh a lot of expenditures to service them or someone who's very healthy and would require very little expenditures to service them uh and uh therefore they're they're going to charge an amount for premiums that's somewhat in the middle as someone who's not very healthy and not very sick but in the middle now if I'm encountered with a premium that's in the middle I know whether I'm sick or I'm healthy so if I'm healthy do I want to buy that insurance probably not um because the amount of the premium is good to be substantially higher than uh what I think I'm actually uh so I'm going to be paying more into Insurance then I ever think I'm going to be getting out um because I think I'm very healthy I'm indestructible not going to be a problem would I get health insurance if I'm very sick yes I would because I think that my health insurance company is going to pay me out substantially more than the premiums so suppose I have cancer suppose I have a heart condition uh suppose I am diabetic um even if these premiums seem uh quite High even if the premiums are like a th000 a month uh I am going to be getting much more than that in medical treatment so this is the heart of an adverse selection problem where the market unravels the only people who are going to buy health insurance are the sick people healthy people are not going to buy health insurance so when only sick people buy health insurance then the population changes uh and the um insurance company always wants to set premiums somewhere in the middle so that they at least Break Even or make a profit and if they're setting their premiums with the medium person not in the population as a whole but the medium person actually buying insurance and they have to set their premiums higher and higher and higher because sicker and sicker and sicker people are buying health insurance and the healthy people are avoiding it they're not buying health insurance so healthy people can no longer subsidize the sick because the healthy people are just avoiding buying Insurance entirely uh so the whole Market unravels because the premiums get to be too expensive and it gets to the point where no one can afford health insurance um and that's a problem that we actually solve for a while in health insurance um you also see adverse selection um a type of adverse selection problem uh not uh with When Buyers possess private information but when sellers possess private information so adver selection with sellers uh would be our use car example so uh with our use car example uh I'm a buyer and I would like to buy a used car but the seller uh knows a lot about whether a car is a lemon or a plum uh a lemon is a car that has a lot of issues is going to need a lot of repairs is not going to run very well I'm going to have to SN a lot of money into it a plum is a car that runs great not going to have any problems with it um not going to have to do any repairs so I don't know whether the car is a lemon or a plum um the uh the person selling the car does know whether it's a lemon or a plum if I don't know where the the car is a lemon or a plum uh and I see the amount that is charged for the car I'm going to assume that the car is a lemon I'm going to assume the worst so I'm not going to be willing to pay that price I'm going to demand that the price be much less CU I'm going to assume that it's a bad car um the problem there again is the market unravels is that the good cars can't sell because people don't trust the high prices of the good cars um and um they have to set their prices very low in order to sell cars at all and the only cars they're going to be willing to sell are the bad cars because they would like to sell the car uh for more money than it's worth so they're only going to sell the bad cars um they're going to have to keep marking down the price and they're going to have to keep keep selling worse and worse cars until the whole Market unravels there are ways of getting around both the car problem and the health insurance problem so how do you get around the car problem uh the main way that they do that is warranties so if you buy a Ed car or a pre-owned car there will be a warranty attached and uh often they there'll be a mechanic who looks at the car and will certify that the car is in a certain condition and if you have problems with the car in the first year or the first two or the first 3 years then you will go to the mechanic and the seller will pay those costs uh those costs will not be born by the buyer because of the warranty that's attached so when I see the warranty I'm confident that the car is what they say it is and I'm still willing to buy the car um now we're going to look at health insurance how do we deal with the health insurance problem uh so uh one way of dealing with the health insurance problem is to have health insurance offered through employers so when employers offer health insurance uh it's offered to all of their workers uh basically as a benefit for working there and when insurance is offered to all their workers some of those workers are going to be very healthy some of those workers are going to be very sick so we don't have the adverse selection problem of only sick patients buying health insurance because everyone gets the health insurance and then the healthy workers can help subsidize the sick workers um another way of dealing with this is uh we had the Affordable Care Act otherwise known as Obamacare here in the US which uh penalized people who did not buy health insurance basically effectively tried to require everyone to buy health insurance uh and it did this by finding people when they didn't have health insurance um and some of that was overturned in the courts but the the same basic idea is still in place right now so when you require everyone to buy health insurance then not only do sick people buy health insurance but healthy people buy it as well then the healthy can help subsidize the sick um we also see this with auto insurance um so why is it that um we don't see the auto insurance uh Market unravel uh because only people who are terrible drivers would buy auto insurance and good drivers would not buy Auto Insurance well the reason is everyone is required to have auto insurance if they have a car um so that mandate that everyone has to have insurance means you have both good drivers and bad drivers and the market doesn't unravel that's how you deal with an adverse selection problem um while we're on this subject or we're talking about cars um I want to give another example of moral hazard that is a little bit well I want to give two examples of moral hazard uh let me see I think first I want to deal with an adverse selection problem um so let me give you the quintessential adverse selection problem one of the things that we've done with American Health insurance with the Affordable Care Act is we've mandated that insurance companies have to accept people with pre-existing conditions and really that makes no sense whatsoever ever um because if we didn't have that second prong that I talked about if we didn't require people require everyone to have health insurance uh then allowing people to get health insurance with pre-existing conditions um without paying higher rates would cause the market to unravel so uh because you uh require uh giving health insurance to people with pre-existing conditions uh I may choose to not get health insurance until I already know that I have cancer or I'm diabetic uh or I'm about to have a heart attack um and that doesn't make much sense um so I'm only going to go get health insurance when it's a really bad deal for the insurance company so that's why that second prong is necessary that everyone has to have health insurance uh not just certain people um but uh allowing people with pre-existing conditions to get health insurance uh the best analogy to that is let's look at fire Insurance um suppose you were able to get fire Insurance when your house was already on fire um so so like I don't have home insurance right now um uhoh uh I just uh have a fire in the kitchen it spread into the rest of the house the fire company has coming to try to save my house I very quick uh dial up the insurance company and say I would like to buy some fire Insurance um now of course that doesn't make much sense uh if I'm able to buy fire Insurance while my house is already on fire uh then of course that's going to be a very bad deal for insurance companies um because everyone's going to wait until their house is on fire to buy fire insurance and then loss is going to be total and my premiums are going to be relatively low compared to total loss and the whole market for fire insurance is going to unravel um but uh I I actually encountered this exact situation uh funnily enough I was living in an apartment complex when I was getting my PhD um and it used to be that insurance for the apartments was covered by the apartment complex itself then ownership changeed and under new ownership New Management they required all the residents uh to get insurance uh and this insurance covered among other things fires um so you know that's an extra cost on top of rent uh but I went ahead and I got this insurance because uh I was told that I had to do this um two months later there was a fire in my apartment complex and it didn't hit my apartment specifically but it hit some other apartments so some apartments um were flooded with uh the sprinkler system and had subst itial damage and I've uh I have a strong memory of when the whole apartment complex was evacuated and there was a guy standing next to me who said who said to me uh hey did you get the insurance and I said yes we were required to get insurance and he said oh I didn't get insurance um my apartment is one of the ones that's flooded I guess I should get insurance right now uh which of course makes no sense um okay so going back to the moral hazard problem um the fundamental thing that you need to see about moral hazard is after purchasing something it changes your behavior um so human behavior changes uh as a result uh of the risk being borne by someone else and we see moral hazard uh not just in uh Insurance situations for individuals uh but we also see it in the macroeconomy uh so uh for example uh there is uh flood insurance uh on uh on homes that is subsidized by the government that causes people to build more homes on flood planes because of that subsidized Insurance um we have a two big to fail policy where banks are bailed out bailed bailed out uh when they lose uh all of their customers money uh by gambling in the stock market um and uh when we socialize losses like that um we have private gains and socialized losses that encourages Banks and other financial institutions to take more risks uh because they know even if they lose all the money uh government is going to go and bail them out that is a moral hazard problem um The Economist I think this was Robert nosic out of Harvard but it might have been Gordon Tok um came up with an uh an interesting hypothetical um so suppose you are a driver um and this is the era when uh when seat belts are not required for cars um and you have a certain way of driv in um either to work or to hang out with your friends or when traveling Etc you drive in a certain way and now all of the sudden um in your car you get installed a a seat belt or an airbag or another safety measure like that um the question is does this change the way you drive are you going to drive less carefully as a result of having a seat belt or an airbag uh and the answer that this has been well studied the answer is that people do Drive less carefully so when people get seat belts and get airbags uh generally the accident rate uh increases significantly it does not decrease it increases because people drive faster uh and they drive less carefully um because they rely on these safety devices um so even though there's substantially more accidents when we have airbags installed and seat belts installed uh that doesn't mean that uh people are hurt more um because the airbags and the seat belts mitigate the damage although damage to the cars does increase significantly uh when there's those safety uh those safety implements installed so what uh Robert nosik uh his thought experiment was suppose you do the opposite instead of having an airbag installed in your car uh suppose in the very middle of your drivein of your uh Drive-In wheel there is a spike so it's a big metal Spike and that Spike goes from the wheel of your car up into your neck and that Spike goes in your neck the faster you drive uh the more the spike goes into your neck um so what's going to happen if you have an accident if you have an accident uh there's no airbag or seat belt to save you what's going to happen is that big metal spike is going to impale you it's going to go through your neck through your head and you're going to die so the question that uh noic asked uh students is um given that the spike is going to change human behavior um what is safer is it safer to have an airbag in your car or is it safer to have a big metal Spike running from your steering wheel to your neck because if you have the big metal Spike running from the steering wheel to your neck you're going to drive much slower and much more carefully and you're going to get in a lot less accidents because human behavior changes uh so this think about with moral hazard that um when uh risk is offloaded to another entity it's going to change human behavior uh the last word in the chapter talks about um the hidden cost of pollution um so uh really we already went over this before but um I'll uh briefly go over again but first of all the government wants to reduce air pollution um the optimal amount of air pollution is not zero the optimal amount of air pollution is you Abate uh as long as the marginal benefits of abatement uh exceed the marginal cost of abatement so in other words you um you reduce pollution as long as the benefits of reducing pollution exceed the costs of reducing pollution um so one system that was implemented relatively recently like within the past 30 years is cap and trade and this sets a cap in the total amount of emissions and it assigns property rights to pollute uh so for example pollution might be carbon dioxide uh so the government would go to various plants that emit carbon dioxide and it would assign each a certain quantity of carbon dioxide that they are allowed to um pollute uh and if you add up all of the pollution rates that they just assigned um it would be the total amount of pollution that the government wants to get the pollution level down to so it' be less than the current amount of pollution um this gives the uh the pollutin uh firms uh which normally are like power plants or something like that uh so you could think of like a coal plant that is producing Power by burning coal uh it gives them a property right in pollution um and those property rights can be bought and sold so uh there may be one coal plant where uh it is relatively inexpensive to put uh scrubbers in their Smoke Stacks uh to uh mitigate the amount of pollution there may be another coal plant that it is incredibly expensive uh to Abate pollution uh by putting scrubbers in there because the technology is just different it's older Etc so what would happen uh the coal plant that it is very expensive to Abate or mitigate pollution would buy uh rights to pollute from another coal plant where it is relatively cheap to Abate or mitigate pollution um and then the coal plant where it's expensive uh would basically have the rights to pollute and it would keep polluting the same amount as it did before uh the other coal plant uh that had sold its right to pollute then needs to reduce the amount that it pollutes so this lets the various coal plants or the various firms in general en they have the best information about uh how much it costs to uh reduce their uh pollution um so uh they are in the best position to know who can reduce pollution the cheapest uh and the for the uh coal plant that has bought a uh a pollution credit uh it was cheaper for them to buy that pollution credit than to Abate the pollution for the coal plant that has sold the pollution credit uh they got more money from uh selling the pollution credit than they needed to spend a B in the pollution so uh both firms are made better off as a result of that trade and cap and trade in practice has reduced pollution uh substantially cheaper and more efficiently than other methods of pollution abatement uh such as a paguan tax or direct controls um or um or or liability uh and lawsuits and fines uh so cap and trade has been very successful uh that's the end of this chapter chapter for um you should have everything you need to complete the smart book review homework assignment and the quiz anyone has any questions feel free to email me through D2L I hope you all have a great weekend and uh next week we're going to look at chapter 5 on government failures