Asymmetric information is where at least one party in an economic relationship has less than full information and has a different amount of information from another party. It can lead to two kinds of problems:
Adverse selection occurs when incomplete or asymmetric information describes an economic relationship. Example – Insurance companies
Moral hazard may characterize behaviour where the costs of certain activities are not incurred by those undertaking them.
Market for lemons A model where sellers are better informed about quality than buyers. Example – User car market.
An externality is a benefit or cost falling on people other than those involved in the activity’s market. It can create a difference between private costs or values and social costs or values.
Market failure A situation where a competitive market does not yield the socially efficient outcome.
Private cost The cost borne by the supplier.
External costs The costs borne by third parties.
Social costs The total costs for all parties.
Social benefit A benefit for all parties.
External benefit Benefits obtained by third parties.
Private benefit The benefit obtained by the buyer.
Demand is marginal private benefit; supply is marginal private cost.
Tragedy of the commons Overuse of a resource due to lack of ownership.
Common resource A resource shared by many people.
Three instruments to control externalities:
Pigouvian Taxes (per unit tax or subsidy): generates negative externalities equal to the marginal externality at the socially efficient quantity. In the case of a positive externality, a subsidy can be used to obtain efficiency.
Quotas: can be maxima or minima, depending on whether the activity generates negative or positive externalities. The goal of a quota is to limit the quantity to the efficient level.
Tradable Permits and Auctions: a hybrid of a quota system and a Pigouvian taxation system. The quota determines the overall quantity of pollution, while the purchase of pollution rights acts like a tax on pollution. The major advantage of a tradable permits system is that it creates the opportunity for efficient exchange. Tradable permits offer the advantages of a taxation scheme—efficient use of pollution—without needing to estimate the social cost of pollution directly.
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