Exercise 7 KEY Econ 460 Fall 1996 Kilkenny

re: Chapter 13 in Microeconomics by W. Baumol and A. Blinder

1. Non-depletability means that the benefits of something to one person are not reduced just because other persons are benefiting from it. Also, the marginal cost of providing the benefit to another is zero.

Examples:

-A "severe weather alarm" signal is non-depletable. No matter how many people hear it, the same amount of signal remains. Once the alarm station is operating, there is no additional cost for serving (alarming ?!) another person. (MC = 0)

-Knowledge is non-depletable. No matter how many people learn the same thing, it is still there to be learned. Once an investment is made to discover the knowledge, there is no additional cost for an additional person knowing it. (MC = 0)

2. Non-excludeability is the characteristic of a good or service that it is IMPOSSIBLE to stop someone from enjoying it's existence. People (physically, technically) CANNOT be made to pay for it. (Do not confuse a legal restriction or right with a physical or technical restriction or right.)

Examples:

-A "severe weather alarm" signal is also non-excludeable. Once it is broadcast, everyone can hear it.

-Vaccination programs provide non-excludeable public health benefits. If everyone else is vaccinated against a communicable disease, even if you aren't, you benefit because you won't get the disease because no one else could be carrying it. (MU > P)

-Swine odor is a non-excludeable cost. Once the swine odor is in the air, everyone has to smell it.

3. Moral Hazard refers to a situation in which the unobserveable actions of one agent affect the other's outcome. The one agent may take advantage of the information asymmetry to maximize their personal benefits while incurring costs on others.

Examples:

-Insurance industry is subject to the moral hazard that persons who pay for insurance (the cost of which is based on probabalistic estimate of the average likelihood of loss given normal careful behavior) would quit being careful. Then the loss becomes more likely, and the actual cost to the insurance company to cover the losses will exceed what was paid for the insurance (MC > P).

-Salaried employment under contract is subject to the moral hazard that salary paid to the employee exceeds the value of the employee's work if the employee shirks (is lazy or unproductive). A similar example is something done for payment-in-advance. Once the supplier is paid, they might do sloppier work than what you originally contracted for. The price you paid (ex ante) exceeds it's value to you (ex post) (P > MU).

Notice: in all these cases, it is HIGHLY LIKELY that prices will not equal marginal costs and/or marginal values. In other words, MARKETS will FAIL to induce the provision of the socially optimal amount.

In the case of non-depletability, since everyone knows that MC = 0, why would anyone be willing to pay anything? The "market" price would be zero. (MU > MC) A private company can't cover it's average costs of production at a zero price. TOO FEW non-depletable GOODS (& too many 'BADS') are provided in private, competitive markets. That's why we all "chip in" and pay taxes so that a government agency will provide these goods, often by government subcontracting with private suppliers.

In the case of non-excludeability, prices people will be willing to pay are zero (even though their marginal benefits due to consuming it may be large.) Thus, MU > P = 0. A private business couldn't cover it's costs of production if there's NO WAY to charge consumers. Again, that's why citizens all pay taxes so that government can make sure that these types of goods (often called "public goods") are provided. (& too many non-excludeable 'bads' would be provided.)