Externalities - University of Victoriaweb.uvic.ca/~pcourty/Chap12-15.pdfExternality: Benchmark...

Externalities

Shopping MallsShopping Malls

Anchor stores: average monthly rent $4.13 per square foot

Specialty stores: average monthly rent $29.37 per square foot

Why the disparity?

2(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutlineOutlineOutline

externality resolving externalitiesg network effects & externalities public goods public goods technology


Externality: BenchmarkBenchmark

Definition: An externality is when one party directly conveys a benefit (positive) or cost (negative) to others

Economic efficiency: collective marginal benefit = collective marginal cost Presence of externality implies the relevant

market does not exist hencemarket does not exist, hence Collective marginal benefit not equal to

collective marginal cost


collective marginal cost

Externality:U.S. shopping malls

Store type Average monthly rent

Average monthly sales

(per sq. ft)y

(per sq. ft)Anchor stores $ 4.13 $185.34

Speciality stores $29.37 $317.68

Source: Gould Pashigian and Prendergast (2005)Source: Gould, Pashigian and Prendergast (2005)


Externality:Silicon ValleySilicon Valley

Stanford University X P l Alt R h C t Xerox Palo Alto Research Center

Hewlett-Packard Ci S t Cisco Systems

3Com Y h ! Yahoo!





Resolving externalitiesResolving externalities

Economic inefficiency opportunity for profitNegative externality g y

Pay sources to reduceCollect fee from victims

Positive externality Pay source to increaseCollect fee from beneficiaries


Resolving externalities: HurdlesResolving externalities: Hurdles

Information Source and recipient of externality may Source and recipient of externality may

disagree over relative benefit/cost and how to pay for resolution

Free-rider Party contributes less than its marginal y g

benefit to the resolution of the externality


Resolving externalities: Disneyland

Anaheim: Bought hotels around theme park.

Hong Kong: Disney Co. has option over real estate adjoining theme park.





Network effect/externalityNetwork effect/externality

Network effect: Benefit/cost depends on total number of other users

Examples Telephone service Internet telephony, eg, Skype Instant messenger serviceOpen source software, eg, LinuxOffice productivity software


Network Effects & ExternalitiesNetwork Effects & Externalities

benefit/cost depends on total number in network through market, not directly conveyed resolved by producer or service providery p p network externalities are a special case of network effects


Net ork Effects & E ternalitiesNetwork Effects & Externalities

knetwork network externality

networkeffect

monopolyseller

fragmentedmarket

no market


Network Effects & Externalities:Critical MassCritical Mass

definition: number of users at which demand becomes positivedemand becomes positive

demand takes longer to take off, then ti llgrows exponentially


Network Effects & Externalities:Installed BaseInstalled Base

quantity of complementary item in service

access devices/Internet service CD players/music CDs computers/software DVD players/DVD titles


Network Effects & externalities: Demand ElasticityDemand Elasticity

highly elastic around tipping pointhighly inelastic at low demand levels (awayhighly inelastic at low demand levels (away

from tipping point)


Network effect/externality:Expectations

Users concerned about inherent usefulness of item what others will buy

Influence them through commitments commitments hype


Network effect/externality: Negative

Congestion Transport facilities – roads, bridges, tunnelsp g Computer networks

VirusesMS Internet Explorer has 95% share – so

malicious programmers target viruses at IEMozilla Firefox relatively safer





Public goodPublic good

Definition: Provides non-rival consumptionNon-rival consumption – one person’s increase p p

does not reduce quantity to other Benefit from one unit is the sum of benefits to

llall users Extreme economy of scale – cost of serving

one user = cost of serving many usersone user = cost of serving many users


Public Goods:RivalnessRivalness


Public Goods:Content visContent vis--àà--vis Deliveryvis Delivery

Distinguish Content – non-rival Delivery - rival


Public good: ExcludabilityPublic good: Excludability

Provider can exclude particular consumer Excludability depends ony p

law technology technologynature of product, eg,

process for distillationprocess for distillationrecipe, eg, fusion cuisine


Public good: LawPublic good: Law

Intellectual property patent – product or p p

process copyright – artistic

iexpression


Public good: LawPublic good: Law

Intellectual property (IP) – trade-off Stronger IP more incentive for creative

work and research and developmentWeaker IP benefit from more usage


Public Goods:Market ProvisionMarket Provision

Market provision typically depends on excludabilityCounter-examples: portals, network television

- advertising open-source software

- customization music

- concerts, novelties





Technology:Delivery mode

Can apply technology to delivery mode, so that possible to exclude and enforce, eg, Scramble broadcast television signal Encrypt digital music and videos

Digital rights management

Delay stock prices


Technology: StandardsTechnology: Standards

Social trade-off Too late opportunity loss Too early discourage innovation


A t i I f tiAsymmetric Information

Life Insurance for Some or for All?

The Hartford offers $5000 of life insurance for all state of Massachusetts employees and optional additional insurance up to 8 times their annual salaryinsurance up to 8 times their annual salaryPremiums vary by age and smoking statusHartford insurance for the general public for premiums g p pwhich vary by age and smoking status (and which require a physical exam)Insurance premiums for the general public areInsurance premiums for the general public are considerably higher than for group insurance for State employees

Wh ?


Why?

Adverse Selection:The Hartford; Term life insurance premiumsTerm life insurance premiums

Massachusetts Group Insurance Commission plan

General public (for coverage of less than $500,000)

Age Smoker Non-smoker Smoker Non-smokergUnder 35 $0.09 $0.05 $0.10 $0.06

35 – 44 $0.13 $0.06 $0.15 $0.08

45 – 49 $0.24 $0.09 $0.26 $0.1345 49 $0.24 $0.09 $0.26 $0.13

50 – 54 $0.38 $0.15 $0.35 $0.18

55 – 59 $0.58 $0.23 $0.43 $0.25

60 – 64 $0 88 $0 34 $0 58 $0 3660 64 $0.88 $0.34 $0.58 $0.36

65 – 69 $1.57 $0.83 $0.89 $0.57

70 and over $2.81 $1.30 $1.16 $0.75

(age 70 only) (age 70 only)


(age 70 only) (age 70 only)

(monthly, per $1,000 of coverage)


imperfect information adverse selection appraisal screening screening signaling


Imperfect vis-à-vis Asymmetric Information

imperfect information – absence of certain knowledge (uncertainty)

asymmetric information -- one party has better information than the other party with worse information also suffers from

imperfect information


Imperfect Information:RiskRisk

uncertainty about benefit or cost arises from imperfect informationp risk-averse person prefers certain payment to

uncertain payments with same expected p y pvalue

risk-averse person will buy insurance





Adverse SelectionAdverse Selection

economic inefficiency possible market failurep


Adverse selectionAdverse selection

Definition: Party with less information draws a selection of bad attributes.

Consequences economic inefficiency possible market failure

“There is almost no correlation between price pand quality”

Allan Sichel, Bordeaux wine expert


Adverse selection:Market equilibrium

Actual demand = combined supply of good and bad

At equilibrium price actual marginal benefit (adjusted for

probability of getting bad vintage) = price actual marginal cost (of good vintage) = price


Adverse Selection:Market FailureMarket Failure

conventional market: when supply exceeds demand, lower price restores equilibrium

wine market with adverse selection: lower price drives out better vintages, leaving even worse adverse selection


Adverse selection:Market failure

Conventional market When supply exceeds demand, lower price pp y p

restores equilibrium.

Wine market with adverse selection Lower price drives out better vintages, leaving

even worse adverse selection.


Adverse selection: Group vis-à-vis individual term life insurance

Group policy avoids adverse selection covers specific class of peoplep p p limits coverage

Individual policy attracts adverse selectionp y open to everyone, regardless of occupation no maximum policy coveragep y g





AppraisalAppraisal

Directly resolving information asymmetry Unknown attribute must be objectively j y

verifiable search attribute experience attribute

Potential gain must cover appraisal costg pp


Appraisal: Moody’sAppraisal: Moody s

Charges Rating 10-year cumulative default Charges issuers for rating

Rating 10 year cumulative default rate

Aaa 0.40%gAa 0.25%-0.33%

A 0.84%-1.69%

Baa 2.31%-7.20%

Ba 12.38%-36.24%

B 47.43%-62.32%

Caa-C 78.81%


Caa C 78.81%

Appraisal: Who procures?Appraisal: Who procures?

Does seller or buyer procure the appraisal? Factors:

number of buyers nature of unknown attributes –

common/specific to various less informed parties


Appraisal: Who procures?Appraisal: Who procures?

Usually, the informed party will procure the appraisal Appraisal is public good – can be supplied to

all uninformed parties at no additional cost. Larger the number of uninformed parties,

greater the saving if informed party procures appraisalappraisal.


SamplingSampling

Directly resolving information asymmetry Unknown attribute need not be objectively j y

verifiable Sampling can resolve asymmetry about

subjective attributes

Potential gain must cover sampling cost low-cost items, eg, wine tasting some high-cost items, eg, car test drive





ScreeningScreening

Less informed party indirectly elicits other party’s characteristic through structured choice

Better informed party must be differentially sensitive to the choice


Screening:Indirect Segment DiscriminationIndirect Segment Discrimination

restricted vis-a-vis unrestricted air fares separate cable channels vis-à-vis bundlep cents-off coupons


Screening:Criminal Justice SystemCriminal Justice System

Defendant might expose his guilt on witness stand Common Law - right to remain silent Civil Law - court can draw inference from defendant’s silence


Screening: AuctionScreening: Auction

Purpose can be to buy, or sell

Applies competitive pressure to induce bidders to reveal informationbidders to reveal information.

Bidders act strategically Bid conservatively greater profit from Bid conservatively – greater profit from

winning Bid aggressively – higher chance of winning.


gg y g g

Screening: AuctionScreening: Auction

Methods Sealed / open biddingp g Reserve price

Seller will not sell at price below this.

Discriminatory / non-discriminatory pricingDo winning bidders pay their bid or last winning

bid?bid?


Screening:Winner’s CurseWinner’s Curse

In auction to buy: winning bidder over-estimates the true value

In auction to sell: winning bidder under-estimates the true cost

More severe where More severe wheremore bidders true value/cost more uncertain true value/cost more uncertain sealed-bid auction





Dividend policyDividend policy

U.S. publicly-listed companiesDividends are costly – subject to double y j

taxation (corporate and shareholder levels).Why pay dividends?


SignalingSignaling

Better informed party communicates attribute through signal

Cost of signal differs according to attribute: self-selection signal is credible


Signaling: ExamplesExamples

auto manufacturers – extended warranty Intuit – money-back guarantee on Quickeny g Q U.S. publicly-listed companies -- dividends



imperfect information adverse selection appraisal screening screening signaling contingent contract contingent contract


Contingent ContractContingent Contract

Payment is contingent on realized characteristic:

international trade -- buyback (supplier of technology must buy future product)

mergers and acquisitions – payment in shares


Contingent Contract:Contingent FeeContingent Fee

Lawyer has better information about likelihood of success at trial contingent fee time-based fee


Resolving Information AsymmetryResolving Information Asymmetry

direct methods appraisalpp sampling

indirect methods screening signalingg g contingent payment


Incentives and OrganizationIncentives and Organization

OutlineOutline

moral hazard incentives holdup and contract ownership and vertical

incentschem

monit

syste

integration organizational

h

tive m

es

toring em

s

architecture ownership


Moral hazard: DoctorsMoral hazard: Doctors

• Brazil: among pregnant women, rate of cesarian section– 30% (81 of 269) in public

hospitalsp– 66% (117 of 177) in private

hospitalshospitals• Happy coincidence?


Moral HazardMoral Hazard

asymmetric information about action conflict of interest



moral hazard incentives holdup and contracts ownership and vertical integration ownership and vertical integration organizational architecture


IncentivesIncentives

incentive scheme conditional paymentp y quota

monitoring systemg y incentives must be based on observables


Incentives:RiskRisk

Efficient scheme balances benefits of more effort benefits of more effort costs of risk bearing

degree of risk degree of risk risk aversion


Incentives:Relative PerformanceRelative Performance

Employment - promote the best worker

Sports - gold, silver, bronze

Examination – grade on a curve Examination grade on a curve





Holdup: Resolution Holdup: Resolution

Avoid specific investmentsSpecificity = percentage of the investment that p y p g

will be lost if the asset is switched to another use

d l d Write more detailed contracts Vertical integration (redistribute ownership)


ContractContract

Complete Contract - specifies actions and payments in every contingency

Degree to which a contract should be lcomplete

potential benefits and costs at stakef bl extent of possible contingencies





OwnershipOwnership

Owner has residual rights Residual rightsg Control – rights that have not been

contracted awayy Income – remaining after payment of all

other claims


Vertical IntegrationVertical Integration

Definition: Combination of assets for two successive stages of production under a common ownershipcommon ownership upstream: away from final consumer

Dominion Resources acquired ConsolidatedDominion Resources acquired Consolidated Natural Gas, 1999

downstream: closer to final consumer Phillips Petroleum acquired Tosco, 2001


Vertical integration: ImpactVertical integration: Impact

Owner gets rights to residual control and residual

iincome reduces potential for holdup

Example: Example: Auto manufacturer acquires parts supplier

can prevent holdup by parts supplier can prevent holdup by parts supplier now faces moral hazard by workers at parts

supplier


Vertical Integration:Make or buy?Make or buy?





Organizational architectureOrganizational architecture

Base – distribution of ownership Two pillarsp incentive schemes monitoring systems monitoring systems


Organizational architecture:Corporate governance

• Incentives– shares and options Monitoring

B d f Di t – bonuses– profit-sharing

Board of Directors major shareholders

• Ownership– proxy fight– takeover


Organizational architecture:Corporate governance

Daimler Chrysler, July 2005: CEO Jurgen Schremp g p

resigned Share price jumped 9.8%


R l tiRegulation


natural monopoly potentially competitive marketp y p asymmetric information externalities externalities public goods


Natural MonopolyNatural Monopoly

Average cost minimized with single supplier large scale/scope economies g / p relative to market demand


Natural Monopoly:ManagementManagement

government ownership beholden to employeesp y cannot borrow or raise capital independently

private franchise subject to regulationp j g


Natural Monopoly:Marginal Cost PricingMarginal Cost Pricing

Require provider set price equal to marginal cost set price equal to marginal cost supply quantity demanded

i t ill i b id price < average cost will require a subsidy


Natural Monopoly:RegulationRegulation

price regulation – incentive to exaggerate reported costs

rate of return regulation – incentive to over-invest in rate baseNew York PSC switched Con Ed from

rate of return regulation to price cap


Natural Monopoly:Rate of Return RegulationRate of Return Regulation

maximum rate of return on rate base costs plus the allowed return comprise the costs plus the allowed return comprise the

“revenue requirement” prices are set to recover the revenue prices are set to recover the revenue

requirement

di ll d fit t d t disallowed profit returned to users





Potentially Competitive MarketPotentially Competitive Market

Economies of scale/scope are small relative to market demand. Natural monopoly markets may be transformed into potentially competitive markets (or vice versa), due to changes in technology market demand


Potentially Competitive Market:TelecommunicationsTelecommunications

Increase in market demand for long-distance service: AT&T break up, 1984 long-distance market opened to competition local providers retained monopoly

Convergence between cable TV and local telephone service: local service opened to

99competition, 1996


Potentially Competitive MarketCompetition LawsCompetition Laws

prohibit collusion limit mergersg deter anti-competitive business practices


Potentially Competitive MarketStructural RegulationStructural Regulation

Natural monopoly may exist at one stage in the production chain, but need not apply upstream or downstreamBar franchise holder from vertically related markets

prevent monopoly from extending market powerpower





Asymmetric Information: ResolutionResolution

mandatory disclosure – requires objectively verifiable information (difficult in medicine)

f regulation of conduct (e.g., prohibit medical advertising, require second opinions, etc.)

structural regulation (e g require doctors to structural regulation (e.g., require doctors to specialize in diagnosis or treatment, but not both))

self-regulation – professional licensing associations


Asymmetric Information:Who to regulate?Who to regulate?

external agency self-regulation: common with professions g p

(lawyers, financial advisors, doctors, architects, engineers)

self-regulation potentially can be anti-competitive

external agency will generally be inefficient





Negative ExternalitiesNegative Externalities

Production will be excessive since it ignores the external costs

Efficiency requires the marginal social benefit to be set equal to the marginal social costs

Many external costs are public bads: the marginal social cost is the sum of the

i l t t th i timarginal costs to the victims


Externalities:Emissions StandardEmissions Standard

allocate licenses through auction allow trading of licensesg also achieves economic efficiency


Externalities:LocationLocation

marginal benefit and cost vary with location economically efficient quantity depends on locationwindy vs still area populated vs unpopulated area

cross-border externalities


Externalities:TimeTime

Marginal benefit and cost vary with time economically efficient quantity depends on time

day vs. night summer vs. winter


Externalities:Tort LawTort Law

Governs interactions between parties with no contractual relationship liability – conditions under which one party must pay damages to another damages = price for harm





Public GoodsPublic Goods

legal framework enables excludability copyright py g patent

trade-off incentive for knowledge creation economically efficient usage of informationy g


Public Goods:U.S. ConstitutionU.S. Constitution

“The Congress shall have power … To promote the progress of science and useful arts, bythe progress of science and useful arts, by securing for limited times to authors and inventors the exclusive right to their respective writings and discoveries”

Article I, Section 8, Clause 8


Public Goods:Public ProvisionPublic Provision

For some public goods, practically difficult to enforce exclusion national defense clean air fireworks


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Externalities - University of Victoriaweb.uvic.ca/~pcourty/Chap12-15.pdfExternality: Benchmark...

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