Question

Illu the Negative Ex Externality Model: Price & Cost Quantity Explain how does asymmetric information affects demand and illustrate the model with asymmetric information: Price Quantity Explain what Coase Theorem Implies in regaras Externalities:

Answer 1

Ans 1 Negative externality occurs when an individual who is making a decision to maximizing his/her utility does not have to pay the full cost of the decision, instead the decision taken by him/her have some cost attached to it whose cost is more than the cost of the product. Consumers buys that quantity of a product where marginal cost of product is equals to marginal benefit of the product, there are cases when social cost is greater than marginal cost which results in market inefficiencies.

Suppliers of a product have lower marginal cost because they do not tale into account the negative externality. When they have lower marginal cost, input cost declines, supply increases and supply curve shifts rightward which is the marginal private cost. At a cost where marginal benefit > social benefit for customer, they buy more quantity of it and the quantity supplied shifts to Q1 from Q2 and the price to P1 from P2. Since marginal benefit is not equal to marginal cost, a deadweight welfare loss results which is shown in diagram in dotted form.

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Ans 2 Asymmetric information occurs when in a competitive market one party have more knowledge than other party about a specific product. Having more knowledge of a product could be useful or disastrous. If all people have some extra knowledge than others about every product, that economy would be more productive and effective, in this case it is useful. If in an uncertain geographical place people staying there have more knowledge of that place about catastrophic events than insurance companies, people having insurance would be in greater benefits, this could be bad for a healthy economy.  

Suppose there is a car market where people sell second hand cars and cars are of good and bad quality. Customers do not have full knowledge about cars, which one is bad or which one is good, but seller have full knowledge. Seller keep prices at normal range. Consider a case where demand = supply in the market for second hand cars and the price is P1 and sell of car is at Q1. If customers have full knowledge of the cars they would be willing to pay lower prices which is P, demand would be less at D and sell of cars reduces at Q.   

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Ans- 3 Coase Theorem helps in solving the issues raised by externalities in market by awarding property rights. Consider the situation where we have a firm a firm named A, producing some goods in a competitive market that causes some pollution while producing goods. Another firm named B, which produces a different good in a different market, is directly harmed by this pollution. i.e. A could be party hall where DJ plays songs in loud volume and B be school where children wants some piece to study. A is disturbing B by playing songs and B is getting directly harmed by A.

Anyway we consider the market for firm A. We said that it was a competitive market so it is a price taker , it faces a horizontal demand curve at the market price, Pc, and can produce as much output as it likes at this price. As the market price is constant and does not vary depending on the output the firm produces, the marginal revenue is also equal to the price. Assume as well that firm A faces an upward sloping (private) marginal cost curve, the more output it produces, the greater its marginal costs.

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Firm A will produce where marginal cost = marginal benefit where quantity produces is Qc, which includes some level of externalities in the market.

Coase Theorem offers two possiblities in a competitive market either it could allow A to keep volume at full or helps B in keeping volume at zero. If A have full property rights of keeping volume at full, B needs to pay some amount of money to A to keep volume at low so that students can study, if B have full rights than A needs to B to keep volume at some level that atleast their customers can enjoy.