Public Economics: Week 4

Definitions to know:

 Externalities
 The Coase Theorem
 Pigouvian tax/subsidy
 Social Insurance
 Actuarial premiums
 Separating vs pooling equilibrium
 Adverse selection
 Moral Hazard

Short answer questions:

Depict how a positive consumption externality yields an equilibrium outcome which does not
maximize social efficiency (make sure to indicate the deadweight loss of the externality). Why
are positive consumption externalities inefficient (i.e. do they lead to the over or under
consumption of a good?).

Suppose a steel plant in southern Minnesota disposes of its productive waste in the Mississippi
River, to the determinant of those living downstream. According to the Coase theorem, this
negative production externality can be rectified with private bargaining. How may this particular
externality be difficult to correct solely through provide bargaining?

A hydraulic fracking plant is contaminating the local water supply of a town. Suppose the plant
realizes it is creating a severe negative externality, and is willing to compensate local town
inhabitants fully. What additional problems may arise from correcting this externality via private
bargaining, even if the transgressor is willing to compensate injured parties in full?

Outline how a Pigouvian tax can correct the deadweight loss associated with a negative
production externality (make sure to outline the tax wedge, the prices for both the consumer and
the producer, and the original deadweight loss).

Graphically depict and explain how a cap-and-trade regulation scheme can reduce pollution for
two firms with different costs of polluting. Under what conditions may a cap and trade system
fail in the regulation of an externality?

What are the five necessary conditions for the efficient provision of insurance? Do the following
types of insurance violate any of these assumptions, and if so how: flood insurance, car
insurance, unemployment insurance and disability insurance?
Car insurance is one insurance market in the US which is does not have significant gaps in
coverage, and is predominately provided by the private sector. Why does this type of insurance
not suffer from a missing market problem in the United States?

How may a separating equilibrium result in a missing market? How may a pooling equilibrium
results in a missing market?

Moral hazard can lead to significant losses for insurance companies. What types of policies can
insurance companies enforce to limit moral hazard?

One of the most significant impediments for the private provision of unemployment insurance is
the presence of moral hazard. How is moral hazard a problem for unemployment insurance?
What types of policy changes have governments attempted to introduce in order to reduce moral
hazard for unemployment insurance?

Adverse selection is a significant problem in the determination of disability insurance awards.

Explain how adverse selection is problematic in disability insurance. What are some policies
governments have introduced to correct these problems? Can you anticipate any adverse effects
from these policies in the awarding of disability insurance?