4 BEHAVIOURIAL ECONOMICS AND ASYMMETRIC INFORMATION 16 marks

4. BEHAVIOURIAL ECONOMICS AND ASYMMETRIC INFORMATION [16 marks]

a. Assumptions made about people must be realistic. Compare and contrast traditional economics with behavioural economics (refer to specific examples to support your answer). [5 marks]

b. What are externalities? Using real-world examples explain the difference between consumption and production externalities and between positive and negative externalities. Choose one (1) specific type of an externality and give a sound reason for government intervention to solve the market failure. [3 marks]

c. Distinguish between public goods and common resources. Explain why each of these goods can cause the market to fail. [3 marks]

d. What is asymmetric information? Using real-world examples distinguish between adverse selection and moral hazard and explain why each can result in market failure. [5 marks]

Solution

a) Traditional economics is mainly based on three assumptions

1) consumers are rational

2) They revise their expectations and beliefs according to the new information

3)They are generally consistent with their utilty .

But as we know that these are not the realistic assumptions .

Behaviourial economics on the other hand is based more on psychology and reasoning and claims that humans are bound to be irrational sometimes .

There are three major phenomena or basis in it known as framing , heuristics , inefficiencies

Eg: let us suppose that one takes his decisions based on overconfidence . This might be a behaviour and exists in real world but is not rational and hence not a part of traditional economics.

So behaviorial economics differs from traditional one because it presents real life scenario based on reasoning .

It unlike the traditional one which is based on the fact that people are rational believes that individuals tend to make mistakes which changes their course of decisions .

b) Externality refers to the cost or benefit that is imposed on the party not involved in the transcation , trade or deal.

Consumption externality could be a hygienic neigbourhood which would not only protect the people who practice it but also the ones who live near them for they will also be till some extent protected by diseases in contrast to a neigbourhood where garbage is being carelessly dumped and there is a lot of pollution and litter .

production externality has the example of beehives on farms. It would be benficial for the farmer and would be a production externality (positive on e) because the bees will help in pollination.

Positive externality occurs when the effect of the transcation or trade on the third party is positive , Like getting eductaion has not only the private benefits for the individuals but also the social ones for the society as it would be rich in the stock of knowledge and would contribute to overall development of the society .

Negative externality is when there is the cost to the third party . Eg: in case of pollution or waste being dumped in water the aquatic life is affected which affects the livelihood of fishermen.

Government is required to intervene in a negative externality like pollution or dumping of waste in water bodies. The government can pass regulations and strict laws with heavy fines on those who do not trat the waste and dump it carelessly in water bodies because when the government defines the property rights there is a flow of compensation from those who want to pollute to those who want to protect.

c) Public goods are the ones which are non rival and non excludable goods . Eg: national defence etc.

In public good since no one can be excluded people tend to free ride ie without providing for the cost of it , they tend to enjoy the benefits . If thsi continues and everyone does it , the good would not be provided and this leads to market failure. so it prevents private firms to provide such a good and may mostly be a government one.

Whereas the common resources are the ones which are rival goods but non excludable . eg : roads , grazing lands etc. A common reasource like the grazing grounds can be subjected to what is known as the tragedy of commons for the reason that all the grazers or herders will find it beneficial for their cattle to have the maximum and this would lead to overexploitation of the land and hence market failure .

d) Asymmetric information refers to the state when one party has more information about the transaction , good or service than the other party . This is a common case in most markets in reality . Existence of asymmetry information leads to market failure .

Moral hazard occurs when someone begans to be careless or tends to pursue risky behaviour because he is being insured . This occurs after the transcation has been done Eg : When car insurance is done , the owner might leave the car unlocked So in a way he is exposing his car to risk of being stolen because he knows that he is being insured and the insurance company has asymmetric information .

This would probably lead to more thefts than before and the insurance company ends up paying more . This would lead to market failure .

Adverse selection

It happens when before the deal or trade there is incomplete information to one of the parties .

Eg: before taking a loan , the borrower knows his capacity to pay more than the lender. So the borrower may hide or let the incomplete information pass to the seller which would lead to market failure.

There are certain measures to avoid such problems like close monitoring , contractual agreements screening etc which could prevent moral hazard and adverse selection.