Case Discussion - Solutions

Business and Industrial Economics
Silvestri Daniela – Case discussion 09/03/2023
Part 1 - Externalities
The brief from The Economist - “Externalities Pigouvian taxes” - touches upon the concept of externalities by
providing some examples and then introduces some possible mechanisms of correction through the Pigouvian taxes
and the internalization of the externality through the Coase principle of property right.
- Identify cases of externalities in the text (a few examples)
- Provide examples of externalities; please, focus on the following industries (non-exhaustive list of examples in
brackets): food and beverage industry (i. CO2 emissions; ii. water consumption; iii. Usage of plastic for packaging),
tourism industry (i. increase in revenues of commercial activities; ii. increase in the rental prices; iii. congestion);
clothes and shoes industry (i. pollution, ii. Indirect negative externalities on the health system for consumption of
high calories food). Think also of some examples of positive externalities! Try to provide structured examples!
- Briefly comment on the following sentences reported in the case:

“By using prices as signals, a tax should encourage people and companies to lower their carbon emissions more
efficiently than a regulator could by diktat (regulators establish a quota of emission reduction).”
Before answering, and especially during the exam, pay attention to the clarity of your answer, the terminology used,
and the flow of the arguments.
The main points to be addressed could be for example:

• Externalities definition: externalities occur whenever the actions of one party make another party worse or
better off, yet the first party neither bears the costs nor receives the benefits of doing so. Externalities, therefore,
cause inefficiencies: specifically, too many resources are allocated to activities that cause negative
externalities, whereas too few resources are allocated to activities that cause positive externalities since parties
that engage in these activities do not fully appropriate the benefits
• Apart from Coase’s theorem, the brief discusses other possible remedies to externalities, namely i) the use of
taxes as a way to change the behavior that causes the externality by relying on Pigou’s insights ii) direct policy
intervention for example through a quota for cutting emissions
• Taxes on negative externalities, often called “sin taxes”, are intended to make consumers/producers pay the
social cost of the good to reduce the consumption of that good and create a more socially efficient outcome.
Pigou’s idea was quite simple if A carries out an activity that imposes a cost on B, then taxing A by the amount
of that cost will provide the proper incentives to consider the externality in his production decisions.
On the other hand, if a good has positive externalities and it is under-consumed, then the government can give a
Pigouvian subsidy equal to the amount of marginal external benefit of the good.
• Without a tax there will be over-consumption/over-production of the good because consumers/producers ignore
the external costs, in this case, firm would not internalize the costs associated with pollution
• The tax, however, is not a perfect instrument and has some limitations. Firms of different size, SMEs vs. large
incumbents, may be affected by the regulation in a different way. Large incumbents maybe feel authorized to
pollute after paying the tax, whereas SMEs cannot sustain the tax. So other mechanisms should be put in place
that acts for example on firms’ reputation
• Discuss the advantages of using taxes:
i) provides economic incentives to reduce the negative externality
ii) concentrate the reduction of CO2 emission in the hands of firms that are responsible for pollution and
on those firms for which is more efficient to cut emissions
iii) raise revenue for the government that can be allocated to tackle problems caused by the externality
• Discuss the disadvantages of using taxes:
i) The use of tax may not be effective when negotiation is impractical due for example to the fact that many
different parties are somehow involved each one with different incentives and objectives
ii) It is challenging to determine the appropriate level of the tax, setting it too high could be economically
burdensome, but setting it too low would not be effective
1
iii) if the demand is inelastic, a tax does not work as expected. Based on the principle of demand and price,
if the demand is inelastic, then the tax will not reduce the demand for that good by a large amount
iv) if the tax is only national then it may not be effective as companies can relocate
v) in the case of international pollution, negotiation is often quite hard to achieve, for example, to design
cross-country regulations. Firms may free ride, it may be difficult to recognize liable firms. It is therefore
important to evaluate the circumstances at hand and act on the firms’ or consumers’ incentives to change
their behavior.
• A tax acts on the economic incentives of consumers/producers and it is, therefore, more efficient than direct
regulation through quotas. Suppose that there are two producers, firm X and firm Y, whose marginal costs are
MCX and MCY, respectively. If the goal is to reduce total emissions by Q= QX +QY tons/day, a tax of T* will
accomplish that goal in the least costly way. When pollution is taxed at a fixed rate, each firm reduces its emission
up to the point where the MC of further reduction is exactly equal to the tax. The direct regulatory approach
through quotas could also achieve any given total pollution reduction at minimum costs if regulators knew each
firm’s marginal cost of reduction curve. They could then simply assign reduction quotas in such a way as to
equate marginal reduction costs across firms. The difficulty is that policymakers hardly know the shape of firms’
MC curves. Quotas therefore would not necessarily lead to an efficient outcome because for one of the plants, the
MC is much less steep and can reduce the emission to a larger extent because each unit of reduction costs less
for one of the plant
Example of the use of tax. In equilibrium Quantity (quantity produced and consumed) decreases from Q0 to Q1.
From Robert H. Frank (Microeconomics and Behavior)
2
“Coase considered externalities as a problem of ill-defined property rights. If it were feasible to assign such
rights properly, people could be left to bargain their way to a good solution without the need for a heavy-
handed tax.”
The main points to be addressed could be for example:

• Definition/intro: another possible way of dealing with the issues generating externalities relies on the use of
Coase’s theorem. Coase argues that externalities result from an inadequate specification of property rights.
• Coase theorem: when the parties affected by externalities can negotiate costlessly with one another, an
efficient outcome results no matter how the law assigns responsibility for damages. This implies that once
policymakers define and enforce property rights, then private parties can trade for these property rights
reaching an efficient solution. In turn, the efficient solution to an externality does not depend on which party
is assigned the property rights, as long as someone is assigned those rights
• Advantages:
i) Efficient solution for small or very localized issues
ii) Enable private parties to trade without a strong policymaker intervention
• Disadvantages
i) negotiation is difficult among several parties, therefore this solution while it is likely to apply to
small scale issues, is hardly applicable to global issues like carbon emissions
ii) assignment problem: how to identify the liable party and how to quantify the damage. This sort of
information is not always available or trivial. Coasian’s solutions are likely to be more effective for
small, localized externalities than for larger, more global externalities
iii) Free rider problem: supposing that firm A is polluting the water of a river used by multiple farmers,
in that case, farmers that are closest to the plant will be willing to pay the firm to stop pollution but
other farmers may free ride by not paying firm A
(See exercise)
Part 2 – Information Asymmetry

Brief from The Economist “Secrets and agents” discussing the problems of information asymmetry in the market for
used cars and the role of signaling in the labor market.
Main idea: The article introduces Akerlof’s model about the market for used cars. Suppose that used cars came in a
variety of qualities, from the worst (the lemons) that are always breaking down, to the best ones, the most reliable (the
peaches). Sellers know the quality of their cars, but the buyers cannot tell which ones are lemons and which one are
peaches. Since buyers cannot tell the difference, they will not be willing to pay more than what an average quality car
is worth. But seeing that buyers are willing to pay just for average quality, sellers of the highest quality cars exit the
market. In turn, when this happened the average quality of cars decreases, and this causes the exit of additional sellers
of good cars.
(See exercises)
3
Part 3 - Signaling
Watch the following TedX Talk: https://www.youtube.com/watch?v=iNgB-j4-5HY
Take-home messages:
- Role of secrecy in firms’ pay systems (Vanity Fair example) and why company owners discourage pay
transparency
- Negative outcomes: when there is no pay transparency, employees are likely to feel they are underpaid or
discriminated against; employees are likely to quit, move to other companies, knowledge spillovers, and gender-
wage gap
- Transparency may have a positive outcome in terms of peer-to-peer collaboration, employees are more likely
to work hard to improve their performances, (examples from Dane Atkinson SumAll, Buffer, Whole Foods)
- There is an increasing interest in investigating these issues in the scientific literature
- Based on the case text and the video, provide one possible suggestion to mitigate the issue of information
asymmetry in the labor market: Few examples could be:
o Link wage to performances
o Public salaries
o Make public the formula for calculating pay
o Post the pay levels
- Briefly comment on the following sentences reported in the case:
Question 1: “Employers may struggle to tell which job candidates are best. Mr. Spence showed that top workers
might signal their talents to firms by collecting gongs, like college degrees”. Provide a meaningful comment to this
sentence.
Examples of key points to discuss:
• In a perfectly competitive market where firms can distinguish high ability employees from low-ability ones, the
firm will pay employees their marginal product that is wH=aH and wL=aL where wH>wL and aH>aL
In this case, there is perfect information where employers can distinguish workers by observing their
productivity. As a consequence, each employee will be paid according to their ability/productivity.
• However, employers may struggle to tell which job candidates are best due to information asymmetries:
employees know better about their productivity than their potential employers.
• Because of this “hidden information problem”, employers tend to pay an average salary, which reflects
candidate employees’ “expected value” that is their expected marginal product and, thus, is lower than salaries
that they would pay to high-productivity workers.
Supposing that h=0.5 and 1-h is 0.5 and that wL=3000 and wH=8000 we have that the average salary the firm
offer is w=8000+0.5+0.5*3000=5500
wP=(1 -h)aL+haH< wH that is the average wage. Low-ability workers are happy about it whereas high-ability
workers are willing to put in place strategies that would enable them to distinguish themselves from low-ability
workers.
High-productive employees do not accept these “average” salaries and tend to “self-select out of the labor
market” which is generating a problem of adverse selection.
• As wP=(1 -h)aL+haH<wH , high-ability employees have incentives to send a credible signal, which distinguishes
them from low-ability employees (e.g., degrees and/or other certificates of accomplishment)
• It is a plus to provide examples of sources of information asymmetries between candidate employees and
potential employers and of (credible) signals above and behind degrees. For example, entrepreneurs looking
for funds may signal their quality through a patent or a record of previous VC received. That is using signals
as observable attributes that communicate information about unobservable attributes.
Something to remember:
Pooling equilibrium: signaling does not yield the desired result, that is the employers are unable to distinguish the
two type of workers either because both types choose the same level of education or because they do not invest in
education at all.
Separating equilibrium: the signaling gives the desired result, and the employers are able to use the signal to
distinguish the two types of workers because for example the high ability acquire education, whereas the low-
ability ones do not acquire it, or because they acquire different level of education which enable employers to
distinguish high ability from low ability workers
4
Question 2: “Crucially, this only works if the signal is credible: if low-productivity workers found it easy to get a
degree, then they could masquerade as clever types.” Comment this sentence, focusing on the notion of “credible
signals”.
Examples of key points to discuss:
• In the labor market context, a signal is credible if it allows separating low-productivity candidate employees
from high-productivity ones. High-quality agents are motivated to send signals if the benefits outweigh costs.
• If credible signals exist, potential employers can distinguish high- from low- productivity employees and pay
adequate salaries to the former.
• To be credible a signal needs to be costly, namely only high-productivity employees should be able to acquire
it. In this way, by observing the signal, potential employers can distinguish high-productivity candidate
employees from low-productivity ones.
• Moreover, credible signals must be observable, namely the recipient (in this case the potential employer) must
be able to “see” and “interpret” the signals
• signals must also be interpretable by the receiver (for example university ranking signal quality when a specific
ranking is internationally accepted or recognized)
• If signals are not costly and observable, low-productivity candidate employees can “fake them”
• It is a plus to provide examples of credible and non-credible signals. For example, obtaining a patent is a costly
signal and it is also time-consuming. Therefore, firms or entrepreneurs applying for a patent communicate
indirectly that their innovation may have market potential

Case Discussion - Solutions

Uploaded by

Copyright:

Available Formats

Case Discussion - Solutions

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Case Discussion - Solutions

Uploaded by

Copyright:

Available Formats

Business and Industrial Economics

Silvestri Daniela – Case discussion 09/03/2023

- Identify cases of externalities in the text (a few examples)

- Briefly comment on the following sentences reported in the case:

The main points to be addressed could be for example:

From Robert H. Frank (Microeconomics and Behavior)

The main points to be addressed could be for example:

Part 2 – Information Asymmetry

- Briefly comment on the following sentences reported in the case:

Examples of key points to discuss:

You might also like