WEEK 3 DISC Incentives and Externalities ECON 103

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Feb 20, 2024

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1 Incentives and Externalities An externality is a widely used concept in economics to explain the effects of a poor decision on uninvolved parties. One could describe externalities as the resultant effects of actions, such as production or consumption, on individuals or populations not involved in the transactions. It often occurs when individuals pursue their interests with a disregard for indirect effects on the population. Externalities could be positive or negative (Helbling, 2020). In a case where a transaction results in negative externalities such as pollution, the government, through relevant agencies, should regulate the transaction to reduce and protect against pollution. For example, a government can impose high taxes and regulate the number of greenhouse emissions if a transaction leads to high greenhouse gas emissions. The definition of moral hazard might vary from one person to another, depending on the issue at hand. One could define moral hazards as extreme behavior that defies logic in that it motivates individuals to engage in risky behavior because they are not held responsible for the action. The fact that another person would take care of the problem if it arises emboldens individuals to act immorally and carelessly (Luther et al., 2011). One example of an immoral hazard is an employee's careless driving of company cars. It is important to note the employer maintains company cars; they are responsible for any mechanical issues, among others. Because they are not responsible for any breakdown, some company employees drive carelessly. Moral hazard and adverse selection are closely related because they involve asymmetric information. However, they differ in their approaches and change in behavior. There is a change in behavior in moral assert after they sign the deal. For example, an insured person may engage in risky behavior or act carelessly because he knows the insurer would cover any costs arising

2 from the immoral behavior (Einav & Finkelstein, 2018). In adverse selection, the seller has the upper hand and modifies the agreement document depending on the issue before signing an agreement with the buyer (Einav & Finkelstein, 2018). For instance, an insurance company is likely to raise insurance premiums or set a liability ceiling if the insured property is more likely to expose the company to high risks. References: Einav, L., & Finkelstein, A. (2018). Moral hazard in health insurance: what we know and how we know it. Journal of the European Economic Association, 16(4), 957-982. DOI: https://doi.org/10.1093/jeea/jvy017 Helbling, T. (2020). Externalities: prices do not capture all costs. Finance & Development. https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Externalities Luther, W., Ryan, M. E., & Williamson, C. (2011, February 17). Marriage as a moral hazard. The Perfect Substitute. Retrieved January 24, 2023, from https://perfectsubstitute.blogspot.com/2011/02/marriage-as-moral-hazard.html Mayer, D. A. (2010). The Everything Economics Book. Retrieved from https://leocontent.umgc.edu/content/dam/course-content/tus/econ/econ-103/document/Chapter %2021_MayerDavidA_2010_21TheEnvironmentAndTh_TheEverythingEconomic.pdf ~KJJ

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