Silvia Stroe, 12.03.

2019 BIE

SOLUTIONS TO EXERCISE SESSION MODULE B MARKETS AND MARKET FAILURE

 
1. A coal-fired power plant jointly produces electricity and air pollution. Air pollution adversely affects a nearby
farm. Assume: pe = 20 the price of electricity, pf = 8 the price of the agricultural product of the farm (both firms
are price-taker), ce(e,x) = e2 + (x - 2.5)2 the cost for the coal-power plant of producing electricity e jointly with
x units of pollution (there are no external costs of pollution), and cf(f,x) = f2 + fx the cost for the farm of producing
f units of agricultural products when the coal-fired plant emits x units of pollution. If the two firms merge to
internalize the negative externality, then

a. e* = 5, f* = 2/3, x* = 11/3
b. e* = 5, f* = 11/3, x* = 2/3
c. e* = 3, f* = 11/3, x* = 3
d. None of the above
pe=20, pf=8, ce(e,x)=e2+(x‐5/2)2, cf(f,x)=f+fx →πM = πM(e,f,x) = 10e+ 8f‐[e2+(x‐5/2)2]‐ (f2+fx) 

δπM/δe=0 →20 ‐2e=0 →e*=10 

δπM/δx=0 → ‐2x+5‐f=0 → f=5‐2x → f*=5‐4/3=11/3 

δπM/δf=0 →‐8‐2f‐x=0 →  8‐2(5‐2x)‐x=0 → 8‐10+4x‐x=0 → 2‐3x=0 → x*=2/3 

D is the right answer 

2. A coal-fired power plant jointly produces electricity and air pollution. Air pollution adversely affects a nearby
farm. Assume that the property rights on air are assigned to the farm, which now can sell pollution rights to the
power plant at the unit price px. Given pe = 10 the price of electricity, pf = 8 the price of the agricultural product
of the farm (both firms are price-taker), ce(e,x)= e2 + (x - 2.5)2 the cost for the coal-power plant of producing
electricity e jointly with x units of pollution, and cf(f,x) = f2 + fx the cost for the farm of producing f units of
agricultural products when the coal-fired plant emits x units of pollution, then
a. px* = 2/3
b. px* = 11/3
c. px* = 5
d. None of the above
We calculate each one’s π: 

πe =  pe*e ‐ ce(e,x) – px *x = 10e ‐ e2 ‐ (x‐5/2)2 ‐ px *x 
δπe/δe=0 →10 ‐2e=0 →e*=5 
δπe/δx=0 → ‐2x+5‐ px =0 → xD*=(5‐ px)/2 → xD *=2,5‐ px /2  (D for demand) 
πf =  pf*f – cf(f,x) + px *x = 8f – (f2 +fx) + px *x 
δπf/δx=0 → ‐f+ px =0 → px=f 
δπf/δf=0 →8 ‐2f – x = 0 →xS*=8 – 2f = 8‐2 px      (S for supply) 
xS* = xD*→ 8‐2 px = 2,5‐ px /2 → 5,5 = 2 px  ‐ px /2 → 5,5 = 3px /2 → 3px = 11→ px = 11/3 
B is the right answer 

3. Consider an economy with two consumers, Ben and Joe. There is public good in this economy in a form of
tornado sirens. Ben’s demand for tornado sirens is given by P = 10 - Q, and Joe’s demand for tornado sirens is
P = 8 – 2Q. Marginal cost for providing tornado sirens in the markets is constant, MC = 9.
a) Which two properties must be satisfied for sirens to be public goods?
Public goods must be non‐rival and non‐excludable. 
b) Are tornado sirens are non-rival? Explain your answer
Silvia Stroe, 12.03.2019 BIE

Yes. If one person uses it (i.e. she can hear sirens), other people’s use of this good is not affected (other 
people can hear the sirens as well) 
c) Are tornado sirens are non-exclusive? Explain your answer
Yes. Everyone in the area will be able to hear the siren, regardless of whether they paid for this good. 
d) Is there a potential for free-rider problem?
Yes. This is implied by the fact that sirens are non‐excludable, i.e. there might be people who didn’t pay for 
the service but these people will still be able to hear the sirens. We call these people free‐riders. 
e) Derive market demand curve for sirens. Draw three graphs on the top of each other– first graph for Ben’s
demand, second graph for Joe’s demand, and the third graph for market demand
The market demand curve can be derived by VERTICAL summation (not horizontal as is the case with private 
goods)  of  the  individual  demand  curves.  At  each  quantity  level,  we  see  the  willingness  to  pay  of  each 
individual and then estimate society’s total willingness to pay by adding the willingness to pay of the various 
individuals. PUBLIC GOODS – VERTICAL SUMMATION – WE START FROM Q 

  
At Q=0, B is willing to pay 10, J is willing to pay 8. Together, 
  they’re willing to pay 18. At Q=4, B is willing to pay 6, J is 
willing to pay 0.  Together, they’re willing to pay 6. At Q=10 
 
both consumers are not willing to pay anything (P=0). 
 
[one might say that QT= 18‐3Q. However, adding the 2 
  demand functions together into a single equation is tricky 
because each consumer has a different maximum willingness 
 
to pay (or value where the demand curve intersects the Y 
  axis). Thus we use the different points as shown above to draw 
the total demand and find the kink point] 
 
Use the information calculated above to draw market demand 
  curve. First draw the three points (10,0), (4, 6), (0, 18), and 
  then draw linear curve between these points. 

  You’ll see that the market demand curve has a kink at point 
(4,6). Therefore, the market demand curve has two parts: 
  P=18‐3Q if P>=6, and P=10‐Q if P<=6.  
   
 

 
Silvia Stroe, 12.03.2019 BIE

f) How many sirens will be provided in the market? What will be the price for these sirens?
Draw the MC on the graph with market demand curve (MC=9). You can see that MC intersects the demand 
curve in the upper. MC = willingness to pay/ demand => 9=18‐3Q  => 9 = 3Q => Q=3 (so there will be 3 sirens 
provided in the market). 

Draw a dotted line up at Q=3 such that you see where it intersects Ben’s and Joe’s demand curve. Plugging 
Q=3 into their individual curves, you get that Ben is willing to pay $7 and Joe is willing to pay $2. Therefore, 
the price in this market for providing 3 sirens will be $9. 
g) Is the result from previous question realistic? Discuss how government funds public goods.
No, the result is not realistic. Our example describes idealized situation in which we are given demand curves 
of  both  individuals.  However,  this  is  not  the  case  in  the  real  life,  because  in  the  real  life,  we  don’t  know 
people’s demand curves. In other words, people don’t publicly reveal how much they are willing to pay for 
public service. In fact, people are often trying to become free‐riders by claiming that they don’t actually need 
the service. The government can do benefit‐cost analysis and charge user fees, for example through taxes, 
or through entry fees. 

 
4. Suppose that there are two types of workers in the labor market. A high-skill worker’s productivity in the project
is aH = 8000 and low-skill worker’s productivity is aL = 3000. Workers know their type, but the firms don’t.
Suppose that a local college offers a certificate program; completion of the program has no impact on workers’
productivity. High-skill worker’s cost of obtaining the certificate (counting both tuition and effort invested) is
cH = 1500 and for the low-skill workers it is cL = 4000.
a.) Suppose that firms believe that having a certificate is a credible signal of a worker being high-skilled. Then
the firms will offer wage wH = 8000 to all workers who choose to obtain it and wL = 3000 to all without
certificate. Who will get the certificate?
Suppose that firms believe that having a certificate is a credible signal of a worker being high‐skilled. Then 
the firms will offer wage wH = 8, 000 to all workers who choose to obtain it and wL = 3, 000 to all without 
certificate. Denote level of education e, which is 1 if worker obtained the education and zero otherwise. 

For high‐skill worker payoff of getting education is then πH(e = 1) = 8000 − 1500 = 6500, which is strictly better 
than not getting education πH(e = 0) = 3000. Given the beliefs of the firms, high‐skill workers find it in their 
interest to choose e = 1. We can rephrase this condition as ‘the expected gain in future income is greater 
than the cost of education, so high‐skill workers will choose to obtain the certificate’; mathematically cH < wH 
− wL. Let’s look at the low‐skilled workers. 

Given the beliefs of the firms, πL(e = 1) = 8000 − 4000 = 4000 > πL(e = 0) = 3000, so low‐skilled worker’s best 
strategy is to obtain the certificate as well. 
b.) Suppose that firms believe that having a certificate is a credible signal of a worker being high-skilled. Then
the firms will offer wage wH = 5500 to all workers who choose to obtain it and wL = 3000 to all without
certificate. Who will get the certificate?
In this case for high‐skill worker payoff of getting education is then πH(e = 1) = 5500 − 1500 = 4000, which is 
strictly better than not getting education πH(e = 0) = 3000.  

For low‐skilled workers, πL(e = 1) = 5500 − 4000 = 1500 < πL(e = 0) = 3000, so low‐skilled worker’s best strategy 
is to not obtain the certificate in this case. 

 
5. Imagine that labor market is perfectly competitive and workers can signal their ability through education. Firms
pay workers their expected productivity a, conditional on their education level e. Specifically, the expected
productivity of high-ability workers is aH = 1200 and their unit cost of education is cH = 250, while the expected
productivity of low-ability workers is aL = 200 and their unit cost of education is cL = 500. Find the level of
education eH that allows high-ability workers to credibly signal their ability on the labor market.
a. 2 𝑒 4
Silvia Stroe, 12.03.2019 BIE

b. 𝑒 5
c. 𝑒 10
d. None of the above answer is correct
The general formula for computing eH is aH‐aL>cH*eH and aH‐aL < cL *eH → (aH‐aL)/cL< eH< (aH‐aL)/ cH  

→ (1200‐200)/500< eH<(1200‐200)/250 → 1000/500< eH<1000/250 → 2< eH<4 

 Thus, the correct answer is A 

6. Patricia owns a boutique and hired Alfred as a salesperson for her store. The daily revenue can be either XH =
60 or XL = 20. The revenue depends on two things: demand and Alfred’s effort. Alfred can work hard e = 1 or
be lazy e = 0. If Alfred works hard the probability of success is 0.8; if Alfred is lazy the probability of success
is 0.25. Patricia, who is the principal, is risk-neutral and maximizes her (expected) profits πP = X − w, where w
is the wage she will pay to Alfred. Alfred (agent) is risk-averse and has payoff πA = √𝑤 −e (notice that this is
his utility of wealth net of the cost of exerting the effort). Instead of working in the boutique Alfred could flip
burgers in McDonalds for 16 dollars a day which does not involve any effort, so his reservation utility is
𝑈 = √16 = 4.
a.) Suppose that the effort is observable. Find the profit-maximizing wage if (i) Patricia wants Alfred to be lazy
(ii) Patricia wants Alfred to work hard. Which level of effort would Patricia choose?
If effort is observable, then in order to max her profits Patricia only needs to offer the lowest acceptable 
wage to Alfred in either case. Wages offered by the principal should be high enough so that agents payoff 
from participating in the project is at least as high as agent’s reservation utility (value of the outside option). 
If P wants A to be lazy, she just needs to pay him $16, which results in payoff of 4, same as what he’ll get in 
MacDonald’s. 

If she wants him to work hard, then she needs to satisfy √w − 1 = 4, so w = 25 (that is provided he works hard, 
which she can verify, and pay him nothing otherwise). 

P wants to max her profits, so she’ll choose the level of effort that results in higher expected profits for her. 
If she contacts Alfred to exert low effort level her expected payoff is πP (e = 0) = 0.25 ∙ 60 + 0.75 ∙ 20 − 16 = 
30 − 16 = 14. If she contacts Alfred to exert high effort level, her expected payoff is πP (e = 1) = 0.8 ∙ 60 + 0.2 
∙ 20 − 25 = 52 − 25 = 27. Patricia will prefer Alfred to work hard. Think about what the numbers tell you about 
Patricia’s choice: if A works hard the expected revenue increases from 30 to 52; to make A work hard P has 
to raise wage from 16 to 25, since the expected revenue increases by more than the increase in wage, for P 
it is profitable to contract A to work hard. 
b.) Now assume that the effort is unobservable. Patricia can no longer make wage contingent on effort, so she
realizes that to create incentive for Alfred to work hard she has to give him a bonus in case the sales turn
out to be high. Suppose the bonus scheme in this case works as follows: if sales are low, she will pay Alfred
wL as you calculated in part (a) for high effort. If sales are high, Alfred will receive wH = wL + B, where B
is the bonus. Calculate the lowest bonus that will induce e = 1. Will Patricia choose Alfred to work hard
now?
When effort level is unobservable, if P wants Alfred to work hard, she needs to design the pay schedule so 
that Alfred will choose to work hard, that is make wage conditional on the outcome of the project, and choose 
wages (in this case bonus) so that for A expected payoff from working hard is greater or equal than his payoff 
of e=0. So, the size of the bonus B should be such that Alfred will choose e = 1. 

Mathematically, 0.8  √25 𝐵+ 0.2  √25 − 1 ≥ 0.25 √25 𝐵 + 0.75 √25, rearrange to obtain 0.55√25 𝐵  ≥ 

3.75 resulting in B ≥ 21.5. Since Patricia wants to max her profits, she’ll offer the lowest acceptable bonus. 

In this specific case, given the wording of this question, when Patricia chooses low effort level, her expected 
profits are exactly the same as in part (a). If Patricia decides to offer the bonus scheme to make Alfred work 
hard, her expected profits are 0.8 ∙ (60 – 25‐21.5) + 0.2 ∙ (20 − 25) = 9.8. So for her it does not make sense to 
encourage Alfred to work hard even though it is efficient to do so 
c.) Discuss your results.
Silvia Stroe, 12.03.2019 BIE

Moral hazard can cause inefficiency. (i) if P wants to impose e=1 he must design a variable pay where wage 
depends on the outcome of the project, so the agent is exposed to risk. (ii) exposing agent to risk means that 
P  will  have  to  offer  higher  expected  wage  to  the  A  to  satisfy  participation  constraint  (compared  to  the 
observable effort), which lowers profitability of the project to P and he may choose e=0 when e=1 is the 
efficient effort level 

 
7. Suppose that half of population drives carefully and will get into an accident with probability 0.2. The other half
of the drivers is not as careful and faces the probability of accident 0.5. Assume all drivers have the same income
of $400 per year. Getting into an accident results into damages of $231. Drivers are risk-averse and have utility
function U = √𝑤. There is a risk-neutral insurance company in the city.
a.) For now assume that information is perfect and symmetric. What will happen if the insurance company
offers full insurance at actuarially fair rates (such that the premium for each dollar insured is equal to the
expected payment by the insurance company)? What will be the total premiums for each type? Which type
will chose to buy the insurance?

Actuarially fair rate is such that the premium for each dollar insured is equal to the expected payment by the 
insurance company, so the expected profits are zero (expected revenue=expected cost). When the insurance 
company sells full coverage to a high‐risk driver, it knows that with probability 0.5 it will have to pay $231, 
so it will break‐even at total premium 0.5 ∙ 231 = 115.5. For the low‐risk drivers the probability of the accident 
is only 0.2, so the expected cost of covering such driver is 0.2 ∙ 231 = 46.2. 

For the low‐risk: expected utility (uninsured) = 0.8 √400+0.2  √169 = 18.6 < 

               expected utility (insured) = √400 46.2= 18.8;  

for the high‐risk expected utility (uninsured) = 0.5 √400 + 0.5 √169 = 16.5 < 

              expected utility (insured) = √400 115.5= 16.9  
b.) Now let’s make a more realistic assumption: each driver knows his type, but this information is not available
to the insurance company. If all drivers decided to purchase the insurance, at what total premium would the
insurance company break-even?
If all drivers purchased the insurance, the company’s expected cost per customer would be 0.5 ∙ 115.5 + 0.5 
∙ 46.2 = 80.85. 
c.) Suppose the insurance company does charge the premium you calculated in part (b), which type will decide
to buy the insurance?
At this premium the high‐risk drivers would be happy to buy insurance, because the coverage is even cheaper 
than in part (a). For the low‐risk drivers now Utility (insured) = 400 80,85 = 17.86, which is lower then 
their  expected  utility  without  insurance,  so  they  will  choose  to  stay  uninsured.  This  also  means  that  the 
insurance company will only sell insurance to high‐risk drivers at the rate calculated in part (a). 
 
d.) Discuss your results.
In this case asymmetric information about the probability of an accident results in adverse selection: the 
price at which the good (insurance) can be sold is not acceptable to the ‘high‐quality’ (low‐risk) side of the 
trade agreement. In case of insurance government can make insurance compulsory, in that case the market 
will not collapse, however, the low‐risk individuals will be worse‐off compared to being uninsured. 

 
8. Consider a second-hand market for cars. There are high-quality cars, which buyers value at most 6000 Euros,
and low-quality cars, which buyers value at most 3000 Euros. High-quality sellers will accept 5000 Euros, while
low-quality sellers will accept 2500 Euros. Assume that buyers cannot observe quality before purchasing, and
that the share of high-quality cars in the market is 0.5. Hence,
Silvia Stroe, 12.03.2019 BIE

a. The market for high-quality cars will be crowded out, as buyers’ expected valuation (EV = 4500 Euros)
is lower than 5000 Euros
b. Both kinds of cars will be sold in the market, as buyers’ expected valuation (EV = 4500 Euros) is higher
than 2500 Euros
c. The market for low-quality cars will be crowded out, as buyers’ expected valuation (EV = 4500 Euros)
is higher than 2500 Euros
d. There is a problem of hidden action, which can be solved by offering sellers a proper incentive contract
to sell only high quality cars
Buyers: Value H = 6000; Value L = 3000 

Sellers: Price H = 5000; Price L = 2500 

Buyers cannot observe quality → probability car is high quality = probability car is low quality = 0,5 

→ Expected valuation buyers = 0,5 *6000 + 0,5 * 3000 = 4500, that is what they are ready to pay, a high 
quality car seller cannot negotiate a price above 4500, so they will exit the market → A is correct 

Why not D? Because here adverse selection, hidden information problem, not hidden action. 

 
9. Consider a second-hand market for motorbikes. There are high-quality motorbikes, which buyers value at most
10,000 Euros, and low-quality motorbikes, which buyers value at most 6,000 Euros. High-quality sellers will
accept 8,000 Euros, while low-quality sellers will accept 5,000 Euros. Assume that buyers cannot observe quality
before purchasing, and that the share of high-quality motorbikes in the market is 0.6. We can conclude that both
kinds of motorbikes are sold in the market, as buyers’ expected value
a. Is 8,000, thus it is higher than 5,000 Euros
b. Is 8,400, thus it is higher than 5,000 Euros
c. Is 6,500, thus it is higher than 5,000 Euros
d. None of the answers above is correct

Buyers: Value H = 10000; Value L = 6000 

Sellers: Price H = 8000; Price L = 5000 

Buyers cannot observe quality → probability car is high quality = 0,6 

→ Expected valuation buyers = 0,6 *10000 + 0,4 * 6000 = 8400, that is what they are ready to pay → D is 
correct 

Why not B? Because Expected valuation 8400 has to be higher than both prices for both kinds of
motorbikes to be sold, NOT higher only than PL = 5000