ECON 100B Lecture Notes - Lecture 15: Demand Curve, Marginal Utility, Marginal Cost
Econ 100B Lecture 15 - May 31, 2018
Externalities and public goods
Principal agent problem
●Can we design some incentive mechanisms to solve problem caused by incomplete
information and costly monitoring?
●Consider a simple set-up of a kiosk with a single employee Joe
●If Joe works hard daily profit is higher
●When Joe works hard (high effort)
○Profit = $1000 with 80% probability and $500 with 20% probability
●When Joe does not work hard (low effort)
○Profit = $1000 with 20% probability and $500 with 80% probability
●If Jack pays a fixed wage, say $150 to Joe, the latter will not put in high effort
●Jack will earn an expected profit of $500 = 0.8 * 500 + 0.2*1000)
●To incentivize to Joe to put in effort, Jack has to connect Joe’s payment to something that
reflects Joe’s effort daily effort
●Extra wage for Joe if higher profit is earned
●Consider the following deal
○Joe is paid $250 if Jack earns $1000 profit (high profit) and $0 otherwise (low
profit of $500)
●Will this incentivize Joe to work hard?
●If Joe works hard (high effort)
○Expected earnings = 0.8 * 250 + 0.2 *0 = $200
●If Joe does not work hard (high effort)
○Expected earnings = 0.2 * 250 + 0.8 *0 = $50
●With the current deal Joe is indifferent
●But a deal that offers net earnings slightly greater than $50 will incentivize hard work
○W = $225 when high profits
●Both parties are better off
○Jack earns higher expected profit of $900
●This is similar to the bonus payment scheme we often see
Externalities
●Perfectly competitive markets assume that the activities in the market affect only its
participants
●Arise whenever the actions of one economics agent directly affect another economic
agent outside the market mechanism
●Market outcomes (equilibrium price and quantity) does not reflect this effect. This caseus
inefficiency
●Therefore, externalities are also an example of market failure
Document Summary
Econ 100b lecture 15 - may 31, 2018. Consider a simple set-up of a kiosk with a single employee joe. If joe works hard daily profit is higher. Profit = with 80% probability and with 20% probability. When joe does not work hard (low effort) Profit = with 20% probability and with 80% probability. If jack pays a fixed wage, say to joe, the latter will not put in high effort. Jack will earn an expected profit of = 0. 8 * 500 + 0. 2*1000) To incentivize to joe to put in effort, jack has to connect joe"s payment to something that reflects joe"s effort daily effort. Extra wage for joe if higher profit is earned. Joe is paid if jack earns profit (high profit) and sh otherwise (low profit of ) Expected earnings = 0. 8 * 250 + 0. 2 *0 = . If joe does not work hard (high effort)
