PART 1 - Externalities (10 points)

A pharmaceutical firm recently received FDA approval for ColdVax, a vaccination that provides immunity against the common cold. The vaccine greatly reduces the chance that somebody gets sick with the cold. Vaccinated individuals are also much less likely to pass along the common cold to others.

a) Does this scenario describe a consumption or production externality? Is the externality positive or negative? Briefly explain why. (2 points)

b) Illustrate this scenario using a plot of supply and demand. For simplicity, assume this is a competitive market and supply and demand are neither perfectly elastic nor perfectly inelastic. Your plot should include lines for supply (S=MPC) and demand (S=MPB). It should also include lines for MSC and MSB, though one of these lines will simply be the supply or demand curve. Indicate as Q_E the equilibrium ColdVax quantity when consumers and producers maximize the own utilities and do not account for the externality. Then indicate as Q* the societal utility-maximizing ColdVax quantity. (3 points)

c) Using your plot from (b), depict how policymakers could use a tax or subsidy (whichever is appropriate) to get the market to reach the societal utility-maximizing ColdVax quantity Q*. Your plot should show the price paid by consumers (P_c), the price received by producers (P_p), and the tax/subsidy (T or S). Briefly explain how the tax or subsidy "fixes" the externality. (3 points)

If you can show everything clearly, you may submit one graph for questions (b) and (c).

d) According to classical economic models, does it matter if this intervention to "fix" the externality happens on the consumer side or the producer side? (That is, if you chose taxation, does it matter if the tax is collected from consumers or producers? If you chose subsidies, does it matter if the subsidies are given to consumers or producers?) Very briefly explain why or why not. (2 points)

PART 2 - Adverse Selection in Insurance Markets (10 points)

Before the Affordable Care Act, New York State's individual insurance market already had some of the Act's policies in place: insurers had to charge everyone the same price ("community rating") and had to offer insurance to anyone who requested a plan ("guaranteed issue"). In this question, we will use the Einav-Finkelstein model of adverse selection discussed in Week 11 to explore this market.

For simplicity, start by assuming the following about New York State's individual insurance market:

• The demand curve for health insurance is downward-sloping and crosses the AC curve at some point.
• The demand curve represents residents' underlying willingness to pay for health insurance.
• There are no fixed costs.
• There is only one health insurance plan, which must be offered to all residents at the same competitive market price. This assumption means that, at any given quantity in the market, P = AC.

Hint: When thinking about how to construct this problem graphically, refer to the graphs on the Week 11 slides for guidance. For this problem, let "Qmax" = 100% of the population.

a) Suppose that the New York State individual insurance market only insures 50% of the population in equilibrium. Draw a graph of this insurance market, including the marginal cost (MC), average cost (AC) and demand (D) curves, assuming adverse selection. Label the axes, curves, price (P_a) and quantity (Q_a) of insurance currently purchased. (3 points)

b) Now, suppose New York adopts a key policy of the 2010 ACA law: penalties for failing to buy insurance. Assume that the penalties are the same for everyone and so they have the effect of raising demand, i.e. willingness-to-pay, at all levels of Q by the same dollar amount. With the penalties in place, the market insures 75% of the population. Repeat the graph from question (a), showing which curves have shifted and labeling the new price (P_b) and quantity (Q_b) of insurance now purchased. (3 points)

If you can show everything clearly, you may submit one graph for questions (a) and (b).

c) Consider two groups of people: the ones who purchased insurance in question (a), and the ones who purchased insurance in question (b) but not in question (a). Which group has lower expected healthcare costs, and how can you tell from the plot? (2 points)

d) How did equilibrium price change from question (a) to question (b)? Briefly explain why adverse selection is responsible for what you found. (2 points)