Question

Define the following terms and explain their importance to the study of economics.
a. public good

b. externality

c. irreversible decision

d. moral hazard

e. rent seeking

Answer 1

a. public good: A public good is a product which can be freely consumed by all consumers without reducing its availability or supply for any other consumer. Examples include breathing clean air, use of national defense, etc. These are goods that are usually free of cost to the consumer.

b. externality: An externality is a cost (negative externality) or a benefit (positive externality) which is caused by a producer who has directly not incurred or received the advantages of such a cost or benefit. Most externalities are environmental. For example, a factory producing cigarettes is releasing toxic wastes in a river which is used by villagers. This pollution is an externality. The cigarettes which are smoked cause harm to passive smokers who are not direct smokers of the cigarettes. This is an example of a negative externality.

c. irreversible decision: A decision that is infinitely costly to reverse. Let's say that a farmer is involved in fish farming on a pond. He gets to know that there might be gold mines below the pond. So he decides to drain ut the water, remove his fish farming and dig for gold. This decision is an irreversible decision as in this case it will be extremely costly for the farmer to cover up the mines, dig the pond and start fish farming again.

d. moral hazard: This happens when there is an incentive for a person to take on additional risks as the probable loss which he may incur will be taken care of someone else. A popular example of this is Insurance. Let us say that a person has taken a health insurance. If a party has not entered into the contract in good faith or has suppressed information, there is  a risk to the insurance company. For example a smoker may not have declared his smoking habits but he contracts a disease due to smoking. The cost is borne by the insurance company. So this risk is known as Moral Hazard.

e. rent seeking: This primarily happens with public goods. It is basically a way to enjoy goods without reciprocating or paying for it. On one hand I want good roads, proper defense and on the other hand I do not want to pay taxes. This is a very simple example of a rent seeking behaviour. It takes place when a person or a firm tries to gain additional wealth without any reciprocal contribution towards it.