Chapter Six Market Failure Basic Concepts Market failure

Chapter Six Market Failure

Basic Concepts ØMarket failure occurs because of either: ØProductive inefficiency where firms are not maximizing output from given factor inputs. The lost output from inefficient production could have been used to satisfy more wants and needs. ØAllocative inefficiency where resources are misallocated and producing goods and services and resources can be put to a better use so that a higher level of wants and needs can be satisfied

Basic Concepts Ø Economic efficiency occurs when any change that benefits someone would result in harm for someone else. Ø Note that technical efficiency is a necessary condition for economic efficiency since a movement toward the production possibilities curve would benefit one or more individuals. Ø When one person cannot be made better off without making someone else worse off is called economic efficiency.

Couses/sources of Market Failure Ø Externalities, Ø Common property resources, Ø Public goods, and Ø Asymmetric information.

Externalities Ø When a market outcome affects parties other than the buyers and sellers in the market, side-effects are created called externalities. Ø Externalities cause markets to be inefficient, and thus fail to maximize total surplus. Ø It arises when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect.

Types of Externalities ØWhen the impact on the bystander is adverse, the externality is called a negative externality. ØExample Automobile exhaust, Cigarette smoking, Barking dogs (loud pets) ØWhen the impact on the bystander is beneficial, the externality is called a positive externality. ØExample Immunizations, Restored historic buildings and Research into new technologies

Internalizing Production Externalities Ø Taxes are the primary tools used to internalize negative externalities. Ø Subsidies are the primary tools used to internalize positive externalities.

Externalities and Market Inefficiency Ø Negative externalities in production or consumption lead markets to produce a larger quantity than is socially desirable. Ø Positive externalities in production or consumption lead markets to produce a larger quantity than is socially desirable.

Possible government action to allow for externalities Ø A variety of methods ØFirstly, It may introduce a pricing system to bring externalities into consideration ØFor example, to deal with congestion, parking-meters may be installed, with even local residents charged for reserved parking permits

Possible government action… ØSecondly, taxation and subsidies may take the idea of charging a stage further. ØThirdly, physical control which is frequently used in the field of land resources to minimize externalities. ØPlanning and building regulations must are regarded as a means of physical control. ØBy imposing conditions on proposed development, it is possible to minimize external costs arising

Possible government action… ØFourth, the government may itself assume responsibility for providing certain goods and services. Øof national importance, for example, the National Rivers Authority can coordinate drainage, water supply and angling interests in order to maximize net benefits; Øso extensive that only government authority can adequately allow for them - for example, providing a major airport

Private Solutions to Externalities ØGovernment action is not always needed to solve the problem of externalities. ØThe Coase Theorem states that if private parties can bargain without cost over the allocation of resources, then the private market will always solve the problem of externalities on its own and allocate resources efficiently. ØHowever Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.

The Different Kinds of Goods Ø When thinking about the various goods in the economy, it is useful to group them according to two characteristics: Ø Is the good excludable? People can be prevented from enjoying the good. Laws recognize and enforce private property rights. u Is the good rival? One person’s use of the good diminishes another person’s enjoyment of it.

Four Types of Goods ØPrivate Goods: Are both excludable and rival ØPublic Goods: Are neither excludable nor rival ØCommon Resources: Are rival but not excludable ØNatural Monopolies : Are excludable but not rival.

Types of Goods Rival? Yes Private Goods Yes Excludable? No · Ice- cream cones · Clothing · Congested toll roads No Natural Monopolies · Fire protection · Cable TV · Uncongested toll roads Common Resources Public Goods · Fish in the ocean · The environment · Congested nontoll roads · National defense · Knowledge · Uncongested nontoll roads

The Free-Rider Problem ØA free-rider is a person who receives the benefit of a good but avoids paying for it. ØSince people cannot be excluded from enjoying the benefits of a public good, individuals may withhold paying for the good hoping that others will pay for it. ØThe free-rider problem prevents private markets from supplying public goods.

Solving the Free-Rider Problem ØThe government can decide to provide the public good if the total benefits exceed the costs. ØThe government can make everyone better off by providing the public good and paying for it with tax revenue.

Common Resources Ø Common resources, like public goods, are not excludable. They are available free of charge to anyone who wishes to use them. Ø Common resources are rival goods because one person’s use of the common resource reduces other people’s use.

Tragedy of the Commons The Tragedy of the Commons is a story with a general lesson: When one person uses a common resource, he or she diminishes another person’s enjoyment of it. u Common resources tend to be used excessively when individuals are not charged for their usage. u This creates a negative externality. u Example : Clean air and water, Oil pools, Congested roads, Fish, whales, and other wildlife

Why Isn’t the Cow Extinct? (As opposed to other animals!) Private Ownership and the Profit Motive!

Imperfect information ØAsituation in which buyers and sellers are not equally well informed about the characteristics of products or service. ØAdverse Selection Ø Adverse selection arises when products of different qualities are sold at a single price because buyers or sellers are not sufficiently informed to determine the true quality at the time of purchase. As a result, too much of the low-quality product and too little of the highly-quality product are sold in the market place. .

Moral Hazard Ø Insurance affects people’s incentives to avoid whatever contingencies they are insured against. Ø A person who has no fire insurance on a house, for example, may choose to limit the risk of fire by buying smoke alarms and home fire extinguishers and being especial cautions.