Market Failures and the Role of Government Chapters 12 and 14.
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Market Failures and the Role of Government
Chapters 12 and 14
Market Failures
• A situation when the market fails to achieve the efficient outcome
Asymmetric Information Monopolies (imperfect competition) Externalities Public Goods
Asymmetric Information
• Situation that exists when some people in the market have better information than others. The people with the least amount of information will choose not to participate in the market
• Examples: Insider trading, markets for lemons, new employment opportunities.
Two Types of Asymmetric Information
• Adverse Selection (hidden characteristics) Things one party to a transaction knows about itself, but
which are unknown by the other party. Lemons, market for insurance
• Moral Hazard (hidden actions) Actions taken by one party in a relationship that cannot
be observed by the other party. Again, the market for insurance Fixed salaries Auto rental market
Possible Solutions
• Signaling Attempt by an informed party to send an observable
indicator of his or her hidden characteristics to an uninformed party.
To be effective, the signal must not be easily mimicked by other types.
Example: Education to signal that you will be a high-productivity employee. Warranties signal product quality.
Possible Solutions• Adverse Selection:
Examples of Private solutions: • Lemons market: high-quality producers may offer
product warranties to signal that their goods are of high quality. This would be a very expensive option for low-quality producers
• Health insurance market: – Company can become better informed about health status– Company can sell GROUP insurance to a company that
employs all health-types– Company can offer different plans. For example, a high-
deductible plan would be purchased by healthier individuals.
Possible Solutions• Adverse Selection:
Examples of Government solutions:• Rules against insider trading• Provides information in many markets (cigarettes,
alcohol), including work environments• Requires certification of skills for authenticity• Truth in advertising laws• Requires financial disclosures for companies with
publicly traded stock• Requires parties to a contract to honor the contract.• Requirement that all drivers purchase liability insurance.
Possible Solutions• Moral Hazard:
Examples of Private solutions: • insurance market:
– Companies don’t offer a complete insurance contract (i.e., deductibles) because they want individuals to bear some of the risk.
• How do firms deal with moral hazard? Government solutions:
• The government faces same information problems. However, the government may do things to ensure a particular level of care (e.g., driving laws)
Mathematical Problems• Suppose we have the following information
regarding the market for used cars.
WTP (buyers) WTA (sellers)
Lemons $2000 $1500
Plums $3000 $2500
• If there are more buyers than sellers and buyers have the same information (or can acquire easily), then all cars should sell at prices = WTP. Surplus is maximized at $500 per car.
Mathematical Problems• Suppose we have the following information
regarding the market for used cars.
WTP (buyers) WTA (sellers)
Lemons (70%)
$2000 $1500
Plums (30%) $3000 $2500
• Suppose buyers cannot observe quality. Is there a market failure? Who benefits? Who is harmed?
Mathematical Problems• Suppose we have the following information
regarding the market for used cars.
WTP (buyers) WTA (sellers)
Lemons (30%)
$2000 $1500
Plums (70%) $3000 $2500
• Suppose buyers cannot observe quality. Is there a market failure? Will any trades take place?
Mathematical Problems• Suppose we have the following information
regarding the labor market.
WTP (firm) WTA (worker)
Bad workers (50%)
$50K $35K
Good workers (50%)
$80K $55K
• Suppose workers are in short supply. Who is hired? At what wage? Is there a market failure.
Mathematical Problems• How might workers signal that they are in fact good
workers? Education. But suppose that students learn nothing that
contributes to their productivity: and that for $25K a good worker can attend college and a bad worker would have to spend an additional $10K (on GMAT prep courses, tutors, foregone wages associated with working twice as hard)
• If education is a signal of quality, what’s the monetary benefit of getting a degree?
• Which set of workers get a degree? Is this signal credible? Who is hired? At what wage?
• If government subsidizes education (which it often does) by $10K, what level of education and wages would prevail?
Market Power • Firms with market
power produce socially inefficient output levels.
Too little output Price exceeds MC Deadweight loss
• Dollar value of society’s welfare loss
MR
PM
QM
Deadweight Loss
MC
D
Q
P
PC
QC
Regulation
• Governments may regulate the price that monopolies charge. Earlier this semester we looked at two ways the
government may regulate price. • P=AC• P=MC (the competitive outcome)
Externalities• Third-party, non-market effects.• Example: Pollution, Cigarette smoking
Caused by the absence of well-defined property rights.
• Government regulations may induce the socially efficient level of output by forcing firms or individuals to internalize pollution costs
DWL: too much is produced and consumed
Externalities in productionPrice/bag of dog food
Quantity of dog food produced in Ogden
S=MPC (marginal internal cost)
D=MPB=MSB
Qu
Pu
MSC=MPC + marginal external cost
Q*
P*
External cost
Externalities in consumption
Price/cigarette
Quantity of cigarettes smoked
S=MPC=MSCD=MPB
Qu
PuDWL
MSB=MPB-marginal external cost
Q*
P*
External cost
ExternalitiesMarket Solutions
• Coase Theorem: Can achieve efficient outcome with no government intervention
No transaction costs Number of bargaining parties is small Property rights are defined, but it doesn’t matter how
they are assigned
• Example: your neighbor mows her lawn at 5am. The marginal damages to you are valued at $6. The marginal benefits to your neighbor are valued at $4.
ExternalitiesGovernment Solutions
• C&C (command and control)• Per-unit emission taxes. Set the tax equal to the
external cost to achieve the efficient outcome. Note: if the externalities are a benefit, then government can use
subsidies, where the subsidy is equal to the external benefit (e.g., education)
• Tradable discharge permit markets• Allow monopolies to exist (e.g., Utah State Liquor
Stores)
• Pollution Control Handout
Public Goods• A good that is nonrival and nonexclusionary in
consumption. Nonrival: A good which when consumed by one
person does not preclude other people from also consuming the good.
Nonexclusionary: No one is excluded from consuming the good once it is provided.
• Examples: Clean air, wilderness areas, to some degree national defense.
• “Free Rider” problem means that public goods will be underprovided if left to the market.
Public Goods
Snowplow Service (monthly)
$
Total demand for snowplow service (vertical summation)
84
54
30
0 30
MC of snowplow service
Individual 1’s demand for snowplow service
Individual 2’s demand for snowplow service
40
3 7
Rent Seeking
• The governments presence in markets provides incentives for firms or individuals to influence government policies.
This undermines the governments ability to make matters better.
• Examples: Tariffs and Quotas. These trade restrictions benefit certain firms and workers, but have a negative effect on consumers (i.e., consumers will pay higher price for these goods and services).
An Example: Seeking Monopoly Rights
• Firm’s monetary incentive to lobby for monopoly rights: A
• Consumers’ monetary incentive to lobby against monopoly: A+B.
• Firm’s incentive is smaller than consumers’ incentives
• But consumers’ incentives are spread among many different individuals
• As a result, firms often succeed in their lobbying efforts.
QM QC
PM
PC
P
Q
MC
DMR
Consumer Surplus
A B
A = Monopoly Profits
B = Deadweight Loss
Summary
• Market power, externalities, public goods, and incomplete information create a potential role for government in the marketplace
• Government’s presence creates rent-seeking incentives, which may undermine its ability to improve matters
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