Market Failure

Ch. 30: Market FailureExternalities, Public Goods,and Asymmetric Information

Del Mar CollegeJohn Daly

©2003 South-Western Publishing, A Division of Thomson Learning

Market Failure

• Market Failure is a situation in which the market does not provide the ideal or optimal amount of a particular good.

• When goods are produced and consumed, side effects occur. These side effects are called externalities because the costs or benefits are external to the person(s) who caused them.

Costs & Benefits: Private & External

• A Negative Externality exists when a person’s or group’s actions cause an adverse side effect to be felt by others.

• A consequence of a negative externality is that social costs do not equal private costs and the socially optimal level of production is not naturally obtained.

• Socially Optimal Output is the output level that takes into account and adjusts for all benefits (external as well as private) and all costs (external as well as private).

Marginal Costs & Benefits

• The sum of marginal private costs (MPC) and marginal external costs (MEC) is Marginal Social Costs (MSC).

• The sum of marginal private benefits (MPB) and marginal external benefits (MEB) is marginal social benefits (MSB).

Social Optimality or Efficiency Conditions

• Socially Optimal Amount (output) is an amount that takes into account and adjusts for all benefits (external and private) and all costs (external and private).

• The socially optimal amount is the amount at which MSB = MSC. Sometimes, the socially optimal amount is referred to as the efficient amount.

Three Categories

Category Definition Meaning In terms of Marginal benefits and costs

1 No negative or positive externality

MEC = 0 and MEB = 0; it follows that MSC = MPC and MSB = MPB

2 Negative externality but no positive externality

MEC > 0 and MEB = 0; it follows that MSC > MPC and MSB = MPB

3 Positive externality but no negative externality

MEC = 0 and MEB > 0; it follows that MSC = MPC and MSB > MPB

Externalities in Consumption and In Production

Externalities can arise because someone consumes something that has an external benefit or cost for others or because someone produces something that has an external benefit or cost for others.

The Negative Externality CaseBecause of a negative externality, marginal social costs (MSC) are greater than marginal private costs (MPC) and the market output is greater than the socially optimal output. The market is said to fail in that it overproduces the good.

The TriangleQ2 is the socially optimal output; Q1 is the market output. If society moves from Q2 to Q1, buyers benefit by an amount represented by the shaded area of Window 1, but sellers and third parties together incur greater costs, represented by the shaded area in Window 2. The triangle, the difference between the two shaded areas, represents the net social cost to society of moving from Q2 to Q1 or producing Q1 instead of Q2.

Positive Externalities

• A Positive Externality exists when a person’s or group’s actions cause a benefit (beneficial side effect) to be felt by others.

• A consequence of a positive externality is that social benefits do not equal private benefits and the socially optimal level of production is not naturally achieved.

The Positive Externality CaseBecause of a positive externality, marginal social benefits (MSB) are greater than marginal private benefits (MPB) and the market output is less than the socially optimal output. The market is said to fail in that it underproduces the good.

Q & A

• What is the major difference between the market output and the socially optimal output?

• For an economist, is the socially optimal output preferred to the market output?

Internalizing Externalities

• An Externality is Internalized if the persons or group that generated the externality incorporate into their own private or internal cost-benefit calculations the external benefits (in the case of a positive externality) or the external costs (in the case of a negative externality) that third parties bear.

• An externality has been internalized or adjusted for completely if, as a result, the socially optimal output emerges.

Persuasion and Assigning Property Rights

• Many negative externalities arise partly because persons or groups do not consider other individuals when they decide to undertake an action. Trying to persuade those who impose external costs on us to adjust their behavior to take these costs into account is one way to make the imposer adjust for – or internalize – externalities.

Taxes and Subsidies

• Taxes and subsidies are sometimes used as corrective devices for a market failure. A tax adjusts for a negative externality, a subsidy for a positive externality.

• One way to deal with externalities is for government to apply regulations directly to the activities that generate the externalities. Critics of this approach note that regulations are difficult to remove, may be inappropriate in every circumstance and entail costs.

A Corrective Tax Gone WrongGovernment may miscalculate external costs and impose a tax that moves the supply curve from S1 to S3, instead of from S1 to S2. As a result, the output level will be farther away from the socially optimal output than before the “corrective” tax was applied. Q3 is farther away from Q2 than Q1 is from Q2.

Assigning Property Rights

If someone owns a resource, then actions that damage it have a price; namely, the resource owner can sue for damages. By having something owned, the owner can then sue for damages.

Voluntary Agreements

• Externalities can sometimes be internalized through individual voluntary agreements.

• A negative externality problem can be successfully addressed by entering into a voluntary agreement if the transaction costs are low relative to the expected benefits of the agreement.

Coase Theorem• In the case of trivial or zero transaction costs, the property

rights assignment does not matter to the resource allocative outcome.

• In the case of trivial or zero transaction costs, a property rights assignment will be undone if it benefits the relative parties to undo it.

• In the case of trivial or zero transaction costs, the resource allocative outcome will be the same no matter who is assigned the property right.

• This theorem is important for two reasons: it shows that under certain conditions the market can internalize externalities; it provides a benchmark for analyzing the externality problems.

Beyond Internalizing: Setting Regulations

• One way to deal with externalities, in particular with negative externalities, is for government to apply regulations directly to the activities that generate the externality.

• Critics of this approach often note that regulations, once instituted, are difficult to remove even if conditions warrant removal.

• Regulation entails cost.

Q & A

• What does it mean to internalize an externality?• Are the transaction costs of buying a house higher

or lower than the transaction costs of buying a hamburger at a fast-food restaurant? Explain your answer.

• Does the property rights assignment a court makes matter to the resource allocative outcome?

• What condition must be satisfied for a corrective tax to correctly adjust for a negative externality?

The Environment

Economists have threepoints about pollution:1. It is a negative

externality.2. No pollution is

sometimes worse than some pollution.

3. The market can be used to deal with the problem of pollution

When Is No Pollution Worse Than Some Pollution?

• When all other things are held constant, no pollution is worse than some pollution.

• Pollution is a by-product of many goods and services; with the current state of pollution technology, no pollution means no products that create pollution as an externality: steel mills, automobile plants, computers.

• Zero pollution is not preferable to some positive amount of pollution when the goods and services must be forfeited to have less pollution.

Two Methods to Reduce Pollution

• Government Sets Pollution Standards: the effected businesses must all meet the same standards, even though some businesses pollute more than others.

• Market Environmentalism at Work: Government Allocates Pollution Permits, Then Allows Them To Be Bought and Sold: the effected businesses buy and sell the permits to lower the price of fighting pollution.

Q & A

• The layperson finds it odd that economists often prefer some pollution to no pollution. Explain how the economists reach this conclusion.

• Why does reducing pollution cost less by using market environmentalism than by setting standards?

• Under market environmentalism, the dollar amount firm Z has to pay to buy the pollution permits from firms X and Y is not counted as a cost to society. Why not?

Public Goods: Excludable and Nonexcludable

• Rivalrous in Consumption: a good is rivalrous in consumption if its consumption by one person reduces its consumption by others.

• A Private Good is a good the consumption of which by one person reduces the consumption for another person.

• A Public Good is a good the consumption of which by one person does not reduce the consumption by another person. Public Goods are nonrivalrous in consumption.

• A Public Good is Excludable if it is possible, or not prohibitively costly, to exclude someone from obtaining the benefits of the good after it has been produced.

Nonexcludable Public Goods

• A Public Good is Nonexcludable if it is impossible, or prohibitively costly, to exclude someone from obtaining the benefits of a good after it has been produced.

• National Defense, for example, is a nonexcludable public good.

Free Riders

• Free Riders are individuals who obtain the benefits of a nonexcludable public good without paying for it.

• Most economists hold that the market will fail to produce nonexcludable public goods, or at least fail to produce them at a desired level because of free riders.

• The free rider argument is the basis for accepting government provision of nonexcludable public goods. However, a nonexcludable public good is not the same thing as a government-provided good.

• The free rider problem only occurs with goods that are nonexcludable.

Q & A• Why won’t the market produce nonexcludable public

goods?• Identify each of the following goods as a nonexcludable

public good, an excludable public good, or a private good: a) Personal computerb) Broadway playc) Tree in someone’s yardd) Telephone in servicee) Sunshine

• Give an example, other than a movie in a movie theater, or a play in a theater, of a good that is nonrivalrous and excludable.

Asymmetric Information

• Asymmetric information exists when either the buyer or the seller in a market exchange has some information that the other does not have.

• Information can cause the buyer or seller to lower the demand or supply of the good in question.

Asymmetric Information in a Product

Market

Initially, the seller has some information that the buyer does not have; there is asymmetric information. As a result, D1 represents the demand for the good and Q1 is the equilibrium quantity. Then, the buyer acquires the information that she did not have earlier and there is symmetric information. The information causes the buyer to lower her demand for the good so that now D2 is the relevant demand curve and Q2 is the equilibrium quantity. Conclusion: Fewer units of the good are bought and sold when there is symmetric information than when there is asymmetric information.

Asymmetric Information in a Factor

Market

Initially, the buyer (of the factor labor), or the firm, has some information that the seller (of the factor) does not have; there is asymmetric information. Consequently, S1 is the relevant supply curve. W1 is the equilibrium wage, and Q1 is the equilibrium quantity of labor. Then, sellers acquire the information that they did not have earlier, and there is symmetric information. The information causes the sellers to reduce their supply of the factor so that now S2 is the relevant supply curve, W2 is the equilibrium wage, and Q2 is the equilibrium quantity of labor. Conclusion: Fewer factor units are bought and sold and wages are higher when there is symmetric information than when there is asymmetric information

Is There Market Failure?• Asymmetric information seemingly resulted in “too much”

or “too many” of something – either too much of a good being consumed or too many workers working for a particular firm.

• The point is whether or not the asymmetric information fundamentally changes the outcome from what it would be if there were symmetric information.

• The presence of asymmetric information does not guarantee that the market fails. What matters is whether the asymmetric information brings about a different outcome than the outcome that would exist if there were symmetric information. If this occurs, the case for market failure can be made.

Adverse Selection• Some economists argue that

under certain conditions, information problems can eliminate markets or change the composition of markets.

• Adverse selection exists when the parties on one side of the market, who have information not known to others, self – select in a way that adversely affects the parties on the other side of the market.

• Asymmetric Information leads to adverse selection.

Moral Hazard

• Asymmetric information can also exist after a transaction has been made. If it does, it can cause a moral hazard problem.

• Moral Hazard occurs when one party to a transaction changes his behavior in a way that is hidden from and costly to the other party.

Q & A

• Give an example that illustrates how asymmetric information can lead to more of a good being consumed than if there is symmetric information.

• Adverse selection has the potential to eliminate some markets. How is this possible?

• Give an example (not discussed in the text) that illustrates moral hazard.