market failure
- the failure of unregulated market system to achieve allocative efficiency
reasons for market failure
- market power
- presence of an externality
- type of good dealth with is a public good
- imperfect information
market power
occurs because
- only a few firms can operate at low cost - as firm gets bigger cost of production decreases making it harder for other firms to enter
- firms sell differentiated products and have some ability to set prices
- firms innovate and gain a temporary monopoly
externalities
- cost or benefit to an external third party
- external cost: too much produced, corrected with taxes, social MCs > private MCs
- external benefit: too little produced, corrected with subsidies or providing goods
private cost
- value of best alternative use of resources used in production as valued by producer
social cost
- value of best alternative use of resources as valued by society
rivalrous good
- if ones person’s consumption of one unit of good means that no one else can also consume it
excludable good
- when people can be prevented from consuming good
rivalrous and excludable goods:
private goods
- ex. an hour of legal advice, a seat on a plane
rivalrous and non excludable goods
- common resource properties
- ex. envronment
non rivalrous and excludable goods
- club goods
- ex. art galleries, roads, cable tv
non rivalrous and non excludable goods
- public goods
- ex. national defence, public information
public goods
- since non excludable, cant prevent anyone from using them once provided
- presents free rider problem, so gov needs to provide public goods
free rider problem
- if provider charged a price, non payers would take a free ride at the expense of those with a social conscience
what public goods should be provided
- goods whose benefits > costs
- if cost collection from individuals is infeasible, covering costs of provision means that taxation is unavoidable
generating market demand curve for private good
- add individual demand curves horizontally
- for a given price add individual quantities
generating demand curve for a public good
- to construct demand curves for a public good add the individual demand curves vertically
optimal provision of a public good
- societies marginal benefit = sum of individual marginal benefit curves
- allocatively efficient quantity is Q* (MB = MC)
imperfect information
- lack of info leads to inefficiency
- uncertainty that can be reduced if more effort/resources are invested in getting indo
- or uncertainty that cant be eliminated due to the nature of the market or incentives to not disclose true info
- one party can often take advantage of special knowledge that can change nature of transaction
asymmetric info
- one party has more info than the other
- invisible hand doesnt assure that optimal amount of info will be available to consumers
- buyers and sellers not equally informed about characteristics of goods
why are differences in who knows what a problem
- adverse selection and moral hazards
adverse selection
- tendency of people who are more at risk than average to purchase insurance and for those who are less likely to purchase insurance
- ex. sickly more likely to purchase
moral hazard
- when one party has both incentive and ability to behave in a way that shifts costs to other party
- arises from insurance contracts- ex. not installing a smoke alarm bc u have insurance
adverse selection: lemons model
- asymmetric info reduces average quality of goods offered for sale
- after you buy a car, more likely to sell if its a lemon
- buyers know that cars in used car market are more likely to be lemons
- price buyers for used cars falls
- makes it more likely for owners of good cars to not sell
- death spiral
