CHAPTER 6: Market Failure CONTENT 1. Inclusion of discussion of Pareto efficiency. 2. (@)_ Examples of private goods, public goods and merit goods. (b) Discussion of issues of rivalry and exclusion, 3. Social costs, private costs, social benefits, private benefits, external costs, external benefits, Use of graphical representations. 4. Divergence of social costs and social benefits and efficiency. Use of graphical representations, 5. Deadweight loss including verbal and graphical representations, 6. Causes of market failure: (a) monopoly; (W)__public goods and merit goods; (0 _extemalites: positive and negative; (@ divergence between social and private costs and social and private benefits; (©) imperfect information; (asymmetric information: adverse selection and moral hazard; (® open access to resources; (&) lack of property rights (squatting, streams, ocean); (non-existence of markets (for trading). 134Efficiency In economics there are various dimensions of efficiency. Efficiency is concerned with the optimal production and distribution of scarce factors of production. Economic efficiency is also known as Pareto Efficiency or Pareto optimality. The term was named after Vilfredo Pareto the italian economist who pioneered studies in resource allocation and income distribution. The concept of Pareto efficiency can be illustrated as follows; given a set of different combinations of ‘outcomes for a group of individuals, switching from one alternative combination to another which makes at least one individual better off without making another worse off is known as a Pareto improvement or a Pareto optimal move. A given allocation is therefore Pareto optimal when no further Pareto improvements are possible. Alternatively, Pareto efficiency occurs when It is not possible to improve the allocation to one outcome without reducing allocations to any other outcome. Pareto efficiency is best illustrated along the boundary of the production possibilty frontier. Such that, increasing production of the x-axis good or service requires a fall in the production of the y-axis good or service. Private Goods ‘A private good in economics is defined as any good which is excludable and rivalrous. The excludable property of such goods relate to the fact that itis possible to prevent consumers from consuming it. The rivalrous nature of the good implies that the consumption of the same good cannot occur simultaneously by more than one consumer. In this regard private goods are very different from public goods which are by nature non-rivalrous. An example of a private good can be bread. Consider that bread eaten by one person cannot be consumed by another (rivalrous nature), coupled with the fact that a bakery reserves the right to refuse to trade a loaf (excludable nature). Public Goods : Public goods are non-rivalrous in nature. This means that several people can consume the good at the same time. E.g. a hamburger is a private good and can only be consumed by one person at a time, whilst a public park offers benefits to several users at the same time. Public goods are also non-excludable, meaning that it is difficult or impossible to exclude other users. E.g. with a national defense system, all citizens benefit i.e. non nationals living in the country, cannot be ‘excluded from benefiting from the national defense system even though they may not be paying taxes, Even more, the cost of this public good to a new migrant worker is zero. The free market system therefore fails in that some Individuals can enjoy these goods at no economic cost. This is known as the “free-rider” problem, 135Merit Goods Merit goods refer to those goods and services that the free market, working through the price mechanism, would only be able to provide in limited quantities. In this regard, a government wishing to see more merit goods on the market (examples of which include secondary school education) may intervene and increase the existing supply by engaging in the production and supply of this commodity. With a merit good at the price Py the free market will produce Qp. Let us assume the relevant good is. secondary school places. If government believes that from a developmental perspective it requires a ‘greater number of its citizens to benefit from secondary school education then it can intervene on the market and increase the existing supply by Q1 ~ Qo by building public secondary schools. The net effect is that the overall cost of secondary school education falls to P, with Q, places utilized. Figure 6.1: Market for Secondary School Places So $ Secondary School Places S)= So + Government Supply of public school places Secondary School Places Private Costs and Social Costs Private benefits and Social benefits Private costs refers to the costs borne by the individual decision maker. Note that these costs are based (on actual market prices. Social costs refer to the total costs borne by the commumity for a particular decision. Social costs in this regard is equal to the sum of private costs plus the externalities faced by third parties, accociated with a particualr decision. In this case also costs are based on market prices and opportunity costs are also considered. 136Private benefits refer to the returns which accrue to the individual decision maker. Social benefits on the other hand refer to the desirable results which accure to third parties of a particular decision, Competitive Markets and Efficiency Goods and services are produced by the market, the government as well as by the bounties of nature. Society values goods and services produced ‘by the market differently from goods produced by government and goods produced by the bounties of nature. As a consequence the level of certain types of goods may be overproduced or underproduced. Take merit goods for example, (as in the diagramatic illustration above) the market underproduces the optimum level of merit goods and as such governments intervene to increase output of such goods in order to expand access, Governments may also intervene in some markets to expand the output produced as in the case with merit goods or may intervene to reduce the amount of goods produced as with demerit goods. Alternatively siad governments intervene to increase the production of those goods which have positive externalities and intervene to decrease the production of those goods which have negative externalities. ‘The theory of the firm indicates that profits are maximized or in other words private producer benefits are maximized at the point where marginal benefit (marginal revenue) equals the marginal cost of production, To determine the quantity of output which is optimal for the society as a whole, social benefits and costs must also be considered. Societal efficiency occurs where the marginal social benefit derived from the production of a good is exactly equal to its marginal social cost. Illustratively therefore a situation where negative externalities occur as a result of a particualar production decision, marginal social costs tends to be higher than marginal private costs. Alternatively ‘when positive externalities accrue, marginal social benefits are greater than marginal private benefits. Figure 6.2: Pos Externalities ‘MPC Socially Optimal Levels, QtyDeadweight Loss Deadweight loss refers to the market inefficiency caused by any type of intervention, Deadweight losses ‘can occur when price floors, price cellings, taxes or subsidies are imposed on a market. The following diagrams illustrate these losses. Figure 6.3: Deadweight loss in various situations, Deadweight Loss Tx ep rene cou » 4 - s Deadweight ae loss r>—_, D D > > i ' Q ier Q@ Q Imposition of «Tax Imposition o Price Floor ’ s Government Sfpported Prige Deadweight Loss Imposition of a Price Ceiling Price Ceiling D D > > Qs Qa Q aa Q@ Q Imposition of a Government S 138Market Failure Market failure arises when the economy is unable to produce an efficient level of output and as such, there is either underproduction or overproduction taking place. Market failure is a prominent feature of the free market system. Causes of Market Failure When the market does not result in an efficient allocation of scarce resources, we say that the market has falled. Market failure emerges in an environment in which the decision makers are not exposed to the full costs and benefits associated with their economic activity. Market failure principally occurs when the price of a commodity is not determined by the interaction of its demand and supply curves. If the market conditions that promote the efficient allocation of scarce resources do not exist, then the net benefit from a particular economic activity will not be fully realized. {In markets that work efficiently, the price on the market is determined by the interaction of demand and supply, implying that decision-making is conditioned by the collective actions of many independent consumers and suppliers. In some free markets, however, for a variety of reasons powerful buyers and sellers can emerge. When a single buyer or single group of buyers dominate a market itis possible that they will try to establish a price below marginal costs, whilst if a seller dominates the market, it Is possible she will try to set price above marginal costs. For market efficiency, price should be equal to marginal costs but in these types of circumstances there is a distortion between marginal cost and prices. Some of the other specific reasons why market failure may occur in a given market can include; 1. Formation of monopolies Imperfect market conditions also lead to the development of monopolies. Monopolies emerge due to information asymmetries and other types of barriers to entry. Monopolies can potentially be exploitative towards consumers given the specific market characteristics under which these firms operate. Monopolies tend to sell relatively price inelastic commodities as the market structure has no close substitutes. 2. Existence of Externalities Externalities often arise out of the fact that there is a divergence between social and private costs and social and private benefits. Negative externalities exist when marginal social cost exceeds marginal private cost. Negative externalities are often associated with over production of a good. Environmental pollution is one type of negative externality for which the social cost incurred far exceeds that of the private costs. There are also positive externalities. Positive externalities accrue when marginal social benefit exceeds marginal private benefit and is often associated with a situation where the good produced by the market is lower than the optimal level required by society. The existence of market failure does not necessarily require government intervention as this can often make the situation worse, Nevertheless, public sector involvement is often the main way of dealing with market failure, 3. Information Asymmetry ‘Asymmetric information occurs when some economic agents know more than others. 139> ‘Applied Example: The Market for Cars If an individual buys a car for $50,000 and uses up 80 miles of driving and decides to sell, he may not be able to get more than $40,000. The car has lost value not only because of the fact that it was driven for 80 miles but because of the asymmetric information involved. Asymmetric information in this case emerges because the seller knows more about the used car than the buyer. For example, the new buyer will always be guessing in that the buyer will want to know why the current owner is seling Keynes view on Market Faure: Information Asymmetry Keynes alluded to the importance of the role of the state, primarily because he identified that markets do not function efficiently, as information asymmetries and market imperfections arise, Keynes insisted on state intervention in situations where the markets themselves either under-produced ‘merit goods or over-produced demerit goods. He also suggested a role for the state in the production of public goods, which are not produced by the private sector. He identified externalities as another type of ‘market failure, defined as both the negative and positive effects of the activity of an economic agent on other agents in the economy. Keynes insisted on specific interventions such as taxation and subsidies to encourage production of those commodities, which are produced in quantities below the socially optimal level, and discourage the production of those commodities, which are produced in quantities above the socially optimal level, 4. Adverse Selection and Moral Hazard ‘Adverse selection is the term used in economics to illustrate how information asymmetry can negatively affect market outcomes. In particular, either buyers or sellers lack complete information that they can adversely select ‘bad’ products or ‘bad! customers respectively. For example, organizations and institutions from which credit can be accessed now have facilities where information on the quality of the applicant can be accessed and disseminated. Information is shared among organizations in this industry through computerized credit histories. This faclty is now being widely used to reduce the extent of information asymmetry when firms negotiate transactions with consumers. ‘The Computerized Credit Histories is a facility which can be accessed to determine the credit worthiness of an applicant. It gives a detailed outlook of the individual's credit history and credit report. This type of information is essential in helping the lending institution make the most optimal decision in order to minimize its own risk of losses. Moral Hazard Moral Hazard behaviour occurs when an insured party has the ability to influence the probability of the event on which payments are made. Let us consider the diagram in 6.4 below 140Figure 6.4: Ilustration of Moral Hazard Consumption 8.Pin. Py Qa @ Qh. ‘Assume that the market for medical services is such that at the price level of $P; the quantity traded of health care is Q;. With health insurance $P; ~ Py dollars is provided by the health insurers. The consumption of Qa ~ Q: extra units of health care represents moral hazard consumption. By lowering the cost of a commodity the allocation of resources to that commodity is affected. a. Implications of Asymmetric Information Ina world of information asymmetry, markets fail resulting in ill-informed decisions by consumers. Ultimately in-such situations consumers lose out. i. Asymmetric Information and Health Care People over 65 years generally find it difficut to get insurance, as older people are more prone to a wider range of illnesses. But the price of insurance does not necessarily increase to reflect this greater risk because people who buy insurance generally know more about their health than the insufance companies. People who are ill or potentially ill are more likely to choose insurance than healthier people. This means that of all the insured people, the proportion of people who are unhealthy is relatively higher than the healthy ones. As the proportion of unhealthy people in the poo! of insured people increases, there will be an increase in demand for insurance claims. The price of insurance will need to increase even further. As the price of Insurance increases healthy people will choose less, ceteris paribus. Asymmetric Information and the Financial Sector A credit card allows the holder to access credit without collateral. Many people carry credit cards from several different financial institutions. Ideally credit card companies will prefer to charge a high rate of interest to low quality borrowers and a low rate of interest to high quality borrowers. Unfortunately because credit card companies are forced to charge the same rate of interest to all borrowers, a greater quantum of low quality borrowers participate at a low rate of interest. When these low quality borrowers 14default on their credit, the price of credit, the rate of interest, Increases. This drives high quality borrowers out of the market, so that it eventually becomes dominated by low quality borrowers. This creates a cycle that can destroy the market for credit. 5. Public and Merit Goods. Public Goods are non rivalrous and non excludable and as such the market which is profit driven does not generally produce such goods. Regarding merit goods, however the market does not produce enough of this type of good. To correct for the shortfalls in market production, the government intervenes to produce public goods and to increase the supply of merit goods available to the society. 6. Open Access to Resources ‘There are some goods which are non excludable but rvalrous; these are common goods or common-pool resources. For such goods consumers have open aécess to common goods such as fish stocks and public health care. Markets for such goods are nonexistent. 7. Lack of property rights ‘The lack of property rights may result in a situation where infringement or the unauthorized use of Property or even intellectual property may occur. Weak institutional support and enforcement may also result in this type of situation, 142