TOPIC 1: MARKET FAILURE

I. Collective goods
1. Definition of pure public goods
Public goods are:
- Non-rival in consumption: my consuming or making use of the goods does not in any way
affect your opportunities to consume the goods.
- Non-excludable: even if you want to deny someone else the opportunity to consume or
access the public goods, there is no way you can do so.
Examples: flood control systems, public water supplies, street lighting for roads and
motorways, national defense, fireworks displays.

2. Problems of public goods

Public goods often have high fixed costs and large economies of scale.

Problem 1. Non- rivalry in consumption - the demand-site criteria: What is the „right“ price?
A price of zero?
 Problem 2. Non-excludability - the supply-site criteria: Without government intervention
there is no supply

3. Free-rider problem

 This occurs when people can benefit from a good/service without paying anything towards it.
 It also occurs, if people can get away with making only a token contribution (Something less
than their overall benefit)
 If enough people can enjoy a good without paying for the cost – then there is a danger that,
in a free market, the good will be under-provided or not provided at all.
 The free-rider problem is common with public goods – goods with non-excludable benefits,
e.g. if you reduce pollution, everyone in society will benefit. Once pollution is reduced –
everyone has to benefit.
 Therefore, public goods like national defense, street lighting, beautiful gardens may not be
provided in a free market.
 A free rider problem is also said to occur when there is overconsumption of shared
resources. – This is also known as The Tragedy of the Commons. For example, a fisherman
may take a high catch and free ride on other fishermen who are more concerned to preserve
sustainable fish stocks.

4. Mixed goods
Either: Non-rivalty in consumption Or: Non-excludability
 5. The Tragedy of the Commons

The tragedy of the commons is a situation where there is overconsumption of a particular

product/service because rational individual decisions lead to an outcome that is damaging to the
overall social welfare.
The tragedy of the commons theory assumes that when making decisions, people take the course of
action that maximises their own utility. However, if many people seek to do this, the net effect may
be to deplete a resource making everyone worse off in the long run.
Example of Tragedy of the Commons
For example, we may have a plot of land which could tolerate 20 animals grazing per year. This level
is sustainable from year to year.
However, if the land is open, there may be 40 villagers each bringing their own cow to graze the land.
This leads the village green to be overgrazed meaning the village lose this common land.
If there was regulation or a common agreement to limit grazing to 20 cows, then the net welfare
would be much greater for the village as it would last from year to year.
 II. Asymmetric information and irrationality
The phenomenon: One site of the market (either the demand or the supply-site) has a lack of
information regarding to certain characteristics or quality standards of the good

The problem: Incomplete information regarding to quality standards will lead to “adverse selection”
or to “moral hazard”

Thesis: A free market will not show a socially efficient supply

Introduction

We can see what happens when some parties know more than others – asymmetric information

Frequently a seller or producer knows more about the quality of the product than the buyer does

Quality Uncertainty Famous Examples

Asymmetric information is a situation in which a buyer and a seller possess different information
about a transaction

The lack of complete information when purchasing a used car increases the risk of the
purchase and lowers the value of the car

Markets for insurance, financial credit and employment are also characterized by asymmetric
information about product quality

There are two basic models that describe information asymmetry and they are: Adverse

Selection and Moral Hazard.

Adverse selection describes a situation in which one party in a deal has

more accurate and different information than the other party. The party with
less information is at a disadvantage to the party with more information.

Moral hazard occurs when a party that has agreed to a transaction

provides misleading information or changes their behavior because they
believe that they won't have to face any consequences for their actions.
The Market for Used Cars

Perfect information: Assume two kinds of cars – high quality and low quality. Buyers and
sellers can distinguish between the cars. There will be two markets – one for high quality and one for
low quality.

Asymmetric information:  happens when one party to a transaction has greater material
knowledge than the other party.

High quality market SH is supply and DH is demand for high quality

Low quality market SL is supply and DL is demand for low quality

 SH is higher than SL because owners of high quality cars need more money to sell them

DH is higher than DL because people are willing to pay more for higher quality

Conclusion: With asymmetric information:

Since the buyer of a used car is uncertain of the quality, he will look at the "average
quality" in the market – even if the actual quality of this specific item is much higher

Owners of lemons know more about their car than a potential buyer

They will tend to sell such a car at the prevailing market price because that price is
greater than the car's true value

Owners of good cars will be reluctant to sell their vehicles at the prevailing average
price because it is lower than true value

When sellers know the quality of individual cars and buyers know only the average
quality of all the cars, sellers of good cars may voluntarily remove their vehicles from the
market

Low quality goods drive high quality goods out of the market - the lemons problem

The market has failed to produce mutually beneficial trade

Too many low and too few high quality cars are on the market

Adverse selection occurs; the only cars on the market will be low quality cars

Market for Insurance

Older individuals have difficulty purchasing health insurance at almost any price

They know more about their health than the insurance company

Because unhealthy people are more likely to want insurance, the proportion of unhealthy people in
the pool of insured people rises

Price of insurance rises so healthy people with low risk drop out – proportion of unhealthy people
rises, increasing price more

Consequences of adverse selection:

asymmetry to the disadvantage of the demand side → price and quality of supply decline until only
bad quality is exchanged on the market. Market for good quality collapses.

asymmetry to the disadvantage of the supply side → price increases until it is only appropriate for
demanders with bad quality.

on principle, there is an interest for transactions in the sphere of good quality, however, such
transactions cannot occur.

III. Externalities
IV. Natural monopoly