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INFORMATION, MARKET FAILURE AND THE ROLE OF THE GOVERNMENT

Market Failure
Inability of the unregulated market activity to provide desired goods and services at competitive market  Exist when market fails to achieve an optimal allocation of resources  Factors that limit the market to promote efficient use of resources includes: insufficient information, externalities and public goods

Market Behavior with Imperfect Information

For the most part of our analysis of market behavior has assumed that market participants have full information about product s and resources. • For customers, full information involves knowledge about a product’ s price, quality, and availability. • For firms, full information includes knowledge about the marginal productivity of various resources , about the appropriate technology for combining them, and about the demand for the firm’s product. • In reality, reliable information is often costly

. as the search widens. the marginal cost curve for additional information slopes upward.Marginal Cost of Search • Individuals gather the easy and obvious information first • However. the marginal cost of acquiring additional information increases because: —Individuals may have to travel greater distances to check prices and services —The opportunity cost of their time increases as they spend more time acquiring information • Thus.

Optimal Search with Imperfect Information .

additional information yields less and less additional benefits Thus. but as more information is gathered and people grow more acquainted with the market.Marginal Benefit of Search • • • The marginal benefit from acquiring additional information is better quality at a given price or a lower price for a given quality The marginal benefit is relatively large at first. the marginal benefit curve for additional information slopes downward. .

Optimal Search with Imperfect Information .

Note also that at some point the value of additional information reaches zero. Note that at search levels exceeding the I*.Optimal Search with Imperfect Information • Market participants will continue to gather information as long as the marginal benefit of additional information exceeds its marginal cost  optimal search occurs when the marginal benefit equals the marginal cost at point I*. Ip. the marginal benefit of additional information is still positive. • . This level of information is identified as perfect information.

Asymmetric Information in Product Markets • The issue of costly and limited information becomes more complicated when one side of the market has more reliable information than does the other side  asymmetric information • Two types of information that a market participant may want but lack: – One side of the market may know more about characteristics of the product for sale than the other side knows  asymmetric information problem involves hidden characteristics .

Asymmetric Information in Product Markets ◦ A second type of problem occurs when one side of a transaction can pursue an action that affects the other side but that cannot be observed by the other side ◦ Whenever one side of an economic relationship can take a relevant action that the other side cannot observe. the situation is described as one of hidden actions .

Hidden Characteristics: Adverse Selection • One type of hidden-characteristic problem occurs when sellers know more about the quality of the product than do buyers. such as the market for used cars The seller of a used car normally has abundant personal experience with important characteristics of that car While buyers have much less information • • .

there are many tasks that individuals do not perform for themselves because others do them better and have a lower opportunity cost This leads to the second problem which occurs because one side of a transaction can pursue hidden actions that affect the other side  .Hidden Actions: Principal-Agent Problem  In the age of specialization.

in the expectation that the agent will act on behalf of the principal – The problem arises when the goals of the agent are incompatible with those of the principal and when the agent can pursue hidden actions .Hidden Actions: Principal-Agent Problem • When buyers have difficulty monitoring and evaluating the quality of goods or services purchased. some suppliers may substitute poor-quality resources or exercise less diligence in providing the service • This is called the principal-agent problem – Describes a situation in which one party. contracts with another party. the principal. the agent.

Asymmetric Information in Insurance Markets • In the insurance market. not the sellers. it is the buyers. who have more information about the characteristics and actions that predict their likely need for insurance in the future If the insurance company has no way of distinguishing among applicants it must charge those who are good health risks the same as those who are poor ones • .

but will seem too high to good health risks. the insured group becomes less healthy on average  rates must rise  insurance is even less attractive to healthy people  adverse selection tends to make insurance buyers less healthy than the population as a whole .Asymmetric Information in Insurance Markets • This price is attractive to poor health risks. some of whom will choose not to buy insurance • As the number of healthy people who don’t buy insurance increases.

Asymmetric Information in Insurance Markets • The insurance problem is compounded by the fact that once people buy insurance. their behavior may change in a way that increases the probability that a claim will be made This incentive problem is referred to as moral hazard  occurs when an individual’s behavior changes in a way that increases the likelihood of an unfavorable outcome • .

moral hazard is a principal-agent problem since it occurs when those on one side of a transaction have an incentive to shirk their responsibilities because the other side is unable to observe them .Asymmetric Information in Insurance Markets  More generally.

Coping with Asymmetric Information • There are ways of reducing the consequences of asymmetric information – An incentive structure or an informationrevealing system can be developed to reduce the problem associated with the lopsided availability of information • Lemon laws that offer compensation to buyers of new or used cars that turn out to be lemons – Health insurance companies use a variety of tools • Physical exams and filling out questionnaires • Deductibles .

if the productivity of each particular worker is easily quantified that measure can be used and serves as a basis for pay  .Asymmetric Information in Labor Markets  Differences in the ability of labor present no particular problem as long as these differences can be readily observed by the employer That is.

because a worker’s ability is not observed prior to employment  hidden characteristics • . the employer may not be able to attribute specific outputs to each particular worker An adverse-selection problem arises in the labor market when labor suppliers have better information about their own productivities than do employers.Asymmetric Information in Labor Markets • But because production often takes place through the coordinated efforts of several workers.

Asymmetric Information in Labor Markets • In a labor market with hidden characteristics. employers might be better off offering a higher wage  makes the job more attractive to morequalified workers Paying a higher wage gets at the problem of hidden actions by workers • • Paying a higher wage to attract and retain more-productive workers is called paying efficiency wages .

Externalities An effect from one activity which has consequences for another activity but is not reflected in market price  Two types of externalities are: external diseconomies of production or consumption (negative externality) and external economies of production or consumption (positive externality)  .

g. smoking (consumption) dumping in lakes and rivers of wastes (production) 1.Types of Externalities External diseconomies of production or consumption – refers to the uncompensated cost impost by the firm or an individual on other firms or individuals based on their actions e. .

Types of Externalities External economies of production or consumption – refers to the uncompensated benefits conferred to firms or individuals by the action of one firm or individual e. .g. attractive garden in front of his or her house education 2.

rather than each individual  Public goods have three characteristics.Public Goods Are commodities the consumption of which has to be decided by society as a whole.  .

. – The consumption of one individual will not deprive others in consuming them.Three characteristics of Public Goods • They yield non-rivalrous consumption. • They are non-excludable. it is impossible to restrict others to do the same. – Individuals cannot abstain from their consumption even if they wanted to. – If one individual consumes them. • They are often non-rejectable.

national weather services  Public goods are examples of a particular kind of externality. each member must consume the same amount of the good or service.Public Goods Example of public goods: national defense.  . public health services.

imposing taxes and subsidies. goods. Property right – is a legally established title to the ownership and use of resources. or services .Role of the Government • • • Existence of market failure implies a potential role for government intervention or regulation Economic instruments to correct market failure: establishing property rights. and direct regulations.

 Pigovian tax – is a tax levied to correct the negative externalities of a market activity  Regulation – legalistic approach that usually involves the setting of standard to be complied with by violators  .Role of the Government The use of taxes to bring private and social costs of production into agreement is known Pigovian taxation.

.True or False      Market Failure is the ability of the unregulated market activity to provide desired goods and services at competitive market. Existence of market failure does not imply a potential role for government intervention or regulation. each member must consume the same amount of the good or service. Public goods are examples of a particular kind of externality. Reliable information is often costly for both consumers and producers. Externality is an effect from one activity which has consequences for another activity but is not reflected in market price.