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Ch.

30: Market Failure


Externalities, Public Goods,
and Asymmetric Information
Del Mar College
John 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

MEC = 0 and MEB = 0; it


No negative or positive
1 externality
follows that MSC = MPC
and MSB = MPB

MEC > 0 and MEB = 0; it


Negative externality but no
2 positive externality
follows that MSC > MPC
and MSB = MPB

MEC = 0 and MEB > 0; it


Positive externality but no
3 negative externality
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 Case
Because 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.
Q2 is the socially optimal
output; Q1 is the market
output. If society moves
The Triangle
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 Case
Because 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 Wrong
Government 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 three
points about pollution:
3. It is a negative
externality.
4. No pollution is
sometimes worse than
some pollution.
5. 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 computer
b) Broadway play
c) Tree in someone’s yard
d) Telephone in service
e) 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
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.