Market Failures and the Role of Government

Chapters 12 and 14

Market Failures

• A situation when the market fails to achieve the efficient outcome

Asymmetric Information Monopolies (imperfect competition) Externalities Public Goods

Asymmetric Information

• Situation that exists when some people in the market have better information than others. The people with the least amount of information will choose not to participate in the market

• Examples: Insider trading, markets for lemons, new employment opportunities.

Two Types of Asymmetric Information

• Adverse Selection (hidden characteristics) Things one party to a transaction knows about itself, but

which are unknown by the other party. Lemons, market for insurance

• Moral Hazard (hidden actions) Actions taken by one party in a relationship that cannot

be observed by the other party. Again, the market for insurance Fixed salaries Auto rental market

Possible Solutions

• Signaling Attempt by an informed party to send an observable

indicator of his or her hidden characteristics to an uninformed party.

To be effective, the signal must not be easily mimicked by other types.

Example: Education to signal that you will be a high-productivity employee. Warranties signal product quality.

Possible Solutions• Adverse Selection:

Examples of Private solutions: • Lemons market: high-quality producers may offer

product warranties to signal that their goods are of high quality. This would be a very expensive option for low-quality producers

• Health insurance market: – Company can become better informed about health status– Company can sell GROUP insurance to a company that

employs all health-types– Company can offer different plans. For example, a high-

deductible plan would be purchased by healthier individuals.

Possible Solutions• Adverse Selection:

Examples of Government solutions:• Rules against insider trading• Provides information in many markets (cigarettes,

alcohol), including work environments• Requires certification of skills for authenticity• Truth in advertising laws• Requires financial disclosures for companies with

publicly traded stock• Requires parties to a contract to honor the contract.• Requirement that all drivers purchase liability insurance.

Possible Solutions• Moral Hazard:

Examples of Private solutions: • insurance market:

– Companies don’t offer a complete insurance contract (i.e., deductibles) because they want individuals to bear some of the risk.

• How do firms deal with moral hazard? Government solutions:

• The government faces same information problems. However, the government may do things to ensure a particular level of care (e.g., driving laws)

Mathematical Problems• Suppose we have the following information

regarding the market for used cars.

WTP (buyers) WTA (sellers)

Lemons $2000 $1500

Plums $3000 $2500

• If there are more buyers than sellers and buyers have the same information (or can acquire easily), then all cars should sell at prices = WTP. Surplus is maximized at $500 per car.

Mathematical Problems• Suppose we have the following information

regarding the market for used cars.

WTP (buyers) WTA (sellers)

Lemons (70%)

$2000 $1500

Plums (30%) $3000 $2500

• Suppose buyers cannot observe quality. Is there a market failure? Who benefits? Who is harmed?

Mathematical Problems• Suppose we have the following information

regarding the market for used cars.

WTP (buyers) WTA (sellers)

Lemons (30%)

$2000 $1500

Plums (70%) $3000 $2500

• Suppose buyers cannot observe quality. Is there a market failure? Will any trades take place?

Mathematical Problems• Suppose we have the following information

regarding the labor market.

WTP (firm) WTA (worker)

Bad workers (50%)

$50K $35K

Good workers (50%)

$80K $55K

• Suppose workers are in short supply. Who is hired? At what wage? Is there a market failure.

Mathematical Problems• How might workers signal that they are in fact good

workers? Education. But suppose that students learn nothing that

contributes to their productivity: and that for $25K a good worker can attend college and a bad worker would have to spend an additional $10K (on GMAT prep courses, tutors, foregone wages associated with working twice as hard)

• If education is a signal of quality, what’s the monetary benefit of getting a degree?

• Which set of workers get a degree? Is this signal credible? Who is hired? At what wage?

• If government subsidizes education (which it often does) by $10K, what level of education and wages would prevail?

Market Power • Firms with market

power produce socially inefficient output levels.

Too little output Price exceeds MC Deadweight loss

• Dollar value of society’s welfare loss

MR

PM

QM

Deadweight Loss

MC

D

Q

P

PC

QC

Regulation

• Governments may regulate the price that monopolies charge. Earlier this semester we looked at two ways the

government may regulate price. • P=AC• P=MC (the competitive outcome)

Externalities• Third-party, non-market effects.• Example: Pollution, Cigarette smoking

Caused by the absence of well-defined property rights.

• Government regulations may induce the socially efficient level of output by forcing firms or individuals to internalize pollution costs

DWL: too much is produced and consumed

Externalities in productionPrice/bag of dog food

Quantity of dog food produced in Ogden

S=MPC (marginal internal cost)

D=MPB=MSB

Qu

Pu

MSC=MPC + marginal external cost

Q*

P*

External cost

Externalities in consumption

Price/cigarette

Quantity of cigarettes smoked

S=MPC=MSCD=MPB

Qu

PuDWL

MSB=MPB-marginal external cost

Q*

P*

External cost

ExternalitiesMarket Solutions

• Coase Theorem: Can achieve efficient outcome with no government intervention

No transaction costs Number of bargaining parties is small Property rights are defined, but it doesn’t matter how

they are assigned

• Example: your neighbor mows her lawn at 5am. The marginal damages to you are valued at $6. The marginal benefits to your neighbor are valued at $4.

ExternalitiesGovernment Solutions

• C&C (command and control)• Per-unit emission taxes. Set the tax equal to the

external cost to achieve the efficient outcome. Note: if the externalities are a benefit, then government can use

subsidies, where the subsidy is equal to the external benefit (e.g., education)

• Tradable discharge permit markets• Allow monopolies to exist (e.g., Utah State Liquor

Stores)

• Pollution Control Handout

Public Goods• A good that is nonrival and nonexclusionary in

consumption. Nonrival: A good which when consumed by one

person does not preclude other people from also consuming the good.

Nonexclusionary: No one is excluded from consuming the good once it is provided.

• Examples: Clean air, wilderness areas, to some degree national defense.

• “Free Rider” problem means that public goods will be underprovided if left to the market.

Public Goods

Snowplow Service (monthly)

$

Total demand for snowplow service (vertical summation)

84

54

30

0 30

MC of snowplow service

Individual 1’s demand for snowplow service

Individual 2’s demand for snowplow service

40

3 7

Rent Seeking

• The governments presence in markets provides incentives for firms or individuals to influence government policies.

This undermines the governments ability to make matters better.

• Examples: Tariffs and Quotas. These trade restrictions benefit certain firms and workers, but have a negative effect on consumers (i.e., consumers will pay higher price for these goods and services).

An Example: Seeking Monopoly Rights

• Firm’s monetary incentive to lobby for monopoly rights: A

• Consumers’ monetary incentive to lobby against monopoly: A+B.

• Firm’s incentive is smaller than consumers’ incentives

• But consumers’ incentives are spread among many different individuals

• As a result, firms often succeed in their lobbying efforts.

QM QC

PM

PC

P

Q

MC

DMR

Consumer Surplus

A B

A = Monopoly Profits

B = Deadweight Loss

Summary

• Market power, externalities, public goods, and incomplete information create a potential role for government in the marketplace

• Government’s presence creates rent-seeking incentives, which may undermine its ability to improve matters