Markets and Government
CHAPTER 13
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Market Failure
A market failure occurs when the market outcome is not the socially
efficient outcome. Some action by the government is sometimes
necessary to ensure that the market does work well.
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Private Property Rights
Private property rights are the rights of individuals to own property.
When private property rights are secure, others are not allowed to steal
or damage your private property.
Private property rights are crucial to a market.
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Private, Public, Commons, and
Club Goods
The principle of mutual excludability states that the owner of private
property is entitled to enjoy the consumption of that property privately.
The principle of rivalry states that when one consumes or uses a good
or service, less remains for others.
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Private, Public, Commons, and
Club Goods
Private good – a good that is both excludable and rivalrous.
Club good – a good that is excludable but nonrivalrous
Public good – a good that is nonexcludable and nonrivalrous.
Commons good – a good that is rivalrous but nonexcludable.
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Classification of Goods
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Free Rider
When goods are nonexcludable, an individual has an incentive to be a
free rider.
A free rider is a consumer or producer who enjoys the benefits of a
good or service without paying for that good or service.
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Externalities
Private costs and benefits are costs and benefits that are borne solely
by the individuals involved in the transaction.
An externality is a cost or benefit of a transaction that is borne by
someone who is not directly involved in the transaction.
If externalities exist, it means that those involved in the demand and
supply in the market are not considering all the costs and benefits when
making their market decisions.
As a result, the market fails to yield optimal results.
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Positive and Negative
Externalities
A positive externality may result when some of the benefits of an activity
are received by consumers or firms not directly involved in the activity.
A negative externality may result when some of the costs of an activity
are borne by consumers or firms not directly involved in the activity.
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Social Cost
Social cost: the total social cost of a transaction is the
private cost plus the external cost.
If all of the costs of a transaction are borne by the
participants in the transaction, the private costs and the
social costs are the same.
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Externalities and Market
Failure
When there is a divergence between social costs and private costs, the
result is either too much or too little production and consumption.
In either case, resources are not being used in their highest-valued
activity and market failure can occur.
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Negative Externalities
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Positive Externalities
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Lambs on the Commons
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Asymmetric Information
Exchange that occurs when one party has more information than the
other is called exchange with asymmetric information.
One manifestation of this is called adverse selection: the problem that
occurs when higher-quality goods, consumers, or producers are driven
out of the market because unobservable qualities are incorrectly
valued.
Lemons market: a market in which adverse selection occurs.
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Adverse Selection
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Moral Hazard
A related issue is moral hazard—the problem that arises when people change
their behavior from what was expected of them when they engaged in a trade
or contract.
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Network Externalities and
Locked In
Network externalities – each additional user increases the value of the entire
network
Locked in – the cost of changing to a more efficient technology is higher than
the benefit
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Solutions to Market Failure
If all the costs or benefits of a private transaction belonged to the people
creating them, then externalities would be no problem.
When people causing externalities pay for them, we say the externality has
been internalized.
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Government’s Role
◦ Tax or subsidize the externality
◦ Command and control
◦ Marketable pollution permits: Cap and trade
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Pollution Tax
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Subsidy
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The Market for Pollution
Permits
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Two Schools of Thought
Public choice economists argue that there is no need for a government to
solve a market failure because having the government attempt to do so
leads to greater costs than did the market failure.
The Austrian school supports free markets and opposes government
intervention in the economy.
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