Market Failure
•HL
material
(Tragakes, 2012, pp. 132-137)
C. Bordoy
UWC Maastricht
Additional types of market failure
1.
2.
Asymmetric information. When the
assumption of complete information does
not hold.
Abuse of monopoly power.
C. Bordoy
UWC Maastricht
Asymmetric information


Competitive market: firms and consumers
have complete information about
products, prices, resources and methods
of production.
Asymmetric information refers to
situations where buyers and sellers do not
have equal access to information, and
usually results in underallocation of
resources to the production of g&s.
C. Bordoy
UWC Maastricht
Information available to sellers but not to buyers




Information about the quality of a good
not made available to consumers.
Examples: sellers of used cars.
In a free and unregulated market: unsafe
medications, doctors with no training,…
If consumers are unaware of possible
hidden dangers, there could result an
overallocation of resources to the
production of those goods and services.
C. Bordoy
UWC Maastricht
Government responses
1.
Regulation

Laws and regulations to ensure quality
standards and safety. (private schools, food,
medications, buildings, toys…)


Time consuming (testing medications)
Large opportunity costs. In the case of food,
large amount of providers involved, which need
to be monitored.
C. Bordoy
UWC Maastricht

Provision of information
a)
Directly to consumers (about the quality of
medical care by different providers, infectious
diseases, health hazards related to particular
products…).

b)
Problems: collection and dissemination of the
information, accuracy and opportunity costs involved.
Forcing producers to provide information


Problems: accuracy and completeness of information
provided.
There is always room for the seller to hide some
information from the buyer. For example, doctors and
lawyers have more information than their clients and
they could selectively reveal information to them that
makes them demand more services than necessary
(supplier-induced demand).
C. Bordoy
UWC Maastricht

Licensure. Some professions require to have a
license: doctors, lawyers, teachers…

Criticised by some economists because it may
work to limit the supply of people in a profession,
causing the price to raise.
C. Bordoy
UWC Maastricht
Information available to buyers but not to sellers
1.
Moral hazard. Situations where one party
takes risks but does not face the full
costs of these risks.


Example: you buy a theft insurance for your
bike and start being less careful about locking
it because you know you will be reimbursed if
it gets stolen.
Result: underallocation of resources to the
production of insurance services.
C. Bordoy
UWC Maastricht

Responses
Provider makes the buyer pay for part of the cost
of damages, so that the buyer faces the
consequences of risky behaviour, thus leading to
less risky behaviour.
 Private companies offer different types of policies,
where the lower the cost of the insurance, the
higher the out-of-pocket payments. Lower income
earners usually choose low cost policies with less
insurance protection and as a result they are more
likely to change their risky behaviour than higher
income earners.
 In the financial area: government regulation of
financial institutions, intended to oversee and
prevent highly risky behaviour.

2.
Adverse selection. When buyers of
insurance have more information about
themselves than the sellers of insurance.


Buyers of health insurance know more about
their health than sellers, and those with
health problems are unlikely to disclose it to
avoid paying higher prices.
Result: underallocation of resources to
health insurance services, as companies
reduce the supply of insurance to avoid
providing insurance coverage to very high
risks or people who are more likely to
become ill. It also leads to high insurance
costs for buyers.

Responses by insurance companies:
Companies offer different policies, so that people
with low risk of getting sick can choose a low-cost
policy with higher out-of pocket payments, while
higher cost policies with lower out-of-pocket
payments can be selected by people who think
they have high levels of health risk.
 First: lower-income earners choose low-cost
policies regardless of the state of their health. This
is undesirable from a fairness perspective.
 Second: insurance firms usually refuse to insure
people above a certain age (higher risk of
becoming ill).
 Result: people on low incomes and elderly people
are left with little or no insurance coverage.


Response by governments:
Direct provision of health care services at low or
zero prices to an entire population, financed by
taxes.
 Social health insurance,




covering a country’s entire population (many EU
countries)
covering only certain vulnerable groups of the population
(US).
Potential problem: difficulties in controlling costs of
providing health care and growing burdens on the
government or social health insurance budgets.
3.
Safety in the workplace


Employers are generally interested in
providing some workplace safety because an
unsafe working environment disrupts
production. However, they may be
interested in hiding information regarding
unsafe working conditions, with negative
consequences for employees’ safety.
This represents market failure due to
asymmetric information in the labour
market.

Responses:
Governments can provide information to workers
about safety information in various firms,
b. they may require employers to provide
information to prospective workers about
hazards and safety conditions, or
c.
they may set minimum safety standards to be
followed by employers (most commonly used).
Although this improves safety conditions for
workers, it is difficult for the gov to cover all
possible hazard eventualities of different
industries and type of work.
b Might be more effective, although it is difficult to
cover all the rage of industries. Labour unions
also provide information but is limited to
particular professions and industries.
a.