• A situation when the market fails to achieve the efficient outcome n
Asymmetric Information n
Monopolies (imperfect competition) n
Externalities n
Public Goods

• 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.

•
Adverse Selection (hidden characteristics) n
Things one party to a transaction knows about itself, but which are unknown by the other party.
n
Lemons, market for insurance
•
Moral Hazard (hidden actions) n
Actions taken by one party in a relationship that cannot be observed by the other party.
n
Again, the market for insurance n
Fixed salaries n
Auto rental market

• Signaling n
Attempt by an informed party to send an observable indicator of his or her hidden characteristics to an uninformed party.
n
To be effective, the signal must not be easily mimicked by other types. n
Example: Education to signal that you will be a highproductivity employee. Warranties signal product quality.

• Adverse Selection: n
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 lowquality 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 highdeductible plan would be purchased by healthier individuals.

• Adverse Selection: n
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.

• Moral Hazard: n
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?
n
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)

• Suppose we have the following information regarding the market for used cars.
Lemons
Plums
WTP (buyers) WTA (sellers)
$2000 $1500
$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.

• Suppose we have the following information regarding the market for used cars.
Lemons
(70%)
Plums (30%)
WTP (buyers) WTA (sellers)
$2000 $1500
$3000 $2500
• Suppose buyers cannot observe quality. Is there a market failure? Who benefits? Who is harmed?

• Suppose we have the following information regarding the market for used cars.
Lemons
(30%)
Plums (70%)
WTP (buyers) WTA (sellers)
$2000 $1500
$3000 $2500
• Suppose buyers cannot observe quality. Is there a market failure? Will any trades take place?

• Suppose we have the following information regarding the labor market.
WTP (firm) WTA
(worker)
$35K Bad workers
(50%)
$50K
Good workers
(50%)
$80K $55K
• Suppose workers are in short supply. Who is hired?
At what wage? Is there a market failure.

• How might workers signal that they are in fact good workers?
n
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?

• Firms with market power produce socially inefficient output levels.
n
Too little output n
Price exceeds MC n
Deadweight loss
• Dollar value of society’s welfare loss
P
P M
P C
Deadweight
Loss
MC
D
Q M
MR
Q C
Q

n
Earlier this semester we looked at two ways the government may regulate price.
• P=AC
• P=MC (the competitive outcome)

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

Price/bag of dog food MSC=MPC + marginal external cost
S=MPC
(marginal internal cost)
P *
P u
DWL: too much is produced and consumed
External cost
D=MPB=MSB
Q * Q u
Quantity of dog food produced in Ogden

Price/cigarette
External cost
D=MPB
P
P u
*
S=MPC=MSC
DWL
Q * Q u
MSB=MPB-marginal external cost
Quantity of cigarettes smoked

• Coase Theorem: Can achieve efficient outcome with no government intervention n
No transaction costs n n
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.

• C&C (command and control)
• Per-unit emission taxes. Set the tax equal to the external cost to achieve the efficient outcome.
n
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

• A good that is nonrival and nonexclusionary in consumption. n
Nonrival: A good which when consumed by one person does not preclude other people from also consuming the good.
n
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 .

54
40
30
$
84
Total demand for snowplow service (vertical summation)
0 3 7 30
MC of snowplow service
Individual 2’s demand for snowplow service
Individual 1’s demand for snowplow service
Snowplow Service
(monthly)

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

• Firm’s monetary incentive to lobby for monopoly rights: A
P
Consumer
Surplus
• Consumers’ monetary incentive to lobby against monopoly: A+B.
P M
A = Monopoly Profits
B = Deadweight Loss
• Firm’s incentive is smaller than consumers’ incentives
• But consumers’ incentives are spread among many different individuals
P C
A B
MC
D
MR • As a result, firms often succeed in their lobbying
Q M Q C Q efforts.

• 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