Chapter 12 and 14


Market Failures and the Role of Government

Chapters 12 and 14

Market Failures

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

Asymmetric Information n

Monopolies (imperfect competition) n

Externalities n

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


Adverse Selection (hidden characteristics) n

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) n

Actions taken by one party in a relationship that cannot be observed by the other party.


Again, the market for insurance n

Fixed salaries n

Auto rental market

Possible Solutions

• Signaling n

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. n

Example: Education to signal that you will be a highproductivity employee. Warranties signal product quality.

Possible Solutions

• 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.

Possible Solutions

• 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.

Possible Solutions

• 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?


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)

$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.

Mathematical Problems

• Suppose we have the following information regarding the market for used cars.



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?

Mathematical Problems

• Suppose we have the following information regarding the market for used cars.



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?

Mathematical Problems

• Suppose we have the following information regarding the labor market.

WTP (firm) WTA


$35K Bad workers



Good workers


$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 n

Price exceeds MC n

Deadweight loss

• Dollar value of society’s welfare loss













• 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)


• 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

Externalities in production

Price/bag of dog food MSC=MPC + marginal external cost


(marginal internal cost)

P *

P u

DWL: too much is produced and consumed

External cost


Q * Q u

Quantity of dog food produced in Ogden

Externalities in consumption


External cost



P u




Q * Q u

MSB=MPB-marginal external cost

Quantity of cigarettes smoked


Market Solutions

• 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.


Government 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


• Pollution Control Handout

Public Goods

• 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.


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

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


Rent Seeking

• 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).

An Example: Seeking

Monopoly Rights

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




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


A = Monopoly Profits

B = Deadweight Loss

• Firm’s incentive is smaller than consumers’ incentives

• But consumers’ incentives are spread among many different individuals





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