MARKET FAILURES - Mr. Chumley FHCI



MARKET FAILURES

Market failure describes the failure in the market economy to achieve an efficient allocation of resources. Most industries have some market power because they face negatively sloped, rather that horizontal, demand curves. No real market economy has ever achieved perfect allocative efficiency. The conditions for efficiency are meant only as a benchmark to help identify important market failures

Market failure describes a situation in which the free market, in the absence of government intervention, fails to achieve allocative efficiency.

There are four situations in which the free market fails to achieve complete allocative efficiency; market power, externalities, non-rivalrous and non-excludable goods, and asymmetric information.

MARKET POWER

Market power is inevitable in any market economy for three reasons:

1. In many industries economies of scale are such that there is room for only a few firms to operate efficiently, each having some ability to influence market conditions.

2. In many industries, firms sell differentiated products and thus have some ability to set their prices.

3. Firms that innovate with new products or new production processes gain a temporary monopoly until other firms learn what the innovator learns.

EXTERNALITIES

An externality arises when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that affect. If the impact on the bystander is adverse, it is called a negative externality; if it is beneficial, it is called a positive externality.

Externalities come in many varieties, as do the policy responses that try to deal with the market failure. Here are some examples.

• The exhaust from automobiles creates a negative externality because it creates smog that people breathe. The government attempts to solve this problem by setting emission standards for cars.

• Restored historic buildings convey a positive externality because people who walk or ride by them can enjoy their beauty and the sense of history that these buildings provide. Many governments regulate the destruction of old buildings and provide tax breaks to owners who restore them.

Externalities are also called third-party effects because parties other than the two primary participants in the transaction are affected.

We must make a distinction between private cost and social cost. Private cost is the cost faced by the producer of the good. These would include production costs, advertising costs and so on. Social costs include private costs (since the producer is a member of society), but also includes any other costs imposed on third parties. These might include the costs of taxpayers cleaning up a river, etc

When social costs equal private costs, we have no externalities. The presence of externalities leads to allocatively inefficient outcomes.

With a positive externality, a competitive free market will produce too little of the good.

With a negative externality, a competitive free market will produce too much of a good.

Discrepancies between private cost and social cost occur when there are externalities. The presence of externalities, even when all markets are perfectly competitive, leads to allocatively inefficient outcomes

With a positive externality, a competitive free market will produce too little of the good, With a negative externality, a competitive free market will produce too much of the good.

The allocative inefficiency caused by an externality provides a justification for government intervention. In the case of a negative externality, the government may levy a tax on the firms or consumers responsible, as is often done in the case of pollution. In the case of positive externalities, the government may provide a subsidy (a negative tax) to the firms or consumers responsible, as in the case of publicly provided education.

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Non-Rivalous and Non-Excludable Goods

Economists classify goods and services into four broad categories depending on the rivalry for the good and the excludability of the good.

A good is said to be rivalrous if one person’s consumption of one unit of the good means that no one else can also consume that same unit. For example, a chocolate bar is rivalrous because if you eat the entire bar it cannot be consumed by anyone else. In contrast, a television signal is not rivalrous. You and your friend can sit in the separate rooms and both receive the exact same signal.

A good is said to be excludable if people can be prevented from consuming it. A chocolate bar is excludable because you cannot eat it unless you buy it first. A regular TV signal is not excludable, but specialty tv channels are because only those that pay for the special receivers can view them. Your use of the light produced by street lights is non-excludable, as is your access to the air you breathe.

Private Goods

Most goods and services that you consume are both rivalrous and excludable. Your consumption of food, clothing, a car is only possible because you pay the seller for the right and you own these goods and services.

Common-Property Resources

Goods that are rivalrous and non-excludable pose an interesting challenge for public policy. Examples of these goods include fisheries, wild-life, rivers, and so on. My use of river water reduces the amount available to you, but there is no practical way that my access to the water can be controlled. The result is that there is zero price. The zero price leads to the obvious result that, in the absence of government intervention, private users will tend to overuse common-property resources.

Excludable But Non-rivalrous Goods

Examples of these types of goods would include art galleries, roads, bridges and goods that are typically provided by the government. For example, an empty art gallery is non-rivalous. One extra person wanting to get into the art gallery will not be prevented from going in and viewing the exhibit. Any positive price would prevent some people from using it, and this would be inefficient.

To avoid inefficient exclusion, the government often provides for free non-rivalrous but excludable goods and services.

What happens on highway 401 outiside Toronto on a weekday morning? The answer is congestion. When congestion occurs on roads, bridges, or in art galleries and museums, providing the goods to one more person imposes costs on those already using the good. If I enter a busy highway, I slow down all the existing traffic. If you visit an already-crowded museum, you make it less pleasant for everybody else. In these cases, goods that are non-rivalrous, become rivalrous when congested.

Public Goods

Goods that are neither excludable or rivalous are public goods. These are also called collective consumption goods. An examples would be National Defence. It is not possible to provide national defence to some Canadians and not to others. Other public goods include street lighting and some forms of environmental protection.

Because of the free-rider problem, private markets will not always provide public goods. In such situations, public goods must be provided by government.

| |EXCLUDABLE |NON-EXCLUDABLE |

|RIVALROUS |Private Goods |Common-Property Resources |

|NON-RIVALROUS | |Public Goods |

Asymmetric Information

A situation in which one party to a transaction has special knowledge is call a situation of asymmetric information. Two important sources of market failure that arise from situation of asymmetric information are moral hazard and adverse selection.

Moral Hazard

A moral hazard exists when one party to a transaction has both the incentive and ability to shift costs onto the other party.

The classic example is the homeowner who does not bother to shovel snow from his sidewalk because he knows that his insurance will cover the cost if the mail carrier should fall and break a leg. The costs of the homeowner’s negligence will be borne largely by others, including the mail carrier and the insurance company.

Another example is professional services. Suppose you ask a dentist if your teeth are healthy. The dentist faces a moral hazard in that he has a financial interest in giving you the answer that will encourage you to buy his or her service, and it is difficult for you to find out if the advice was good.

Adverse Selection

This refers to the tendency for people who are more at risk than the average to purchase insurance and for those who are less at risk to reject the insurance. An example would be a person who has a heart condition my seek to increase his life insurance coverage by purchasing as much additional coverage as is available without a medical examination. People who buy insurance almost always know themselves as individual insurance risks than do their insurance companies. The insurance company can try to limit their insurance risk by requiring a physical examination and by setting up broad categories based on variables such as age, occupation, lifestyle, etc.

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