5. Market Failures

What is market failure?

a situation in which a market left to itself does not produce the most efficient allocation of resources

What is an externality?

a cost or benefit from an economic activity that affects third parties

Give 2 examples of negative externalities.

1. smoking in public → pollution

2. dance → noise disturbance

Give 2 examples of positive externalities.

1. trees → absorb carbon dioxide

2. mark wearing → reduced transmission

What can the government do to limit external damage in the presence of negative externalities?

• regulation

• taxation

Commodities with negative externalities are produced in _________ quantities than are socially optimal.

larger

Commodities with positive externalities are produced in _______ quantities than are socially optimal.

smaller

Markets with externalities equilibrate at _____________.

sub-optimal outcomes

What are the 2 categories goods can be grouped into?

1. excludable

2. rival in consumption

What does it mean if a good is excludable?

people can be prevented from using the good

What does it mean if a good is rival in consumption?

one person’s use of the good reduces another person’s ability to use it

What are examples of excludable goods? (5)

• food

• a movie ticket

• gym membership

• clothing

• TV subscriptions

What are some examples of non-excludable goods? (3)

• national defense

• public roads

• fireworks display

What are examples of rival goods? (3)

• a cup of coffee

• a seat on an airplane

• a doctor’s appointment

What are examples of non-rival goods? (4)

• public defense

• national parks

• fireworks display

• broadcast television

What are common goods?

non-excludable and rivalrous goods that are available to everyone but are depleted by individual use

What are examples of common goods? (2)

• fish stock

• shared roads

What are public goods?

non-rivalrous and non-excludable, meaning one person's use doesn't diminish the supply for others, and it's difficult or impossible to prevent people from using them, even if they don't pay

What are examples of public goods? (4)

• public safety

• public health

• road signage

• street lighting

What can be done about the problem with public goods? (3)

• privatization

• public provision

• takeaway

What is information asymmetry?

a difference in two or more parties’ access to relevant knowledge

What are the two types of asymmetric information?

1. hidden actions - one person knows more than another about an action he/she is taking

2. hidden characteristics - one person knows more than another about the attributes of good he/she is selling

Give 3 examples of hidden actions.

1. Workers sometimes shirk their responsibilities because their employer cannot continually monitor their effort and performance.

2. Someone whose property is insured may not try as hard to protect it from theft/damage.

3. While the parents are out, the babysitter may spend more time watching videos than watching the children

What is a consequence of hidden actions?

moral hazard

What is moral hazard?

the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behavior

Who is the agent in the principal-agent problem?

a person who is performing a task on someone else’s behalf (e.g., a worker)

Who is the principal in the principal-agent problem?

is the person for whom this action is being performed (e.g., an employer)

What can the principals do in the principal-agent problem? (3)

• better monitoring (eg. cameras)

• higher wages

• delayed payment

What are examples of hidden characteristics?

• used cars

• health insurance

What is adverse selection?

a market outcome in which, because of asymmetric information, better quality commodities are driven out of the market

When does adverse selection arise?

when the seller knows more than the buyer about the good being sold

What are 2 examples of adverse selection?

• the used car market

• health insurance

What are 2 market responses to asymmetric information?

• signaling

• screening

What is signaling?

action taken by an informed party to reveal private information to an uninformed party

What are 4 examples of signaling?

1. Individual selling a good used car provides all receipts for work done on car.

2. Dealership provides warranties on used cars.

3. Firms spend huge sums on advertising and branding to signal product quality to buyers.

4. Highly competent workers get college degree to signal their quality to employers.

What is screening?

action taken by an uninformed party to induce informed party to reveal private information.

What are 2 examples of screening?

1. Health insurance company requires physical exam before selling policy.

2. Buyer of a used car requires inspection by a mechanic.

What is the role of the market?

guides individual behaviour and maximizes welfare in the absence of market failures

What is the role of the government?

can improve welfare by correcting and compensating for market failures

When will markets fail?

when the conditions for an optimal outcome are absent

Externalities cause market participants to affect those _______ the market.

ourside

Name one instance of the tragedy of the commons.

climate change

The private sector will not provide goods that are _________ and __________.

non-excludable and non-rival

Markets can break down if both sides don’t have the same information. True or False?

True