Theme 3B - Market failure

Rest of causes of market failure

Explain how underestimation of true private benefit (consumer ignorance) causes welfare loss

Describe problem	Due to imperfect information, consumers may be ignorant about the long-term gains of preventive healthcare and under-estimate the true benefits that consuming healthcare provides to themselves
Explain market outcome	Causes perceived marginal private benefit (MPB) to be lower than true MPB  Consumers would base their consumption decision on their perceived MPB -> consume until perceived MPB curve = market demand curve
Explain socially optimal outcome	Assuming no externalities, the MSB curve = true MPB, while the MSC curve = MPC curve = supply curve -> socially optimal output at Q*, where MSC = MSB (true MPB = MPC), which is where society’s welfare is maximised
Explain welfare loss and allocative inefficiency	Since the market equilibrium is at Q, there is an underconsumption of healthcare of Q* - Q units For Q to Q* units, the MSB is greater than the MSC, so there is additional gain to society’s welfare if more healthcare is consumed.  At the output level Q, a deadweight loss of area M (NOT consumed) is incurred by society in under-producing/under-consuming this good, because for Q to Q* the total social benefits (areas M+N) are greater than the total social costs (area N) Therefore, the free market has failed to achieve allocative efficiency as society’s welfare is not maximised

Draw the graph of how underestimation of true private benefit (consumer ignorance) causes welfare loss

Explain how overestimation of true private benefit (consumer ignorance) causes welfare loss

Describe problem	Due to imperfect information, consumers may be ignorant about the harms from smoking and over-estimate the true value that smoking cigarettes provides
Explain market outcome	Causes perceived marginal private benefit (MPB) to be higher than the true MPB of smoking cigarettes Consumers would base their consumption decision on their perceived MPB, perceived MPB curve = demand curve -> consumers consume until perceived MPB = MPC at market equilibrium Q
Explain socially optimal outcome	Assuming no externalities, the MSB curve = true MPB curve, MSC curve = MPC curve = supply curve Left to market forces, market equilibrium output will be at Q* The socially optimal output is Q*, where MSC = MSB, which is where society’s welfare is actually maximised
Explain welfare loss and allocative inefficiency	Since the market equilibrium is at Q, there is an overconsumption of cigarettes of Q – Q* units For Q* to Q, the MSB is lower than the MSC -> loss to society’s welfare from these additional units of cigarettes consumed At the output of Q, a deadweight (welfare) loss of area A is incurred by society in over-producing/over-consuming this good, because the total social costs of consuming Q* to Q units (areas A+B) is greater than the total social benefits (area B) Therefore, the free market has failed to achieve allocative efficiency as society’s welfare is not maximised

Draw the graph of how overestimation of true private benefit (consumer ignorance) causes welfare loss

Describe asymmetric information

• Occurs when one side of the market – either buyers or sellers, has better information than the other 

• This results in distortion of incentives and inefficient market outcomes -> problems of adverse selection, moral hazard, or supplier-induced demand -> market failure -> can lead to full market collapse, if no action is taken to correct them 

Describe how AI leads to adverse selection

• Situation in asymmetric information between consumers and producers results in an unfavourable selection of products / buyers participating in a market, which leads to a missing market for a segment of other buyers / sellers, who do not get to buy or sell the good even though it is beneficial for them to do so

• Occurs BEFORE the transaction has been completed

Describe AI of Uninformed sellers and knowledgeable buyers and its effects

• AI leads to adverse selection 

• A person who buys a health insurance policy knows much more about his / her risks and needs for insurance than the insurance firm knows before the transaction 

• The insurance firm must pick from a pool of customers who the firm has no information on, in deciding to whom to sell the insurance to and at what price

• High-cost customers -> high medical expenses (fall ill frequently) 

• Company assumes 50-50 high and low cost -> charge average cost of providing insurance coverage 

• Price would be higher than what low-cost customers are willing to pay -> drop out of the insurance market

• Price is lower than what high-cost customers are prepared to pay -> join the market

Effects: 

1. As more high-cost customers buy insurance 

• Average cost of insurance companies rises and the average price that insurance companies charge consequently rises

• More low-cost customers drop out of the market -> the market will increasingly be dominated by high-cost customers

2. Only high-cost customers are left in the insurance market

• Market for insurance for low-income customers disappears -> missing market 

• Low-cost consumers cannot buy the good and producers cannot sell the good to low-cost consumers 

• Since the low-cost customers are driven out of the market by high-cost customers due to asymmetric information, the potential net benefit to society from having some low- cost customers insured is lost and society’s welfare is not maximised

• Hence, adverse selection leads to allocative inefficiency

Describe moral hazard

• Situation in which economic agents take greater risks / act less carefully than they normally would because the resulting costs will not be borne by them (does not bear full consequences of its actions) 

• Occurs after transaction has been completed

Give an example of moral hazard using the insurance market

Example (insurance market)	Cause people to take greater risks because they know part of the costs of undesirable outcomes of taking risks will be borne by the insurance companies -> drive insurer's cost -> service will no longer be provided since there is insufficient incentive (profits) to offer it for sale -> missing market
Cause (principal-agent problem)	When one person (agent) is performing some tasks on behalf of another person (principal) If the action of the agent cannot be perfectly monitored, the agent would tend to undertake more risk or put in less effort than what is desired by the principal -> less than desirable work performance
Impact	Lack of trust between potential buyers and sellers for a product -> mutually advantageous trade might not take place -> no market for it -> market failure as the potential net benefit to society from having these goods and services traded is lost and society’s welfare is not maximised -> allocative inefficiency

Describe supplied-induced demand using doctors and patients

• Arises when a producer has more information than a consumer -> consumers end up buying more goods/services than what is optimal for them

• Profit-motivated doctors may lead patients to believe that certain non-essential healthcare services or tests are required

• This causes the consumers’ perceived MPB to be higher than the true MPB

• Since consumers’ demand is based on their perceived MPB of the service, consumers consume until perceived MPB = MPC, at Qe

• If consumers had full information on true MPB, they will consume until true MPB = MPC at Q*e 

• Q > Q* (overconsumption) 

• This results in welfare loss of area A because for each of the units between Q* and Q, the MSB (True MPB) is lower than the MSC and a net loss is incurred by society from consuming those units
  

Draw graph of supplied-induced demand using doctors and patients

Compare adverse selection, moral hazard and supplier-induced demand

Define factor immobility

(Def.): refers to the inability or/and unwillingness (barriers) of factors of production to move between different industries of locations

Compare occupational and geographical immobility

	Occupational immobility	Geographical immobility
Definition	Refers to the inability or/and unwillingness of factors of production to move between occupations or industries	Refers to the inability or/and unwillingness of factors of production to move between geographical areas
Causes	Lack of skills and knowledge acquired from training and education Lack of natural talent  Eg. Not everyone can be a master chef because the job requires a sharp palette Barriers imposed by professional associations and trade unions  Unions or professional associations can make it difficult for outsiders to enter a particular industry such as by recognising qualifications from certain universities only, or require a person to be a member first in order to obtain employment in the particular industry	Family and other social ties A person may not be willing to relocate and take on a job in another city because he does not want to be separated from relatives and friends Costs of moving can be high  Cost of selling and buying a house, removal expenses and other associated expenditure Differences in cost of living in different regions Cost of living is higher in cities than rural areas -> unwilling and unable to move to and work in cities

Explain how factor immobility leads to market failure

• DD may change -> FOP unwilling or unable to move to expanding sectors that needs more FOP -> FI leads to unemployment -> wastage of resources -> economy producing at a point inside the PPC -> productivity inefficient -> allocative inefficient 

• Eg. Aging population -> increase demand for healthcare and decrease demand for primary education: 

  • Decrease in derived demand for primary school teachers -> teachers retrenched -> these people with job-specific skills probably do not have the relevant skills to take up jobs available in the healthcare industry and will remain unemployed (resources ‘wasted’) (this is structural unemployment) 

  • Healthcare industry not able to get the desired amount of labour needed to increase quantity supplied to meet the rise in demand -> cannot produce at the socially optimal level of healthcare services -> welfare loss

Describe market dominance

Imperfectly competitive firms that possess market power will produce at a level of output lower than the socially optimal level (underproduction) -> welfare loss to society -> allocative inefficiency

Describe public goods

• Good that is non-excludable, non-rivalrous and non-rejectable

• Eg. National defence, street lighting, flood control systems 

1. Non-excludability:  it is impossible or very costly to prevent someone who has not paid from consuming the good

2. Non-rivalry: consumption of the good by one person does not diminish the availability of the good for another person -> consumption of the good by more people does not incur any additional costs (marginal cost of providing for an additional user is zero,this does NOT mean MC of producing the good is zero)

3. Non-rejectability: inability of consumers to refuse the consumption of a good once it has been produced

Explain how public goods lead to market failure

• Since public goods are by nature non-excludable, it is impossible or impractical for producers to exclude those who have not paid from consuming the flood protection

• Since consumers can be free riders, they would not be willing to pay for the good and hence there is no effective demand

• With no demand, producers will be unable to sell their good at any positive price level and thus will not be able to earn revenue to cover the cost of production

• At zero price, no profit-motivated private producers would be willing and able to supply the flood protection

• When left to the free market, there will be no production of coastal protection infrastructure and total market failure occurs

• The potential net benefit to society from having some level of coastal protection infrastructure produced and consumed is lost

State policies to address occupational and geographical immobility

The government could invest in education and retraining programmes  This would equip workers with skills that align with the requirements of today’s job market, reducing the skills mismatch and allowing them to take up jobs they were previously unable to.

The government subsidize housing for workers from outside the city who have obtained jobs in the city  Reduce cost of living -> afford moving into the city

Occupational Geographical