Chapter 4: Market Failures Caused by Externalities and Asymmetric Information

Terms

market failure

the inability of a market to bring about the allocation of resources that best satisfies the wants of society; in particular, the overallocation or underallocation of resources to the production of a particular good or service because of externalities, assymmetric information, or because markets fail to provide desired public goods

total/social surplus

the sum of cosumer surplus and producer surplus (a measure of social welfare)

consumer surplus

the difference between the maxiumum price a cosumer is willing to pay for an additional unit of a product and its market price; the triangular area below the demand curve and aboce the market price.

producer surplus

the difference between the actual price a producer recieves and the minimum acceptable price; the triangular area above the supply curve and below the market price

productive efficiency

the production of a good in the least costly way; occurs when production takes place at the output level at which per-unit production costs are minimized.

allocative efficiency

the apportionment of resources among firms and industries to obtain the production of the products most wanted by society (consumers); the output of each product at which its marginal cost and marginal benefit are equal, and at which the sum of consumer surplus and producer surplus is maximized

why Q1 is the correct quantity of oranges

MC=MC

Supply curves are marginal cost curves

Demand curves are marginal benefit curves

Each point on a demand curve represents both some consumer’s maximum willingness to pay and the marginal benefit that she will get from consuming that particular unit.

efficiency loss/dead-weight loss

reductions in combined consumer and producer surplus caused by an underallocation or overallocation of resources to the production of a good or service.

externality

a cost or benefit from production or consumption that accrues to someone other than the immediate buyers and sellers of the product being produced or consumed

negative externality

a cost imposed without compensation on third parties by the production or consumption of sellers or buyers. (ex: a manufacturer dumps toxic chemicals into a river, killing fish prized by sports fishers. also known as a cost or a spillover cost)

positive externality

a benefit obtained without compensation by third parties from the production or consumption of sellers or buyers. (ex: a beekeper benefits when a neighboring farmer plants clover. also known as an external benefit or spillover benefit)

Coase theorem

the idea, first stated by economist Ronald Coase, that some externalities can be resolved through private negotiations among the affected parties.

direct controls

government policies that directly constrain activities that generate negative externalities. (ex: maximum emissions limits for factory smokestacks and laws mandating the proper disposal of toxic wastes.)

Pigovian tax

a tax or charge levied on the production of a product that generates negative externalities. If set correctly, the tax will precisely offset the overallocation (overproduction) generated by the negative externality

optimal reduction of an externality

the reduction of a negative externality such as pollution to the level at which the marginal benefit and marginal cost of reduction are equal

asymmetric information

a situation where one party to a market transaction has more information about a product or service than the other. the result may be an under or overallocation of resources

moral hazard problem

the possibility that individuals or insisuttions will behave more recklessly after they obtain insurance or similar contracts that shift the financial burden of bad oucomes to others. (ex: a bank whose deposits are insured against losses may make riskier loans and investments)

adverse selection problem

a problem arising when information known to one party to a contract or agreement is not known to the other party, causing the latter to incur major costs. (ex: individuals who have the poorest health are most likely to buy health insurance)