6.4 Market Failure

1. Market Failure Defined and Its Conditions

• Definition: Market failure occurs when private decisions in the marketplace do not lead to the most efficient use of resources, meaning that net benefits to society are not maximized.

• Conditions Leading to Market Failure:

  • Noncompetitive Markets: When markets are not competitive, individual buyers or sellers can influence market prices, leading to prices different from marginal cost and resulting in opportunity losses.

  • Undefined or Non-transferable Property Rights: When property rights are not well defined and fully transferable, decision-makers do not face the true marginal benefits or costs of their choices.

  • Examples: Driving a car imposes external costs (pollution, congestion, accident risk) on society that drivers typically ignore in their cost-benefit calculations, leading to decisions that fail to maximize net benefits to society.

2. Noncompetitive Markets

• Principle: The model of demand and supply assumes competitive markets where no single player influences equilibrium price. However, in some markets, individual buyers or sellers possess significant market power.

• Impact of Market Power: When a player gains market power, they can set prices above marginal cost, leading to inefficient resource allocation and opportunity losses.

• Fact/Example: Mylan Pharmaceuticals' EpiPen exemplifies this. After a competitor was pulled and a generic option rejected, Mylan significantly increased prices from about 100 in 2007 to 609 in 2016 for two EpiPens. This pricing power, exercised above marginal cost, forced many with severe allergies to forgo life-saving medication, leading to a societal loss.

3. Public Goods vs. Private Goods and the Free Rider Problem

• Learning Objective: Distinguish between private goods and public goods and relate them to the free rider problem and the role of government.

• Private Good: A good for which exclusion is possible (producers can keep people from enjoying it unless they pay) and for which the marginal cost of another user is positive.

  • Example: Steak. You must pay to eat it, and producing another steak for another person has a positive marginal cost.

• Public Good: A good that is nonexcludable (once produced for one person, anyone else can view/use it for free, and you can't keep them from doing so) and for which the marginal cost of an additional user is zero.

  • Example: A fireworks show. Once produced, anyone in the area can see it for free, and an additional viewer doesn't add cost or obstruct others' views.

• The Free Rider Problem: This occurs when people or firms consume a public good without paying for it.

  • Explanation: Because public goods are nonexcludable, individuals can benefit from them without contributing to their cost. This leads to private firms being unable to cover their costs, making them unlikely to produce public goods in socially ideal amounts.

  • Fact/Example: A private firm developing a 40/month terrorist alert system (a public good) might find many households refusing to pay the 20/month bill, as they would still receive the benefits whether they pay or not. This free riding prevents the system from being financially viable, even if its total societal benefit far outweighs its cost.

• Role of Government: Since private firms under-provide public goods due to free riding, government intervention is often desirable to achieve an efficient allocation of resources.

  • Government Solutions:

  • Direct Provision: Using tax revenues to directly provide the good (e.g., national defense, law enforcement).

  • Subsidies: Using tax revenues to subsidize consumption or private provision (e.g., making charitable donations tax-deductible).

  • Enforcement: Governments have the power to enforce payment (via taxes) that private firms lack, effectively discouraging free riding and ensuring the provision of public goods at a more efficient level (e.g., avoiding deadweight loss as illustrated by the triangle ABC in Figure 6.15).

4. External Costs and Benefits

• Learning Objective: Discuss the concepts of external costs and benefits and describe the role of government intervention when they are present.

• External Cost: A cost imposed on others outside of any market exchange.

  • Explanation: Producers generating external costs (e.g., pollution) do not bear all the costs of their actions, leading to decisions that are not socially efficient.

  • Fact/Example: Firms generating air pollution impose costs on affected individuals without market compensation. Similarly, driving a car generates external costs like air pollution, traffic congestion, and accident risk that the driver often ignores.

• External Benefit: An action taken by a person or firm that creates benefits for others in the absence of any market agreement.

  • Fact/Example: A firm building a beautiful building provides enjoyment to everyone who admires it, an external benefit.

• External Costs and Efficiency: When firms generate external costs, their private marginal costs (MCp) are lower than the marginal social costs (MCS), which include external costs. This leads to an overproduction of goods (Qp) at a lower price (Pp) than the socially efficient quantity (QS) and price (PS), creating deadweight losses.

• Role of Government Intervention for External Costs:

  • To reduce activity towards the efficient quantity, government may intervene.

  • Policy Tools:

  • Per-unit pollution taxes: Increase private marginal costs to reflect social costs, shifting supply and leading to socially efficient output and pollution levels.

  • Permits: Requiring firms to purchase permits to pollute forces them to internalize the costs they impose on others.

  • Direct Regulation: Ordering firms to reduce pollution (e.g., cleaning up garbage dumps, silencing loud parties).

5. Common Property Resources

• Learning Objective: Explain why a common property resource is unlikely to be allocated efficiently in the marketplace.

• Definition: Resources for which no property rights have been defined, meaning everyone has equal access. Also known as open-access resources or common pool resources.

• Problem: When a resource belongs to nobody (because it belongs to everybody), individuals lack incentives to preserve, conserve, or protect it. Each individual has an incentive to exploit it before others do, leading to overexploitation or depletion.

• Fact/Example: Endangered species (whales, condors, rhinos, elephants in Central Africa) are common property resources. Without exclusive, enforceable property rights, individual incentives lead to poaching and depletion.

• Historical Example (Cattle vs. Buffalo):

  • Cattle: Property rights were exclusive, giving owners incentives to maintain herd sizes, breed high-quality livestock, and invest in sustainable management. Theft was punishable by hanging, enforcing these rights.

  • Buffalo: Were a common property resource. Hunters had no individual stake in maintaining herds. Any buffalo left to breed would likely be taken by someone else. This led to their near extinction in the 19^{th} century.

• Modern Impact: Today, with exclusive rights established for buffalo, herds are privately managed, and their population is increasing despite rising demand for buffalo meat, demonstrating the efficiency created by well-defined property rights.

6. Asymmetric Information

• Learning Objective: Define asymmetric information and explain how it can cause market failure.

• Definition: A situation in which buyers and sellers do not have equal information about the qualities of a product or the other options available to them.

• Problem: When information is incomplete or unevenly distributed, market participants cannot assess true benefits and costs, leading to market failure or even collapse.

• Fact/Example (Used Car Market):

  • Scenario: Suppose half of used cars are 'lemons' (worth 1,000) and half are 'peaches' (worth 5,000). Sellers know which type they have, but buyers don't.

  • Buyer's Dilemma: Buyers offer an average price (e.g., 3,000). This price is too high for lemons and too low for peaches.

  • Market Collapse: Lemon owners rush to sell, while peach owners withdraw their cars from the market. The market becomes increasingly dominated by lemons, and the price approaches the true value of a lemon (1,000). The market for peaches collapses entirely, even though there are willing buyers and sellers for peaches at 5,000. This results in a deadweight loss for society.

• Solutions to Asymmetric Information:

  • Information Services: Services like Carfax provide vehicle history reports (VIN checks) to buyers, reducing information asymmetry.

  • Inspections and Warranties: Institutions like Carmax (125-point inspection) and Certified Pre-Owned (CPO) programs inspect and repair cars, then offer warranties, assuring buyers of quality and mitigating the 'lemon' risk. If a covered car turns out to be a 'lemon,' it can be returned, restoring confidence in the market for higher-quality used cars.