The “invisible Hand” Of Free Markets

• Businesses Have The Incentive To Meet Societal Demands To Earn Profit

• Information Asymmetry: A Situation In Which One Party Is More Informed Than Another Because Of The Possession Of Private Information

  • Adverse Selection: Parties Involved In A Transaction Fear That There Is Negative Information About The Other Party, Goods, Or Services That They May Not Know

  • Example Of Information Asymmetry

• Moral Hazard: A Market Failure That Results From A Change In The Buyer’s Behavior After A Purchase As A Result Of The Buyer’s Belief That Losses Will Be Passed Onto The Seller

Market Failure

• Market Failure: A Situation In Which The Free-market System Fails To Satisfy Society’s Wants

  • Ie. When The Invisible Hand Doesn’t Work

• Private Markets Do Not Efficiently Bring About The Allocation Of Resources

• Results In The Government Being Called Upon To Attempt To Satisfy Society’s Demands

The Four Market Failures

1. Public Goods

2. Externalities (third-person Side Effects)

3. Imperfect Competition (monopolies)

4. Unequal Distribution Of Income

Supply And Demand

• Demand = marginal Social Benefit Of A Good And Its Usefulness And Society

• Supply = marginal Social Cost Of Providing Each Additional Quantity

• Socially Optimal Quantity: MSB=MSC

Externalities

• Externality: A Third-person Side Effect

• External Benefits/external Costs To Someone Other Than The Original Decision Maker

Externalities As Market Failures

• The Free Market Fails To Include External Costs Or External Benefits

• With No Government Involvement, There Would Be Too Much Of Some Goods And Too Little Of Others

  Eg. Smoking Cigarettes

  • The Free Market Assumes That The Cost Of Smoking Is Fully Paid By People Who Smoke

  • The Government Recognizes External Costs And Makes Policies To Limit Smoking

Negative Externalities

• Negative Externality: A Situation That Results In A Cost For A Different Person Other Than The Original Decision Maker

  • The Costs “spill Over” To Other People In Society

Positive Externalities

• Positive Externality: A Situation That Results In A Benefit For Someone Other Than The Original Decision Maker

  • The Benefits “spill Over” To Other People Or Society

  • Eg. Flu Vaccines