R

6.1: Market Economies

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