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