Market Failures Caused by Externalities and Asymmetric Information

Efficiently Functioning Markets

  • Market failures occur when the quantity of a product produced is not optimal.

  • Efficient outcomes require:

    • Market demand reflects full willingness to pay.

    • Market supply reflects all production costs.

    • Total surplus = Consumer Surplus + Producer Surplus.

Consumer Surplus

  • Definition: Difference between what a consumer is willing to pay and what they actually pay.

  • Represents extra benefit from lower payment than maximum price.

Producer Surplus

  • Definition: Difference between equilibrium price received and minimum acceptable price.

  • Represents extra benefit from receiving a higher price than minimum.

Total Surplus and Efficiency

  • Total surplus is maximized when the market is in equilibrium.

  • Efficiency losses can occur due to underproduction or overproduction.

Externalities

  • Definition: Costs or benefits of market transactions that affect third parties.

  • Negative Externalities: Linked with overproduction (e.g., pollution).

  • Positive Externalities: Linked with underproduction (e.g., education).

Government Intervention for Externalities

  • Negative externalities are corrected through:

    • Direct controls

    • Pigovian taxes

  • Positive externalities are corrected through:

    • Subsidies

    • Government provision.

Correcting for Externalities

  • Methods for negative externalities include:

    • Private bargaining

    • Taxes

    • Liability rules

  • Methods for positive externalities include:

    • Subsidies to consumers/producers.

Optimal Abatement and Government's Role

  • Society's optimal pollution abatement requires balancing marginal costs and benefits.

  • Coase theorem states private bargaining can resolve externalities but may require government oversight if failures occur.

Asymmetric Information

  • Occurs when one party has private information affecting resource allocation efficiency.

  • Examples include:

    • Sellers knowing more than buyers (e.g., market for used cars).

    • Moral hazard and adverse selection issues in insurance markets.