Notes on Market Failure, Governmental Failure, and Tools for Action

Market Efficiency and Social Surplus

• Course: PLCY 210 — Policy Innovation and Analysis; Topic: Market Failure, Governmental Failure, and Tools for Action
• Key question: How can we measure whether a market is performing efficiently?
• Social surplus definition: the sum of consumer surplus (CS) and producer surplus (PS)
• Efficiency criterion: a market is efficient if it maximizes total social surplus (SS)
• Mathematical relation: $SS = CS + PS$
• Implication: if a market allocation maximizes SS, it is considered socially efficient; otherwise there is misallocation of resources.

Common Forms of Market Failure

• Monopoly: a single seller with market power; price influence; competitive firms have no market power.
• Externalities: actions of buyers or sellers affect third parties not directly involved in the market transaction (positive or negative).
• Public goods: non-excludable and non-rival; may be underproduced because private firms lack profitability incentives.
• Information asymmetries: consumers lack information to make fully informed choices; can lead to suboptimal decisions.

Characteristics of a Monopoly

• Definition: a monopoly is a firm that is the sole seller of a product with no close substitutes.
• Market power: the ability to influence the market price of the product it sells; competitive firms lack market power.

Why Monopolies Arise

• Barriers to entry are the main cause; other firms cannot enter the market.
• Three sources of entry barriers:
  • 1) A single firm owns a key resource (example: DeBeers historically controlled most diamond mines).
  • 2) Government grants exclusive rights (patents, copyrights).
  • 3) Economics of scale: a single firm can produce the entire market at a lower cost than several firms.

Monopoly is not a Guaranteed Money Machine

• A monopolist cannot charge any price it wants and expect unbounded profits; profits depend on demand.
• A monopolist is sensitive to consumer demand.
• A monopolist can operate at a loss; must get pricing and output decisions right to maximize profits.

Government Granting a Monopoly

• Examples of granting monopolies:
  • Natural monopolies: electricity, water, gas.
  • Universal access: state licensing of hospitals.
  • National security/control: defense, telecommunications.

Patent and Invention Incentives

• Patent definition: exclusive right to produce a good or service for 20 years.
• Patent laws encourage investment in discovery and development of new products and processes.
• Incentives help turn inventions into marketable products.
• Societal question: trade-offs between encouraging invention and granting monopoly rights.

Legal Restrictions

• Entry barriers can be legal: prohibit new firms from entering markets.
• Protection against competition can come from unions, professional associations, and other legal structures.

Public Policy Options Toward Monopolies

• Toward monopolized industries: aim to increase competition or regulate behavior.
• Turn some private monopolies into public enterprises.
• Do nothing as a possible option when regulation is impractical.

Externalities

Externalities as Market Failure

• Externalities create a wedge between private and social benefits and costs.
• Externalities are borne by third parties or society at large, not by the seller or buyer.
• Relationships:
  • Private benefits + external benefits = social benefits
  • Private costs + external costs = social costs
• External benefits/costs are not perceived by buyers and sellers; markets fail to capture them.
• Consequence: markets may fail to allocate resources efficiently.

Examples of Negative Externalities

• Noise from airports or roads
• Traffic congestion
• Neighbor’s barking dog
• Cell phones used in public places

Examples of Positive Externalities

• Vaccination reduces spread; benefits others in the community
• Research generates knowledge useful to others
• College completion benefits society (crime reduction, civic engagement)

Negative Externality Example: Pollution

• Pollution is harmful but often a byproduct of human activity; some level is inevitable.
• Scarce resources require choices; purification and reduction involve costs and benefits.
• Key questions:
  1) Can we eliminate pollution? No.
  2) Can we reduce pollution? Yes.
  3) By how much? Must compare costs and benefits.

Negative Externality Example: Pollution (Continued)

• Private markets tend to overproduce goods with negative externalities (too much resource allocation toward them).
• Policy question: how can we lower the quantity produced to the socially optimal level q*?

Solutions to Externality Problems

• Three broad approaches:
  1) Taxes or subsidies (Pigouvian taxes/subsidies)
  2) Direct regulation
  3) Assign property rights (Coasean approach)
• Principle: policy should internalize external costs or benefits to align private incentives with social welfare.

Policies: Taxes and Subsidies; Incidence and Regulation

• Taxes and subsidies depend on who bears the incidence (who actually pays or benefits).
• External costs: relate to supply (or demand) and the optimal tax level.
• External benefits: relate to demand (or supply) and the optimal subsidy level.
• Regulation instruments include limits and specific requirements; government can take over production in some cases; permitting systems may be used.

Coase Theorem

• The proposition: private bargaining can solve externality problems if property rights are clearly defined and transaction costs are low.
• Quote paraphrase: Coase highlighted that private solutions could work under certain conditions.
• Assumptions needed for private/market solutions:
  • Clearly defined property rights
  • Low transaction costs

Why Private Solutions Do Not Always Work

• Transaction costs can be high: the process of agreeing and monitoring a bargain.
• Large numbers of parties complicate coordination and increase costs.
• Stubbornness: each party may hold out for a better deal, hindering agreement.
• The need for clear property rights: they must be 1) clearly defined, 2) exclusive, 3) enforceable, 4) transferable.

Additional Policy-based Solutions

• Command-and-control policies: regulate behavior directly; limits on quantity; technology requirements.
• Corrective taxes: Pigouvian taxes that align private decisions with social costs; tax equals external cost per unit (MEC).
• Market-based policies: incentives to private decision-makers to solve problems; tradable permits.

Public Goods

Why does the market allocate public goods inefficiently?

• Private goods: rivalrous and excludable.
• Public goods: nonrival and nonexcludable.
• As a result, markets underprovide public goods because individuals cannot be charged for usage or excluded from consumption without cost.

Types of Goods

• Private Good: excludable and rival (e.g., hamburger)
• Public Good: non-excludable and non-rival (e.g., warning siren)
• Common Resource: rival but non-excludable (e.g., common pasture)
• Club Good: excludable and non-rival (e.g., cable TV)

Public Goods and Common Resources

• Some goods are underproduced due to positive externalities (merit goods) because markets lack sufficient incentives.
• Some resources are overused when owned collectively or nonexcludable, leading to overuse.

Collective Action Problem / Tragedy of the Commons

• Group members fail to organize to achieve long-run benefits; leads to overuse of a rival resource (e.g., ocean fishing).
• Congestible public goods (e.g., National Parks) can experience overload; pricing strategies can address congestion.
• Reference note: a linked discussion on tragedy of the commons and sustainability issues.

Valuation of Public Goods

• Everyone consumes the same quantity of a public good by default, leading to free-rider incentives.
• Private incentives to contribute voluntarily are weak because marginal benefits vary by person and benefits can be enjoyed without paying.
• Incentive misalignment means no private market equilibrium for optimal provision.

Why Pay If I Can Get Out of It?

• Free-rider problem: if no one can be excluded, individuals have little incentive to pay for the good or service.
• Free-riders hinder private provision from achieving the social optimum.

Policy Responses To Problems Of Public Goods

• Government Provision: direct provision of public goods.
• Government funding with private provision: leverage non-profit and for-profit sectors to achieve provision.
• Public provision does not imply public production; there is a dissatisfaction problem (people don’t control the quantity).

Asymmetric Information

• Concepts: lemons, hidden information, and related dangers; moral hazard and adverse selection are key concerns.

Properties of Information

• Information can be costly to obtain but is often easily distributed once obtained.
• Information is durable and valuable after use; in some cases, information acts as a public good (nonrival and nonexcludable).
• Information quality concerns include fraud and misinformation; trusted agents matter.

The Lemons Model (Asymmetric Information)

• Asymmetric information tends to reduce the average quality of goods offered for sale.
• Sellers with below-average quality (lemons) are more likely to want to sell.
• Buyers anticipate lower quality and lower their reserve prices.
• Higher-quality goods stay off the market; average quality falls further, triggering a downward spiral.

Signals: How to Convey Quality Credibly

• How and where a good is sold, plus ancillary information, can help reduce information problems.
• Costly-to-Fake Principle: a signal must be costly or difficult to imitate to credibly convey information about quality.

Adverse Selection

• Individuals use private information to sort themselves into or out of a market transaction.
• Example: insurance contracts; high-risk individuals are attracted to lower-priced plans, while average/low-risk individuals face higher premiums when uneven information exists.
• Government-mandated insurance policies can alter premiums in the market.

Moral Hazard

• Moral hazard occurs when protection against loss leads to riskier behavior or reduced precaution.
• Happens after an insurance contract is signed; insured individuals may take on riskier behavior because losses are borne by others.
• Deductibles mitigate moral hazard by aligning incentives: lower risk of claims, safer behavior, and lower premiums.
• Benefits of deductibles include lower rates, incentives to drive safely, and reduced claim frequency.

Addressing Information Problems

• Branding: create a strong identity that signals quality.
• Signaling: actions that convey information about quality (even if not directly valuable to the product).
• Certification: third-party verification of quality (e.g., Consumer Reports).
• Screening: mechanism design to elicit private information (e.g., deductibles, performance-based compensation).

Beyond Market Failure / Beyond Efficiency

• Providing a Social Safety Net: redistribution to address equity concerns.
• Paternalism: policies aimed at preventing individuals from harming themselves or others, improving social welfare.
• Private troubles can become public problems (e.g., discrimination).

Government Failure

• Government interventions can fail as well as markets.
• Examples of government failure:
  • Political control causing mediocrity; lack of direct link between performance and persistence.
  • Perverse incentives that distort goals (goal displacement, e.g., in schooling).
  • Institutional inertia that slows system improvement and innovation.

Real-world Reference

• As of February 1, 2024, total settlements amount to $655\,\text{million}$, with the bulk paid out by the state of Michigan.

Governmental Failure

• Problems of direct democracy: majority imposing high costs on a minority.
• Problems of representative democracy: organized groups or special interests can influence outcomes.
• Problems of government production and supply: administrative burdens from civil service or procurement rules.

How to Address Government Failure?

• System redesign is preferred to elimination; relying solely on decentralized private action may be infeasible.
• Government functions can include market making, direct service provision, regulation, taxes, subsidies, and facilitation, among others.

Major Takeaways

• Do not view markets as good and government as bad, or vice versa.
• Markets rely on government and governments rely on markets; they are interdependent.
• A balanced, design-aware approach can address failures in both domains to improve overall welfare.