Unit-12- Markets, Efficiency, and Public Policy
Unit 12: Markets, Efficiency, and Public Policy
Page 1:
Overview of the unit
Page 2: Outline
Introduction
External effects
Market failure: Other types
Limits to markets
Page 3: Introduction
Page 4: The Context for This Unit
Examines buyer and seller behaviors under different market conditions.
Focus on competitive equilibrium and Pareto efficiency.
Markets may allocate resources ineffectively (market failure).
Key questions: Sources of inefficiencies? Government solutions?
Page 5: Examples of Market Failure
Pesticides in the Caribbean
Banana plantations utilize harmful pesticides to cut costs and boost profits.
Result: Chemical runoff contaminates rivers, harming local seafood and residents' health.
Overuse of Antibiotics
Excessive use leads to antibiotic-resistant pathogens, threatening public health.
Page 6: Why Do Markets Fail?
Essential conditions for effective markets include:
Private Property: Rights to traded goods.
Institutions: Governments must enforce property rights.
Social Norms: Respect for property rights is crucial.
Contracts: Ability to create enforceable contracts.
Market failure occurs when property rights are lacking, incomplete, or difficult to enforce.
Page 7: Causes of Market Failure
Key Issues:
External effects, asymmetric information, incomplete contracts.
Possible Solutions:
Private bargaining, government interventions.
Market Limits:
Examination of whether all goods should be allocated via markets.
Page 8: External Effects
Page 9: Key Concepts of External Effects
External Effect (Externality):
An effect of an economic decision not included in the contract's benefits or liabilities.
Pesticide Pollution Example:
Marginal Private Cost (MPC): Cost to decision-maker (plantations).
Marginal External Cost (MEC): Costs imposed on society (fishermen).
Marginal Social Cost (MSC): Total cost to society (MSC = MPC + MEC).
Negative externalities occur when MSC > MPC.
Page 10: Result: Pareto Inefficiency
Outcome is not Pareto efficient.
Graph Example:
At point A, fishermen could compensate plantations to reduce output.
Plantations produce at Price = MPC instead of at the Pareto-efficient level where Price = MSC.
Leads to overproduction and excessive pesticide use.
Page 11: Solution #1: Bargaining
Assign property rights related to the externality (e.g., pollution rights).
Private bargaining can yield a Pareto-efficient result absent transaction costs.
Effectiveness may exceed that of government intervention, as private parties may have better information.
Obstacles:
Transaction costs (information acquisition, contract enforcement).
Page 12: Bargaining Example
Social gains are possible from reducing pesticide production.
Plantation owners' minimum acceptable offer = lost profits.
Fishermen's maximum compensation = total gains for fishermen.
Compensation outcomes influenced by bargaining power.
Page 13: Practical Limits of Bargaining
Challenges include impediments to collective action and missing information on pollution's costs.
Difficulties in enforcement of compliance with agreements.
Limited funds may hinder fishermen from compensating plantations.
Page 14: Solution #2: Government Policies
Regulation of production with quotas.
Pigouvian Tax/Subsidy:
Tax/subsidy for firms generating external effects to correct market inefficiencies.
Enforce compensation for affected parties.
Page 15: Example: Pollution Tax
Producers maximize profit where MPC = after-tax price (socially optimal).
Tax requires producers to account for full social costs.
Page 16: Example: Compensation
Compensation = difference between MSC and MPC.
Ensures fishermen receive payments from plantations, achieving socially optimal output.
Page 17: Practical Limits of Policies
Similar issues as private bargaining.
Challenges: Missing information, measurement of marginal social costs, and lobbying influence on government decisions.
Page 18: Why Do External Costs/Benefits Occur?
Incomplete contracts lead to market failures by not covering all relevant factors.
Contracts with external costs often unviable due to unverifiable or asymmetric information.
Page 19: Market Failure: Other Types
Page 20: 1. Public Goods
Classification by nature and institutions.
Public Good: Non-rival and may or may not be excludable.
Non-rival: One’s use doesn’t limit others’ availability.
Non-excludable: Difficult to restrict access.
Page 21: Public Goods and Market Failure
Markets struggle with allocating public goods.
Non-rival goods have zero marginal cost, complicating price settings.
Instances arise where providers cannot charge for non-excludable benefits, leading to inefficiencies.
Page 22: 2. Asymmetric Information
Occurs when one party possesses relevant information unknown to the other.
Types:
Hidden Action (moral hazard).
Hidden Attributes (adverse selection).
Page 23: Example #1: Health Insurance
Adverse selection occurs as healthier individuals may avoid purchasing insurance.
Profitability for insurers relies on pricing based on knowledge asymmetry.
Missing markets for healthier applicants, perpetuating inequities.
Page 24: Example #2: Car Insurance
Insured individuals may take higher risks (moral hazard).
Contracts can limit risks but enforcing behavior remains challenging.
Page 25: Example #3: Banking System
Borrowing and lending exemplify principal-agent issues; borrowers' actions impact lenders.
Risky bank practices can lead to broader economic implications and government bailouts.
Page 26: 3. Price > Marginal Cost
Market failure occurs when firms charge above marginal cost due to limited competition or economies of scale.
Solutions include price discrimination or competition policy to eliminate deadweight loss.
Page 27: Limits to Markets
Page 28: Should Markets Allocate Everything?
Critiques of universal market allocation:
Ethical issues (repugnant markets).
Alternative institutions (governments, families) may function better.
Potential erosion of social norms and preferences.
Merit goods should be universally accessible regardless of payment ability.
Page 29: Summary
Sources of Market Failure:
Externalities, asymmetric information, limited competition.
Potential Solutions:
Regulation, taxation, compensation frameworks.
Market Limitations:
Public goods and derived market inefficiencies.
Page 30: In the Next Unit
Transition from microeconomic models to broader macroeconomic perspectives.
Focus on government roles regarding unemployment, inflation, and labor productivity.