Market Failure: Externalities, Public Goods, and Asymmetric Information

Market Failure

Learning Objectives

• How markets can fail:
  • Don't produce important goods and services (public goods).
  • Don't allocate resources properly (externalities).
  • Buyers and sellers don't have full information (asymmetric information).
• Understanding of private and public goods.
• Understanding of externalities and solutions.
• Understanding of adverse selection and moral hazard.

Public Goods

• Public good: Something that makes us better off but would not be provided in the private sector because it:
  • Has no price.
  • Cannot be provided at a profit.
  • Some other reason.
• Provided by the public sector (government) instead.

Public vs. Private Goods

• Rival: One person using a good (or service) means that others cannot use it OR get less.
• Excludable: CAN be prevented from using the good or service.

Private Goods vs. Public Goods

• Free-Rider Problem: Free riders get the benefit of good or service without having to pay.
• Examples:
  • Radiohead “In Rainbows” 2007
  • Stephan King “The Plant”
• Market can eliminate Free Rider Problem for Private Goods.
• Question is asked: Can government eliminate Free Rider problem for Public goods?

Other Types of Goods

• Quasi-Public Goods (club goods)
  • Excludable
  • Nonrival
• Common Resources
  • Nonexcludable
  • Rival
• The Tragedy of the Commons

Tragedy of the Commons

• Occurs when a common resource is depleted or ruined.
• Original example:
  • Garret Hardin, Science Magazine, 1968
  • Cattle grazing
  • Commons = shared area that all cattle farmers get to use to let cattle graze
• Goal of each herder: maximize income.
• Suppose 100 farmers are each allowed to have 1 cow freely graze in the commons.
• One farmer thinks: What if I bring 2 cows? MB > MC

Common Property Incentives

• Incentive to neglect

  • Good cannot be protected. No political borders or ownership.

• Incentive to overuse

  • Each individual wants to fish as much as possible for higher profits. If one conserves, others will fish even more.

• Incentive to ignore others

  • No one has the ability to define how many resources can be used. I may still break the rules set even if others follow them.

• The commons get destroyed, even though this was in nobody's best interest.

Solution to the Tragedy of the Commons

• General proactive management is needed.
  • Taxes, regulations, or other ways to internalize a negative externality
• Legislation has to be designed correctly

Ways Markets Can Fail

• Don’t produce important goods and services
• Don’t allocate resources properly
  • Overallocation
  • Underallocation
• Buyers and sellers involved in a transaction don’t have full information
  • Adverse selection
  • Moral hazard

Externalities

• Externalities
  • A benefit or cost that affects someone who is not directly involved in an activity