Overview
This lecture covers Chapter 4: Market Failures, focusing on how and why markets sometimes fail to allocate resources efficiently, externalities, methods for correction, and asymmetric information problems.
Market Failures and Efficiency
- A market failure occurs when markets do not produce the optimal amount of a good.
- Efficient outcomes require that market demand reflects total willingness to pay and market supply reflects all costs.
- Overallocation or underallocation happens due to externalities—costs or benefits not reflected in supply or demand curves.
Surplus Concepts
- Consumer surplus is the difference between what a consumer is willing to pay and what they actually pay.
- Producer surplus is the difference between the price sellers receive and their minimum acceptable price.
- Total surplus is the sum of consumer and producer surplus, maximized at market equilibrium (where marginal benefit = marginal cost).
- Deadweight loss occurs when there is underproduction or overproduction compared to the efficient equilibrium.
Externalities and Market Failures
- Externalities are costs or benefits to third parties not involved in the transaction.
- Negative externalities (e.g., pollution) cause overproduction; positive externalities (e.g., vaccinations) cause underproduction.
- The vertical distance between private and social curves represents the externality's size.
- Without correction, resources are misallocated, creating deadweight loss.
Correcting Externalities
- Negative externalities can be addressed by direct controls, Pigovian taxes (taxes matching the external cost), liability rules, or cap-and-trade systems.
- Positive externalities can be corrected through government subsidies to buyers or producers, or government provision.
- Accurately correcting externalities requires knowing the size and source, which is often challenging for governments.
- Private bargaining (Coase theorem) and markets for externality rights (cap-and-trade) offer non-government solutions.
Asymmetric Information
- Asymmetric information arises when one party in a transaction has more or better information than the other, causing inefficiency.
- Examples include buyers not knowing the quality of used cars or sellers not knowing buyers' health risks.
- Government solutions include regulation, licensing, or weights and measures, but reputation and warranties also help.
Moral Hazard and Adverse Selection
- Moral hazard occurs when insured parties take greater risks because costs are borne by others (ex-post).
- Adverse selection happens when only high-risk individuals participate because of private information (ex-ante).
- Solutions include deductibles, co-insurance, mandatory participation (as in employer health insurance), and warranties.
Limits of Government Intervention
- Government solutions may fail due to lack of perfect information and conflicting incentives (public choice theory).
- Market and private solutions often exist and may outperform government approaches.
Key Terms & Definitions
- Market Failure — Situation where markets do not allocate resources efficiently.
- Externality — Cost or benefit affecting third parties outside the transaction.
- Consumer Surplus — Willingness to pay minus actual price paid.
- Producer Surplus — Price received minus minimum acceptable price.
- Deadweight Loss — Efficiency loss from under- or overproduction.
- Pigovian Tax — Tax equal to external cost to correct negative externality.
- Coase Theorem — Private solutions are possible when property rights are clear.
- Asymmetric Information — Unequal knowledge between transaction parties.
- Moral Hazard — Increased risk-taking when protected from consequences.
- Adverse Selection — High-risk individuals are more likely to participate due to hidden information.
- Cap-and-Trade — Marketable rights to pollute, setting a maximum pollution cap.
Action Items / Next Steps
- Complete the SmartBook review homework and quiz for Chapter 4.
- Prepare to study Chapter 5: Government Failures for next lecture.