Understanding Market Failure: Sources and Solutions

1. Chapter 3 continued Market Failure

2. What is market failure? • Market Failure exists when the free market system fails to allocate resources in an efficient manner. • This section covers several sources of market failure including • Market power • Non-Existence of Markets • Asymmetric information, adverse selection, and moral hazard concerns • Externalities • Public Goods

3. Market power • From principles remember that firms with market power (such as monopolies) find it advantageous to under-produce goods in order to maximize profit • This meant they produced a quantity such that P > MC Implication:

4. Non-existence of markets • Markets either do not exist for every good and/or service or there are situations in which one person’s behavior affects the welfare of another outside the existing market • The inefficiency stems from several different causes: 1. problems of asymmetric information:

5. Non-existence and insurance markets • insurance markets are used to protect against uncertainty. However, there is not insurance for everything. • There is no private market for “poverty insurance”—insurance against the possibility of becoming poor. Private markets don’t supply such insurance because of the asymmetric information and adverse incentives. • Current solution: so government uses payroll taxes to fund unemployment benefits and/or welfare payments.

6. Asymmetric information and adverse selection example • Ex: health care: asymmetric information—individuals may know if they are in a high risk or low risk category for illness and base decision to buy insurance on relative costs and benefits. • Asymmetric information: The insurance company can’t determine who is high risk and low risk and therefore charges an average premium to all clients • Adverse selection means the people that choose to buy insurance are typically those in high risk categories who believe the benefits > costs; those that think they are at low risk will not buy insurance. Hence, end up insuring a pool of high risk applicants. • Current solution: try to spread risks through mandatory health care via employers and therefore generate a larger pool with differing levels of risk (State Health insurance). • Original health care bill: wanted to make every person purchase health insurance to bring down premium costs (get these low risk people back in the market).

7. Asymmetric information and moral hazard • moral hazard • Ex: home owners insurance: if you’re covered for theft may not be as diligent about locking your doors. • Ex: in health care; people who have insurance may overuse health care by engaging in more risky behavior or more costly behavior—extreme sports or more commonly patients want unneeded procedures, MRIs, testing, etc) because they are covered and pay very little in incremental costs.

8. Externalities • Externalities • Ex: Positive externalities – because individuals consider only their private costs and benefits and not the full social benefits of their decisions there is an under-production or under-consumption of these goods--flu vaccines. • Ex: negative externalities—– because individuals and firms consider only their private costs and benefits and not the full social costs of their decisions there is an over-production or over-consumption of these goods—pollution.

9. Public goods • Public goods—a good that in non-rival in consumption and non-excludable in consumption • Non-rival: • Non-excludable • Ex: lighthouse; national defense; fire protection • The market failure stems from the idea that people will “free ride” or “cheap ride” and not pay for something even though they receive the benefits. This results in an under-production of the good or service.

10. Government intervention in markets

11. Public policy should address 3 vital questions • Compass Lexecon (change in administration and change in objectives)