Market Failures and the Role of Government

1. Market Failures and the Role of Government Chapters 12 and 14

2. Market Failures • A situation when the market fails to achieve the efficient outcome • Asymmetric Information • Monopolies (imperfect competition) • Externalities • Public Goods

3. Asymmetric Information • Situation that exists when some people in the market have better information than others. The people with the least amount of information will choose not to participate in the market • Examples: Insider trading, markets for lemons, new employment opportunities.

4. Two Types of Asymmetric Information • Adverse Selection (hidden characteristics) • Things one party to a transaction knows about itself, but which are unknown by the other party. • Lemons, market for insurance • Moral Hazard (hidden actions) • Actions taken by one party in a relationship that cannot be observed by the other party. • Again, the market for insurance • Fixed salaries • Auto rental market

5. Possible Solutions • Signaling • Attempt by an informed party to send an observable indicator of his or her hidden characteristics to an uninformed party. • To be effective, the signal must not be easily mimicked by other types. • Example: Education to signal that you will be a high-productivity employee. Warranties signal product quality.

6. Possible Solutions • Adverse Selection: • Examples of Private solutions: • Lemons market: high-quality producers may offer product warranties to signal that their goods are of high quality. This would be a very expensive option for low-quality producers • Health insurance market: • Company can become better informed about health status • Company can sell GROUP insurance to a company that employs all health-types • Company can offer different plans. For example, a high-deductible plan would be purchased by healthier individuals.

7. Possible Solutions • Adverse Selection: • Examples of Government solutions: • Rules against insider trading • Provides information in many markets (cigarettes, alcohol), including work environments • Requires certification of skills for authenticity • Truth in advertising laws • Requires financial disclosures for companies with publicly traded stock • Requires parties to a contract to honor the contract. • Requirement that all drivers purchase liability insurance.

8. Possible Solutions • Moral Hazard: • Examples of Private solutions: • insurance market: • Companies don’t offer a complete insurance contract (i.e., deductibles) because they want individuals to bear some of the risk. • How do firms deal with moral hazard? • Government solutions: • The government faces same information problems. However, the government may do things to ensure a particular level of care (e.g., driving laws)

9. Mathematical Problems • Suppose we have the following information regarding the market for used cars. • If there are more buyers than sellers and buyers have the same information (or can acquire easily), then all cars should sell at prices = WTP. Surplus is maximized at $500 per car.

10. Mathematical Problems • Suppose we have the following information regarding the market for used cars. • Suppose buyers cannot observe quality. Is there a market failure? Who benefits? Who is harmed?

11. Mathematical Problems • Suppose we have the following information regarding the market for used cars. • Suppose buyers cannot observe quality. Is there a market failure? Will any trades take place?

12. Mathematical Problems • Suppose we have the following information regarding the labor market. • Suppose workers are in short supply. Who is hired? At what wage? Is there a market failure.

13. Mathematical Problems • How might workers signal that they are in fact good workers? • Education. But suppose that students learn nothing that contributes to their productivity: and that for $25K a good worker can attend college and a bad worker would have to spend an additional $10K (on GMAT prep courses, tutors, foregone wages associated with working twice as hard) • If education is a signal of quality, what’s the monetary benefit of getting a degree? • Which set of workers get a degree? Is this signal credible? Who is hired? At what wage? • If government subsidizes education (which it often does) by $10K, what level of education and wages would prevail?

14. Market Power • Firms with market power produce socially inefficient output levels. • Too little output • Price exceeds MC • Deadweight loss • Dollar value of society’s welfare loss P Deadweight Loss MC PM PC D QC Q QM MR

15. Regulation • Governments may regulate the price that monopolies charge. • Earlier this semester we looked at two ways the government may regulate price. • P=AC • P=MC (the competitive outcome)

16. Externalities • Third-party, non-market effects. • Example: Pollution, Cigarette smoking • Caused by the absence of well-defined property rights. • Government regulations may induce the socially efficient level of output by forcing firms or individuals to internalize pollution costs

17. MSC=MPC + marginal external cost P* DWL: too much is produced and consumed External cost Q* Externalities in production Price/bag of dog food S=MPC (marginal internal cost) Pu D=MPB=MSB Quantity of dog food produced in Ogden Qu

18. External cost DWL P* MSB=MPB-marginal external cost Q* Externalities in consumption Price/cigarette D=MPB S=MPC=MSC Pu Quantity of cigarettes smoked Qu

19. ExternalitiesMarket Solutions • Coase Theorem: Can achieve efficient outcome with no government intervention • No transaction costs • Number of bargaining parties is small • Property rights are defined, but it doesn’t matter how they are assigned • Example: your neighbor mows her lawn at 5am. The marginal damages to you are valued at $6. The marginal benefits to your neighbor are valued at $4.

20. ExternalitiesGovernment Solutions • C&C (command and control) • Per-unit emission taxes. Set the tax equal to the external cost to achieve the efficient outcome. • Note: if the externalities are a benefit, then government can use subsidies, where the subsidy is equal to the external benefit (e.g., education) • Tradable discharge permit markets • Allow monopolies to exist (e.g., Utah State Liquor Stores) • Pollution Control Handout

21. Public Goods • A good that is nonrival and nonexclusionary in consumption. • Nonrival: A good which when consumed by one person does not preclude other people from also consuming the good. • Nonexclusionary: No one is excluded from consuming the good once it is provided. • Examples: Clean air, wilderness areas, to some degree national defense. • “Free Rider” problem means that public goods will be underprovided if left to the market.

22. Public Goods $ Total demand for snowplow service (vertical summation) 84 54 40 MC of snowplow service 30 Individual 2’s demand for snowplow service Individual 1’s demand for snowplow service 0 3 7 30 Snowplow Service (monthly)

23. Rent Seeking • The governments presence in markets provides incentives for firms or individuals to influence government policies. • This undermines the governments ability to make matters better. • Examples: Tariffs and Quotas. These trade restrictions benefit certain firms and workers, but have a negative effect on consumers (i.e., consumers will pay higher price for these goods and services).

24. An Example: Seeking Monopoly Rights Consumer Surplus • Firm’s monetary incentive to lobby for monopoly rights: A • Consumers’ monetary incentive to lobby against monopoly: A+B. • Firm’s incentive is smaller than consumers’ incentives • But consumers’ incentives are spread among many different individuals • As a result, firms often succeed in their lobbying efforts. P A = Monopoly Profits B = Deadweight Loss PM A B MC PC D MR QM QC Q

25. Summary • Market power, externalities, public goods, and incomplete information create a potential role for government in the marketplace • Government’s presence creates rent-seeking incentives, which may undermine its ability to improve matters