Market Failure: Externalities, Public Goods, and Asymmetric Information

Market Failure

Introduction

Market failure occurs when the allocation of goods and services by a free market is not efficient. This typically happens when the assumptions of perfect competition are violated, leading to outcomes where resources are not allocated to their highest-valued uses.

• Competitive markets are efficient only if:

  • There are many buyers and sellers, none of which is large in relation to total sales or purchases.

  • Each firm produces and sells a homogeneous product.

  • Buyers and sellers have all relevant information about prices, product quality, sources of supply, etc.

  • Firms have easy entry and exit.

Externalities

Definition and Examples

Externalities are side effects (spillover or third-party effects) from production or consumption that affect people not directly involved in the market exchange. These effects can be either costs or benefits and are external to the market participants.

• Example: Pollution produced during electricity generation is a negative externality.

Negative Externalities

Negative externalities occur when the social cost of a good exceeds the private cost, leading to overproduction.

• Marginal External Cost (MEC): The additional cost imposed on society by one more unit of production.

• Marginal Social Cost (MSC): The sum of private cost and external cost: $MSC = ext{Private Cost} + ext{External Cost}$

• Market equilibrium ignores external costs, resulting in overproduction.

Positive Externalities

Positive externalities occur when the social benefit of a good exceeds the private benefit, leading to underproduction.

• Marginal Social Benefit (MSB): The sum of private benefit and external benefit: $MSB = ext{Private Benefit} + ext{External Benefit}$

• Market equilibrium ignores external benefits, resulting in underproduction.

Summary Table: Externalities

Type	Market Outcome	Socially Efficient Outcome
Negative Externality	Overproduction	Lower output
Positive Externality	Underproduction	Higher output

Solutions to Externalities

• Pigovian Taxes/Subsidies: Tax goods with negative externalities or subsidize goods with positive externalities to align private and social costs/benefits.

• Arrow's Solution: Create a market for the externality (e.g., cap-and-trade for pollution permits).

• Coase Theorem: Assign property rights and allow bargaining; if transaction costs are low, parties can negotiate to reach the efficient outcome.

Reducing Emissions: Policy Options

Tons of SO2	Firm 1	Firm 2	Firm 3
1st	10	20	30
2nd	20	30	40
3rd	30	40	50
4th	40	50	60
5th	50	60	70

• Direct Regulation: Set a maximum emission per firm.

• Emissions Tax: Charge a tax per unit of emission (e.g., $31/ton).

• Cap and Trade: Issue permits for emissions and allow trading.

Coase Theorem

• If there are no transaction costs and no income effects, any assignment of property rights will lead to the socially efficient output level.

• Example: If firms are liable for pollution, the supply curve shifts to reflect the marginal social cost.

Public Goods

Rivalness and Excludability

• Rival: One person's consumption reduces availability for others.

• Non-rival: Many can consume simultaneously.

• Excludable: People can be prevented from consuming.

• Non-excludable: People cannot be prevented from consuming once available.

Types of Goods

	Excludable	Non-excludable
Rival	Private good	Common pool resource
Non-rival	Club good	Public good

Indivisible Public Good

• A good is indivisible when its utility depends on the number of users.

• If total benefit exceeds total cost (TC), it is efficient to provide the good.

• Example: If five people are willing to pay $800, $700, $600, $500, and $400, and TC = $2,500, the good is not provided if each pays $500.

Divisible Public Good

• For divisible public goods, the efficient quantity is where the sum of marginal benefits equals marginal cost: $MSB = MC$

• Market provision often leads to underprovision and deadweight loss.

Asymmetric Information

Types of Informational Asymmetry

• Hidden Information: One party knows more than the other (leads to adverse selection).

• Hidden Action: One party's actions are unobservable (leads to moral hazard).

Adverse Selection

• Occurs when buyers or sellers have information that the other party does not, leading to market inefficiency.

• Example: In health insurance, less healthy people are more likely to buy insurance, raising costs for insurers.

Moral Hazard

• Occurs when one party takes more risks because they do not bear the full consequences of their actions.

• Example: Insured individuals may use more healthcare services than if they were paying out of pocket.

Practice Problem Example

• Scenario: Health insurer offers Bronze, Silver, and Gold plans. Healthy individuals select Bronze (cheaper, less coverage), sicker individuals select Silver/Gold (more coverage, higher cost). Once insured, Silver/Gold users consume more healthcare.

• Adverse Selection: Individuals self-selecting into plans based on hidden health status.

• Moral Hazard: Overconsumption of healthcare due to insurance coverage.

Summary Table: Types of Market Failure

Type	Cause	Result	Solution
Externality	Unpriced side effects	Over/underproduction	Tax/subsidy, tradable permits, property rights
Public Good	Non-rival, non-excludable	Underprovision	Government provision, collective action
Asymmetric Information	Hidden info/action	Adverse selection, moral hazard	Screening, monitoring, regulation