Chapter 16 - Market Failures and Government Intervention: Study Notes

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Chapter 16: Market Failures and Government Intervention

16.1 Basic Functions of Government

Governments play a crucial role in modern economies by providing essential services and maintaining order. The choice between market mechanisms and government intervention depends on which mix best serves societal needs.

Monopoly of Violence: The government’s exclusive authority to enforce laws and maintain order is fundamental for economic and social activities to proceed safely.
Institutional Importance: Effective institutions are key to a country’s economic success or failure.

Additional info: Minimal government functions include enforcing property rights, providing public goods, and correcting market failures.

16.2 The Case for Free Markets

Free markets are often defended on the grounds of allocative efficiency, where resources are used to maximize total societal surplus.

Formal Case: In perfectly competitive markets, prices equal marginal costs, leading to allocative efficiency.
Informal Case:
1. Free markets coordinate actions automatically.
2. The pursuit of profits drives innovation and growth.
3. Free markets decentralize economic power.

Allocative Efficiency: Achieved when resources are distributed such that total surplus (consumer plus producer surplus) is maximized.

16.3 Market Failures

Market failure occurs when the free market fails to achieve allocative efficiency. The main causes include:

Market Power
Externalities
Public Goods
Asymmetric Information

Market Power

Firms with market power (e.g., monopolies) restrict output below competitive levels, causing inefficiency.
This motivates competition policy to promote efficiency.
However, imperfect competition can also foster innovation.

Externalities

Externality: When an action by a firm or consumer imposes costs or benefits on third parties.
Private Costs: Costs borne by the decision maker.
Social Costs: Private costs plus any external costs imposed on others.

Even with perfect competition, externalities cause inefficiency.

Negative Externality: e.g., pollution, second-hand smoke (social cost > private cost).
Positive Externality: e.g., beautiful gardens, vaccinations (social benefit > private benefit).

Externalities and Allocative Inefficiency

With a negative externality, the market produces too much ().
With a positive externality, the market produces too little ().

Solutions to Externalities

Private Solutions: Clearly assigned property rights can allow bargaining (Coase Theorem) to reach efficient outcomes.
Public Solutions: Government intervention via taxes (for negative externalities) or subsidies (for positive externalities).

Coase Theorem: If bargaining is costless and property rights are clear, parties can negotiate efficient outcomes. However, high transaction costs or unclear rights can prevent this.

Externalities and Taxes/Subsidies

Tax: Imposed on firms causing negative externalities to internalize the external cost, reducing output to the efficient level.
Subsidy: Provided for activities with positive externalities to increase output to the efficient level.

16.3.1 Non-Rivalrous and Non-Excludable Goods

Goods can be classified by whether they are rivalrous and/or excludable.

Rivalrous: One person’s consumption reduces availability for others.
Excludable: People can be prevented from consuming the good.

	Excludable	Non-Excludable
Rivalrous	Private Goods e.g., DVDs, a seat on an airplane	Common-Property Resources e.g., fisheries, rivers, wildlife
Non-Rivalrous (up to capacity)	Club Goods e.g., art galleries, bridges, cable TV	Public Goods e.g., national defense, public information

Common-Property Resources

Non-excludable but rivalrous (e.g., fisheries, river water).
Prone to overuse ("tragedy of the commons") due to zero price and lack of exclusion.

Club Goods

Excludable but non-rivalrous (e.g., art galleries, bridges).
Marginal cost of serving an extra user is zero until congestion occurs.
Governments may provide these goods to avoid inefficient exclusion.

Public Goods

Non-excludable and non-rivalrous (e.g., national defense, public information).
Subject to the free-rider problem: individuals have an incentive to underpay, leading to underprovision by the market.
Governments must provide these goods to achieve efficient outcomes.

The Optimal Provision of a Public Good

The marginal benefit (MB) curve for society is the vertical sum of individual MB curves.
The optimal quantity is where .

16.3.2 Asymmetric Information

Market failure can also arise when one party in a transaction has more or better information than the other.

Moral Hazard: Hidden actions after a contract is signed (e.g., less careful behavior after obtaining insurance).
Adverse Selection: Hidden characteristics before a contract is signed (e.g., high-risk individuals more likely to buy insurance).

Adverse Selection and Health Insurance

Private Solutions: Insurance companies use screening (e.g., past claims, tests) to reduce adverse selection.
Public Solutions: Governments may require compulsory insurance to ensure risk pooling.

Moral Hazard in Insurance

Policyholders may take fewer precautions after obtaining insurance.
Solutions include incomplete coverage, deductibles, and risk assessment.
Government intervention is less often needed compared to other market failures.

16.4 Broader Social Goals

Governments may intervene in markets for reasons beyond correcting market failures, such as achieving social goals.

Income Distribution: Tax-and-transfer systems and social benefits redistribute income, often at the cost of some efficiency.
Preferences for Public Provision: Some services (e.g., justice, police) are widely viewed as best provided by government.
Protecting Individuals: Laws prevent individuals from harming others.
Paternalism: Policies protect individuals from self-harm (e.g., seatbelt laws).
Social Responsibility: Certain rights (e.g., voting) cannot be bought or sold.
Economic Growth: Policies are evaluated for their impact on productivity and living standards.

General Principle: There is often a tradeoff between achieving social goals and allocative efficiency.

Summary Table: Causes of Market Failure

Cause	Description
Market Power	Firms restrict output, causing inefficiency
Externalities	Uncompensated costs or benefits to third parties
Common-Property Resources & Public Goods	Non-excludability leads to overuse or underprovision
Asymmetric Information	Moral hazard and adverse selection distort market outcomes

Key Formulas and Concepts

Allocative Efficiency:
Social Cost: where = social cost, = private cost, = external cost
Optimal Provision of Public Good:

Examples and Applications

Negative Externality: Pollution from a factory increases health costs for nearby residents.
Positive Externality: Vaccinations reduce disease transmission, benefiting society.
Public Good: National defense protects all citizens, regardless of individual payment.
Common-Property Resource: Overfishing in open-access fisheries leads to resource depletion.