Microeconomics Study Guide: Market Failure, Externalities, Public Goods, Common Goods, and Information

Unit 5: Market Failure

Introduction

Market failure occurs when the allocation of goods and services by a free market is not efficient, often leading to a net social welfare loss. Understanding market failure is essential in microeconomics, as it explains why government intervention may be necessary.

• Definition: Market failure is a situation in which the market does not allocate resources efficiently on its own.

• Main causes: Externalities, public goods, common goods, and information asymmetries.

Externalities

Negative and Positive Externalities

Externalities are costs or benefits that affect third parties who are not directly involved in a transaction. They can be negative (imposing costs) or positive (providing benefits).

• Negative Externality: Occurs when an action imposes a cost on others (e.g., pollution).

• Positive Externality: Occurs when an action provides a benefit to others (e.g., education).

• Efficiency Loss: The difference between the private outcome and the socially optimal (cooperative) outcome.

Example: Pollution from a factory affects nearby residents who are not compensated for the harm.

Formula:

• Marginal Social Cost (MSC) = Marginal Private Cost (MPC) + Marginal External Cost (MEC)

• Marginal Social Benefit (MSB) = Marginal Private Benefit (MPB) + Marginal External Benefit (MEB)

$MSC = MPC + MEC$ $MSB = MPB + MEB$

Coase Theorem

The Coase Theorem states that if property rights are well-defined and transaction costs are low, private parties can negotiate to resolve externalities efficiently without government intervention.

• Key Points: Assigning property rights can lead to efficient outcomes.

• Limitations: High transaction costs or ill-defined property rights can prevent negotiation.

Taxes and Subsidies

Governments can correct externalities by imposing taxes (for negative externalities) or providing subsidies (for positive externalities).

• Pigovian Tax: A tax imposed to correct a negative externality, set equal to the marginal external cost.

• Pigovian Subsidy: A subsidy provided to encourage activities with positive externalities, set equal to the marginal external benefit.

Formula:

• Pigovian Tax = Marginal External Cost

• Pigovian Subsidy = Marginal External Benefit

$\text{Pigovian Tax} = MEC$ $\text{Pigovian Subsidy} = MEB$

Public Goods

Characteristics of Public Goods

Public goods are goods that are non-excludable and non-rivalrous, meaning that no one can be prevented from using them and one person's use does not reduce availability to others.

• Non-excludable: Cannot prevent people from using the good.

• Non-rivalrous: One person's use does not diminish another's use.

Examples: National defense, public parks, street lighting.

The Free-Rider Problem

The free-rider problem occurs when individuals benefit from a good without paying for it, leading to under-provision of public goods.

• Key Point: Because people can benefit without paying, private markets may fail to supply public goods efficiently.

Properties of Public Goods

• Non-excludable and non-rivalrous

• Subject to free-rider problem

• Often provided by government

Table: Demand for a Public Good

The following table shows the quantities demanded by Angela and Barbara at various prices. It illustrates how to aggregate individual demand for a public good.

Price	Angela	Barbara	Aggregate
0	10	8	18
2	6	4	10
4	4	2	6
6	2	0	2
8	0	0	0

Additional info: The aggregate demand for a public good is found by summing individual quantities at each price.

Examples of Public Goods

• Taylor Swift concert at Rogers Centre (if open to all)

• Public transit and subway systems

• National defense

Common Goods

Characteristics of Common Goods

Common goods are non-excludable but rivalrous, meaning anyone can use them, but one person's use reduces availability for others.

• Non-excludable: Cannot prevent people from using the good.

• Rivalrous: One person's use diminishes another's use.

Examples: Fisheries, public highways, clean air.

Tragedy of the Commons

The tragedy of the commons occurs when individuals overuse a common resource, leading to depletion or degradation.

• Key Point: Without regulation, common goods tend to be overused.

Table: Classification of Goods

Type of Good	Rivalrous	Excludable
Private Good	Yes	Yes
Public Good	No	No
Common Good	Yes	No
Club Good	No	Yes

Additional info: Club goods are excludable but non-rivalrous (e.g., subscription services).

Examples of Common-Goods Problems

• Light from a lighthouse

• Airport runway at night

• Highway toll-free at night

Information

Information Asymmetry

Information asymmetry occurs when one party in a transaction has more or better information than the other, leading to market inefficiency.

• Principal-Agent Problem: Occurs when an agent (e.g., employee) has different incentives than the principal (e.g., employer).

• Adverse Selection: Occurs when one party takes advantage of having more information (e.g., in insurance markets).

• Moral Hazard: Occurs when one party takes more risks because they do not bear the full consequences.

Examples of Information Problems

• Lemons and Plums: Used to describe markets with quality uncertainty (e.g., used cars).

• Principal-Agent: Employees may not act in the best interest of employers.

• Adverse Selection: Purchasing insurance when you know you are at higher risk.

• Moral Hazard: Taking more risks after obtaining insurance.

Table: Information Problems

Problem	Description	Example
Principal-Agent	Agent acts in own interest, not principal's	Employee shirking at work
Adverse Selection	One party has hidden information before transaction	High-risk individuals buying insurance
Moral Hazard	One party changes behavior after transaction	Driving recklessly after buying car insurance

Summary Table: Types of Goods

Type	Rivalrous	Excludable	Examples
Private Good	Yes	Yes	Food, clothing
Public Good	No	No	National defense, street lighting
Common Good	Yes	No	Fisheries, clean air
Club Good	No	Yes	Subscription TV, private parks

Additional info: These classifications help determine the appropriate policy response to market failures.