© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 14: Market Failures and Government Policy Prepared by: Kevin Richter, Douglas College

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

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Chapter 14: Market Failures and Government PolicyPrepared by:Kevin Richter, Douglas CollegeCharlene Richter,British Columbia Institute of Technology


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Chapter Objectives

1. Explain what is meant by market failure.

2a. Explain what an externality is.

2b. Show how an externality affects the market outcome.

3. Describe three methods of dealing with externalities.


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Chapter Objectives

4. Distinguish four types of goods.

5. Define a public good and explain the problem with determining the value of a public good to society.

6. Explain how informational problems can lead to market failure.


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Chapter Objectives

7. Explain how a market for information can solve a market failure.

8. List five reasons why government’s solution to a market failure could worsen the market failure.


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Introduction

The private market framework presented so far may be called the invisible hand framework.

Invisible hand framework – perfectly competitive markets lead individuals who maximize their own benefit to make voluntary choices; these choices also turn out to be in society’s best interest.


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Introduction

There are two cases where the market does not yield an appropriate outcome:

Market failure, where the market fails to produce an efficient outcome, and

Market outcome failure, where the market outcome, although efficient, is not socially optimal.


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Externalities

Externalities are the effect of a decision on a third party that is not taken into account by the decision-maker.

Externalities can be either positive or negative.


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Negative Externality

When there is a negative externality, social marginal cost is greater than private marginal cost. A steel plant benefits the owner of the plant and

the buyers of steel.

The plant’s neighbours are made worse off by the pollution caused by the plant.


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Social marginal cost includes all the marginal costs borne by society.

It is the private marginal costs of production plus the cost of the negative externalities associated with that production.


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When there are negative externalities, the competitive price is too low and equilibrium quantity too high to maximize social welfare.


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D = social marginal benefit

S = private marginal cost

S1 = social marginal costPrice

Quantity0 Q0

P0

Q1

P1

Marginal cost from externality


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Positive Externality

Social marginal benefit equals the private marginal benefit of consuming a good plus the positive externalities resulting from consuming that good.


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Positive Externality

Price

Quantity0

Marginal benefit of an externality

D0 = private marginal benefit

Q0

P0

Q1

P1

S = Social marginal cost

D1 = Social marginal benefit


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Direct Regulation

Direct regulation –the amount of a good people are allowed to use is directly limited by the government.


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Tax Incentive Policies

A tax incentive program uses a tax to create incentives for individuals to structure their activities in a way that is consistent with the desired ends.

The tax often yields the desired end more efficiently than direct regulation.


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Regulation Through Taxation

Social marginal benefit

Private marginal cost

Social marginal costPrice

Quantity0 Q0

P0

Q1

P1 Efficient tax


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Market Incentive Policies

A market incentive program differs from a regulatory solution.

Individuals who reduce consumption by more than the required amount receive marketable certificates that can be sold to others.


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Optimal Policy

An optimal policy is one in which the marginal cost of undertaking the policy equals the marginal benefit of that policy.


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Optimal Policy

Optimal level of pollution – the amount of pollution at which the marginal benefit of reducing pollution equals the marginal cost.


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Property Rights

Property rights are a set of use and ownership rules in society which dictate who may use or enjoy a particular resource.


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Coase Theorem states that the optimal allocation of resources can always be achieved through market forces, regardless of the initial assignment of property rights.

Property Rights


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Four Types of Goods

Rival Nonrival (jointly consumable)

Excludable Private market goods. Examples: shirts, haircuts

Congestion. Examples: art exhibits, roads and bridges.

Non-excludable

Common Property. Examples: fishery, atmosphere.

Public Goods. Examples: national defense, national parks


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With rival goods, other people are automatically prevented from consuming the good.

Goods are excludable if access to them can be controlled.

Private Market Goods


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Congestion

Nonrival excludable goods do not trade well in an ordinary market.

These goods can be jointly consumed, and access to them can be controlled.


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Common Property

Nonexcludable goods are difficult for markets to handle, because nonpayers cannot be excluded.

Nonexcludable rival goods are those goods whose access cannot be controlled and one person’s use of it precludes the use of it by another. The fishery is an example.


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Public Goods

A public good is nonexcludable and nonrival.

Nonexcludable – no one can be excluded from its benefits.

Nonrival – consumption by one does not preclude consumption by others.


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Market Value of a Public Good

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Price

1 2 3 Quantity

8

6

4

2

10

Market demandDB

DA

1

4

1

6 5


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Asymmetric Information

Asymmetric information is a situation in which one person has information relevant to the exchange, but the other person does not.

Asymmetric information can be a cause of market failure.


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Adverse Selection

Some market failures result from adverse selection problems.

Adverse selection occurs when a buyer or a seller has more information about the good for sale, and uses this information to swing the deal in their favour.


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Adverse selection is often a problem when the good is an experience good, a good where the person must use it to learn its characteristics.

Adverse Selection


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Moral Hazard

Market failure can arise from moral hazard problems.

Moral hazard occurs when one of the parties to the exchange can misrepresent his intentions and behave differently than what was agreed to.


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Moral Hazard

Drafting a complete contract – where all behaviour is specified -- can reduce moral hazard. Can be prohibitively costly.

Long-term relationships can also reduce moral hazard.


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Market in Information

A market in information is one solution to the information problem.

Information is valuable, and is an economic product in its own right.


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Licensing of Doctors

Providing information rather than licensing would give rise to consumer sovereignty.

Consumer sovereignty – the right of the individual to make choices about what is consumed and produced.


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Government Failures

Government failure occurs when the government intervention in the market to improve the market failure actually makes the situation worse.


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Reasons for Government Failures Governments do not have an incentive to

correct the problem.

Governments do not have enough information to deal with the problem.

Intervention in the markets is almost always more complicated than it initially looks.


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Government Intervention

Although government failure can occur, government intervention often can improve a poorly functioning market, or correct a market failure.


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Market Failures and Government Policy

End of Chapter 14

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 14: Market Failures and Government Policy Prepared by: Kevin Richter, Douglas College