Market Failures

1
Market Failures Investigating the conditions
under which international trade can lead to
undesirable consequences.
2
Market Efficiency Summary

• Under certain conditions the market arranges all
  potential mutually beneficial exchanges.
• The sum of consumer and producer surpluses are
  greatest at the market equilibrium.

3
Market Efficiency Summary

• In some cases potential gains from trade are not
  realized. This is called a market failure.
• A monopoly price set above the market equilibrium
  is one example of a market failure.

4
Four Major Types of Market Failure

• Monopoly
• Externalities
• Public Goods
• Asymmetric Information

5
Other Noted Shortcomings of Market Economies

• Income Inequality
• Game Theoretic Considerations
• QWERTY
• Capital Market Myopia
• Orphan Goods
• Macroeconomic Instability

6
Market Failure 1 Monopoly

• Monopoly prices are set above the market
  equilibrium prices and above MC, and the
  monopolists output will be lower than that
  observed in a competitive market.

7
Other Monopoly Inefficiencies

• Monopolists will spend resources to prevent entry
  into their market. (Rent Seeking Costs like
  advertising)
• Monopolists, protected from competition, are
  claimed to have higher production costs. (X
  Inefficiency)
• It is argued that monopolists are less innovative
  than their competitive counterparts.

8
Is the Monopoly Problem Important?

• The magnitude of the loss in gains from trade is
  measured by a triangle. Triangles are relatively
  small.
• The problem of monopoly was more important
  historically when transportation costs were
  higher and local producers were more protected
  from competition.
• With decreases in barriers to trade, the monopoly
  problem has decreased.
• With deregulation, the power of government
  protected monopolies has decreased.

9
Creative Destruction

• With increased rates of technological change and
  product innovation, current monopolists are
  increasingly short lived.
• Perhaps the most important type of competition is
  between old and new ideas.

10
Policies to Reduce Monopoly Problems

• Antitrust Action (the case against Microsoft)
• Increased International Trade
• Deregulation

11
Market Failure 2 Externalities

• In a market place trade takes place when both the
  buyer and seller expect to benefit from the
  trade. Market trade increases expected consumer
  and producer surpluses.
• When a market trade affects a third party it is
  called an externality since it is external to
  the market participants.
• In the presence of externalities, the market
  price does not contain information which reflects
  all costs of production.

12
Externalities

• Negative Externalities exist when a market trade
  imposes extra costs on third parties. An
  important class of negative externalities are
  various forms of pollution.
• Positive Externalities exist when a third party
  benefits from a market transaction.

13
Negative Externalities

• The cost of negative externalities are not
  reflected in the MC curves of the sellers and are
  not reflected in the market supply curve.
• Lets call the Marginal External Costs MEC

14
Negative Externalities

• The market equilibrium price would be about 350
  and the quantity would be 3.
• HOWEVER, this equilibrium does not take into
  account external costs.

15
Negative Externalities

• The market price does not fully reflect the
  true marginal costs.
• The market price is 350 while the true marginal
  costs are 450.

16
Negative Externalities

• The market inefficiency when goods traded in the
  market are valued by consumers at a level which
  is less than the true marginal costs associated
  with the good.

17
Pollution Solutions

• Standards setting restrictions on technology,
  production, and consumption.
• Bans on pesticides, leaded gasoline, smoking in
  public places, decibel limits
• Pollution Taxes
• Taxes on tobacco and gasoline.

• Liability Laws asbestos, tobacco

18
Tradable Pollution Permits

• Each polluting company is issued the rights to
  emit X tons of sulfur dioxide.
• If the company emits more than X tons they must
  buy more permits in the market.
• If the company emits less than X tons they can
  sell permits in the market.

19
The Effects of the Permit Program

• After the program began, the price of the permits
  fell.
• The first response for polluters was to switch
  from high sulfur to low sulfur coal.
• The market price and quantity of low sulfur coal
  increased.

20
The Market Price of Permits

• The price fell from 150/ton to about 75.
• More recently it has settled at 200/ton

21
Market Failure 3Public Goods and Common Property
Resources

• Markets tend to produce inefficient results when
  it is not possible to exclude non payers (free
  riders) from consuming a product.
• It is possible to exclude non payers from a movie
  theatre at low collection costs.
• But it is more costly to exclude non payers from
  benefiting from the provision of national defense
  services.

22
Public Goods and Common Property Resources

• Consumption of an apple is rival if I eat it,
  you cant.
• Consumption of a movie is non rival (given the
  theatre is not full).

23
Market Failure 4 Asymmetric Information

• Information costs can be high, and because of
  this, we are always imperfectly informed. This is
  called rational ignorance.
• Markets tend to produce inefficient results when
  one side of the market has lower information
  costs than the other side. A common example is
  fraud.
• This is called the Asymmetric Information
  problem.

24
Asymmetric Information

• Typically, the seller of a product knows more
  about the product than the potential buyer. (The
  buyer knows this!)
• Consider the market for used cars. The seller
  knows the cars history. The seller who knows
  that her used car is in better than average
  condition will try to convince the potential
  buyer that this car is worth a higher than
  average price.
• Should the potential buyer believe the seller?

25
Asymmetric Information

• If buyers cannot verify the alleged above
  average condition of the used car, they will not
  be willing to pay an above average price.
• The seller of the above average used car, not
  able to get the above average price, will be more
  likely to withhold the above average condition
  car from this market.

26
Asymmetric Information

• If above average products are withheld from the
  market, consumers come to expect a lower quality
  and will not be willing to pay a price high
  enough to cover the costs of the producers of
  high quality products.
• This is a market failure in the sense that the
  trade for higher quality products does not occur
  despite the fact that potential consumer benefits
  exceed the costs of producing these higher
  quality products.

27
Asymmetric Information - Examples

• Labor markets you know that you are a higher
  quality product, but how do you convince
  potential employers?
• Insurance Markets you know that you are
  relatively healthy, but how do you convince the
  insurance company to charge you a lower health
  insurance premium?
• Financial Markets you know you are a good credit
  risk..

28
Asymmetric Information - Solutions

• Red Lining and insurance qualifying rules.
• Reputation and standardization (At Holiday Inn,
  the room is the same in Beijing and Seattle.)
• Market Signaling College Degrees and other
  signaling costs.
• Self Selection Mechanisms If you offer this
  warrantee, then you must have a good product.