Failures
Motivation:
Market request from students for clarification
we ended last lecture with a tension between 1) identifying & defending your personal interest; 2)
sacrificing for the national interest.
-How can we tell when the national interest is really at stake?
-How can we tell when a policy solution helps the national interest or is actually re-distribution
of wealth (or protectionism) in disguise? (e.g. tariffs, subsidies, regulation, etc.)
Answer: market failures are often cited as situations in which the government has a clear role for
advancing the public interest via sound policy.
-Question: Why are markets good?
-efficient (but what do we mean by this? less wastesupply meets demandno surplus or
shortage)
-decentralized (no person or organization has power to determine supply, demand, price,
distribution, production. No one has to tell )
-innovative (dynamic efficiency)
Whats a market?
-A market is created whenever potential sellers of a good or service are brought into contact with
potential buyers, and a means of exchange is available.
- In classical economics, a market is characterized by:
Market informed, rational individuals involved in the free exchange of goods, services, & capital,
resulting in economic efficiency
Focus on individuals: rational, free, secure, informed, have property rights
-(in special cases: a single prevailing price for commodities of uniform quality).
Economic Efficiency The state of an economy such that no one can be made better off (without
somebody else being made worse off). This requires:
*productive efficiency (output is being produced at the lowest cost possible),
*allocative efficiency (resources are allocated to the production of goods/services most valued by
consumers)
*distributional efficiency (output is distributed such that consumers do not wish to spend their incomes
in any other way).
Given a set of alternative allocations and a set of individuals, a movement from one allocation to another
that can make at least one individual better off, without making any other individual worse off, is called
a Pareto improvement or Pareto optimization. An allocation of resources is Pareto efficient or Pareto
optimal when no further Pareto improvements can be made.
-static (quantities of major economic factors dont change; no shocks or disturbances)
-dynamic (things change over time; technology, population, forms of organization)
For example:
Dynamic gains from trade:
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The dynamic gains from trade are the economic growth and development stimulated by international
trade, and include a: (a) technology transfers; (b) capital accumulation fostered because trade increases
real income; and (c) gains from economies of scale and economies of scope made feasible from larger
markets.
Static gains from trade:
The static gains from trade are the improvements in human welfare because trading parties gain by
acquiring (a) unique goods that they could not produce, (b) goods at lower costs than could be yielded
by own-production, (c) calmer relations between nations because mutual interdependence raises the cost
of conflict.
Wolf, Martin Why Globalization Works
A sophisticated market economy must solve five problems:
1) information must flow smoothly & symmetrically= confidence for buyers and sellers in products & exchanges (market for
lemons)
2) confidence that buyers/sellers will live up to their promises, even these promises are for the far future (enforceable
contracts)
3) competition must be fostered
4) property rights must be protected
5) externalities must be curtailed
Market Failure When the self-interested behavior of individuals involved in free exchange does
NOT result in economic efficiency. That is, even though people act rationally as individuals, their
actions get added up to an irrational result for the group (here the group is the economy). They can be
seen as having two main sources:
1) many transactions, which need to occur for the sake of economic efficiency, do not occur because of:
-high transaction costs-menu costs (and lack of an efficient cost)
-negative/positive spillovers
-poor info
-strategic behavior (firms play it tough) -poorly defined property rights
-asymmetric info [moral hazard, adverse selection, agency costs]
2) Collective interests not served by individual interests
-public goods
-increasing returns to scale (concentration/monopoly)
-free riders
-prisoners dilemmas (pollution)
-panics
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Major Forms of Market Failure
Market
Failure:
GTech
example:
How efficiency
is reduced:
Unstable
Property
Rights
Parking space
on streets in
snow storm
Availability of
lounge in dorm
Private time
living in triple
Decreases
incentives to
invest in
innovative or
value-added
activity
Imperfect
Competition
(monopolies,
cartels,
collusion)
Student center
food services
Course
textbooks
-Price fixing
leads to higher
than market
prices
-Decrease in
competition
reduces
incentives to
innovate
GTech/Comm
on Solution:
Private/Public
Claims or Plow
House
Manager
Negotiation
Co-op, food
trucks,
Chic-Fil-A,
Coke products,
Barnes &
Noble +
kickback
Boeing v.
Airbus,
Microsoft,
telecoms,
IPE Example:
IPR, genetic
codes,
pharmacticals
Govt.
solution
Grant patents
and and
enforce copyrights
Regulation
Anti-trust:
initiate breakup
or create
competition;
Problems/Side
effects of the
Govt. solution:
Influence and
bargaining
costs,
Olsonian
collective
action
Stiglerian
capture,
Organztnl
interests/proces
s, Olsonian
collective actn
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Externalities
(good & bad)
Imperfect
Information
Imperfect
Consent
Good:
Cleaning the
dorm lounge
Bad:
Smoking, loud
music,
cats/dogs
-Good: benefits
of production
get accrued by
outsiders, thus
reducing
incentives to
produce
-Bad: costs of
production
born by
outsiders, thus
increasing
incentives to
produce
Mitigation/co
mpensation,
regulation,
force
Used cars
Vanishing
dining halls
GTech
medical
Sex
Drugs
Alcohol
Junk food
Cigarettes
Information
asymmetries
between buyers
and sellers can
shrink or
eliminate
markets
Inability of
economic
actors to
allocate
resources
optimally
Guarantees
Require
bailout
Licensing
Safety labels
Regulation
Education
Pollution,
defense tech,
inoculations,
R&D
-FDI
-foreign stock
markets
-Medical
insurance;
-Job market
Regulation,
disclosure
Human
subjects,
GMOs
Stiglerian
capture,
Organizational
interests/proces
s
Stiglerian
capture,
Organizational
interests/proces
s
Good:
Subsidies, trade
protection
Bad:
Regulation,
subsidies for
alternatives
Influence and
bargaining
costs,
Stiglerian
capture, pork
Prohibition,
market
restrictions
1) Unstable Property Rights
-We defined markets as existing whenever well-informed, rational individuals come together in the free
exchange of goods, services, & capital, resulting in economic efficiency.
-This definition is assumes that people have property rights over their goods, services, and capital.
Because if they dont have property rights, then they cant trade them in a market. And property rights
cannot exist without a government to define and enforce them. Without government, people must define
and enforce property rights themselves, which can lead to inefficient outcomes.
2) Imperfect Competition (monopolies, cartels, collusion)
-Some economic actors may be so efficient, or become so wealthy in their resources, that they can drive
out their competition. And once competition is gone, they have less incentive to charge the
lowest possible price or to innovate.
-There is no strict measure of anti-competitive markets.
-Government has several policy solutions to choose from. It can break up non-competitive markets (e.g.
anti-trust). It can regulate monopolies by setting prices and provision (e.g. utilities). It can takeover the
economic activity (e.g. mail)
3) Externalities
-Negative externalities occur when ever the cost of an economic activity is transferred to actors not
involved in the performance of the economic activity (e.g. pollution). Since she doesnt have to
bear all the costs, the producer will therefore perform more of this activity than an efficient
market would dictate. The role for government here is to regulate or fine the producer.
-Positive externalities occur when ever the benefits of an economic activity is transferred to actors not
involved in the performance of the economic activity (e.g. scientific research). Since he cannot
capture all of the benefits, the producer will therefore perform less of this activity than an
efficient market would dictate. The role for government here is to subsidize the producer.
4) Imperfect Information
-If information on a good, service, or investment is bad or missing, then it clouds the ability of economic
actors to make good decisions. It also drives up the costs and risks of economic activity. Where
one party to a transaction has substantially more information than the other, you can get a
market for lemons result.
-In any case, information problems drive up the costs of economic activities and thereby shrink markets.
-The role for government here is to require private actors to provide more information, and/or for
government itself to provide information
5) Imperfect Consent
Others:
-Bank runs
-Adverse selection
POTENTIAL PROBLEMS WITH THE GOVT. SOLUTIONS:
1) Influence and bargaining costs,
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2) Olsonian collective action
3) Stiglerian capture,
4) Organztnl interests/process,
5) pork
Some Optional Core Readings on Market Failures
-Stigler, George The Theory of Economic Regulation Bell Journal of Economics and Management
Science (Sept 1971)
-Coase, Ronald The Problem of Social Cost Journal of Law & Economics (October 1960)
-Akerlof, George A. The Market for Lemons: Quality Uncertainty and the Market Mechanism
Quarterly Journal of Economics 84,3 (Aug 1970)
-Baron, David The Economics and Politics of Regulation in Banks & Hanushek Modern Political
Economy (1995)
-Milgrom, Paul and John Roberts Bargaining Costs, Influence Costs, and the Organization of Economic
Activity in Alt & Shepsle Perspectives on Pos. PE
-Olson, Mancur Rise and Decline of Nations Chapter 2 The Logic
-Polanyi, Karl The Great Transformation Chapter 6 The Self-Regulating Market
-Stiglitz, Joseph Private Uses of Public Interests: Incentives and Institutions Journal of Economic
Perspectives (Spring 1999)
Prop 24 in CA 2010 midterms
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