Types of Goods
Another cause of market failure is tied to the use of public goods. A public good is a product or service that is equally available to all citizens, regardless of their ability to pay. In contrast, a private good—a good or service bought for consumption—is bought and sold as buyers and sellers see fit, using the free market. Public goods are usually (but not always) paid for by the government using money provided by taxes. A tax is a compulsory contribution required by the government and levied on income, profits, and some goods and services. Examples of public goods include law enforcement, national defense, public school systems, and roads and other infrastructure. These goods and services cause market failure because it is usually hard to make a profit from them, and therefore private firms will not provide them.
A public good is one that is neither rivalrous or excludable. A good is said to be rivalrous if it can only be consumed by one person at a time, such as a restaurant meal. It is said to be excludable if someone who has not paid for the good can be prevented from consuming it, such a stay in a hotel room. The public education system is an example of a public good because everyone has access to it, regardless of their ability to pay, and one student enrolling does not exclude another student from enrolling as well. A private good is both rivalrous and excludable. A piece of clothing is an example of a private good because if one person purchases it, another person is prevented from doing so, and the person must pay for the good in order to use it.
Some goods may be rivalrous and non-excludable, or they may be non-rivalrous and excludable . Netflix and paid dating apps are modern examples of a club good: they are excludable but not rivalrous, because the number of people who can use them on a given day is not limited, but everyone who does so must pay. On the other hand, a park bench is an example of a common good; it is rivalrous but not excludable, because everyone is free to use it without paying to do so, but there is a limit to the number of people who can use a park bench at the same time. One issue that arises with common goods is known as the tragedy of the commons, which is when individuals deplete a common good to personally benefit themselves despite the cost to the society. Overfishing is one of the best present day examples, as fishing in the ocean is not excludable, but is rivalrous. Fish are currently being depleted because demand for fish is outpacing the growth of schools of fish.
An externality is a consequence of an economic activity on a third party who is not directly involved in the action or decision. Externalities can be either a cost or a benefit. These are examples of market failures because they can cause the quantities of goods and services consumed to not be socially optimal, that is, as good as possible. Market failures result in too little or too much of a good or service being supplied.A product's price may not accurately reflect the costs associated with the product if some costs are not taken into account by the market in pricing. For example, suppose a factory emits pollution that affects the people living nearby. The factory owner considers many production costs, including building, equipment, labor, supplies, and transportation expenses, which are private costs. But the owner does not factor in the costs incurred by the people who live near the factory, such as medical and clean-up expenses. By not cleaning up its pollution, the factory makes the clean-up cost a social cost (which is shouldered by the society) instead of a private cost, which therefore does not need to be factored into the price of the product. The pollution is a negative externality, a side effect of an economic activity that produces additional costs to society. An externality can also be positive. A positive externality is an additional benefit produced by an economic activity that accrues to people not directly involved in the economic activity. For example, governments provide public education. This public good directly benefits the students attending the schools. Also, educated communities provide additional benefits to society as a whole, such as improving people's personal lives and increasing economic growth. Positive externalities can also be seen in private goods, such as when a child receives a flu shot. There is an obvious benefit to the child because they do not get sick, but they are also more likely to finish school and be financially successful in the future. There is also a societal benefit to flu shots because if a person does not get the flu, they also prevent the spread of the flu, protecting the people around them, particularly people who did not get the flu shot. When a product's price does not reflect the costs associated with a negative externality, a free market will supply an excess of the product. Conversely, when a product's price does not reflect the benefits associated with a positive externality, a free market will supply too little of the product. In cases of both negative and positive externalities, the quantity consumed in the free market is not socially efficient. In economics, social benefits are the sum of private benefits and the value of positive externalities, while social costs are the sum of private costs and the value of negative externalities.
A clear cause of market failures is a lack of complete knowledge by one or both parties about factors that would affect decision making, or imperfect information. Most market transactions involve some type of imperfect information. Imperfect information can deter buyers and sellers from entering the market. Buyers and sellers cannot properly determine the quality, and sellers struggle to demonstrate the quality of their product to consumers.
One main type of imperfect information involves the market for used goods. The market for used goods is one of imperfect information because the seller has more information about the quality of the good than the buyer. Given two identical used items (used cars for instance), the best choice may not be the cheaper one, because the consumer is uncertain of the quality. Taking the cheaper car has the risk of being a lower quality. If the choice was between two identical goods that were new, the rational choice of the consumer would be to choose the lower price of the two because he now has more complete information.
Sellers in a market with imperfect information need to offer signals to suggest that their product has good quality. Examples of signals from producers are warranties, money-back guarantees, and service contracts. In other instances, occupational licenses may need to be obtained and they demonstrate a defined level of quality. Those entering the labor market signal their quality through resumes, degrees, and letters of recommendation. To ensure borrowers are going to repay loans, lenders request signals such as cosigners, collateral, and income verification.
Asymmetric information is when one party in the market transaction has more information on the quality of the good than the other. Insurance is a prime example of an industry that exhibits asymmetric information. Situations like this, when a market is inefficient because of one party lacking complete information (like proper assessment of a risk pool), are known as adverse selection. In this case, insurance companies know what they need to charge overall, but don’t know at which risk level each driver is. Thus, if they end up overcharging the low-risk customer, that customer will leave. This result is more high-risk buyers paying less than the expected value of what their claims will be. Insurance companies need to find a way to accurately assess risk pools and keep low-risk customers in order to avoid adverse selection. The individual mandate of the Affordable Care Act (ACA), the healthcare reform legislation passed into law in 2010, actually aimed to solve this problem by mandating that everyone carry health insurance or they run the risk of being charged a fee.
Another type of market failure based on imperfect information is a moral hazard, a situation in which an entity takes on a risk because they are protected against that risk. For example, an insured driver might choose to drive more recklessly, because insurance will cover them if there is an accident. Insurance companies have policies that are aimed at reducing moral hazard. Good driver discounts, deductibles, and co-payment options are examples that aim to reduces moral hazard and their underlying costs.