Market Failure: Externalities,

Monopoly, Asymmetric Information,

and Public Goods
Three major functions of state
 Correcting Market failures
 Redistribution of income
 Promoting and discouraging merit goods
and bads.
 Measuring Economic
Efficiency
 How might we measure the extent to which courier
industry in India is being economically efficient?
 Economic efficiency generally relates to how well a
market or the economy allocates resources to satisfy
consumers.
 Efficiency occurs when society is using its scarce
resources to produce the highest possible amount of
goods and services that consumers most want to
buy.
 Allocative Efficiency
 Does the market economy deliver goods and services
to us at a price that fairly reflects the cost of supply?

 Does the market deliver the goods and services we

most value at a fair price?

 The technical condition required for allocative efficiency

is that price=marginal cost= marginal value.

 When this happens, total economic welfare is

maximized.
Consumer and Producer
Surplus
Consumer Surplus:
The extra benefits enjoyed by
consumer in a market who pay
less for a product than they were
willing and able to pay.

Producer Surplus:
The extra benefits enjoyed by the
market who sell their product for
more than they were willing and
able to sell it for.
 Types of Goods
Excludable good refers to the degree to which
consumption of a good or service is limited to paying
customers.
Rival Good in consumption refers to the degree to
which one person consuming a particular unit of a good
or service precludes others from consuming that same
unit of a good or service.
 Market Failures
 Market failure can be viewed as a scenario in which
individuals' pursuit of self-interest leads to bad results
for society as a whole.

 Sources of Market Failure:

1. Externalities:
2. Imperfect Information.
3. Market Power.
4. Public Goods.
 Externalities: A case Study
 The market for Aluminium
 Can the Market Provide Adequate Protection for the
Environment?
Figure 1 The Market for Aluminum

Price of
Aluminum Supply
(private cost)

Equilibrium

Demand
(private value)

0 QMARKET Quantity of
Aluminum
 EXTERNALITIES AND
MARKET INEFFICIENCY
An externality refers to the uncompensated impact of one
person’s actions on the well-being of a bystander.

 Externalities cause markets to be inefficient, and thus

fail to maximize total surplus.

 Two types of externalities

1. Negative : Adverse Impact on the bystander.
2. Positive: Beneficial Impact on the bystander.
 Externalities: Examples
Negative Externalities:
 Automobile exhaust
 Cigarette smoking
 Barking dogs (loud pets)
 Loud stereos in an apartment building
Positive Externalities:
 Immunizations
 Restored historic buildings
 Research into new technologies (Technological
Externalities)
 EXTERNALITIES AND
MARKET INEFFICIENCY
 Negative externalities lead markets to produce a larger
quantity than is socially desirable.

 Positive externalities lead markets to produce a lesser

quantity than is socially desirable.
 The Market for Aluminum
 The quantity produced and consumed in the market
equilibrium is efficient in the sense that it maximizes the
sum of producer and consumer surplus.
 If the aluminum factories emit pollution (a negative
externality), then the cost to society of producing
aluminum is larger than the cost to aluminum producers.
 For each unit of aluminum produced, the social cost
includes the private costs of the producers plus the cost
to those bystanders adversely affected by the pollution
 Figure 2 Pollution and the Social Optimum

Price of
Social
Aluminum
cost
Cost of
pollution
Supply
(private cost)

Optimum

Equilibrium

Demand
(private value)

0 QOPTIMUM QMARKET Quantity of

Aluminum
Positive Externalities
 A technology spillover is a type of positive externality
that exists when a firm’s innovation or design not only
benefits the firm, but enters society’s pool of
technological knowledge and benefits society as a
whole.

 Marshallian and Pigouvian partial equilibrium

framework.
 Figure 3 Technology and the Social Optimum

Price of
Technology
Supply
(private cost)

Social
value
Demand
(private value)

0 QMARKET QOPTIMUM Quantity of

Technology
 Market Externalities: A Recap
1. Externalities arise when incentives facing individual
decision-maker diverge from those of society as a whole

1. Negative externalities in production or consumption

Production level is greater than the socially optimal level.
Want to alter incentives of producer to consider external
costs and reduce production

2. Positive externalities in production or consumption

Production level is less than the socially optimal level.
Want to alter incentives of producer to increase production.
 Types of Private Solutions to Externalities
Government action is not always needed to solve the
problem of externalities.

 Moral codes and social sanctions

 Charitable organizations
Coase theorem

 If transaction costs are low then private bargaining will

result in an efficient solution to the problem of
externalities.
 Profits under Alternative
Emission Choices
Factory’s Profit Fishermen’s Total Profit
Profit
No filter, no 500 100 600
treatment plant
Filter, no 300 500 800
treatment
No filter, 500 200 700
treatment plant
Filter, treatment 300 300 600
plant
 Bargaining with alternative
property rights
No Cooperation Right to dump Right to Clean water
Profit of factory 500 300
Profit of fishermen 200 500
Cooperation
Profit of factory 550 300
Profit of fishermen 250 500

When parties can bargain without cost and to their mutual advantage, the
outcome will be efficient regardless of how property rights are specified.
 Government interventions
When externalities are significant and private solutions
are not found, government may attempt to solve the
problem through . . .

 command-and-control policies.
 market-based policies.
 Public Policy Towards
Externalities
Command-and-control policies: Usually take the form of
regulations through forbid certain behaviors or require
certain behaviors. Examples: requirements that all
students be immunized, stipulations on pollution
emission levels set by the Environmental Protection
Agency.

Market-based policies:
 Government uses subsidies to align private incentives
with social efficiency.
 taxes enacted to correct the effects of a negative
externalities
 Tradeable permits
 Public Goods
Closely related to an externality is the case of a Public
Good, which is a commodity defined as follows:

1. Non-rival in consumption – meaning that one

persons consumption does not prevent anyone else
from doing so as well.

2. Non-excludable – it is impossible (or very

expensive) to prevent anyone else from benefiting
or consuming the good.
 Combined cause of market
failure

Non excludable Excludable

Non rival Public Club goods

Rival Common goods Private

Examples of Public Goods

Excludable
No Yes
National
Bridges,
defense,
No swimming
mosquito
pools
control
Rival Hot dogs,
Fishing
Yes cars,
grounds,
houses
 CONSEQUENCES
Non-excludable:

Very difficult for the private sector to provide it.

Information and R&D

Non-rivalry

Do not want to exclude people as it is inefficient.

 Conclusion: Individual
Incentives Don’t Work Here.

Need a government to provide the good.

 Public Goods
Public Goods cause market failures because private
markets will not provide them.

• The basic argument relies on incentive effects and

the “free-rider” problem.

• If the good is nonexclusive, no consumer has an

incentive to pay.
 Public Goods
• In other words, each consumer has an incentive to be a
“free-rider”.

• As an example, if societies relied on the private market to

provide national defence, lighthouses or public parks,
these Public Goods would likely not be provided for at all.
 Public Goods
• Governments can provide Public Goods that will not be
provided by the private sector because governments can
coerce payment from individuals.

• Through taxation and other means, government can

force individuals to contribute to the provision of public
goods.
 Free Riding Problem
 Free Riding occurs when people are not
honest in stating their marginal benefit,
because if they understate it, they can get a
slightly reduced level of the public good while
paying nothing for it.
 Free-riding is easier with
 Anonymity: If everyone knows who contributes,
there can be powerful social stigmas applied to
shirkers.
 Large numbers of people: It’s easier to
determine the shirkers in a small group and the
punishment is more profound when people
close to you shun you for not paying your
share.
 Efficient allocation for public
goods
 Public provision
 Taxes
 Debt
 Public production
 Market creation
 Public Private partnership
 Market Failures with
Asymmetric Information
 Asymmetric Information
Some parties know more than others:

 A seller of a product knows more about its quality than the

buyer does.

 Workers usually know their own skills and abilities better

than employers.

 Business managers know more about their firms’ costs,

competitive positions, and investment opportunities than do
the firms’ owners.

Asymmetric Information: A situation in which one party in

a transaction has more or superior information compared
to another.
 Adverse Selection & Moral Hazard
 When a person buys medical insurance, the insuring
company does not know whether the person is
healthy–a hidden type problem, or adverse selection
problem.

 Nor does it know how well he is going to take care of

himself after buying insurance–a hidden action
problem, or moral hazard problem
 Adverse Selection
 It arises when products of different qualities are sold at the
same price because buyers are not sufficiently informed
about the qualities of the products. As a result too much low
quality products and too little high quality products are sold
in the market place.

 It refers to the self-selection of individuals who purchase

insurance policies. In other words, people who are less risky
will choose not to insure, while risky people will choose to
insure. As a result, the insurance company is left with a
riskier pool of policy holders.
 Health Insurance: An
Example
 An illness costs Rs. 100,000/ episode.
Type % Risk Cost Willingness
of Of To to pay
Population Illness Insure (Rs.)
(Rs.)
Healthy 90 1/1000 100 200

Sick 10 1/100 1000 1500

Since the insurance company cannot determine who

is sick and who is healthy, it can only charge one
insurance rate, Rs. 190.

Everyone is willing to pay the proposed rate.

 Health Insurance: Modified
Example
Type % Risk Cost Willingness
of Of To to pay
Population Illness Insure (Rs.)
(Rs.)
Healthy 80 1/1000 100 200

Sick 20 1/100 1000 1500

Healthy people are unwilling to buy insurance and only sick

people will buy insurance. Since the insurance company knows
this, the rate will be Rs. 1,000.

In this case, a large majority of the population is uninsured.

 Moral Hazard
 Moral Hazard occurs after the insurance is purchased.

 A person with insurance would be more willing to take

risks, or, more generally, to incur expenses that the
person would not otherwise be willing to incur. If policy
holders are fully insured, they have little incentive to
avoid risky situations.
 Asymmetric Information and
Market Failure
 There are some ways in which the problem of
asymmetric information can be at least partially
remedied: Screening and Signaling.

 Screening : Ex. Health Insurance.

Type % Risk Cost to Willing to Cost of
Of Illness Insure Pay physical
exam
Healthy 50 1/1000 100 140 40

Sick 50 1/500 200 250 150

 Screening Continued
 The company decides to offer two policies

 It offers a general insurance policy for Rs. 240 and another policy for Rs.
100 to anyone who can pass a physical.

 Note that even sick people can pass the physical, but they have to bribe
the doctor to be able to do it, and it is very costly to be able to do so.

 Healthy people are unwilling to buy insurance at Rs.240. However, they

are willing to pay the Rs.100 + Rs.40 to get the new insurance policy.

 Sick people are willing to pay Rs.240 for the general policy. They might
prefer to pay Rs.100 for the other policy, but it costs them Rs.100 +
Rs.150.

 The company uses a medical test to screen people and determine their
types.
 Signalling
 The difference between Screening and Signalling is that Screening
is a cost imposed by the ignorant party (ex. the insurance
company) and Signalling is a cost voluntarily adopted by the
knowledgeable party to distinguish types.

 Used Car Market:

Type % Value to Value to Cost to
Buyer Seller pass
inspection
Cherries 50 2000 1600 200
Lemons' 50 1000 500 1100
Sellers can submit their cars to an inspection agency that will certify that
the car is good. Owners can sneak lemons past the inspectors, but it costs
a great deal of money to prepare the car in order to fool the inspector.
The owners of cherries will submit their cars for inspection. Why?
What about the owners of lemons?
 Signalling Continued
 A Modified Example:
Type % Value to Value to Cost to
Buyer Seller pass
inspection
Cherries 50 2000 1500 600

Lemons' 50 1000 500 1100

 Result ?

 Warranties as a form of market signaling ?

Winner’s curse in Bidding due
to asymmetric information
 Winner overestimates the value and end up by paying
more in order to win the bid

 A huge difference in bid value between winner and

runners up

 The second feature present mainly in closed bid

 The first feature present in both types