Market Failure

  1. Ideal Economic Efficiency

    Economic Efficiency means creating as much value as possible from a given set of resources. As a goal, it gives us a standard by which we can compare various economic institutions and policies.

    Economic Efficiency Criterion: An economic action is efficient if it makes at least one person better off without making anyone worse off. Economic Efficiency is possible under either of the following two rules:

    1. Rule I: An economic Action is efficient if it produces more benefits than costs.
    2. Rule II: An economic Action is inefficient if it produces more costs than benefits.

      Example: Consider the following policy which will cost $40 to fund. A tax will be levied to pay for the policy. Each person will pay 1/2 of the tax. The table summarizes the effects of the policy.

      Individual A Individual B Total
      Costs $20 $20 $40
      Benefits $100 $0 $100
      Net Benefits $80 -$20 $60

      Is the Policy Economically Efficient?

      What will have to happen in order to satisfy the economic efficiency criterion?

      Economic Efficiency Continued:

      In the context of Supply and Demand Economic Efficiency occurs as a result of competitive equilibrium. Under certain circumstances, market forces (the Invisible Hand) work to maximize economic efficiency and welfare.

      Demand Curve represents the value of a good in the eyes of consumers. Remember, it is the maximum people will pay for various quantities of the good.

      Supply Curve represents the opportunity cost of producing various quantities of a good.

      It stands to reason, that when value (Demand) equals cost (Supply) economic efficiency will be met.

      Lowering prices will result cause cost to exceed benefits.

      Raising prices will result in a cause potential benefits to be foregone.

      Definition: Consumer Surplus--the difference between the selling price and the value a person places on a good. Graphically, it is the area below the demand curve and above the selling price.

      Example: Suppose that I buy a beer for $1. If I had been willing to pay $1.50 for the beer, then I will actually be receiving consumer surplus of $.50.

      Definition: Producer Surplus--the difference between the selling price and the opportunity cost of producing the good. Graphically, it is the area above the supply curve and below the equilibrium price.

  2. Why might the Invisible Hand Not bring about economic Efficiency?

    There are four basic reasons why the invisible hand may not be economically efficient.

    1. There might not be enough competition.

      Competition among sellers drives prices down. This benefits consumers. If sellers can limit competition then they can charge higher prices than would be economically efficient.

      1. Collusion among sellers (illegal in most cases)
      2. Legal Barriers
      3. Cartel (legal in some countries, but not ours)

    2. Externalities

      An externality is a side effect of an action that influences the well-being of non consenting parties. Sometimes an externality is called a spillover.

      1. External Costs: These are costs that spillover onto parties other than the buyer and seller within a market. They cause rule 2 to be violated, since resources tend to be over allocated to the production of a good when these are present.
      2. External Benefits: These are benefits that spillover onto parties other than the buyer and seller within a market. They cause rule 1 to be violated, since resources tend to be under allocated to the production of a good when these are present.

    3. Public Goods

      A pure public good is one which is consumed jointly by everyone. With public goods, there is no effective way to exclude nonpaying consumers and consumption by one person does not diminish the amount available for others.

      1. Since people can receive the good without paying, they have an incentive to not pay. Those who receive benefits without paying are called free riders.
      2. Because of free-riders, actual demand tends to understate the value place on the good by consumers. Free markets tend to under produce public goods in amounts which are economically efficient.
      3. There are few examples of pure public goods. One is national defense.

        A near public good is one which is consumed jointly by everyone even though nonpaying consumers can be excluded. Until congestion sets in, the marginal cost of providing additional units is virtually zero.

        1. Examples include national parks, highways, movies and other goods that are consumed jointly.
        2. Marginal cost pricing would require the price to be set at or near zero. Taxes will be required to make the goods available.
    4. Poor Information
      1. Firms relying on repeat business have an incentive to promote customer satisfaction. Trial and error is likely to lead to customer satisfaction.
      2. When goods are either:
        1. difficult to evaluate on inspection (principal-agent problem) and seldom purchased repeatedly from the same vend or
        2. have serious long-lasting harmful effects on the consumer

          trial and error purchasing may be unsatisfactory in determining product quality.

      3. Asymmetric information is also a problem.
Either the buyer or seller has information about the product not possessed by the other party. Market for "lemons".

III. Property Rights

Definition: Property Right: The right to use, control and obtain the benefits associated with a particular good.

Private Property Right: Exists when the property right is:

  1. Exclusively held by one owner.
  2. Transferable to someone else as the owners wishes.

  1. Private property owners gain by using their property in ways that benefit themselves and others; they lose by ignoring the wishes of others.
  2. Private owners have strong incentives to care for their property.
  3. Private property owners have strong incentives to conserve for the future.
  4. Private owners who negligently use their property can be held accountable for that misuse.
Common-property Resource: A resource for which rights are held in common by a group of individuals, none of whom has a transferable ownership interest. Access may be open or it may be controlled by a political authority. Without political control, external costs are almost certain.

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This page was last modified Tuesday, April 8, 1997.