16.3 Market Failures

Question 1

What is market failure?

Answer 1

Failure of the unregulated market system to achieve allocative efficiency.

Question 2

Is the statement that the economy is allocatively efficient a positive or normative statement?

Answer 2

The statement that the economy is allocatively efficient (or not) is a positive statement.

Question 3

What are the four situations in which the free market fails to achieve allocative efficiency?

Answer 3

We now examine four situations in which the free market fails to achieve allocative efficiency—market power, externalities, non-rivalrous and non-excludable goods, and asymmetric information.

Question 4

What are the three reasons that Market power is inevitable in a free market?

Answer 4

First, in many industries economies of scale are such that there is room for only a few firms to operate at low costs, each having some ability to influence market conditions.

Second, in many industries, firms sell differentiated products and thus have some ability to set their prices.

Third, firms that innovate with new products or new production processes gain a temporary monopoly until other firms learn what the innovator knows.

Question 5

What is an externality?

Answer 5

An effect on parties not directly involved in the production or use of a commodity. Also called third-party effects.

Question 6

What is a private cost?

Answer 6

The value of the resources used in production as valued by the producer.

Question 7

What is a social cost?

Answer 7

Includes private cost to producers plus any external costs imposed on third parties.

Question 8

When do discrepancies between private cost/benefit and social cost/benefit occur?

Answer 8

Discrepancies between private cost and social cost, or between private benefit and social benefit, occur when there are externalities. The presence of externalities, even when all markets are perfectly competitive, leads to allocatively inefficient outcomes.

Question 9

What are the difference between positive and negative externalities?

Answer 9

Externalities arise in many different ways, and they may be harmful or beneficial to the third parties. When they are harmful, they are called negative externalities; when they are beneficial, they are called positive externalities.

Question 10

What is the difference between a positive and negative externality?

Answer 10

With a positive externality, a competitive free market will produce too little of the good. With a negative externality, a competitive free market will produce too much of the good.

Question 11

How does government respond to externalities?

Answer 11

The allocative inefficiency caused by an externality provides a justification for government intervention. In the case of a negative externality, the government may levy a tax on the firms or consumers responsible, as is often done in the case of pollution. In the case of positive externalities, the government may provide a subsidy (a negative tax) to the firms or consumers responsible, as is done in the case of publicly provided education

Question 12

What kinds of goods to free markets cope best with?

Answer 12

Free markets cope best with rivalrous and excludable goods—what we here call “private” goods.

Question 13

What is a rivalrous good?

Answer 13

A good or service is rivalrous if one person’s consumption of it reduces the amount available for others.

For example, a chocolate bar is rivalrous because if you eat the entire bar, it cannot also be eaten by your friend. In contrast, a radio signal is not rivalrous. You and your friend can sit in your separate living rooms and both receive the same signal, neither of you diminishing the amount available to the other.

Question 14

What is an excludable good?

Answer 14

A good is said to be excludable if people can be prevented from consuming it. A chocolate bar is excludable because you cannot eat it unless you buy it first. A radio signal is not excludable; the signal is there for anyone to access.

Question 15

What is a private good?

Answer 15

Goods or services that are both rivalrous and excludable

Your consumption of food, clothing, a rental apartment, a car, gasoline, airline tickets, and textbooks are only possible because you pay the seller for the right to own those goods or services. Furthermore, your consumption of those goods reduces the amount available for others.

Question 16

What is a common-property resource?

Answer 16

A product that is rivalrous but not excludable.

Posean interesting challenge for public policy

Common-property resources tend to be overused by private firms and consumers.

Question 17

What is a club good?

Answer 17

Goods that are excludable but not rivalrous are sometimes called club goods. Many of the obvious examples of these—such as art galleries, roads, and bridges—are typically provided by the government.

The non-rivalry for these goods means that the marginal cost of providing the good to one extra person is zero.

To avoid inefficient exclusion, the government often provides goods that are non-rivalrous but excludable.

Question 18

What is congestion in terms of club goods?

Answer 18

The positive price in some of these cases can be explained by another feature of club goods. What happens in the Canadian Museum of History on a summer Saturday morning? What happens on Highway 401 outside Toronto at rush hour? The answer is congestion. When congestion occurs on roads and bridges, or in art galleries and museums, it is no longer true that the marginal cost of providing a club good to one more user is zero.

Question 19

How do governments prevent congestion of club goods?

Answer 19

Governments that provide such goods often charge a price to help ration the good when rivalry becomes significant.

Question 20

What is a public good?

Answer 20

Goods or services that can simultaneously provide benefits to a large group of people. Also called collective consumption goods.

The classic case of a public good is national defence. All residents of Canada are equally protected and defended by the Canadian Armed Forces. It is not possible to provide national defence to some residents and not to others.

Question 21

What is the free-rider problem?

Answer 21

All these examples raise what is called the free-rider problem. Since public goods are (by definition) not excludable, it is impossible to prevent anyone from using them once they are provided. If the provider charged a price, non-payers would take a free ride at the expense of those individuals with a social conscience who do pay. But the existence of free riders, in turn, implies that the private market will generally not produce public goods because producers would not be able to collect the payments required to cover their costs. The obvious remedy in these cases is for the government to provide the good, financed from its general tax revenues.

Question 22

Who provides public goods?

Answer 22

Because of the free-rider problem, private markets will usually not provide public goods. In such situations, public goods must be provided by government.

Question 23

What is asymmetric information?

Answer 23

A situation in which one party to a transaction has more or better information about the transaction than the other party.

Question 24

Why are markets for expertise prone to market failure?

Answer 24

Even when information is not a public good, markets for expertise are prone to market failure. The reason is that one party to a transaction can often take advantage of special knowledge in ways that change the nature of the transaction itself.

Question 25

What are the two important sources of market failure that arise from situations of asymmetric information?

Answer 25

The two important sources of market failure that arise from situations of asymmetric information are moral hazard and adverse selection.

Question 26

What is a moral hazard?

Answer 26

A situation in which an individual or a firm takes advantage of special knowledge while engaging in socially inefficient behaviour.

In general, moral hazard exists when one party to a transaction has both the incentive and the ability to behave in a way that shifts costs onto the other party.

Question 27

What is an example of a moral hazard (Insurance)

Answer 27

For example, if you have not insured your home against fire and theft, you have an incentive to protect yourself against those events by installing fire extinguishers and burglar alarms. If, however, you are fully insured against those events, in the event of mishap you do not really lose anything since the costs will be borne by the insurance company. With insurance, therefore, you have less incentive to install fire extinguishers and burglar alarms and prevent those mishaps in the first place.

Question 28

Where does market failure arise in instances of moral hazard?

Answer 28

With moral hazard, the market failure arises because the action by the insured individual or firm raises total costs for society. In our example, the decision not to take action to prevent fire and theft reduces costs for the individual but, in the event of a mishap, increases by much more the costs to the insurance company.