Chapter 9 - Market failure: information failure and public goods Flashcards
What is asymmetric information?
A situation in which some participants in a market have better information about market conditions than others.
How does asymmetric information affect healthcare?
e.g. A situation might be going to a dentist for a check up. He has said that a filling needs to be replaced, but the person has had no pain or problems with it. In this situation the seller in a market has much better information about the product than the buyer.
The buyer has no idea whether or not the recommended treatment is needed, without going to another dentist for a second opinion you have no way of finding out.
The same argument applies in the case of other areas of healthcare, where doctors have better information than their patients about the sort of treatment that is needed.
How does asymmetric information affect education?
Teachers or government inspectors may know more about the subjects and topics that students need to study than the students themselves. This is partly because teachers are able to take a longer view and can see education provision from a broader perspective. Students taking economics at university may have to take a course in mathematics and statistics in their first year, and some will always complain that they have come to study economics, not maths. It is only later that they come to realise that competence in maths is crucial for the economics they will study later in their course.
How could this problem be tackled? The answer would seem to be obvious - if the problem arises from an information failure, then the answer should be to improve the information flow, in this case to students. This might be achieved by providing a convincing explanation of why the curriculum has been designed in a particular way. It may also be necessary to provide incentives for students to study particularly unpopular subjects, perhaps by making success a requirement for progression to the next stage of the course. By understanding the economic cause of a problem, it is possible to devise a strategy that should go some way towards removing the market failure.
What effect would this sort of information failure have on a market? Suppose that education provides benefits to society that are not fully understood by parents and their children. Another way of expressing this is that the perceived marginal private benefits of education are lower than the marginal social benefits that society will gain from having a educated workforce.
In this situation, the best outcome for society would be if Q* education was provided, this being the position in which MSB = MC. In a free market situation, only Q, would be demanded, reflecting the private perception of the value of education to individuals. You will realise that this is actually an example of a consumption externality - but it arises because private individuals (whether it be the parents or their children) do not have full information about the value of education.
How does asymmetric information affect second hand cars?
George Akerlof, a Nobel laureate argued that there are two types of car. Some cars are good runners and are totally reliable, whereas some are continually breaking down and needing parts and servicing. The problem in the second-hand car market arises because the owners of cars (potential sellers) have better information about their cars than the potential buyers.
Car dealers buying second-hand cars can adopt one of two possible strategies. One is to offer a high price and buy up all the cars in the market, knowing that the bad cars will be sold on at a loss but hoping for a return on the quality ones. The problem is that, if the bad cars make up a large proportion of the cars in the market, this could generate overall losses for the dealers.
The alternative is to offer a low price, and just buy up all the bad cars to sell for scrap. In this situation, the market for good-quality used cars is effectively destroyed because owners of good-quality cars will not accept the low price - an extreme form of market failure.
How does asymmetric information affect pensions?
The pensions market is another market that is fraught with information problems by its very nature. A key source of information failure here arises from uncertainty and risk. Individuals face uncertainty in predicting their need for an adequate pension in their old age, which depends upon their future state of health, their longevity, and so on. There is risk involved in the sense that pension funds depend critically on movements in the stock market.
There is also the fact that there is a vast array of alternative pension schemes available, many of them very complex. This makes it very difficult for individuals to know how to take a rational decision - especially when their need for a pension is many years away. If people make bad decisions about pensions, this creates problems for the future, and society may find that it needs to cope with care for the elderly, especially when improvements in health mean that more people are living longer.
The regulations introduced in the UK that mean workers are automatically enrolled in a workplace pensions scheme (unless they consciously opt out) are one attempt to tackle this issue.
How does asymmetric information affect the insurance market?
People take out insurance to cover themselves against the risk of uncertain future events. Asymmetric information can cause problems with this market in two different ways.
Suppose an individual approaches an insurance company wanting health insurance. The individual knows more about his or her health and health history than the insurance company. After all, the individual knows whether they are prone to illness or if they are accident-prone. This could mean that the people most likely to take out health insurance are the ones most likely to fall ill or be involved in accidents. This is known as adverse selection.
A second form of information failure in terms of insurance is known as moral hazard. An individual who has taken out insurance may be more likely to take risks, knowing that he or she is covered by insurance. For example, if someone has taken out insurance against the loss of their mobile phone, they may be less careful about leaving it around.
What is adverse selection?
A situation in which a person at risk is more likely to take out insurance.
What is moral selection?
A situation in which a person who has taken out insurance is prone to taking more risk.
What is a merit good?
A good that bring unanticipated benefits to consumers, such that society believes it will be underconsumed in a free market.
How does a merit good cause information failure?
This is an example of information failure, as the problem stems from people’s lack of knowledge about the benefits from consuming a good or service - or, rather, from the government’s belief that they lack knowledge.
One situation in which the merit good phenomenon arises is where the government is in a better position than individuals to take a long-term view of what is good for society. In particular, governments may need to take decisions on behalf of future generations as well as the present. Resources need to be used wisely in the present in order to protect the interests of tomorrow’s citizens. Notice that this may require decision-makers to make normative judgements about the appropriate weighting to be given to the present as opposed to the future. There is a strong political element involved in identifying the goods that should be regarded as merit goods: this is because of the subjective or normative judgement involved, since declaring a good to be a merit good requires the decision-maker to make a choice on behalf of the population, which may be seen as being paternalistic (selfish).
At the heart of the notion of a merit good, therefore, is the decision-maker’s perception that there is a divergence between the marginal benefit that individuals perceive to arise from consuming a good, and the social benefit that actually accrues from its consumption. This is reminiscent of the arguments about consumption externalities, where a positive consumption externality arises when the marginal social benefit from consuming a good is greater than the marginal private benefit.
How is milk considered a merit good?
Pupils under 5 years old in primary education are entitled to daily free or subsidised milk under a government scheme. This is an example of a merit good. The government saw this as a way of improving nutritional standards, when parents may not fully see the health benefits of milk.
In other words, it was thought that there was a divergence between the actual benefits from consuming milk and those seen by parents.
This echoes the discussion of information failure, when education was shown as an example of how parents (or their children) might not be fully aware of its value.
How is education considered a merit good?
In the UK, everyone is required to attend school, at least up to age 16. Part of this requirement may be attributed to a merit good argument. It can be argued that education provides benefits to society in excess of those that are perceived by individuals.
In other words, society believes that individuals will derive a benefit from education that they will not realise until after they have acquired that education. So, the government decrees that everyone must consume education up to the age of 16, whether they want to or not and whether they have the means to do so or not. This is a merit good argument. Marginal social benefit (MSB) is shown as being higher than marginal private benefit (MPB).
Therefore, society would like to provide Q* education, where MSB = MC (marginal social cost), but individuals would choose to consume only Q, education, where MPB = MC, because they do not expect the future benefits to be as high as the government does.
In this case there may be other issues affecting the market for education. It was argued that there would also be positive externality effects if educated workers were better able to cooperate with each other. There may be a further argument that individuals may fail to demand sufficient education because of information failure: in other words, they may not perceive the full benefits that will arise from education.
The situation may be aggravated if parents have the responsibility of financing their children’s education, because they are taking decisions on behalf of their children. In the case of higher education, there is no guarantee that parents will agree with their children about the benefits of a university education - it could go either way. In some societies it has been suggested that the merits of education are better perceived by some groups in society than others. In some less developed countries, individuals in relatively well-off households demand high levels of education, as they realise the long-run benefits that they can receive in terms of higher earnings - and, perhaps, political influence. In contrast, low-income households in remote rural areas may not see the value of education. As a result, dropout from secondary - and even primary - education tends to be high.
This is clearly a merit good argument that may need to be addressed by government, perhaps by making primary education compulsory or free, or both.
What is a demerit good?
A good that brings less benefit to consumers than they expect, such that too much will be consumed by individuals in a free market.
How does demerit goods cause information failure?
Marginal private benefits (MPB) are shown as being much higher than marginal social benefits (MSB), so that in a free market too much of the good is consumed. Society would like to be at Q* but ends up at Q1. In this particular market, the government may see the marginal social benefit from consuming the good to be so low (e.g. at MSB* in the figure) that consumption should be driven to zero.
Again, this could be interpreted as partly an information problem, in the sense that individual consumers may not perceive the dangers of consuming the good, and may overvalue it as a result.
In addition, if the good is addictive, this would have the effect of making an individual’s demand for the good highly inelastic in the long run. However, it is paternalistic (selfish) of the government to intervene directly for this reason, although it might wish to correct other externalities - for instance, those imposed on others when addicts steal to fund their habit.
An alternative approach is to try to remove the information failure - clearly, the government has adopted this approach in seeking to educate people about the dangers of tobacco smoking.
What is a private good?
A good that, once consumed by one person, cannot be consumed by somebody
else - such a good has excludability and is rivalrous
What does non-excludabilty mean?
A situation in which it is not possible to
provide a product to one person without allowing others to consume it as well.
What does non-rivalry mean?
A situation in which one person’s consumption of a good does not prevent others from consuming it as well.
What is a public good?
A good that is non-exclusive, non-rivalrous and non-rejectable.
Consumers cannot be excluded from consuming the good, consumption by one person does not affect the amount of the good available for others
to consume, and once provided to all, no individual can reject it
What does non-rejectability mean?
A situation in which an individual cannot avoid consuming a good
What is the free-rider problem?
When an individual cannot be excluded
from consuming a good, and so has no incentive to pay for its provision.
What are some examples of quasi-public goods?
There are many goods that are either non rivalrous, non-excludable or non-rejectable, but not all three.
One example of this is a football match. If I go to watch a Premiership football match, my ‘consumption’ of the match does not prevent the person sitting next to me from also consuming it, so it is non-rivalrous: at least, for those attending the match. However, if I go along without my season ticket (or do not have a ticket), I can clearly be excluded from consuming the match, so it is not non-exclusive. It is also rejectable, as I can choose not to attend (even if I have a ticket).
A stretch of road may be considered non-exclusive, as road users are free to drive along it. However, it is not non rivalrous, in the sense that as congestion builds up consumption is affected. This example is also imperfect as a public good because, by installing toll barriers, users can be excluded from consuming it. It may also be considered to be rejectable, as users have other route options from which to choose.
Particular problems are posed when a good is non-excludable but not non-rivalrous. Where goods have some features of a public good, the free market may fail to produce an ideal outcome for society.
How does public goods provision work?
For some public goods, the failure of the free market to ensure provision (looking after something) may be regarded as a serious problem - for example, in such cases as street lighting or law and order.
Some government intervention may be needed to make sure that a sufficient quantity of the good or service is provided. Notice that this does not necessarily mean that the government has to provide the good itself. It may be that the government will raise funds through taxation in order to ensure that street lighting is provided, but could still make use of private firms to supply the good through some sort of subcontracting arrangement. In the UK, it may be that the government delegates the responsibility for the provision of public goods to local authorities, which in turn may subcontract to private firms.
How effective will this be? The delegation of provision of a good or service to a local area may have the benefit of ensuring that decisions are taken at the local level - that is, close to those who benefit. However, local authorities face the need to provide a wide range of services, and need to set priorities between conflicting demands for limited resources. In many areas around the UK, complaints about potholes in roads suggest that local motorists do not always find the priorities set by local authorities to be to their liking.
In some other cases, it may be that changes in technology may alter the economic characteristics of a good. For example, in the case of television programmes, originally provision was entirely through the BBC, funded by the licence fee. Subsequently, ITV set up in competition, using advertising as a way of funding its supply. More recently, the advent of satellite and digital broadcasting has reduced the degree to which television programmes are non-excludable, allowing private firms to charge for transmissions.
