Market Failures Flashcards
Well Functioning Markets
- Appropriate Incentive Structures
- Competition
- Well established property rights
- A method to deal with externalities
- Rational Agents
Constraint 1: Objectives and Preferences
Need to consider:
1. Factors affecting individual preferences
- Consider idea that households are rational in decision making (idea of maximising utility)
2. Business objectives
3. Gov objectives (low inflation etc)
Utility Function
Assigning numbers to every possible bundle of goods: more preferred bundles get a higher rank
- ordinal utility: ordering them
Social Welfare Function
A government trying to maximise the utility of all individuals in the population
- Adding a utility function of all individuals
Problem: Should they maximise pop. welfare or welfare of those in poverty?
Constructing Social Welfare Function
- Classical utilitarian or Benthamite welfare function which weights everyone equally
- Minimax or Rawlsian social welfare function which depends on the welfare of the worst-off individual.
Constraint 2: Property Rights
Property Rights are needed for a market to function properly (e.g. over-fishing in the north sea = eventually turns into a free for all)
- ^ Example of ‘Externality’ = market fail to reach solution
Idea that market failures come from ill-defined property rights is linked with Ronald Coase
Ronald Coase
If property rights can be sorted property then markets can function properly
- Coase’s Theorem = the efficient amount of good involved in externality is independent of the distribution of property rights
- The restrictive assumption is that demand doesn’t depend on income distribution
- Requirement of equal information between negotiating parties.
Social vs. Private Costs
Households take into account private costs when making decisions but not social costs imposed by rising externalities (CO2 emission)
Therefore steps taken to reduce externality to social optimal level:
1. Physical control
2. Taxation
^ Ways of internalising social costs
Constraint 3: Asymmetric Information
Economic Theory assumes perfect information among all agents: only then can markets operate efficiently (not realistic)
This leads to:
- Lower transactions that would occur in an efficient market
- Credit Rationality
- Problems of moral hazard
- Problems of adverse selection
Market of Lemons
Made by George Akerlof:
- 100 people want to sell a used car, 100 want to buy a used car
- Everyone knows that 50 cars are ‘plums’ the other 50 are ‘lemons’
- Owners know which are lemons but buyers don’t (asymmetric information)
- Buyers have a 50-50 chance of each car and therefore might pay the ‘expected value’
- Sellers of plums would want a different price to that of lemons which would make buyers know which is which
- Only lemons would be sold as they’d be cheaper
Credit Markets
In the UK credit markets experienced rationing- people couldnt get as much credit as they wanted (partly because interest rates didn’t change to equate supply and demand)
- 1980s financial markets were liberalised and interest rates moved rapidly (not all consumers could still get credit)
Adverse Selection
Problems rise when agents have more private information than is publicly available
Moral Hazard
Problems rise when agents hide information about their action
The Grameen Bank
World Banks argue for the opening of developing countries to international capital markets vs. domestic institutions are in a better position to provide development finance.
Grameen Bank argues:
- Village money lenders can deal more effectively with small loans
- Local has better information on good and bad risks
- Local is in a better position to monitor progression of loan repayments
Grameen plan = entrepreneurs with separate projects get together and apply for loans as a group (have joint liability in repayment)
