Market Failures Flashcards
Externality
Occurs when a persons well being or a firms profits are directly affected by the actions of other consumers or firms rather than indirectly through price changes
How are mergers used in response to externalities
Mergers can be used to internalise the externality.
Coase theorem
If ownership rights to a recourse can be clearly assigned, the affected parties can bargain and externalities do not create efficiency problems. However this rarely happens, the cost of bargaining may be too high, affected parties may have asymmetric information
Types of government intervention
Quantity restrictions (emission standard for cars) Taxes (congestion charge) Creation of markets (EU emissions trading system)
What is required to set the right tax or standard?
Perfect information and a way of measuring the value of the damage done.
What does the deadweight loss from a standard of tax depend on?
The steepness of the MB curve. If curve is steep, the DWL from taxes is bigger. If curve is shallow, DWL from standards is bigger.
Private goods
Good which are rivalrous and exclusive
Rivalrous
Only one person can consume the good
Exclusive
Can prevent other people from consuming the good
Open access common properties
Goods which lack exclusion (ocean fisheries)
Club goods
Goods which lack rivalry (streaming service)
Main types of asymmetric information
Hidden characteristics
Hidden actions
Hidden characteristics
A fact about a person or thing that is known to one party but unknown to others (second hand cars)
Hidden actions
One party in a transaction can’t observe important actions fandom by another party (a firms manager uses the consonants private jet for personal use)
Adverse selection
Asymmetric information about a hidden characteristic causes low quality products to be over represented in transactions. This creates a market failure by reducing the size of a market or eliminating it
Moral hazard
An informed person takes advantage of a less informed person through an unobserved action (a homeowner pays less attention to fire hazards because they have fire insurance)
Ways to reduce adverse selection
- Government intervention- to prevent opportunism by better informed sellers by product liability laws and standards and certificates
- screening- consumers can avoid lemons if they can obtain reliable information about quality
- signalling- actions through which producers of high quality goods can distinguish themselves from low quality producers (brands and reputations, guarantees and warranties)
Explain why a homeowner cares less about fire safety once they have insurance.
Once they have insurance, the marginal benefits of them looking after fire safety decrease so MC=MB Is now smaller. This means the homeowner dedicates less care since the cost of the fire is split between himself and the insurer so MSB>MPB
Wats to reduce moral hazard
- insurance to co insurance
* employer-employee relationships
How do adverse selections and moral hazard require different kinds of solutions?
Adverse selection: need to create mechanisms to transfer information to uninformed party
Moral hazard: need to create incentives for the informed party not to undertake harmful hidden actions
