V 654: One Rationale for Government Delivery of Goods and Services Market Failures

Market Failure In our last presentation we looked at the idealized competitive market and the mechanisms behind a market that maximizes producer and consumer surplus. In a simple world, a well functioning market can lead to Pareto efficient outcomes. Market failures can be viewed as scenarios where individuals’ pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the societal point-of-view. The concept of market failures is often used as a justification for government intervention (public policy) or government delivery of services (an alternative to delivery via the private sector).

Types of Market Failures Public goods Monopolies Externalities Information Asymmetry

Public Goods A public good is a good that is non-rivalrous and non- excludable. Non-rivalry means that consumption of the good by one individual does not reduce availability of the good for consumption by others. Simply, if a good is non-rivalrous it can be jointly consumed. The characteristic of non-excludability means that no one can be effectively excluded from using the good.

Public Goods The economic concept of public goods should not be confused with the expression “the public good,” which is usually an application of a collective ethical notion of “the good” in political decision-making. Another common confusion is that public goods are goods provided by the public sector. Although it is often the case that government is involved in producing public goods, this is not necessarily the case. Public goods may be naturally available. They may be produced by private individuals and firms, by non-state collective action, or they may not be produced at all.

Public Goods In the real world, there may be no such thing as an absolutely non-rivaled and non-excludable good; but economists think that some goods approximate the concept closely enough for the analysis to be economically useful. For example, breathing air does not significantly reduce the amount of air available to others, and people cannot be effectively excluded from using the air. Goods can have partial characteristics: Excludable and rivalrous Excludable and non-rivalrous Non-excludable and rivalrous Non-excludable and non-rivalrous

ExcludableNon-excludable Rivalrous Private Goods: food, clothing, cars, personal electronics Common Goods (common pool resources): fish stocks, timber, coal, national health service Non- rivalrous Club Goods: cinemas, private parks, satellite television Public goods free-to-air television, air, national defense

Monopoly An efficient market requires that there are many buyers and sellers. A monopoly exists when one company has control over a particular product or service. Monopolies are thus characterized by a lack of economic competition for the good or service. With a lack of competition there is a lack of viable substitutes. Monopolies derive their market power from barriers to entry - circumstances that prevent or greatly impede a potential competitor's entry into the market or ability to compete in the market. Monopolists typically produce fewer goods and sell them at a higher price than under perfect competition, resulting in abnormal and sustained profit or what economists call rent. A similar situation is an oligopoly, when only a few entities exert considerable influence over an industry.

Externalities An externality (or transaction spillover) is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit. In other words, the transaction affected more than the original parties in the exchange –most importantly, parties who may not have chosen to be involved in the transaction. A benefit in this case is called a positive externality or external benefit, while a cost is called a negative externality or external cost. The concern with externalities is that prices do not reflect the full costs or benefits of producing or consuming a product or service. Producers and consumers may either not bear all of the costs or not reap all of the benefits of the economic activity, and too much or too little of the good will be produced or consumed in terms of overall costs and benefits to society.

Externalities Examples of negative externalities Smokers can usually not contain smoke from cigarettes- second hand smoke is a negative externality with health implications. Thus, people who did not choose to be involved in the purchase of the cigarettes are affected by the purchase. Society is also affected by the health costs. Societal costs are not factored into the purchase price. The consumption of alcohol by bar-goers in some can leads to drinking and driving accidents which injure or kill pedestrians and other drivers.

Externalities Examples of positive externalities A property owner that landscapes his/ her property produces a benefit to neighbors. The benefit usually takes the form of increased property values for adjacent property owners. A public organization that coordinates the control of an infectious disease preventing others in society from getting sick. An individual who receives a vaccination decreases the risk of others (who did not get a vaccination) from infection. Education creates a positive externality. People pass on what they know to others. Also, more educated people are less likely to engage in violent crime, which makes everyone in the community, even people who are not well educated, better off.

Information Asymmetry Sometimes people involved in a transaction do not have all relevant information. When one party ahs an information advantage there is information asymmetry. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry. In the study of contracts information asymmetries are studied in the context of principal-agent problems. Adverse selection and moral hazard are two types of information asymmetry.

Adverse Selection Adverse selection refers to a situation where the ignorant party lacks information while negotiating an agreed understanding of or contract to the transaction. An example of adverse selection is when people who are high risk are more likely to buy insurance because the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual’ s risk but also sometimes by force of law or other constraints.

Moral Hazard In moral hazard, the ignorant party lacks information about performance of the agreed-upon transaction or lacks the ability to retaliate for a breach of the agreement. An example of moral hazard is when people are more likely to behave recklessly after becoming insured, either because the insurer cannot observe this behavior or cannot effectively retaliate against it, for example by failing to renew the insurance.

Summing it Up The market is in many ways “a marvel,” but the idea that it always produces efficient outcomes is a myth. The “invisible hand” has its faults. These slides provided 4 conditions under which the market fails in the sense that it does not lead to efficiency. These traditional market failures are situations in which equilibrium market behavior does not maximize social surplus.

Additional Sources Weimer, David and Adrian Vining Chapter 5 in Policy Analysis Practice and Concepts 4 th edition. Upper Saddle River, NJ: Pearson.