AGEC/FNR 406 LECTURE 3 Tomatoes for sale in a rural Indonesian market

Markets and market failure Lecture Goals: 1.Introduce concept of “market failure” 2. Identify key reasons why markets sometimes fail to achieve socially optimal outcomes.

What is a market? A place where BUYERS and SELLERS come together to express… …willingness to purchase goods … willingness to sell goods This process of EXCHANGE leads to the identification of economic value.

Categories of economic value Consumptive use Existence value Non-consumptive use Option value Some values apply to stocks, some to flows!

Resource allocation The central problem in economics is how best to allocate scarce resources among competing uses. The logic of scarcity says using resources will add value to the economy. Efficiency requires benefits (goods) to be balanced with costs (bads).

Market Failure Markets tend to work well when allocating most goods. But when it comes to allocating natural resources or environmental goods, they often fail. “Market failure” is a term that economists use to describe situations in which private valuation and social valuation diverge.

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Why do markets fail? 5. Imperfect competition 3. Imperfect information 1. Externalities 4. Inappropriate government intervention 2. Public goods

Failure #1: Externalities An externality is an unintended side-effect of production or consumption. An externality may be either beneficial or harmful. In either case, the market price does not reflect the spillover impact. An example is pollution, as when damages associated with a production process are not included in the market price of the good.

Failure #2: Public goods A public good is nonrival and nonexcludable in consumption. My enjoyment does not detract from your enjoyment, and once provided, access to the good cannot be restricted. Incentives for private provision of public goods are low, and they tend to be underprovided by the market.

Public vs. private goods 0 Degree of nonexcludability 100% 0 Degree of nonrivalry 100% Lunch Global climate Fish in a lake Concert

Failure #3: Imperfect information Imperfect information describes the situation in which firms or consumers are unaware of the impacts of their actions. It does not include cases in which agents deliberately ignore information. Examples include health risks due to exposure to toxic substances, or global environmental effects of human activity.

Failure #4: Gov’t intervention If the government intervenes in a market in a way that affects the market price and moves it away from the socially efficient price, then the outcome is a market failure. An example cited in the textbook is that of roads provided by the US Forest Service, which may reduce the cost of timber extraction for private timber companies who lease public land.

Failure #5: Imperfect competition Under imperfect competition the market price does not reflect the true value of a good to society. This is the case because of firm behavior. The most frequently cited case is a monopoly (a single producer) that restricts output in order to raise the price.