Chapter 14: Government and Market Failure

Externalities Negative externalities Positive externalities

Negative externalities

Positive externality

Solution Taxes or subsidies regulations

Pollution Marketable pollution permits

Coase theorem If property rights are well defined and there are no transaction costs, private bargaining can correct for the presence of positive or negative externalities

Common property resources Examples: fisheries endangered species collective farms communes Solutions: establishment of property rights regulations

Public goods A good that is nonrival in consumption free rider problem  underproduction Solutions: subsidies or public provision

Imperfect information Asymmetric information – one party to a contract has different information than the other party Adverse selection Moral hazard

Adverse selection Occurs when the parties who are willing to accept a contract are of “lower quality” (from the perspective of the other party) than a random member of the population “Lemon’s problem” Examples: used cars, insurance issues, financial markets

Moral hazard Occurs when one party to a contract has an incentive to alter his or her behavior to the detriment of the other party once a contract exists

Solutions to asymmetric information problems Mandated information requirements Mandated warranties Copayments and deductibles Incentive-compatible contracts designed to reduce the moral hazard problem

Government failure Public choice theory Logrolling Rent seeking