C. Bordoy UWC Maastricht Market Failure HL material HL material (Tragakes, 2012, pp )

Additional types of market failure 1. Asymmetric information. When the assumption of complete information does not hold. 2. Abuse of monopoly power. C. Bordoy UWC Maastricht

Asymmetric information Competitive market: firms and consumers have complete information about products, prices, resources and methods of production. Competitive market: firms and consumers have complete information about products, prices, resources and methods of production. Asymmetric information refers to situations where buyers and sellers do not have equal access to information, and usually results in underallocation of resources to the production of g&s. Asymmetric information refers to situations where buyers and sellers do not have equal access to information, and usually results in underallocation of resources to the production of g&s. C. Bordoy UWC Maastricht

Information available to sellers but not to buyers Information about the quality of a good not made available to consumers. Information about the quality of a good not made available to consumers. Examples: sellers of used cars. Examples: sellers of used cars. In a free and unregulated market: unsafe medications, doctors with no training,… In a free and unregulated market: unsafe medications, doctors with no training,… If consumers are unaware of possible hidden dangers, there could result an overallocation of resources to the production of those goods and services. If consumers are unaware of possible hidden dangers, there could result an overallocation of resources to the production of those goods and services. C. Bordoy UWC Maastricht

Government responses 1. Regulation Laws and regulations to ensure quality standards and safety. (private schools, food, medications, buildings, toys…) Laws and regulations to ensure quality standards and safety. (private schools, food, medications, buildings, toys…) Time consuming (testing medications) Time consuming (testing medications) Large opportunity costs. In the case of food, large amount of providers involved, which need to be monitored. Large opportunity costs. In the case of food, large amount of providers involved, which need to be monitored. C. Bordoy UWC Maastricht

Provision of information Provision of information a) Directly to consumers (about the quality of medical care by different providers, infectious diseases, health hazards related to particular products…). Problems: collection and dissemination of the information, accuracy and opportunity costs involved. Problems: collection and dissemination of the information, accuracy and opportunity costs involved. b) Forcing producers to provide information Problems: accuracy and completeness of information provided. Problems: accuracy and completeness of information provided. There is always room for the seller to hide some information from the buyer. For example, doctors and lawyers have more information than their clients and they could selectively reveal information to them that makes them demand more services than necessary (supplier-induced demand). There is always room for the seller to hide some information from the buyer. For example, doctors and lawyers have more information than their clients and they could selectively reveal information to them that makes them demand more services than necessary (supplier-induced demand). C. Bordoy UWC Maastricht

Licensure. Some professions require to have a license: doctors, lawyers, teachers… Licensure. Some professions require to have a license: doctors, lawyers, teachers… Criticised by some economists because it may work to limit the supply of people in a profession, causing the price to raise. Criticised by some economists because it may work to limit the supply of people in a profession, causing the price to raise. C. Bordoy UWC Maastricht

Information available to buyers but not to sellers 1. Moral hazard. Situations where one party takes risks but does not face the full costs of these risks.  Example: you buy a theft insurance for your bike and start being less careful about locking it because you know you will be reimbursed if it gets stolen.  Result: underallocation of resources to the production of insurance services. C. Bordoy UWC Maastricht

Responses Provider makes the buyer pay for part of the cost of damages, so that the buyer faces the consequences of risky behaviour, thus leading to less risky behaviour. Private companies offer different types of policies, where the lower the cost of the insurance, the higher the out-of-pocket payments. Lower income earners usually choose low cost policies with less insurance protection and as a result they are more likely to change their risky behaviour than higher income earners. In the financial area: government regulation of financial institutions, intended to oversee and prevent highly risky behaviour.

2. 2. Adverse selection. When buyers of insurance have more information about themselves than the sellers of insurance. Buyers of health insurance know more about their health than sellers, and those with health problems are unlikely to disclose it to avoid paying higher prices. Result: underallocation of resources to health insurance services, as companies reduce the supply of insurance to avoid providing insurance coverage to very high risks or people who are more likely to become ill. It also leads to high insurance costs for buyers.

Responses by insurance companies: Companies offer different policies, so that people with low risk of getting sick can choose a low-cost policy with higher out-of pocket payments, while higher cost policies with lower out-of-pocket payments can be selected by people who think they have high levels of health risk. First: lower-income earners choose low-cost policies regardless of the state of their health. This is undesirable from a fairness perspective. Second: insurance firms usually refuse to insure people above a certain age (higher risk of becoming ill). Result: people on low incomes and elderly people are left with little or no insurance coverage.

Response by governments: Direct provision of health care services at low or zero prices to an entire population, financed by taxes. Social health insurance, covering a country’s entire population (many EU countries) covering only certain vulnerable groups of the population (US). Potential problem: difficulties in controlling costs of providing health care and growing burdens on the government or social health insurance budgets.

3. 3. Safety in the workplace Employers are generally interested in providing some workplace safety because an unsafe working environment disrupts production. However, they may be interested in hiding information regarding unsafe working conditions, with negative consequences for employees’ safety. This represents market failure due to asymmetric information in the labour market.

Responses: a. a. Governments can provide information to workers about safety information in various firms, b. b. they may require employers to provide information to prospective workers about hazards and safety conditions, or c. c. they may set minimum safety standards to be followed by employers (most commonly used). Although this improves safety conditions for workers, it is difficult for the gov to cover all possible hazard eventualities of different industries and type of work. b Might be more effective, although it is difficult to cover all the rage of industries. Labour unions also provide information but is limited to particular professions and industries.