1. Announcements: Tuesday
This week in the breakout sessions we will be reviewing market failure and surplus analysis.
Case questions are up on Oncourse for all 4 cases.
September 17, Eric Rasmusen

2. Assignments: Thursday
Read: notes on public goods, Blumenthal article, “The Greasy Pole” for next week.
Next breakout: Discuss “The Greasy Pole”, Blumenthal.
Case questions are up on Oncourse for all 4 cases.

3. G302, Week 3 Market Failure
Juoy 15, 2002 Eric Rasmusen

4. Why does the government care about Pacific Gas and Electric?
But they don’t deliver profits
Yet electricity prices are high
And they are in constant trouble about pollution
It wants to transfer its watersheds to federal instead of state regulation.
It wants delay in upgrading pollution control in its Massachusetts plants.
Its chromium emissions may have been poisoning people.

5. When do free markets lead to bad results?
What you will learn today:
When do free markets lead to bad results?
Remember, I told you I wasn’t going to teach you how to defend indefensible business practices.

6. Perfect competition requires…
Well-Defined Property Rights
Many Buyers and Sellers (price takers)
Homogeneous Products
Free Entry
Perfect Information (on product, price)
No Externalities (no spillovers)
Property rights. If they are not defined, or if property is communal when it shouldn’t be, free markets can’t work.
Napster. It is hard even to decide what property rights protection maximizes surplus.
Overfishing. If nobody owns the fish in an ocean, then fishermen will fish too intensively and not enough fish will be left to breed future fish.

7. Weak property rights leads to:
Taking instead of making
Low incentives for effort and innovation
Property rights. If they are not defined, or if property is communal when it shouldn’t be, free markets can’t work.
Napster. It is hard even to decide what property rights protection maximizes surplus.
Overfishing. If nobody owns the fish in an ocean, then fishermen will fish too intensively and not enough fish will be left to breed future fish.

8. Perfect competition requires…
Well-Defined Property Rights
Many Buyers and Sellers (price takers)
Homogeneous Products
Free Entry
Perfect Information (on product, price)
No Externalities (no spillovers)
MARKET POWER
All 3 things are related.
Napster. It is hard even to decide what property rights protection maximizes surplus.
Overfishing. If nobody owns the fish in an ocean, then fishermen will fish too intensively and not enough fish will be left to breed future fish.
A firm has market power if
it can affect the price by
how much it sells

9. Choosing how much to sell
MC = P
A price taker picks Q so _______
A firm with market power picks Q _________, so MC = marginal revenue
smaller

10. A price-taking firm supply P P average cost P* market price profit
demand
marginal cost (supply) Q
Qfirm
market Q*
Q*firm
market
Market Scale
Firm-Level Scale

11. New firms enter... MC S P S’ P AC average cost P* market price P*’
demand
The price settles down to P=MC=AC.
If some firm has higher costs, it must exit.
marginal cost (supply) Q
Qfirm
market Q*
Q*’
Q*’ Q*
Market Scale
Firm-Level Scale

12. What if entry is blocked?
Costs and prices stay high. The market fails to maximize surplus.
Why might entry be blocked?
Government regulation
Predatory pricing and other anticompetitive tactics
Violence
Students have this slide.

13. A Monopoly’s Use of Market Power
Price-Taking Firm:
CS = ______
PS =_______
A+B+D
C+E
Monopoly or
Cartel:
CS =____
PS = ____
DWL= ____
Use an overhead here. A
B+C
D+E
The Problem:
____________________
Monopolies reduce trade
Readings: Figure 13.1

14. Imperfect Information
If consumers lack information about products, they may buy products that yield negative consumer surplus.
Supply
CS = -A-B
PS= A
DWL= B
Perceived value B A
Actual value

15. What if producers differ?
High-quality producers will have to leave the market if their costs are higher
Consumers may stop buying altogether, knowing this

16. Examples of Info Problems
Firestone tires
Diet drugs
Quality of doctors, dentists, lawyers
Initial public offerings
Used cars

17. The principal-agent problem
What if you can’t watch your employees all the time to see if they’re working hard?
They know the effort they are selling you, but you don’t
Solutions? (write on a notecard)
Here, the problem is that the person COULD be high quality, but might not put the effort out

18. Externalities (spillovers)
Two people exchange a good, but _______________ are also affected
If external effects are__________, markets produce_____________ trade
If external effects are ____________, markets produce _____________trade
third parties
harmful
too much
beneficial
Go to the overheads again here.
Some good such as pollution is unpriced in the market-- it is not bought or sold.
too little

19. A $3/unit negative externality
social cost
supply+
$3/unit
The __________
is the
supply cost plus the
externality cost P
supply 23
DWL 22
efficient
competitive
With a negative
externality, output
is ____________ 20
Beyond output of 100, the gains from trade are less than $3, the cost to third parties. To
maximize surplus, use
the social cost curve,
not the supply curve.
How would you show the effect of a positive externality on a graph?
Will a firm produce too much output if it both has market power and pollutes?
Extra questions:
too high
demand Q
100
120
Readings: Figure 13.5

20. Examples of Externalities
Negative
Positive
Negative
Toxic wastes (-)
Car exhaust (-)
Party noise next door when you want to sleep (-)
Positive
Home landscaping (+)
New users of a high-tech system (+)
If there is extra time: what is the most confusing concept of this lecture?