What’s this unit about
Reasons for and solutions to market failure
Market failure =
market allocates resources in a Pareto inefficient way.
- Usually due to externalities - costs on third parties sometimes called external diseconomies and negative externalities.
- typically means over/under consumption of particular good
Marginal private cost =
marginal cost paid by firm
Marginal external cost
cost on farmers due to the banana production as fish getting killed
MSC =
MPC+MEC
are between MSC and MPC on diagram
Total cost to third party due to private interactions
In perfectly competitive market
- horizontal demand curve, firms are price takers and market is perfectly competitive
- Will choose P = Mc (MPC)
- Point A is Pareto inefficient as not accounting for social costs, should produce at MSC = P
How to solve market failure in perfectly competitive market?
- Moving from point A to B is beneficial for farmers but worse off for firm, so not necessarily a Pareto improvement movement.
- This is where bargaining element comes in. If farmer negotiates with firm and offers to give them exactly how much they’ll lose out out of their benefit, then firm is no worse off and farmers are better off - Pareto improvement. Called coasian bargaining
But is bargaining realistic?
- impediments to collective action: within groups people may not agree which could cause conflict
- Missing information - assumption of perfect information
- Tradeability: involves trading of property rights, contract must be enforceable as firm might just cheat the agreement.
- Limited funds: may not be able to borrow, or have the retained funds
Policies to fix market failure:
- pigouvian tax - tax exactly as much as externality cost. To parallel shift MPC to MPC + tax which is at the socially optimum level of output.
- Regulation of quantity produced
- Enforcing compensation of fishermen - pay all external costs
Public goods =
Non rivalrous and non excludable
Reasons for market failure:
- incomplete contract
- Public/ private goods
- Asymmetric information, i.e hidden action which leads to moral hazard, as lets say employee will never know employers effort level so will not receive outcome level they want
Why Limiting the extent of markets being involved in production/ consumption of goods:
- repugnant markets - marketing some goods and services violates ethical norms like vital organs
- Merit goods - some goods and services should be available to all
Why do market failures happen?
People, guided only by market prices do not take account of the full effect of their actions on others
why is the full effect of their actions onto others not taken into account
There are external costs and benefits that are not compensated by payments
Why are some costs and benefits not compensated
No markers exit in which they can be traded
Why not? And why cant private bargaining and payent solve the problem
The required property rights and contracts cant be enforced by courts of law
What prevents property rights and contracts from being enforceable ?
Asymmetric or non verifiable information.
Government can step in to correct market failure
- regulation of quantity of bananas produced
- taxation of the production or sale of bananas - tax of MEC
- enforcing compensation of the fishermen for the costs imposed on them - pay the external cost to farmers.
Reasons for market failure - hidden attributes and adverse selection
- people more likely to buy insurance if ill
- info is asymmetric, i know but insurance dont
- insurance only profit if higher charged
- leads to price high enough that only those who know ill would buy
- leads to even higher prices for insurance
- healthy are priced out of the market.
