7. Market Failures

1. Market participants are not equal and some of them have different levels of power and influence.

2. Buyers and sellers don’t behave rationally.

3. Market entry is not free

4. Property rights are difficult to establish

5. Market players have imperfect information and are making choices based on wrong data or beliefs.

• Not all goods can be provided in competitive markets. In fact, some goods may end up not being provided at all, despite being desirable due to scale or costs. The are referred to as public goods.

• The nature of some goods or economic activities can lead to situations in which not all costs and benefits are accounted for. If the economic calculations of consumers and producers are incomplete, market equilibrium will fail to maximise welfare. We then speak of externalities.

• Excludability refers to the property of a good whereby a person can be prevented from using it.

• Rivalry refers to the property of a good whereby one person’s use diminishes other people’s use.

A free-rider is a person who receives the benefit of a good but avoids paying for it.

• Since people cannot be excluded from enjoying the benefits of a public good, individuals may not be willing to pay for the good hoping that others will pay for it.

• The free rider problem prevents private markets from supplying public goods.

• The government can make everyone better off by providing the public good and paying for it with tax revenue.

should be provided up to the point where the marginal benefit gained from an extra unit by the society is equal to the marginal costs of providing that extra unit.

• Common resources tend to be used excessively when individuals are not charged for their usage. Since they are non-rival, they use up and will eventually disappear.

• An analysis by Garret Hardin suggests that where communities shared common resources, the inevitable result was the destruction of those resources.

• This is similar to a negative externality

arise because consumers may have imperfect information about the benefits of these goods and are not able to value them appropriately as a result.

• Merit goods can be provided by the market but may be under-consumed as a result.

• Intertemporal choice where decisions made today can affect choices facing individuals in the future

Education

• Private benefits of education include career prospects, but they are far in the future and might be difficult to estimate from the point of view of young people.

• Social benefits include better stock of human capital, but individuals don’t take it into account when making decisions about their education,

• As a result, if left to private markets, education would be under-consumed.

Health Insurance

• Healthy people not always think of what might happen in the future. Being too optimistic about their own health may lead to under-insurance.

Pensions

• The benefits of a pension are far in the future (even further then the benefits of education, so people may tend to ignore it at young age.

is an uncompensated impact of one person’s actions on the well-being of a bystander.

• Externalities cause markets to be inefficient, and so fail to maximize total surplus.

• An externality arises when a person engages in an activity that affects the well-being of a bystander and yet neither pays nor receives any compensation for that effect.

• When the impact on the bystander is adverse, the externality is called a negative externality. For example:

• Car exhaust fumes

• Cigarette smoking

• Barking dogs (loud pets)

• Loud stereos in an apartment building

• When the impact on the bystander is beneficial, the externality is called a positive externality. For example:

• Immunizations

• Restored historic buildings

• Research into new technologies

• Market decisions are be based on weighing up private costs and private benefits.

• Social costs and social benefits are lost or gained by those not party to the initial decision.

• Market decisions may not take account of the social costs and benefits of their actions.

• The market equilibrium is not efficient when there are externalities, that is, welfare is lost.

• Negative externalities lead markets to produce a larger quantity than is socially desirable, since the cost to the individual is lower than the cost to the society.

• Example: If there was no limitation of loud behaviour at night in densely populated areas, it would be probably a lot more difficult to get a good sleep.

• Positive externalities lead markets to produce a smaller quantity than is socially desirable since the benefit to the individual is smaller than the benefit to the society.

• Example: If there was no regulation on architecture in the city, there would be probably rather few beautiful (but impractical) buildings.

... involves altering incentives so that people take account of the external effects of their actions.

How to internalise external effects?

• ... by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.

• ...by reducing the cost of education to encourage people to study .

1. Property Rights

2. Public Policies

3. Private Solutions

• Property rights is the exclusive tight of an individual, group or organization to determine how a resource is used.

For example: If I have ownership rights over the air 1 km above my house, then no one can legally pollute it. I can negotiate with a firm that wishes to pollute that air and agree a price for the right to do so.

• Extending property rights is therefore one area where externalities can be internalized.

• However, it is a complex task to establish a system of such property rights and they may be expensive to enforce. The applies in particular to non- excludable goods.

For example: enforcing intellectual rights (copyrights) is proving notoriously difficult.

1. Regulations:

Government can forbid or enforce certain behaviours by law – not complying will lead to a penalty.

2. Taxes:

Government can impose taxes or subsidies on certain behaviours – they will effectively increase the cost or benefit.

3. Tradablepermits:

Overall limits on negative external effects are imposed, but they can be traded between affected parties

Government action is not always needed to solve the problem of externalities. Private solutions to internalizing external effects can be found

• Social Norms and Moral Behaviour • Charities

• Self-interest

• Social Contracts

Private Goods are excludable and Rival while Public goods are non-excludable and Non- Rival.

Persons can be prevented from using Private goods and by using a private good another person´s use for that good diminishes. Public goods cannot exclude other people from using it aswell as it is not limited for the usage of one person. It thus has the free rider problem, given the non-excludabliity of public goods, individuals may not be willing to pay for the good hoping that other will pay for it.

The Tragedy of the Commons, individuals are not charged for their usage it might be used too excessively until its dirty and too crowded destroying the natural beauty of the beach. This could happen if an entry fee or a users limit keeps getting avoided.

Private benefits of studying IIM would be a higher grade of education, Building a solid soil for your future, entrance for your future jobs…

Social benefits are the benefits people get who werent party to the initial decision, in other words the society. Higher educated people are essential for innvoation for example. Which is why the state invests in Universities. The Social benefits therefore form with other students a perspective for the future.

They do differ.

Negative Externality

Solution is planting property rights on those roads Ms Maple wishes to minimize heavy traffic. For example a Ban for heavy trucks.