ECON1194 - Prices and Markets

Topic 9: Market failure: Information failures,

Externalities and Public Goods
Outline
1. Information failures
1-a) Asymmetric information
1-b) Bounded rationality
1-c) Transaction costs
2. Externalities
2-a) Production externalities
2-b) Consumption externalities
2-c) Solutions to externalities
3. Public goods
3-a) Public goods
3-b) Common resources (Reference reading)
Introduction
Definition: Market failure refers to a situation in which the market
on its own fails to allocate resources efficiently.
A number of types of market failure exists which correspond to
violations of the assumptions of the model of the market.
Market model assumptions Types of market failure
• Rational agents • Bounded rationality
• Perfect information • Asymmetric information
• Zero transactions cost • Transactions cost
• Flexible prices • Externalities
• Property rights defined and enforced • Public goods
• Perfect competition • Imperfect competition
• Inequality

When markets fail, sometimes they correct themselves (private

solutions); sometimes, government needs to intervene (public
policy solutions).
1. Information failures
The model of the competitive market assumes that decision
makers (consumers and firms) are rational.

Definition: Rationality is the assumption that people are

“homo economicus”, i.e. gather information and carefully
weigh costs and benefits to choose the optimal course of
action.

Information failure arises when people fail to be rational in

terms of having inconsistent preferences; having insufficient
or incorrect information; or failing to act according to their
own preferences and available information.
1-a) Asymmetric information
Definition: Asymmetric information exists when one party
to an economic interaction has more (market-) relevant
information than another.

Asymmetric information can prevent mutually beneficial

trades or cause shortages and surpluses in the market.

Adverse selection (hidden characteristics): the seller knows

more about the attributes of the good than the buyer who
runs a risk of being sold a good of low quality. Example: used
car, labour, insurance markets.
Asymmetric information (cont)
Moral hazard (hidden action): An “agent” performs a task on behalf of a
“principal” who cannot perfectly monitor the agent’s behaviour. The agent
tends to undertake less effort than the principal considers desirable.
Example: shirking, lack of reasonable care.

Private solutions
- Signaling (informed party reveals private info to uninformed party)
- Screening (uninformed party induces informed party to reveal
private info)

Public policy solutions

- Government provides information or
regulates firms to provide information.
1-b) Bounded rationality
Definition: Bounded rationality is the assumption that real
people are homo sapiens and face imperfections in
information and human reasoning and “satisfice” instead.

Real people sometimes:

• fail to understand information and make mistakes;
• act against their own self interest;
• take excessive risks or act overconfidently;
• give too much weight to small no. of vivid observations;
• are reluctant to change their minds.
Bounded rationality (cont)
Public policy solutions
• governments provide information (awareness campaigns
• governments regulate firms to provide information
• governments regulate consumption and production of certain
goods and services

Definition: Merit (demerit) goods are goods and services that

government thinks people ought (ought not) to consume
irrespective of tastes or incomes. In the free market, people
under (over) consume merit (demerit) goods. Government
enforces or subsidies (prohibits or taxes) the consumption of
merit (demerit) goods.
1-c) Transaction costs
Definition: Transaction costs are the costs of using the market, i.e. the costs
that parties incur in the process of agreeing and following through on an
exchange.
Transactions involve:
- Identifying trading partners
- Negotiating contracts
- Monitoring compliance
- Enforcing fulfilment
These are costly due to bounded rationality and moral hazard
(opportunism).
Private solutions
Moral codes and social sanctions
Firms are command-and-control mechanisms that can internalise
transactions when carrying them out within the firm is cheaper than in the
market
Public policy solutions
Legal framework
2. Externalities
Definition: Externalities exist when the production or
consumption of a good has positive or negative side-effects on
third parties which are not accounted for in the price of the
good. Externalities are the uncompensated impact of one
person’s actions on the wellbeing of a bystander.
Positive externalities make bystanders better off; negative
externalities make bystanders worse off. Some examples of
common externalities:
Positive Negative
Innovation;
Production Technological Pollution
spillovers
Public
Consumption Vaccination; Education
disorder
Externalities
Externalities: Example of Toyota Altona
The production and consumption of cars has many side-
effects on people not directly involved that are not reflected
in the price car buyers pay and manufacturers receive.

Toyota
Positive Negative
Altona

Innovation, Skills,
Production Pollution
Economic stimulus

Consumption Labour mobility Congestion, pollution

 2-a) Negative externalities in production
A production process causes air
pollution which creates a health risk
for those who breathe the air.
Price The cost to society of producing a
unit of the good is the private costs of
Social cost (private sellers plus the costs to bystanders
cost + externality)
Cost of pollution who are adversely affected by the
pollution.
A benevolent social planner
Supply (Private
cost) maximises the value to consumers
𝑃𝑜𝑝𝑡 minus the cost of production, including
𝑃𝑀𝑎𝑟𝑘𝑒𝑡 the external costs.
The planner would choose the level of
production at which the demand curve
crosses the social cost curve.
Below 𝑄𝑜𝑝𝑡 the value of the good to
Demand consumers exceeds the social cost of
(Private value) producing it. Above 𝑄𝑜𝑝𝑡 the social
0 𝑄𝑜𝑝𝑡 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 Quantity cost exceeds the value to consumers.
 Positive externalities in production
A production process gives rise to a
chance that the producer will make a
technological advance. Such
advances create benefits for society
Price as a whole, known as spillovers,
because they add to our pool of
Supply (Private knowledge.
Value of spillover cost)

Because of these spillovers, the cost

to society of producing a unit is less
Social cost (private
cost + externality) than the private cost of sellers.
𝑃𝑀𝑎𝑟𝑘𝑒𝑡

𝑃𝑜𝑝𝑡 Once again, a benevolent social

planner maximises the value to
consumers minus the cost of
production.

Demand In this case the planner would want to

(Private value)
increase production until the social
0 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 𝑄𝑜𝑝𝑡 Quantity cost is equal to the private benefit.
 2-b) Negative externalities in
consumption
The consumption of alcohol
. can yield negative
Price
externalities if consumers
drive under the influence or
Externality Supply (Private
cost)
engage in violent or
antisocial behaviour.
𝑃𝑀𝑎𝑟𝑘𝑒𝑡
Because of the external
𝑃𝑜𝑝𝑡 costs associated with such
consumption, the social
value is less than the private
Demand value.
(Private value)

Social value The planner would want to

(private value lower the quantity produced
+ externality)
0 𝑄𝑜𝑝𝑡 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 Quantity
and consumed to 𝑄𝑜𝑝𝑡
Positive externalities in consumption
Vaccines yield positive
. externalities because they
lower the risk of catching
Price diseases for everyone in the
population, even those who
Externality Supply (Private are not vaccinated.
cost)

Because of the external

𝑃𝑜𝑝𝑡 benefits associated with such
𝑃𝑀𝑎𝑟𝑘𝑒𝑡 consumption, the social
value is greater than the
private value.
Social value
(private value
+ externality)
The planner would want to
increase the quantity
Demand produced and consumed to
(Private value)
𝑄𝑜𝑝𝑡
0 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 𝑄𝑜𝑝𝑡 Quantity
2-c) Solutions to externalities
Private solutions
• Moral codes and social sanctions
• Charities
• Self-regulation: firms voluntarily agree to and monitor an industry code
of conduct
• Internalising externalities via contracting (the Coase theorem): private
parties can negotiate a payment from one to the other, achieving the
socially optimum outcome.
Definition: Coase theorem: the proposition that if private parties can
bargain without cost over the allocation of resources, they can solve the
problem of externalities on their own.
Problems with the solutions
• Transaction costs (monitoring, negotiation, compliance)
• Break down in bargaining
Solutions to externalities (cont)
Public policy solutions
• Regulation (command-and-control): Forbidding, limiting
or mandating certain activities;
• Market-based policies: To align private incentives with
social efficiency:
1. Corrective taxes and subsidies: tax activities that have
negative externalities and subsidise activities that have positive
externalities;
2. Tradeable pollution permits.

Problems with the solutions

• Information (origin and value of externality, technology)
• Regulatory capture
Solutions to externalities (cont)
. .
Price Price

Social cost (private

cost + externality) Supply (Private
Cost of pollution Value of spillover cost)

Supply (Private
cost) Social cost (private
cost + externality)

Tax Subsidy

Demand Demand
(Private value) (Private value)

0 𝑄𝑜𝑝𝑡 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 Quantity 0 𝑄𝑀𝑎𝑟𝑘𝑒𝑡 𝑄𝑜𝑝𝑡 Quantity

3. Public goods - Introduction
In the perfectly competitive market, property rights are
assumed to be perfectly defined and enforced. This implies
goods and services are excludable and rivalrous in
consumption.
In reality, many goods and services are associated with
property rights problems:

Definitions:
Non-excludable: one produced, no one can be prevented
from using the good; and
Non-rivalrous: one person’s use of the good does not
diminish other people’s use.
Examples for goods
Rivalrous Non-rivalous

Private goods Club goods

food, clothing, cars, cinemas, private parks,

Excludable parking spaces satellite television

Common resources Public goods

Non- fish stocks, timber, coal free-to-air television, air,

excludable national defense
Examples for good: Roads
We can illustrate the four types of goods using the example of
roads. Roads can fall into any of the four types depending on
whether a toll system is enforced and whether there is
congestion.
Non-rivalrous (Not
Rivalrous (Congested) congested)
Excludable (Toll) Private goods Club goods

Toll-charged and Too-charged road but

congested road not congested road
Non-excludable Common resources Public goods
(No Toll) Free-charged but Free-charged as always
congested road
Market failure
Private goods and club goods do not present market failure – they
have prices attached to them.
Public goods and common resources present market failure –
externalities arise because something of value has no price
attached:
• If a person were to provide a public good, for e.g. national defence,
others would be better off and yet they are not charged for this
benefit;
• If a person uses a common resources, for e.g. fish in the ocean,
others would be worse off and yet they are not compensated for
this loss.

Due to these externalities, private decisions about production and

consumption can lead to inefficient outcomes (market failure).
Government intervention (public solutions) can potentially correct
inefficiency and raise economic well-being
3-a) Public goods
Definition: public goods are goods that are non-excludable
and non-rivalrous. Some examples: Fireworks displays,
lighthouses, national defence, basic research (knowledge),
free-to-air TV and radio.

Due to these two features, people have an incentive to be

free riders:
Definition: Free rider is a person who receives the benefit of
a goods but avoids paying for it.
The existence of free riders lead to the under-provision of
public goods in the market (the free rider problem).