CHAPTER 3 CONTINUED
Market Failure
WHAT IS MARKET FAILURE?


Market Failure exists when the free market
system fails to allocate resources in an efficient
manner.
This section covers several sources of market
failure including
Market power
 Non-Existence of Markets


Asymmetric information, adverse selection, and moral
hazard concerns
Externalities
 Public Goods

MARKET POWER


From principles remember that firms with
market power (such as monopolies) find it
advantageous to under-produce goods in order to
maximize profit
This meant they produced a quantity such that
P > MC
Implication:


NON-EXISTENCE OF MARKETS


Markets either do not exist for every good and/or
service or there are situations in which one
person’s behavior affects the welfare of another
outside the existing market
The inefficiency stems from several different
causes:
1. problems of asymmetric information:
NON-EXISTENCE AND INSURANCE
MARKETS

insurance markets are used to protect against
uncertainty. However, there is not insurance for
everything.

There is no private market for “poverty insurance”—
insurance against the possibility of becoming poor.
Private markets don’t supply such insurance because
of the asymmetric information and adverse
incentives.

Current solution: so government uses payroll taxes to
fund unemployment benefits and/or welfare
payments.
ASYMMETRIC INFORMATION AND ADVERSE
SELECTION EXAMPLE





Ex: health care: asymmetric information—individuals may know if
they are in a high risk or low risk category for illness and base
decision to buy insurance on relative costs and benefits.
Asymmetric information: The insurance company can’t determine
who is high risk and low risk and therefore charges an average
premium to all clients
Adverse selection means the people that choose to buy insurance are
typically those in high risk categories who believe the benefits > costs;
those that think they are at low risk will not buy insurance. Hence,
end up insuring a pool of high risk applicants.
Current solution: try to spread risks through mandatory health care
via employers and therefore generate a larger pool with differing
levels of risk (State Health insurance).
Original health care bill: wanted to make every person purchase
health insurance to bring down premium costs (get these low risk
people back in the market).
ASYMMETRIC INFORMATION AND MORAL
HAZARD



moral hazard
Ex: home owners insurance: if you’re covered for theft
may not be as diligent about locking your doors.
Ex: in health care; people who have insurance may
overuse health care by engaging in more risky
behavior or more costly behavior—extreme sports or
more commonly patients want unneeded procedures,
MRIs, testing, etc) because they are covered and pay
very little in incremental costs.
EXTERNALITIES



Externalities
Ex: Positive externalities – because individuals consider
only their private costs and benefits and not the full social
benefits of their decisions there is an under-production or
under-consumption of these goods--flu vaccines.
Ex: negative externalities—– because individuals and firms
consider only their private costs and benefits and not the
full social costs of their decisions there is an overproduction or over-consumption of these goods—pollution.
PUBLIC GOODS



Public goods—a good that in non-rival in
consumption and non-excludable in consumption

Non-rival:

Non-excludable
Ex: lighthouse; national defense; fire protection
The market failure stems from the idea that people
will “free ride” or “cheap ride” and not pay for
something even though they receive the benefits. This
results in an under-production of the good or service.
GOVERNMENT INTERVENTION IN
MARKETS
PUBLIC POLICY SHOULD ADDRESS 3 VITAL
QUESTIONS




Compass Lexecon (change in administration and
change in objectives)