Principles of Microeconomics
Lecture 15: Market failures
University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Overview
• Introduction
• Externalities
• Asymmetric information
• Low-equilibrium traps
Slide 1
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Introduction
• What is market failure?
• Why is it important to address?
• Efficiency and equity (again!)
Slide 2
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Introduction
• A typology to identify products where
government intervention may be needed:
• Rivalrous: where the consumption of the
product by one consumer prevents its
consumption by another consumer
• Excludable: non-paying consumers can be
excluded from consuming the product
Slide 3
The University of Papua New Guinea
Lecture 15: Market failures
Excludable
Rival
Private goods
Examples:
• Hamburgers
• Clothes
Quasi-public goods
Examples:
Non-rival
• Cable TV
• Fire-fighting
Michael Cornish
Non-excludable
Common resources
Examples:
• Tuna in the ocean
• Public parks
Public goods
Examples:
• National defence
• Street lighting
Are more
likely to
be subject
to market
failures
Tragedy of the commons:
Where (rational) self-interest leads to the depletion of
common resources
- Solved through cooperation, coupled with enforcement!
Slide 4
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Externalities
• An externality is a benefit or cost created
by a market that is borne by people
outside of the market
– I.e., a benefit or cost external to the
market
• We can categorise these externalities as:
– Positive or negative;
– Production or consumption
Slide 5
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Externalities
Negative externalities:
• Production:
– Classic example? Pollution
• Consumption:
– Classic example? Passive-smoking
• How should we address negative externalities?
– One approach: (Pigouvian) taxes!
Slide 6
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Negative production externality
Price of
electricity
Efficient
equilibrium
Deadweight
loss
S1 = Social cost
S0 = Private cost
Cost of pollution
PEFFICIENT
PMARKET
Market equilibrium
Demand
0
Slide 7
QEFFICIENT QMARKET
Quantity of electricity
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Dealing with a negative production externality
Price of
electricity
Price paid by
consumers
Market
equilibrium
with tax
S1 = Private cost
before tax
Cost of pollution = amount of
tax imposed by government
PEFFICIENT
PMARKET
Market equilibrium
without tax
Price
received by
producers
Demand
0
Slide 8
S2 = Social cost and private
cost after tax
QEFFICIENT QMARKET
Quantity of electricity
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Externalities
Positive externalities:
• Production:
– Classic example? Bee-keeping and crop
pollination
– There are not many great examples!
• Consumption
– Classic examples? Education, immunisation
• How should we address positive externalities?
– One approach: (Pigouvian) subsidies!
Slide 9
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Positive consumption externality
Price of a
university
education
Positive externality
Deadweight
loss
Supply
Efficient equilibrium
PEFFICIENT
PMARKET
Market
equilibrium
D1 = Social benefit
D0 = Private benefit
0
Slide 10
QMARKET QEFFICIENT
Quantity of university education
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Dealing with a positive consumption externality
Price of
university
education
Price
received by
producers
Positive externality =
amount of subsidy
Market equilibrium
with subsidy =
efficient equilibrium
PEFFICIENT
PMARKET
Price paid by
consumers
0
Slide 11
Supply
Market
equilibrium
without
subsidy
D2 = social benefit
and private benefit
after subsidy
D1 = private benefit
before subsidy
QMARKET QEFFICIENT
Quantity of university education
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Externalities
Another approach: The Coase Theorem
• Private bargaining will result in an
efficient solution to the problem of
externalities, as long as:
– There is perfect information (‘full
information’)
– Transactions costs are sufficiently low
– There are property rights
Slide 12
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Externalities
The Coase Theorem (cont.)
• E.g., a company creating pollution could
pay the victims for the right to pollute; or
• The victims could pay the polluting
company to reduce its pollution
Slide 13
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Externalities
Yet another approach: Market-based solutions
• Tradeable rights markets
– Cap-and-trade (e.g. greenhouse gases)
– Entitlements (e.g. Murray River water
markets)
And (another!) approach: Central planning
• Also known as ‘command and control’
– Use of quantitative controls
Slide 14
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Asymmetric information
• Where a party to a transaction has a
different level of information than the other
(‘information gaps’)
– E.g. the second-hand car market,
university education
– Leads to inefficient distortions in the
market
Slide 15
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Asymmetric information
• Adverse selection is where a party
takes advantage of this asymmetric
information
– Leads to even more inefficient
distortions in the market!
Slide 16
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Asymmetric information
Asymmetric information can also lead to…
• Moral hazard:
– Where one person takes more risks
because they know that the burden of
those risks is borne by another party
– E.g. subprime mortgage crisis (the GFC!)
Slide 17
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Asymmetric information
Asymmetric information can also lead to…
• Principal-agent problem:
– Where an agent’s self-interest conflicts
with that of their client
– E.g. real estate agents
Slide 18
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Low-equilibrium traps
• Occurs where decisions by multiple parties are
required simultaneously in order to achieve a more
desirable outcome
– E.g. creating a manufacturing sector in a poor
developing country where none currently exists
• Instead, economic decision-makers (such as major
investors) remain inactive until all the conditions
for them to invest are fulfilled
Slide 19
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Multiple
Equilibria
Lowequilibrium
trap
Slide 20
The University of Papua New Guinea
Lecture 15: Market failures
Michael Cornish
Case Study: Latin American Time
Slide 21
The University of Papua New Guinea