1.4 Market Failures

Anmerkungen:

• Externality leads to a market failure as either more or less than the socially optimal amount is produced or consumed (therefore inefficient resource allocation)

1. Components
   1. MSC
   2. MSB
   3. MPB
   4. MPS
2. Types
   1. Positive Externality of Consumption

      Anmerkungen:

      • If there is an external benefit then the MSB curve lies below the D,MPB curve
      • Example: - Flu Shots (less people infected)
      1. Underconsumption of certain products
         1. Merit Goods

            Anmerkungen:

            • Consumption of these goods creates a very positive externality (e.g. education and health care)
            • Alternative Definition: Goods that government would like all members of society to consume in adequate quantities independently of their income or even their preferences (e.g. compulsory education)
      2. Solution
         1. Granting a Subsidy

            Anmerkungen:

            • Type of MARKET-BASED SOLUTION
         2. Legislation and Direct Provision

            Anmerkungen:

            • Type of COMMAND-AND-CONTROL SOLUTION e.g. Free Education
         3. Advertisements/ Moral Pursuation
   2. Positive Externality of Production

      Anmerkungen:

      • If there is an external benefit from the MSC curve lies below the S,MPC curve
      • Example: - Beekeepers producing honey next to apple orchards (as bees will pollinate flowers)
      1. Underproduction of Good
      2. Solution
         1. Granting a Subsidy

            Anmerkungen:

            • Type of MARKET-BASED solution 
         2. Assigning Intellectual Property Rights

            Anmerkungen:

            • Type of MARKET-BASED solution 
         3. Mergers

            Anmerkungen:

            • Type of MARKET-BASED solution 
         4. Direct Regulation

            Anmerkungen:

            • Type of COMMAND-AND-CONTROL SOLUTION
   3. Negative Externality of Consumption

      Anmerkungen:

      • If there is an external cost then the MSB curve lies below the D, MPB curve
      • Example: Consumption of alcoholic beverages (leading to violence, drunk driving, etc.)
      1. Overconsumption of certain products
         1. Demerit Goods

            Anmerkungen:

            • The consumption of a good creates very significant negative externalities (e.g. Alcoholic drinks and Tobacco)
            • Alternative Definition: Goods of which governments would like to limit consumption
      2. Solutions
         1. Imposing Indirect Taxes

            Anmerkungen:

            • Type of MARKET-BASED solution
         2. Direct Regulation

            Anmerkungen:

            • Type of Command-and-Control Solution
         3. Advertisements

            Anmerkungen:

            • Type of Command-and-Control Solution
   4. Negative Externality of Production

      Anmerkungen:

      • If there is an external cost then the MSC curve lies above the S, MPC curve
      • Example: Cement INdustry polluting the atmosphere
      1. Overproduction of the good/ service
      2. Solutions
         1. Market-Based Solutions
            1. Indirect Taxation

               Anmerkungen:

               • - raises the production costs (therefore forcing the supply curve to shift to the left)
            2. Property Rights over Assets
            3. Tradable Pollution Permits

               Anmerkungen:

               • e.g. cap and trade schemes
         2. Command and Control Solutions
            1. Direct Government Regulations
            2. Advertisements
               1. Persuading the public through education

Anmerkungen:

• Pure Public Goods example: Lighthouse, Traffic Lights, Law and Order (debatable), Broadcast Television and Radio (debatable) 

1. Characteristics
   1. Non-Excludable
      1. Existence of Free-Riders

         Anmerkungen:

         • Individuals hiding their true preferences due to the fact that they can enjoy the good without having to pay for it once it becomes available for others
   2. Non-Rival
      1. No marginal cost of an extra user
2. Externality
   1. Positive Externality of Consumption
      1. MSB > MPB
      2. BUT: MPC > MPB
         1. Good may not be supplied
            1. Lack of incentives

1. Tragedy of the Common
   1. Causes Negative Externality of Production
   2. Solutions
      1. Extending Property Rights
      2. Appropriate Institutional Framework
      3. Direct Regulation
      4. Education

1. Solutions
   1. Governments ensure competitive conditions
      1. Liberalizing Free Trade
      2. NO mergers / acquisitions
      3. Monitoring anti-competitive practices
2. Abnormal Profits

1. Problems
   1. Adverse Selection

      Anmerkungen:

      • Producers may not be able to test the true quality of its product
   2. Misalignment of incentives
   3. Moral Hazard Problem arises
2. Solutions for Firms
   1. Signalling

      Anmerkungen:

      • One of the parties tries to convey information about itself that will make it seem credible (e,g, issuing warranties, etc.)
   2. Screening

      Anmerkungen:

      • Individuals try to infer additional information from other observable characteristics
   3. Building good reputations
   4. Contracts Creations
3. Solutions for Governments
   1. Providing more information
   2. Legislations
      1. Standards
   3. Regulating Firm's Behavior