Econ 201 Market Failures PDF

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Summary of Market Failures and what professor Mark Witte wanted his students to know for the exams. ...

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Economics 201: Introduction to Macroeconomics Northwestern University Mark Witte Market Failure & Dead Weight Loss Market Failure #1: Failure of Competition

Failure of competition A. Imperfectly competitive industries restrict market quantity to drive up the market selling price above the marginal cost of production, creating DWL as in the Lemonade Stand example. B. At a price of $0.40 per cup the quantity sold was 10 cups. But lemonade only cost $0.15 per cup to make, and setting the price at $0.15 per cup would allow 22.5 cups to be sold. At a price of $0.40, the profit to the monopolist was ($0.40-$0.15) * 10 cups = $2.50, but there is DWL of 0.5*($0.40-$0.15)*(22.5 cups – 10 cups) = $28.125. C. DWL here comes from a loss of consumer surplus. II. Why do we have different market structures? Why are some markets perfectly competitive (supply curve, lots of competing firms), some oligopolies (a few sort-of-competing firms), and some monopolies (only one firm)? A. Barriers to entry: Oligopoly of monopoly may result because other firms are prevented from doing business in the industry. i. Government may restrict entry (Adam Smith hated this! Think of the Post Office.) ii. Only one of a few firms may have access to the patents or trade secrets that allow production of the good. iii. Only one of a few firms may have access to the scarce resources that allow production of the good. B. Economies of scale versus the overall size of the market i. Perfectly competitive markets would be expected where firms can be competitive as a size that is much smaller than the total market for the product (“the MES is small relative to the overall size of the market at a price near the minimum AC”). That is, lots of firms could fit into the market. (MES is small relative to the total market.) ii. Oligopoly would be where only a few firms could “fit” into the market (“the MES is so large that only a few firms could fit into the market). iii. Monopoly is one firm in the industry, limited only by its costs and the demand curve for the market.

I.

Market failure #2: Public Goods

Public Good: A commodity of service whose benefits are not depleted by an additional user and where it is very difficult or impossible to exclude people from enjoying these benefits II. Non-excludable – makes it hard to get people to pay for the benefit III. Non-depletable – makes it hard to justify charging someone for enjoying the benefit IV. Examples: National defense, local roads and parks, flood and mosquito control, beautiful views, public art, TV and radio signals V. The reason private markets have trouble supplying public goods is due to “non-excludability.” It takes government to force people to pay for them. I.

Market Failure #3: Externalities (side effects) We get DWL when some of the costs or benefits fall on people who aren’t the buyer or seller, side effects A. When all benefits and costs are private, then we get no DWL B. Private costs or benefits of production are different from social costs or benefits of production, so buyers and sellers interacting have effects on those who are “external” to the transaction II. Negative Externalities: True social cost above private cost. Examples: pollution, litter, traffic, ugliness, noise, contagious disease, antibiotic ineffectiveness A. “Social” supply curve includes both private costs to producers plus externality costs to the rest of society. B. “Private” supply (considers only private costs to producers) to the right or below the social supply curve C. DWL occurs because in market quantity is chosen by the private equilibrium, not the social one, so the cost of the negative externality is ignored. As a result, on the margin the benefit to society of production is less than the cost (private plus externality) D. Can be solved by: i. Government rules limiting production (regulations, zoning) ii. "Internalize the externality" a. Make private buyers or sellers feel the external cost to society of the negative externality b. A “pollution tax” that makes private producers consider the externality in their private production decisions (make producers pay for the value of the environment they destroy) c. “Cap and trade” systems were producers must buy a tradable permit for each unit of pollution that they want to emit. III. Beneficial Externalities: Social benefit or demand includes private benefit plus externality of benefit to the rest of society. Examples: beauty, safety, pollination A. Social demand curve above/to the right of the private demand curve. B. DWL occurs because the market quantity is chosen by the private equilibrium, not the social one, so the benefit of the externality on the rest of society is ignored. As a result, on the margin the benefit to society (private plus externality) of production is greater than the cost. C. Can be solved by subsidizing the production of the good (such as flu shots). D. (And yes, for beneficial externality reasons, you really should get a flu shot) I.

Market Failure #4: Asymmetric Information

I. Asymmetric information advantages can mess up markets II. Used cars (“The Market for Lemons”) A. People are willing to pay a price that matches the quality of a car, but don’t want to pay

a lot for a car that’s bad. B. It’s hard for a potential buyer of a used car to tell if the car is any good or not, so all

used cars, good and bad, tend to sell for the price of a bad one, which means that cars that aren’t bad, don’t get sold, even though the owner might prefer to sell for a reasonable price and buy a new car. III. People who know they have bad health have high demand for health insurance, driving up the cost of providing insurance, and thus discouraging healthy people from buying it. A. Should there be a “mandate” that everyone have health insurance? B. Clinton & Edwards: Yes! Obama: Two years ago, no! Now, yes! Romney: Three years ago, yes! Now, no! C. Everyone who works for Northwestern has to have insurance, which results in insurance being cheaper than if we had a choice about buying it or not. IV. Information failures result in fewer sales of insurance and used cars than if information were perfect, and this creates DWL....