(12) Market Failures

Total Video Time: 106 minutes + lecture notes


In Modules 2-4, we learned the basics of supply, demand, and market equilibrium. While it may not have been specified, there are certain assumptions underlying those markets that, when they hold, mean that when supply and demand are equal, the result is socially optimal. However, when those assumptions do not hold, the result is not, and government intervention may increase economic surplus.
Before you read the examples below of externalities and public goods, you really should watch the videos from the chapter in the Asarta/Butters Library first. That way, you’ll understand that the problem in both of these cases is that the good is non-excludable: you get to consume the good whether you paid for it or not. Public goods are non-rival, while common resources are rival. The result is that the free market doesn’t provide enough public goods (there is under-provision), and not enough common resources exist (there is over-consumption). Okay, now read on. (And note that there are no videos in Asarta/Butters on asymmetric information, so you just have lecture notes for that part of market failures.)


The first market failure we’ll see is externalities, a situation where people outside of the market are affected by the actions (consumption or production) inside the market. Thus, the market outcome does not reflect all of the costs or benefits from the good. After examining how externalities lead to inefficient outcomes, we then discuss a variety of mechanisms to resolve the externality.


Video 12.1: Externalities (8 minutes)

This video explains the notation that is used when talking about externalities, which can sometimes be complicated for students. The key is that the ideal level of output for society is where the marginal social benefit (MSB) of another unit of output is equal to the marginal social cost (MSC) of another unit of output.


Video 12.2: Negative Externalities (10 minutes)

This video goes through both kinds of negative externalities (production and consumption), showing the deadweight loss that would result in a perfectly competitive market.


Video 12.3: Positive Externalities (13 minutes)

This video goes through both kinds of positive externalities (production and consumption), showing the deadweight loss that would result in a perfectly competitive market. It finishes by discussing a few ways to use government intervention to move the market towards the socially optimal level of output.


Video 12.4: Reducing Negative Externalities (12 minutes)

This video examines solutions to negative externalities, moving the level of output in the market closer to the socially optimal level of output.

Public Goods
When I was growing up in Los Angeles, there were a few summers where the city would sent out helicopters on summer nights to spray malathion, a chemical that kills mosquitoes and their larvae. It was an annoying thing: as kids, you want to stay out all night playing during summer, but there were a few days a week where we were told to stay indoors because apparently malathion isn’t good for you. However inconvenient, it was necessary because mosquito containment in a large city is a public good: everyone benefits from it whether they pay their taxes or not (or whether they would pay for the area around their home to be sprayed), and the fact that they kill mosquitoes that bother me doesn’t mean they can’t kill mosquitoes that are bothering you. If this kind of service were offered on an individual basis, few people would purchase it — they would rather be free-riders on everyone else.
Some cities in Los Angeles were having the same problem in the last year or two. Many houses went into foreclosure and were abandoned by their owners and weren’t sold by banks. With so many properties they couldn’t take care of all of them. The pools in the backyards (we Californians love our pools) turned into festering swamps of mosquitoes and were causing major problems.
Ever wonder why, many decades ago, we used to have “fire companies” and now we have “fire departments” run by the city? It’s because of the free-rider problem. A hundred years ago, when most of the country was not urbanized or suburbanized, people lived a distance from their neighbors. In that time, you had to pay fire companies for fire insurance. If your house caught on fire, it didn’t immediately threaten your neighbor’s house, so you couldn’t rely on them having fire insurance: you had to pay for it yourself or your house would burn.
But when urbanization, houses moved closer together. These days, if my house caught on fire, it would threaten my neighbors on both sides. If either of them purchased fire insurance, they would call the fire department and tell them to put my house out before it caused theirs to catch on fire. Thus, I have an incentive to free-ride off of my neighbors. Since we all have the same incentive, few of us are willing to buy fire insurance, and a private fire company can’t earn enough revenues to stay in business. Thus, cities now provide fire protection and take some of the money we all pay in property taxes and use it to fund their operations. And we’re all better off for it.
Actually, it’s not true that every city has a fire department run by (or at least paid for by) the government. Here’s a great example, but sad story about International Falls, MN. Please take a few minutes and read it — it points out the free-rider problem. And one of your discussion questions will be about this article, too. (Here’s another more recent example.)

Common Resources
Instead of using the same old “tragedy of the commons” that every textbook does, I’ll use something I found a few weeks ago that many people in relationships (or who have hungry siblings) might be able to relate to. The text of the story is provided below (from this webpage):
My fiancée makes amazing Guacamole, but it leads to the following problem: she only makes one bowl of it, which we then share. The issue is, I like to utilize small amounts of Guac on each chip in order to maximize the amount of time I get to enjoy the sweet green stuff, while she likes to heap massive amounts on each chip, in an effort to eat less chips (which I find laughable). This drives me crazy as I always end up with the short end of the Guac stick, and so lately I have been separating the Guac into two equally-sized bowls once she’s made it, in an effort to preserve my fair share. She thinks this qualifies as me being [a jerk] and says I “must have failed sharing in Kindergarten”, but on the contrary, I think it’s her poor sharing that’s lead to the whole situation.
Here’s one man’s reponse to this letter, from the same webpage:
Well, the obvious solution here is for her to make MORE guac. The other solution? Ask her the recipe, and then begin making it yourself. As head chef of the household, you are in full control of when that guacamole will be presented for consumption. I cook for my wife because it allows me the freedom to eat half of what I’ve made before it even reaches the table.
Furthermore, the strategy of using less guac per chip is fatally flawed. It’s guacamole. All guac is first come, first serve. You must heap as much guac onto one chip as humanly possible (as your fiancée does), only do it at a much faster rate. Think guacamole isn’t a race? IT IS. The faster you eat, the more you get. That’s how it works. And it’s a crucial strategy to exploit when dealing with guacamole, nachos, pizza, wings, and other shared food. Do not hesitate. Don’t even chew. You inhale until there’s nothing left for her. That’s what I do.
If you were out to eat with your guy friends at a Mexican restaurant, and you ordered guacamole for all to share, would you get [mad] at your friends for digging in too quickly? [Heck] NO. That guac is chum, and you are the sharks. ATTACK ATTACK ATTACK. Never play defense with appetizers.
Get the idea? Personally, I like to consume my guacamole throughout a meal of Mexican food, not just at the beginning. But if the person you’re eating with gets to it first, you have no choice but to focus on the guacamole from the beginning and not let up until it’s done. By that time your burrito may be cold, but you have to decide: is it better to have a hot burrito and little guaco or a warm burrito and more guaco; we’d have to know more about your preferences to determine what the optimal strategy is, but for the guy writing the letter, it appears he’d rather have more guaco and a luke-warm burrito.
My friend Dave has a brother, Adam, who growing up was a very fast, very avid eater. As long as Adam had food in front of him, everything was fine. But when Adam was finished, he would scavenge. If Dave hadn’t finished his french fries, Adam would start eating them. So Dave had to change his eating strategy: he ate his fries first. Adam had no problem picking off a few fries (property rights on fries are pretty blurry when you’re a kid), so Dave had to guard against that; but Dave knew that Adam wouldn’t pick up his burger and take a bite out of it (property rights to burgers are more clearly defined), so the burger was safe. It wasn’t an ideal solution — Dave’s hamburger always got cold — but at least he got to eat his own fries. To this day, Dave still eats all his french fries before touching his burger. Sometimes when we’re grabbing a burger and, five minutes into it, he’s still eating fries and hasn’t touched his burger, I want to tell him, “It’s okay. Adam’s not here. He can’t take your fries.” In fact, I think I may have told him that on more than one occasion. But it didn’t work. I’m convinced Dave will be 90 years old and still be eating fries while his burger gets cold.
Sorry about that tangent, but it was designed to illustrate a point: in the end, everyone is worse off when property rights aren’t clearly defined and the good is rival. They each want to have guacamole and a hot burrito, but because the only way to claim guacamole is to eat it, they end up overconsuming guacamole early. This is what happens in oceans, where people overfish because the only way to own a fish is to catch it. If you could tag it with an RF chip when it’s small, and leave it for years to get big and fat so you had a really good catch, then this problem would be avoided. But without property rights on the high seas, you get overfishing.
In the real world, how do we limit overconsumption of a common resource? You can assign the property right to an individual. If one person owned all the fish in the oceans, they would have an incentive to limit the amount of fish that are caught so that the stock isn’t depeleted. Or you can assign the property right to the government and it can impose limits — the way that hunting and fishing licenses are done. Ideally, the Department of Natural Resources knows how many fish and deer are out there and how many can be lost this year to fishing and hunting, and issue licenses accordingly. By making people pay for fish and deer, they are forced to bear the cost of their actions (unlike the person who eats all the guacamole).

Asymmetric Information

There is another kind of market failure, called asymmetric information. It means one side of the market has more information than the other, and ultimately it usually causes a breakdown in the market.


Video 12.5: Asymmetric Information, part 1 (13 min)

This video uses the market for health insurance as an example of asymmetric information and what can happen to the market as a result. It starts by assuming symmetric information and shows that there would be different health insurance markets for different people, then shows what happens when health insurance companies cannot determine whether you are healthy or unhealthy.


Video 12.6: Asymmetric Information, part 2 (14 min)

This video picks up where the last one left off and goes into the two main problems that result from asymmetric information: adverse selection and moral hazard. It finishes by examining some of the provisions in the 2010 Health Care Reform Act to determine if we should expect health insurance rates to increase or decrease as a result of the new law.


Be sure you understand the difference between adverse selection and moral hazard. They are two very different effects of asymmetric information, and you should be able to identify each and explain them — especially in the context of health care and health insurance.

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