Draft:Market failures

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Paul Krugman Ross McKitrick Karl Marx Dick Armey v - t - e

A in microeconomics, a market failure is a situation in which a market left on its own fails to allocate resources efficiently. While most economists agree that these market failures require government action, some economists, also argue that such action will only makes things worse, while a small minority (such as some Austrian school economists) arguing that these market failures either do not exist, or are caused by the government.

Externalities

See the main article on this topic: Externalities

An externality exists when a third party is affected during an exchange between two agents. These spillover costs of an action are that portion of the total costs passed on to others. For example, a mining company that dumps its waste into a river, contaminating the water. The consumers who live far from the river will benefit from this arrangement, while people who live along the river are harmed by such a productive system.

People generally undertake only those activities for which they expect the additional personal costs will be less than the additional personal benefits. When there are no costs created for others, an individual comparing costs and benefits avoids waste and searches for efficiency. But if some of the costs of your action spill over to others while you capture the benefits, then comparing private costs and benefits will lead to actions that are costly to society.

Another example are the fumes expelled by cars. If all of your car’s exhaust fumes were pumped into the interior of your car, you would be the only one breathing them, so you would probably not drive at all. Fortunately for you (but not for the rest of us), you can vent your exhaust fumes into the atmosphere, where others will breathe them, so you are not likely to reduce your emissions voluntarily because your cost of reducing emissions outweighs your benefits. In other words, since other people, share the cost of your pollution, you get a net benefit from polluting.

When costs can be socialized, as in the examples above, the individual weighs the total benefits against only a portion of the costs (the ones they bear) and improve their own position at the expense of others. Socialized costs and privatized benefits mean that people get a “free ride” (something that will be at others' expense. Where those spillovers occur, the market will is respoinding imperfectly to the desires of the public.

A free market fundamentalist can argue that, with the Coase theorem, the efficient arrangement can be arrived at through market exchanges alone. However, the condition that the theorem establishes to arrive at an efficient private arrangement is the absence of transaction costs, and this may not always occur in practice, as the Coase theorem only works when property rights are well-defined and transaction costs are low. In cases that it does not apply, a third party must establish rules that force private costs to equal social costs. This third part is the state, and some of the forms used to arrive at the economically efficient arrangement are the Pigouvian tax and regulation.

Public goods and the free rider problem

Public goods are goods that are neither rival nor excludable. These goods are goods whose usufruct by one person does not prevent another person from also using them, as well as they are goods whose possibility of excluding those who do not pay for their production or maintenance is practically nil. Economists usually mention fireworks as a textbook exemple of a public good. If a company wants to make fireworks show, it can't prevent others who are close enough from watching it, so people don't need to pay for it. As a result, goods of this type, if provided solely by the market, are under-produced, as they are susceptible to the free-rider problem.

The free-rider problem characterizes a situation in which those who do not pay for the supply of a good use it anyway, and, as a result its production is sub-optimal. The army is the most obvious example of a public good. Let's suppose that there is a nation whose funding of national defense is on an entirely voluntary basis. What will happen? The most rational action from a person's point of view is not to pay anything, because that if they do, the marginal benefit they will receive from a marginal improvement in national defense is less than the marginal cost of the outlay. But if they don't pay for it, they still enjoy the benefits of having such good. However, what happens when everyone thinks like this? Ultimately, if all people act thinking only for themselves, there is no national defense at all. Again the only way to resolve this issue is when an agent is capable of coercing everyone else to pay the necessary quota to match marginal costs to marginal benefits. (aka the state collecting taxes). Public defense is just one example of a public good. There are many others, from roads to sanitation.

Public goods also pose another problem for markets. Without the guidance of prices, how much of the good should be produced? For instance, if a bridge has excess capacity, the cost to other users of allowing an additional person to cross the bridge is zero. Charging a toll in this situation would discourage some people from using the bridge who would otherwise use it—even though their use would not decrease other people’s use. The result is that total social welfare is less than what it could be.<Bator>

Imperfect competition and market power

See the main article on this topic: Monopoly

Market power refers to the ability of a single person (or small group of people) to unduly influence market prices.Let's suppose, for example that everyone in town needs water but there is only one well. The owner of the well has market power (in this case, the monopoly) over the sale of water in the whole town. The well owner is not subject to the competition with which the invisible hand normally keeps self-interest in check. As a result, we might have deadweight losses. In this case, the government should consider regulating the price of the water. Monopolists also don't have many reasons to care about the quality of their products too, since people have no option but to buy their products anyway, so regulation is often required.

Even though monopolies are rare in the long term, it's very hard to deny the existence of this problem, but some microeconomists, like the Nobel Prize winner George Stigler, argue that the economic history shows that the government has done more harm than good on this matter, and maybe it's a better idea to let monopolies be eroded by new competitors.

Asymmetric information, adverse selection and moral hazard

Sometimes buyers and sellers are not both perfectly informed about the quality of the goods being sold in the market, and information is costly or even impossible to gain accurate information about the quality of the goods being sold. For instance, when a consumer buys a used car, it it is often very difficult for them to determine whether or not it is a good car. On the other hand, the seller of the used car e will probably have a pretty good idea of the quality of the car. This sort of problem is called adverse selection. Because owners of the worst cars are more likely to sell them than are the owners of the best cars, buyers are often worried about getting a bad one. As a result many people don't buy used cars. This is the reason why a used car only a few weeks old sells for thousands of dollars less than a similar new car. A buyer of the used car might surmise that the seller is getting rid of the car quickly because the seller knows something about it that the buyer does not. When markets suffer from adverse selection, markets fail. In our used car market example, owners of good cars may choose to keep them rather than sell them at the low price that skeptical buyers are willing to pay, crowding out the number of good used cars in the market.

Another problem arising from asymmetric information is called moral hazard. When with more information are often tempted tempted to exploit their this advantages at the expense of their trading partners. For example, a taxi driver who takes the long route to jack up the fare, or an auto mechanic or the dentist who recommends unnecessary services. For example if a mechanic tells you that your car needs an engine overhaul when all it actually needs is are minor new parts. Not only this is a a ripoff, but is also a waste of time and resources, as the economy is producing a good that no one actually wants or needs.

While it's very hard to fix these problems, one thing that the government can do is to demand that companies have a standardized data disclosure system in order to prevent such distortions. The market itself can also fix these problems to some extent. Consumers will probably realize if they are being constantly ripped off and will end up looking for another mechanic, for instance.