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Chapter 4: Market Efficiency,
Market Failure, and Government
CoreEconomics 2nd edition by Gerald W. Stone
Slides By: Debbie
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Chapter Outline
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Markets and Efficiency
Market Failures
Government Intervention
Paul A. Samuelson
© 2011 Worth Publishers ▪ CoreEconomics
▪ Stone
Learning Objectives
• At the end of this chapter, the student will be
able to:
– Understand how markets allocate resources
– Define the conditions needed for markets to be
efficient
– Understand how markets impose discipline on
producers and consumers
– Understand and be able to use the concepts of
consumer and producer surplus
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Learning Objectives
• At the end of this chapter, the student will be
able to:
– Understand what market failure is, and when it
occurs
– Describe the different types of market failure
– Understand the history of the changing
landscape between free markets and
government intervention
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Efficient Markets
• Requirements for an efficient market:
– Accurate information is available
– Property rights are protected
– Contract obligations are enforced
– No external costs or benefits
– Competitive markets prevail
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Competitive Markets
• In a market system, resources are allocated
according to the interaction of supply and
demand.
• Through the price
mechanism, markets
ration scarce resources
to their most highly valued uses.
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Consumer and Producer Surplus
Measures of the gains from trade:
 Consumer surplus
 Producer surplus
P
S
D
Q
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Consumer and Producer Surplus
• Consumer surplus is the difference between
the amount a consumer would be willing to
pay and the actual price.
– Someone who receives a
lot of consumer surplus
might feel that he or she
found “a bargain.”
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Consumer and Producer Surplus
• Producer surplus is the difference between
the actual price and the minimum price the
firm requires in order to supply the good.
– A firm receiving a lot of producer surplus might
consider themselves to be selling “at a market
premium.”
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Consumer and Producer Surplus
• Measures of producer and consumer surplus
help us determine the amount of net benefit
created by a market.
• This determination usually rests on
considerations of efficiency, rather than
fairness.
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Efficient Markets
• If a market rations efficiently, it will allocate
goods to those who value them the most.
• Market failure refers to those instances in
which the allocation does not achieve the
best possible outcome, from society’s point
of view.
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Markets and Efficiency
• Markets are efficient mechanisms for
allocating resources.
• Efficient markets require
– Property rights
– Contracts
– Minimum of spillovers
– Competition
– Accurate information
made widely available
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Market Failure
• When the efficient market requirements are
not met, market failure occurs. We consider
each of these in turn.
– Asymmetric information
– Public goods
– Externalities
– Common property resources
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Asymmetric Information
• Asymmetric information occurs when
one party to a transaction
knows more than does the other.
• Some otherwise efficient trades
may be prevented.
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Adverse Selection
• Adverse selection occurs when products of
different qualities are sold at the same price
because of asymmetric information.
– This is apparent in insurance markets.
– Deductibles and co-payments are attractive to
low-risk individuals.
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Moral Hazard
• Moral hazard occurs when an insurance
policy or some other arrangement changes
the economic incentives we face, thus
leading us to change our behavior, usually in
a way that is detrimental to the market.
• To limit the moral hazard problem, insurance
companies will place restrictions on
individual behavior in some contracts.
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Problems with Property Rights
• There are two general instances of market
failure caused by property right issues:
– Public goods
– Common property resources
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Public Goods
• Public goods are non-exclusive, and they
arise in situations of non-rivalry.
• This means that they can be consumed by
one person without diminishing what is left
for others.
• And if they are provided for one person,
others can enjoy them as well.
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Public Goods
• Public goods give rise to the free rider
problem. On its own, the free market will not
provide enough of these goods.
• Examples:
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Weather forecasts
Lighthouses
National defense
GPS satellites
Mosquito eradication
Immunization
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Common Property Resources
• The “tragedy of the commons” arises when
an open-access resource is overused.
– Ocean fisheries are an example. Because no one
“owns” the stock of ocean fish, there is not an
incentive to preserve its value.
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Common Property Resources
• The “tragedy of the anticommons” arises
when one owner of a resource can block
development of a good that would have
benefits to many, such as an airport.
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Contract Enforcement
• When there is no legal system present to
guarantee the execution of a contract, then
the scope of commercial transactions will be
limited.
• When corruption prevails in the political
structure, businesses will invest less.
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Externalities
• When externalities are present, the free
market will overproduce or underproduce
the good in question.
• Government intervention may be required to
correct the market failure.
• One of the tools used by government could
be the market itself, as in the case of trading
permits for pollution emissions.
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Monopoly Power
• Antitrust legislation is employed to create a
competitive environment when monopolistic
practices threaten to establish noncompetitive prices.
• The aim of such legislation is to create a more
efficient outcome.
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Market Failures
• When markets fail, they do not totally
collapse; they simply fail to create the
socially optimal outcome.
• Asymmetric information – when one party
to a transaction has better information
than another – can lead to market failure.
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Market Failures
• Adverse selection occurs when products of
different qualities are sold at one price.
• Moral hazard occurs when an insurance policy or
other arrangement changes the economic
incentives people face and so leads them to
change their behaviors.
• Public goods give rise to the free rider problem.
• Common property resources are typically subject
to overexploitation.
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Market Failures
• Markets rarely are efficient when external
benefits or costs are present.
• Monopoly markets result in prices higher
than what is socially optimal.
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Markets and Intervention
• Throughout the past century and a half,
tension has existed between free markets,
market failure, and government intervention.
• Sometimes the market can be creative in
solving problems and generating growth, but
sometimes markets lead to unbridled excess
and cause trouble.
• Some government intervention has helped
set down the rules of the game.
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Timeline of Intervention
• Industrialization
– The growth of large, market-dominating firms in
the late nineteenth century led to passage of the
Sherman Antitrust Act.
– The growing strength of unions resulted in
protection for the right of collective bargaining.
• Consumerism and World War I
– Development of the automobile and residential
electrification led to higher living standards.
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Timeline of Intervention
• The stock market crash of 1929 precipitated
the onset of the Great Depression.
• Stocks eventually lost 90 percent of their
value, and the unemployment rate peaked at
25 percent.
• Government spending under the New Deal
was aimed at boosting the overall level of
economic activity.
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Timeline of Intervention
• As the decade of the 1930’s unfolded,
economic conditions gradually improved,
but the unemployment rate never fell below
10 percent.
• World War II and economic recovery
– Production for the war effort resulted in the
unemployment rate falling to around 1 percent.
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Timeline of Intervention
• Postwar economy
– The IMF and World Bank were established by the
Bretton Woods Conference in 1944.
– U.S. domestic policy was guided by a desire to
promote full employment.
– Economic growth was strong due to consumption
and investment spending.
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Timeline of Intervention
• 1960s
– Keynesian policy was used to stabilize
the overall economy.
– President Johnson initiated a War on Poverty
along with other Great Society Programs.
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Timeline of Intervention
• 1970s
– A decade of stagflation: high inflation
accompanied by high unemployment
– Increasing government intervention in terms of
the environment, health, and safety
– Deregulation of transportation industries
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Timeline of Intervention
• 1980 to the Present
– President Reagan lowered income taxes to
encourage business growth.
– Following the 1983 recession, the economy
experienced a sustained period of low inflation,
low unemployment, and steady growth.
– Deregulation of financial markets led to “bubble”
prices which eventually collapsed, causing the
financial panic of 2008.
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Try It!
• Market failure can occur in the case of public goods
due to
A) the free rider problem.
B) the fact that public goods create negative
externalities.
C) the fact that there is asymmetric information
surrounding public goods.
D) the moral hazard associated with public goods.
© 2011 Worth Publishers ▪ CoreEconomics
▪ Stone
Try It!
• Market failure can occur in the case of public goods
due to
A) the free rider problem.
Correct!
B) the fact that public goods create negative
externalities.
C) the fact that there is asymmetric information
surrounding public goods.
D) the moral hazard associated with public goods.
© 2011 Worth Publishers ▪ CoreEconomics
▪ Stone
Chapter Summary
• Markets are efficient mechanisms for
allocating resources.
• For markets to be efficient, they must have
well-structured institutions. These include:
– (1) information is widely available;
– (2) property rights are protected;
– (3) private contracts are enforced;
– (4) spillovers are minimal; and
– (5) competition prevails.
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Chapter Summary
• Market failure can arise in cases of
– Asymmetric information
– Adverse selection and moral hazard
– Public goods
– Common property resources
– Externalities
– Monopolies
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Chapter Summary
• Following the Civil War, the U.S. emerged as
an industrial power with large firms.
• During the Great Depression, an expanded
role for government intervention was
accepted.
• The stagflation of the 1970s turned the
policy focus more in the direction of
market efficiency.
• The current financial crisis invites a
reconsideration of market regulation.
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