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Chapter 4: Market Efficiency, Market Failure, and Government CoreEconomics 2nd edition by Gerald W. Stone Slides By: Debbie © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Evercloud Chapter Outline • • • • 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 © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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 © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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 © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Consumer and Producer Surplus Measures of the gains from trade: Consumer surplus Producer surplus P S D Q © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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.” © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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.” © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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 © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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 © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Asymmetric Information • Asymmetric information occurs when one party to a transaction knows more than does the other. • Some otherwise efficient trades may be prevented. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Problems with Property Rights • There are two general instances of market failure caused by property right issues: – Public goods – Common property resources © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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: – – – – – – Weather forecasts Lighthouses National defense GPS satellites Mosquito eradication Immunization © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Market Failures • Markets rarely are efficient when external benefits or costs are present. • Monopoly markets result in prices higher than what is socially optimal. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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 © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone Chapter Summary • Market failure can arise in cases of – Asymmetric information – Adverse selection and moral hazard – Public goods – Common property resources – Externalities – Monopolies © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone 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. © 2011 Worth Publishers ▪ CoreEconomics ▪ Stone