pharma lectures

The Shortcomings of Free Markets

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Copyright 2006 South-Western/Thomson Publishing. All rights reserved.

ContentsExternalities: Getting the Prices WrongProvision of Public GoodsResource Allocation Between Present and Future Imperfections of InformationThe Cost Disease of the Service Sector


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What Does the Market Do Poorly?We saw perfect competition leads to efficient allocation of resourcesWe also saw that allocations may fail to be efficient if firms have market powerRecall the deadweight loss of monopolyThere are other things that free markets are not perfect at implementing

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ExternalitiesA classic example of market shortcoming is an externality - an impact on any party not involved in a given economic transactionCan be beneficial or detrimentalBeneficial externality an incidental benefit of some economic activityDetrimental externality an incidental cost of an economic activity

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Externalities: ExamplesThere are many examples of externalities:Negative examples include:Pollution (c.f. Guest Lecture on pollution)Traffic jamsSecond-hand smoking Positive ones include:Academic researchFitness

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Externalities and InefficiencyDetrimental externalities marginal social cost > marginal private costToo much is producedBeneficial externalities marginal social cost < marginal private cost Too little output is produced

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FIGURE 1: Equilibrium of a Firm with Detrimental Externality Copyright 2006 South-Western/Thomson Publishing. All rights reserved.100 Marginal Cost and Revenue 35 0

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Government Policy and ExternalitiesGovernments can promote efficiency by moving private costs closer to social costsThis is sometimes called internalization of externalityThey can do this by taxing in the case of detrimental externalities and subsidizing in the case of beneficial externalitiesSee Guest Lecture on pollution

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Public GoodsSo far all the goods or services we considered were privateA good or service is private when either:It cannot be consumed by two people at onceOr easy to exclude others from consumptionA cake or a concert are examples of private goods (or services)

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Public GoodsIn contrast, a good is public when:it is not depleted by repeated use (non-rival)people cannot be excluded from access to itA relevant example is snow-plowingOnce the snow is plowed, consumption of the plowed road by one driver hardly impairs the ability of others to consume the same plowed road

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Provision of Public GoodsIt is in general a bad idea to charge a price for access to public good:It is hard to exclude people from consuming itIt may discourage some people from benefiting, which is inefficientA so-called collective action problem arises everyone must pay a lot, but enjoys only a part of the benefit, so doesnt want to pay

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Provision of Public GoodsConclusion: If public goods are to be produced, the government must do itIt is actually the local government that provides most of the public goodsLike snow-plowingBut some public goods are produced by the federal governmentLike the U.S. army

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Resource Allocation Between Present and FutureRecall the model of consumer choice between two goodsWe can use it to model the choice between consumption and savingsIn this case, the relative price of consumption and savings will be the interest rate

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Resource Allocation Between Present and FutureInterest rate represents the opportunity cost of money. Consider an example:You have $100 today, interest rate is 10%Put it in a bank today get $110 tomorrowOr if you put $91 in a bank today, you get $100 tomorrowSo $100 today are worth the same as $91 yesterday or $110 tomorrow

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Resource Allocation Between Present and FutureIn general, we can find an optimal rule for savings via our modelBut there are some issues about the models predictions and reality

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Resource AllocationBetween Present and FutureHow Does It Work in Practice?Since interest rates are manipulated for many purposes, there is little reason to think that they represent a good evaluation of the future. The market tends to devote too many resources to immediate consumption since todays population may not be good judges of future needs.

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Resource Allocation Between Present and FutureHow Does It Work in Practice?The inherent risk of investment projects means that investment for the future may fall short of the socially optimal amount.It may not be in societys best interests to allow the market to make irreversible decisions about the future.

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Asymmetric InformationAll our models assumed full availability of information to all partiesWhen you buy a used car, this is rarely the caseUsually the dealer knows much more about itWhen information is asymmetric, some mutually beneficial transactions may not occur

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Asymmetric InformationA classic example is market for lemons and plums (i.e. bad and good used cars)Suppose only these two types of cars are soldBuyers cannot tell a lemon from a plumIf plums are more expensive, nobody will buy those due to the fear of buying a lemon for a high priceSo no plums will be sold at all

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Asymmetric InformationThis problem occurs with almost all experience goodsA good that you have to use before you can determine its qualitySo sellers of high-quality goods try to disclose information about their quality:WarrantiesMoney-back guarantees

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Rent-seeking BehaviorRent-seeking occurs when an individual, or firm seeks to make money by manipulating the economic and/or legal environment rather than by making a profit through trade and production of wealthNowadays it usually refers to any sort of legal battles and misuse of government regulation

Harcourt, Inc.Konstantin Golyaev (KG)


Rent-seeking BehaviorA good example is modern Russia:Due to high oil prices, it is very profitable to control an oil producing companySo there are many (semi)-legal battles among the Russian businessmen and top government officials for the rights of control of the major oil producing companiesTechnically this is an inefficient waste of resources

Harcourt, Inc.Konstantin Golyaev (KG)


Moral HazardMany people do not like riskSo providing insurance for them is optimalSuppose you are a beginner driver and decide to buy collision insuranceBut now, knowing that youre covered, you may start driving a bit more recklesslyThis is a problem of moral hazard in action

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Moral HazardProblem of moral hazard is critical to insurance marketYou buy insurance if you think you need itSo there is some self-selection going on (those who dont need insurance do not buy it)Hence an insurance company expects its clients to be more prone to accidentsAs a result, companies charge higher prices

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Principal-Agent ProblemPrincipals = owners or beneficiaries of an enterprise (i.e. a boss)Agents = hired by principals to run an enterprise (i.e. an employee)Many situations in economics are characterized by principal-agent type of relationships

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Principal-Agent ProblemAgent is hired to work for the principal in order to earn profits for himBut it can be that some actions of the agent will be more profitable for him than for the principalIf the latter cannot perfectly monitor the actions of the agent, there is a problem

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Principals, Agents and Recent Stock Option ScandalsStock option = owners (principals) grant an individual (agent) the option to buy some of a companys stock at a predetermined priceThese stimulate agent to work so that companys stock prices go upBut they also created incentives for the agents to illegally manipulate the stock prices

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Market Failure and Government FailureSo the market has failuresBut it has many strengths as well And governments are also subject to failureIf the government can correct things, it does not mean that it actually would do that properlySometimes market failures are best left aloneIn some cases best government action is to reinforce the best aspects of the marketAnd not to replace the market.

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The Cost Disease of the Service SectorThe service sector includes such huge industries as education and health careServices can be public or privateCosts for services have risen more rapidly than other costsAlthough not strictly a market failure, this often leads to government action that threatens general welfare

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The Cost Disease of the Service SectorWhy Are Some Personal Services Getting Worse but Costing More?The cost disease of personal services stems from their labor-intensive natureCompetition forces wages in the service sector to grow as rapidly as wages in manufacturing

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The Cost Disease of the Service SectorWhy Are Some Personal Services Getting Worse but Costing More?Productivity grows more rapidly in manufacturing than servicesIf wage growth cannot be accommodated by productivity growth, prices must rise

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The Cost Disease of the Service SectorA Future of More Goods, but Fewer Services: Is It Inevitable?As the society becomes richer, it becomes more difficult, not less, to provide services such as health care, teaching, and the performing artsIf we value services sufficiently, we can have more and better services at some sacrifice in the growth rate of manufactured goods

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The Cost Disease of the Service SectorGovernment May Make the Problem WorseThe market does give the appropriate price signals, but government is likely to misunderstand these signals and to make decisions that do not promote the public interest most effectivelyThis problem is not a market failure, but the way government attempts to deal with it may distort the market in inefficient ways

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The Cost Disease of the Service SectorGovernment May Make the Problem WorseIn many cases, price controls are proposed for sectors of the economy affected by the cost diseaseBut price controls can, at best, only eliminate the symptoms of the disease, and they often create problems--sometimes more serious than the disease itself

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Epilogue: The Unforgiving MarketThe market system produces growth and prosperity as no other system has been able to doAt the same time, it allocates its rewards in ways that many people believe to be unjust

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Epilogue: The Unforgiving MarketWhile the market mechanism is virtually irreplaceable, the public interest, nevertheless, requires considerable modifications in the way it worksSometimes the proposals of alleged friends of the free market are just as dangerous to its long-term health as are the attacks of its enemies

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The End???

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