The Shortcomings of Free Markets. ●Externalities: Getting the Prices Wrong ●Provision of Public Goods ●Resource Allocation Between Present and Future

The Shortcomings of Free Markets

● Externalities: Getting the Prices Wrong

● Provision of Public Goods

● Resource Allocation Between Present and Future

● Imperfections of Information

● The Cost Disease of the Service Sector

● Externalities: Getting the Prices Wrong

● Provision of Public Goods

● Resource Allocation Between Present and Future

● Imperfections of Information

● The Cost Disease of the Service Sector

ContentsContents

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


What Does the Market Do Poorly?What Does the Market Do Poorly?

● We saw perfect competition leads to efficient allocation of resources

● We also saw that allocations may fail to be efficient if firms have market power♦ Recall the deadweight loss of monopoly

● There are other things that free markets are not perfect at implementing

● We saw perfect competition leads to efficient allocation of resources

● We also saw that allocations may fail to be efficient if firms have market power♦ Recall the deadweight loss of monopoly

● There are other things that free markets are not perfect at implementing


● A classic example of market shortcoming is an externality - an impact on any party not involved in a given economic transaction

● Can be beneficial or detrimental♦ Beneficial externality – an incidental benefit of

some economic activity

♦ Detrimental externality – an incidental cost of an economic activity

● A classic example of market shortcoming is an externality - an impact on any party not involved in a given economic transaction

● Can be beneficial or detrimental♦ Beneficial externality – an incidental benefit of

some economic activity

♦ Detrimental externality – an incidental cost of an economic activity

ExternalitiesExternalities


● There are many examples of externalities:♦ Negative examples include:

■Pollution (c.f. Guest Lecture on pollution)■Traffic jams■Second-hand smoking

♦ Positive ones include:■Academic research■Fitness

● There are many examples of externalities:♦ Negative examples include:

■Pollution (c.f. Guest Lecture on pollution)■Traffic jams■Second-hand smoking

♦ Positive ones include:■Academic research■Fitness

Externalities: ExamplesExternalities: Examples


● Detrimental externalities marginal social cost > marginal private cost♦ Too much is produced

● Beneficial externalities marginal social cost < marginal private cost ♦ Too little output is produced

● Detrimental externalities marginal social cost > marginal private cost♦ Too much is produced

● Beneficial externalities marginal social cost < marginal private cost ♦ Too little output is produced

Externalities and InefficiencyExternalities and Inefficiency

FIGURE 1: Equilibrium of a Firm with Detrimental Externality

FIGURE 1: Equilibrium of a Firm with Detrimental Externality


Marginal private cost

Marginal revenue

Marginal social cost

B A

100

Mar

gin

al C

os

t an

d R

eve

nu

e

Thousands of Tons of Paper per Year

35 0


Government Policy and ExternalitiesGovernment Policy and Externalities

● Governments can promote efficiency by moving private costs closer to social costs♦ This is sometimes called “internalization of

externality”

● They can do this by taxing in the case of detrimental externalities and subsidizing in the case of beneficial externalities

● See Guest Lecture on pollution

● Governments can promote efficiency by moving private costs closer to social costs♦ This is sometimes called “internalization of

externality”

● They can do this by taxing in the case of detrimental externalities and subsidizing in the case of beneficial externalities

● See Guest Lecture on pollution


Public GoodsPublic Goods

● So far all the goods or services we considered were private

● A good or service is private when either:♦ It cannot be consumed by two people at once

♦ Or easy to exclude others from consumption

● A cake or a concert are examples of private goods (or services)

● So far all the goods or services we considered were private

● A good or service is private when either:♦ It cannot be consumed by two people at once

♦ Or easy to exclude others from consumption

● A cake or a concert are examples of private goods (or services)


Public GoodsPublic Goods

● In contrast, a good is public when:♦ it is not depleted by repeated use (non-rival)

♦ people cannot be excluded from access to it

● A relevant example is snow-plowing♦ Once the snow is plowed, “consumption” of

the plowed road by one driver hardly impairs the ability of others to “consume” the same plowed road

● In contrast, a good is public when:♦ it is not depleted by repeated use (non-rival)

♦ people cannot be excluded from access to it

● A relevant example is snow-plowing♦ Once the snow is plowed, “consumption” of

the plowed road by one driver hardly impairs the ability of others to “consume” the same plowed road


● It is in general a bad idea to charge a price for access to public good:♦ It is hard to exclude people from consuming it

♦ It may discourage some people from benefiting, which is inefficient

♦ A so-called “collective action” problem arises – everyone must pay a lot, but enjoys only a part of the benefit, so doesn’t want to pay

● It is in general a bad idea to charge a price for access to public good:♦ It is hard to exclude people from consuming it

♦ It may discourage some people from benefiting, which is inefficient

♦ A so-called “collective action” problem arises – everyone must pay a lot, but enjoys only a part of the benefit, so doesn’t want to pay

Provision of Public GoodsProvision of Public Goods


● Conclusion: If public goods are to be produced, the government must do it

● It is actually the local government that provides most of the public goods♦ Like snow-plowing

● But some public goods are produced by the federal government♦ Like the U.S. army

● Conclusion: If public goods are to be produced, the government must do it

● It is actually the local government that provides most of the public goods♦ Like snow-plowing

● But some public goods are produced by the federal government♦ Like the U.S. army

Provision of Public GoodsProvision of Public Goods


Resource Allocation Between Present and FutureResource Allocation Between Present and Future

● Recall the model of consumer choice between two goods

● We can use it to model the choice between consumption and savings

● In this case, the relative price of consumption and savings will be the interest rate

● Recall the model of consumer choice between two goods

● We can use it to model the choice between consumption and savings

● In this case, the relative price of consumption and savings will be the interest rate



● Interest 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 tomorrow

♦ Or if you put $91 in a bank today, you get $100 tomorrow

♦ So $100 today are worth the same as $91 yesterday or $110 tomorrow

● Interest 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 tomorrow

♦ Or if you put $91 in a bank today, you get $100 tomorrow

♦ So $100 today are worth the same as $91 yesterday or $110 tomorrow



● In general, we can find an optimal rule for savings via our model

● But there are some issues about the model’s predictions and reality

● In general, we can find an optimal rule for savings via our model

● But there are some issues about the model’s predictions and reality


Resource AllocationBetween Present and FutureResource AllocationBetween Present and Future

● How 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 today’s population may not be good judges of future needs.

● How 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 today’s population may not be good judges of future needs.



● How 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 society’s best interests to allow the market to make irreversible decisions about the future.

● How 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 society’s best interests to allow the market to make irreversible decisions about the future.


● All our models assumed full availability of information to all parties♦ When you buy a used car, this is rarely the case

♦ Usually the dealer knows much more about it

● When information is asymmetric, some mutually beneficial transactions may not occur

● All our models assumed full availability of information to all parties♦ When you buy a used car, this is rarely the case

♦ Usually the dealer knows much more about it

● When information is asymmetric, some mutually beneficial transactions may not occur

Asymmetric InformationAsymmetric Information


● A classic example is market for lemons and plums (i.e. bad and good used cars)♦ Suppose only these two types of cars are sold

♦ Buyers cannot tell a lemon from a plum

♦ If plums are more expensive, nobody will buy those due to the fear of buying a lemon for a high price

♦ So no plums will be sold at all

● A classic example is market for lemons and plums (i.e. bad and good used cars)♦ Suppose only these two types of cars are sold

♦ Buyers cannot tell a lemon from a plum

♦ If plums are more expensive, nobody will buy those due to the fear of buying a lemon for a high price

♦ So no plums will be sold at all



● This problem occurs with almost all experience goods♦ A good that you have to use before you can

determine its quality

● So sellers of high-quality goods try to disclose information about their quality:♦ Warranties

♦ Money-back guarantees

● This problem occurs with almost all experience goods♦ A good that you have to use before you can

determine its quality

● So sellers of high-quality goods try to disclose information about their quality:♦ Warranties

♦ Money-back guarantees



● Rent-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 wealth

● Nowadays it usually refers to any sort of legal battles and misuse of government regulation

● Rent-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 wealth

● Nowadays it usually refers to any sort of legal battles and misuse of government regulation

Rent-seeking BehaviorRent-seeking Behavior

Konstantin Golyaev


● A good example is modern Russia:♦ Due to high oil prices, it is very profitable to

control an oil producing company♦ So there are many (semi)-legal battles among

the Russian businessmen and top government officials for the rights of control of the major oil producing companies

♦ Technically this is an inefficient waste of resources

● A good example is modern Russia:♦ Due to high oil prices, it is very profitable to

control an oil producing company♦ So there are many (semi)-legal battles among

the Russian businessmen and top government officials for the rights of control of the major oil producing companies

♦ Technically this is an inefficient waste of resources

Rent-seeking BehaviorRent-seeking Behavior

Konstantin Golyaev


Moral HazardMoral Hazard

● Many people do not like risk

● So providing insurance for them is optimal♦ Suppose you are a beginner driver and decide

to buy collision insurance

♦ But now, knowing that you’re covered, you may start driving a bit more recklessly

♦ This is a problem of moral hazard in action

● Many people do not like risk

● So providing insurance for them is optimal♦ Suppose you are a beginner driver and decide

to buy collision insurance

♦ But now, knowing that you’re covered, you may start driving a bit more recklessly

♦ This is a problem of moral hazard in action


Moral HazardMoral Hazard

● Problem of moral hazard is critical to insurance market♦ You buy insurance if you think you need it

♦ So there is some self-selection going on (those who don’t need insurance do not buy it)

♦ Hence an insurance company expects its clients to be more prone to accidents

♦ As a result, companies charge higher prices

● Problem of moral hazard is critical to insurance market♦ You buy insurance if you think you need it

♦ So there is some self-selection going on (those who don’t need insurance do not buy it)

♦ Hence an insurance company expects its clients to be more prone to accidents

♦ As a result, companies charge higher prices


● Principals = 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

● Principals = 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

Principal-Agent ProblemPrincipal-Agent Problem


● Agent is hired to work for the principal in order to earn profits for him

● But it can be that some actions of the agent will be more profitable for him than for the principal

● If the latter cannot perfectly monitor the actions of the agent, there is a problem

● Agent is hired to work for the principal in order to earn profits for him

● But it can be that some actions of the agent will be more profitable for him than for the principal

● If the latter cannot perfectly monitor the actions of the agent, there is a problem

Principal-Agent ProblemPrincipal-Agent Problem


● Stock option = owners (principals) grant an individual (agent) the option to buy some of a company’s stock at a predetermined price♦ These stimulate agent to work so that

company’s stock prices go up

♦ But they also created incentives for the agents to illegally manipulate the stock prices

● Stock option = owners (principals) grant an individual (agent) the option to buy some of a company’s stock at a predetermined price♦ These stimulate agent to work so that

company’s stock prices go up

♦ But they also created incentives for the agents to illegally manipulate the stock prices

Principals, Agents and Recent Stock Option ScandalsPrincipals, Agents and Recent Stock Option Scandals


Market Failure and Government FailureMarket Failure and Government Failure

● So the market has failures● But it has many strengths as well ● And governments are also subject to failure

♦ If the government can correct things, it does not mean that it actually would do that properly

● Sometimes market failures are best left alone● In some cases best government action is to

reinforce the best aspects of the market♦ And not to replace the market.

● So the market has failures● But it has many strengths as well ● And governments are also subject to failure

♦ If the government can correct things, it does not mean that it actually would do that properly

● Sometimes market failures are best left alone● In some cases best government action is to

reinforce the best aspects of the market♦ And not to replace the market.


● The service sector includes such huge industries as education and health care

● Services can be public or private● Costs for services have risen more rapidly

than other costs● Although not strictly a market failure, this

often leads to government action that threatens general welfare

● The service sector includes such huge industries as education and health care

● Services can be public or private● Costs for services have risen more rapidly

than other costs● Although not strictly a market failure, this

often leads to government action that threatens general welfare

The Cost Disease of the Service SectorThe Cost Disease of the Service Sector



● Why Are Some Personal Services Getting Worse but Costing More?♦ The “cost disease” of personal services stems

from their labor-intensive nature

♦ Competition forces wages in the service sector to grow as rapidly as wages in manufacturing

● Why Are Some Personal Services Getting Worse but Costing More?♦ The “cost disease” of personal services stems

from their labor-intensive nature

♦ Competition forces wages in the service sector to grow as rapidly as wages in manufacturing



● Why Are Some Personal Services Getting Worse but Costing More?♦ Productivity grows more rapidly in

manufacturing than services

♦ If wage growth cannot be accommodated by productivity growth, prices must rise

● Why Are Some Personal Services Getting Worse but Costing More?♦ Productivity grows more rapidly in

manufacturing than services

♦ If wage growth cannot be accommodated by productivity growth, prices must rise



● A 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 arts

♦ If we value services sufficiently, we can have more and better services – at some sacrifice in the growth rate of manufactured goods

● A 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 arts

♦ If we value services sufficiently, we can have more and better services – at some sacrifice in the growth rate of manufactured goods



● Government May Make the Problem Worse♦ The 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 effectively

♦ This problem is not a market failure, but the way government attempts to deal with it may distort the market in inefficient ways

● Government May Make the Problem Worse♦ The 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 effectively

♦ This problem is not a market failure, but the way government attempts to deal with it may distort the market in inefficient ways



● Government May Make the Problem Worse♦ In many cases, price controls are proposed for

sectors of the economy affected by the cost disease

♦ But price controls can, at best, only eliminate the symptoms of the disease, and they often create problems--sometimes more serious than the disease itself

● Government May Make the Problem Worse♦ In many cases, price controls are proposed for

sectors of the economy affected by the cost disease

♦ But price controls can, at best, only eliminate the symptoms of the disease, and they often create problems--sometimes more serious than the disease itself


Epilogue: The Unforgiving MarketEpilogue: The Unforgiving Market

● The market system produces growth and prosperity as no other system has been able to do

● At the same time, it allocates its rewards in ways that many people believe to be unjust

● The market system produces growth and prosperity as no other system has been able to do

● At the same time, it allocates its rewards in ways that many people believe to be unjust


Epilogue: The Unforgiving MarketEpilogue: The Unforgiving Market

● While the market mechanism is virtually irreplaceable, the public interest, nevertheless, requires considerable modifications in the way it works

● Sometimes 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

● While the market mechanism is virtually irreplaceable, the public interest, nevertheless, requires considerable modifications in the way it works

● Sometimes 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


The EndThe End

??????

Documents

The Shortcomings of Free Markets. ●Externalities: Getting the Prices Wrong ●Provision of Public Goods ●Resource Allocation Between Present and Future