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Market Failure Basics

by: Chip Brothers

Market Failure Basics ECON 201

Chip Brothers
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The Most Critical Information you will need on market failure for the exam
Intro to Economics
Dr. Ken Baker
Class Notes




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This 6 page Class Notes was uploaded by Chip Brothers on Thursday September 29, 2016. The Class Notes belongs to ECON 201 at University of Tennessee - Knoxville taught by Dr. Ken Baker in Fall 2016. Since its upload, it has received 3 views. For similar materials see Intro to Economics in Economics at University of Tennessee - Knoxville.


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Date Created: 09/29/16
Markets III Market Failure Basics I. Market Failure What is it? For the majority of goods / services / inputs / resources / labor / etc., markets do a ‘good job’ for society • Markets allocate goods and services effectively and efficiently • However, sometimes they don’t… Market Failure: A situation where the market equilibrium results in too few or too many resources used in production Sometimes, government policies can help improve the situation Market Failure: A Perfect Example What does a ‘Perfect Market’ look like? 1. Demand is composed of lots of buyers • Buyers compete and they cant direct/influence the outcome 2. Supply is composed of lots of sellers • Sellers compete and can’t control the price • They can’t direct/influence the outcome 3. The market finds the ‘correct’ price • P* accurately reflects the value of the product to society 4. The market finds the ‘correct’ quantity • We as a society actually want this much of a product • We want to use resources to make only this much Evolution of Market Understanding For many, many decades: • All markets in real life work perfectly • Real life markets work just like those in theory Several decades ago: • Most markets in real like work perfectly • Some markets have failures that need very slightly correcting Today: • No market in real life works perfectly • Most markets work good enough to mostly be left alone • However, many markets have so much failure that government must do something Market Failure: Some Causes • When might the market do a bad job? • What are the results? • How can government policy help improve the situation? 1. Lack of Competition 2. Externalities 3. Public Goods 4. Income Inequality 5. Others • Asymmetric information • Moral hazard • Principle-Agent problem Market Failure: Lack of Competition The Problem • Sometimes firms get greedy • Several competitors will ‘collude’ • They reduce output and drive up prices to buyers • This increases their profits • Buyers end up paying more for product • Resources are NOT allocated efficiently The Solution • The government has passed several antitrust laws • It is illegal for firms to ‘restrict trade’ (fix the market) • Corporations can be fined • Individuals perpetrators can be fined AND sent to jail When firms collude, they generally agree to collectively reduce their output  This works like a decrease in market supply  PRODUCING LESS IN ORDER TO CHARGE MORE Market Failure: Externalities Some goods have unique properties whereby people not represented in the market are affected by the decisions/actions of those in the market Externality: A cost or benefit imposed on people (third parties) other than the direct (private) consumers/producers • Externalities can be negative or positive • Negative externalities: when market participants impose some cost on outside parties • Positive externalities: when market participants impose some benefit on outside parties Negative Externalities Producers only take their private costs into account  This results in inefficient outcome e1, at Q1, and P1  The optimal outcome would incorporate all costs of production (private and public)  This would result in the efficient outcome e*, Q*,P* The Problem • Production of some goods creates special costs that aren’t taken into account • Therefore, the cost of production is ‘too low’ • Thus, too much of the good is produced (Q is too high) • The price is too low (P is too low) • Resources are NOT allocated efficiently The Solution • Two common methods to force firms to reduce production 1. Tax goods that cause negative externalities 2. Regulate the production of goods that cause negative externalities 3. Either method attempts to reduce the Q Market Failure: Public Goods • Some goods have unique properties that make it difficult for normal firms to profitably provide Public Good: A good or service with the following properties: 1. Users collectively consume (enjoy) the benefits 2. There is no way to bar non-payers (free-riders) from consuming the good Q. Why is this a problem? A. Free-Riders: people who get to enjoy the benefit of the good without having to pay • Fireworks example Private Good – markets typically do a pretty good job • Pants / shoes / shirts / jewelry • Ice Cream / tacos / apples • Houses / furniture Public Goods – markets typically do NOT do a good job • National defense / security / safety • Roads / sidewalks • Public education • Clean air / water • National Parks Free Markets and the Economic ‘Pie’ The ‘Economic Pie’ represents the total value of what a country produces  It represent the goods & services produced that we all enjoy  It also represents income, as these are ultimately sold to buyers Most people agree that the free market system results in a larger pie Market Failure: Income Inequality ‘The market’ is an amoral entity • The market doesn’t care about the outcome generated • The market doesn’t care if a person X has 4 homes, while person Y sleeps on the streets • The market doesn’t care that social workers (who take care of children) earn $40,000 and Kim Kardashian earns $4,000,000 • But as a society, do we care? • Several government programs aim to provide a some minimum standard of living for the very poor • This is known as the social safety net • Progressive income tax; social security; unemployment insurance; Supplemental Nutrition Assistance program (SNAP); Temporary Assistance for Needy Families program (TANF); Minimum wage; others BIG IDEA IN ECONOMICS Markets, on the whole, are a tremendous way to organize economic activity • On the whole, they are the most efficient way known to allocate our resources, inputs, commodities, labor, goods and services However, there are several instances when they are NOT • These cases are known as market failure • There are situations where the market does NOT allocate goods and services in a way that society may want • Lack of Competition • Externalities • Public Goods • Extreme Inequality Sometimes, the government can ‘help’ the market achieve a better outcome


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