02 Market Failure

7/31/2019 02 Market Failure

1/27

Market Failure 21

2: Market Failure

What was good for our country was goodfor General Motors and vice versa. The dif-ference did not exist. Our company is too big.It goes with the welfare of the country.

January 7, 2012 (Version 0.3.0)

http://rasmusen.org/g406/reg-rasmusen.htm, [email protected]
http://%20http//rasmusen.org/g406/reg-rasmusen.htmhttp://%20http//rasmusen.org/g406/reg-rasmusen.htmhttp://%20http//rasmusen.org/g406/reg-rasmusen.htm


2/27


3/27

Market Failure 23

theft are a form of regulation and a constraint on our liberty, but if Smith

can steal the bottle easily he will steal it even if his value is less than Joness,and surplus will not be maximized. Moreover, Jones uses time, energy and

Sidebar 2.1Self-Help in PropertyRights

As thugs have been burning,beating, and stealing their waythrough London, citizens of thatdisarmed society had little to de-fend themselves with as the po-lice were completely overwhelmed.

Desperate Brits are resortingto shopping online for improvisedweapons. They are buying Ama-zon.uk out of baseball bats, billyclubs, and folding shovels. Yester-day, billy clubs saw a 41,000%+

increase in sales, until the itemwas pulled. Shipping times ontheir most popular baseball bat(up over 36,000%) slipped to 4-6weeks. Today, a folding shovel istheir new Sports and Leisure topseller, with sales up 239,000% inthe past 24 hours! . . .

During the Los Angeles riots. . . the police having been over-whelmed, the Korean communitybanded together to defend theirstores and lives against the riot-ers, even though it was too late formany. Using Korean-language ra-

dio, they called for security volun-teers.

resources to prevent theft and Smithuses time, energy, and resources to over-come that prevention. Buying and sell-ing create transaction costs too, as do thecourts and police necessary to suppresstheft, but not as high as theft. The gov-ernments police are a useful supplementto Joness private precautions againsttheft, and the mere threat of punishment

reduces Smiths incentive to incur the ef-fort of stealing. In practice we see amix of ways property rights are enforced,both private precautions locks, alarms,and handguns and public precautionspolice, courts, and prisons.

The government does more than pro-vide police and courts: it literally de-fines property rights. Not only do

courts decide who owns property in par-ticular cases, but the law also providesstandard terminology in the form of legaldefinitions. The definition may be sim-ple when it comes to bottles of whisky,but definitions get more intricate whenit comes to ownership of corporations,wild animals, and stolen goods. Evenfor simpler goods, standard definitionsmake life easier. The holder of a landtitle that says he owns it in fee simple

can use the land for his entire life, leaveit to heirs, or sell it in fee simple to some-one else, without having to worry aboutwhat kinds of rights he has over the land.

Rather than checking the fine print on the property deed, he can rest assured
http://www.amazon.co.uk/gp/movers-and-shakers/sports/ref=zg_bsms_tabhttp://www.amazon.co.uk/gp/movers-and-shakers/sports/ref=zg_bsms_tabhttp://www.amazon.co.uk/gp/movers-and-shakers/sports/ref=zg_bsms_tabhttp://www.amazon.co.uk/Rucanor-Aluminium-Baseball-Bat-Silver/dp/B003XII2U6/ref=zg_bsms_sports_2http://www.amazon.co.uk/Rucanor-Aluminium-Baseball-Bat-Silver/dp/B003XII2U6/ref=zg_bsms_sports_2http://www.amazon.co.uk/Gelert-Folding-Shovel/dp/B0010AA0TU/ref=zg_bsms_sports_1http://www.amazon.co.uk/Gelert-Folding-Shovel/dp/B0010AA0TU/ref=zg_bsms_sports_1http://www.amazon.co.uk/Rucanor-Aluminium-Baseball-Bat-Silver/dp/B003XII2U6/ref=zg_bsms_sports_2http://www.amazon.co.uk/Rucanor-Aluminium-Baseball-Bat-Silver/dp/B003XII2U6/ref=zg_bsms_sports_2http://www.amazon.co.uk/gp/movers-and-shakers/sports/ref=zg_bsms_tabhttp://www.amazon.co.uk/gp/movers-and-shakers/sports/ref=zg_bsms_tabhttp://www.amazon.co.uk/gp/movers-and-shakers/sports/ref=zg_bsms_tab


4/27

24 Market Failure

that he has bought the conventional package of rights.1

Particularly important is that property rules award ownership to someonewho creates something new. This is most obvious if someone creates a newphysical good. If Jones distills whisky using his own labor and supplies, thenatural property rule is to give him ownership of that whisky. Otherwise, hewill not produce it. The government does not have to give Jones the right to100% of the whisky he produces to give him reasonable incentives, however,and very few governments do. The usual rule is that Jones has the rightto keep most but not all of what he produces, giving up some of it to thegovernment as taxes.

The property rule for another class of goods is that the producer ownsthem, but only temporarily. This class is intellectual property: patent

and copyright. If someone comes up with a new idea, rather than a newphysical object, the government faces a quandry. If the person has completeand exclusive rights to his idea, he will overcharge others to use it theproblem of market power that we will discuss later. But if he has fewerrights, he has less incentive to come up with new ideas. The compromise isfor the creator to own his creation for a limited period of time. A patentgives the inventor of an idea ownership for 20 years, but after that anybodycan use it for free. Copyright gives the writer of a book exclusive rights forhis lifetime plus 70 years.

Figure 2.1

Parking Spot Property

Still other goods are common prop-

erty. This is different from governmentproperty. A parking place with a parkingmeter is government property that it leasesout to private people for specified amountsof time. A parking place without a meteris common property. Anybody can use it,the rule being first-come-first-served. Thatis efficient, because in those locations, park-ing space is so abundant that it isnt worth

the transactions cost to make it into private or government property. If,however, demand increases enough, it will become efficient to install parking

meters and create property rights. This can even happen if just one persons1For an economics-oriented discussion of how the government limits the types of prop-

erty rights in land, see Thomas W. Merrill & Henry E. Smith, Optimal Standardizationin the Law of Property: The Numerus Clausus Principle, Yale Law Journal, 110(1): 170(October 2000).


5/27

Market Failure 25

demand increases enough. In Covina, California Mark Shoff kept five unreg-

istered cars in his driveway plus 43 others in the surrounding streets as shownin Figure 2.1. His neighbors didnt like the looks of that (the externalitycause of market failure) or the loss of places to park. They sent him notesand circulated a petition. The county responded by assigning street sweep-ing days to some of the surrounding streets, with ticketing of cars parkedover 72 hours. I dont know what happened, but my guess is that Mr. Shoffwas quite willing to drive his cars to new parking spots a block away. Afterall, its not good for a car never to be driven. But what regulation wouldmaximize surplus?2

Property rights need to be established before buying and selling takeplace, but the trading process also needs laws. Suppose Jones would like for

Smith to pay today for a bottle of whisky that Jones will deliver tomorrow.Without a law against breach of contract, Smith will be reluctant to handover the money, since Jones could just keep it and not deliver. A law mustsay what happens if Jones violates his promise. The law could be that Jonesmust refund the money, or that he must deliver the bottle or be jailed, orthat he must pay Smith enough to make Smith as happy as delivery wouldhave. Which of these rules maximizes surplus is not clear, but any of themis better than no rule at all.

What matters most for surplus maximization is that there be clear rulesabout who owns what, and that there be high enough penalties for broken

promises. Getting the exact rules right is less important, because people canadapt to imperfect rules. But if nobody is quite sure what the rules are, orwho has the power to get what he wants, total surplus falls.

Some people have suggested that private organizations could replace gov-ernment in defining and protecting property and contract rights. Peoplecould sign up with one of various competing protective organizations andpay the organization a yearly fee, a fee similar to taxes but a price ratherthan a tax.3 The idea is intriguing, but the result would be like having severalgovernments simultaneously without clarity as to which organizations lawwould prevail or what they would do with their power. While the yearly feesmight start out being voluntary, what is to prevent a protective organization

2Residents Car Collection Frustrates Covina Community: Residents Say One Neigh-bor Owns Nearly 50 Cars that Are Parked Everywhere, KTLA News, http://www.ktla.com/news/landing/ktla-covina-car-collection,0,2951813.story (November 2, 2010).

3See David Friedman, The Machinery of Freedom, 2nd edition, Open Court Publishing(1989).
http://www.ktla.com/news/landing/ktla-covina-car-collection,0,2951813.storyhttp://www.ktla.com/news/landing/ktla-covina-car-collection,0,2951813.storyhttp://www.ktla.com/news/landing/ktla-covina-car-collection,0,2951813.storyhttp://www.ktla.com/news/landing/ktla-covina-car-collection,0,2951813.story


6/27

26 Market Failure

from using its police to make them compulsory?

Sidebar 2.2The World Banks Doing Business Project

The World Bank is an international agency topromote economic development in poor countries.One reason some poor countries stay poor whileothers grow out of poverty is whether property isprotected and contracts enforced. The World Bankmeasured these things across 183 countries. Here is asampling (1 is best)

Land Investor ContractCountry All Records Security Payment

Singapore 1 16 2 13New Zealand 2 3 1 10Hong Kong 3 75 3 3U.S.A. 4 12 5 8U.K. 5 23 10 23Poland 72 88 41 75Brazil 129 120 73 100D.R. Congo 182 157 154 172

The rankings are based on the complexity, time,and cost of the various business activities. Below aresome of the entries for contract enforcement.

Procedures Time CostCountry (number) (days) (% of claim)

Iceland 26 417 6.2United States 32 300 14.4Germany 30 394 14.4Malaysia 30 585 27.5Kenya 40 465 47.2

Even in the United States, enforcing a contractis troublesome. If people know that the courts willenforce contracts at relatively low cost, however, theywill keep their promises and actual lawsuits seldomoccur.

If the governmentprovides clear rules andenforces them honestly,its overwhelming powerprovides a backgroundin which people will usevoluntary trade insteadof deceit or coercion.This benefits everyonein society, both thestrong and the weak.

The strong have moreproperty to protect andtrade, so they have aclear interest in govern-ment protection. Theweak have less prop-erty, but also less abil-ity to protect what theydo have, so they relyeven more on govern-

ment protection. Bothstrong and weak knowthat law prevents themfrom stealing from oth-ers, but for both, thebenefits of law out-weigh the infringementon their liberty.

2.3: Monopoly andMarket Power

Governments role increating property rightsand enforcing contracts

is easy to accept. We take it for granted that whoever produces something isthe owner that we dont think consider rules against theft are intrusive. This
http://www.doingbusiness.org/http://www.doingbusiness.org/


7/27

Market Failure 27

form of government regulation is more like an essential part of a free market

than a restriction. We now come to a different form of market failure, wheresurplus maximization requires the government to stop someone from freelydeciding whether to sell his property. This form is market power.

A monopoly can capture more producer surplus, but at the expense of di-minishing total surplus. Monopoly welfare losses arise from these inefficientattempts to capture surplus. The loss may arise either from the attemptto become a monopoly (as in the expense of lobbying the government for amonopoly), from the attempt to exploit the monopoly, as in the administra-tive costs of price discrimination, or from the allocative inefficiency ofmonopoly the triangle loss since it shows up as a triangle on surplusdiagrams. .

The easiest way to think about market power is in terms of monopoly,but the problem is broader than that. A firm has market power wheneverthe demand curve facing that firm individually is downward sloping insteadof flat. If firm with market power raises its price, it loses some but not all ofits customers. In particular, it can raise its price above marginal cost, whichis what creates inefficiency.

In a perfectly competitive market of very small firms selling an identicalproduct, firms do not have market power. Any firm that raises its price willlose 100% of its sales the demand facing it is perfectly elastic, perfectlyprice-sensitive. This is true even though the market demand curve slopes

down and is not perfectly elastic. The reason is that the market demandcurve shows what happens to quantity demanded when the market pricerises, which happens when all sellers raise their price simultaneously. Thedemand curve facing one firm shows what happens to the quantity demandedfrom that one firm if only that firm raises its price. If just one firm raises itsprice and all the others do not, that firm loses all of its sales.

In the real world, almost all firms have market power in the short run,but if the demand facing the firm is sufficiently elastic that is, sensitiveenough to price then the firm has so little choice over its price that wecan ignore market power. If a firm would lose 90% of its sales if it raised itsprice 10% of its competitors prices, then that firm does not need to spend a

lot of energy on optimal pricing strategies; it should focus on cost reductionand output decisions. If the firm has a distinct product or market niche, onthe other hand, or if it is literally a monopoly, on the other hand, then itwill think about manipulating the price and we have to worry about marketfailure.


8/27

28 Market Failure

Surplus analysis shows the size of a monopolys allocative inefficiency. Fig-

ure 2.2 shows an industry with a flat supply curve and a downward slopingdemand curve. We will use flat supply curves in this chapter for simplicity,returning to upward-sloping supply curves in later chapters. A flat supplycurve is realistic for many industries, though by no means all. It is appropri-ate when most firms in the industry use the same technology, so as industry

Figure 2.2

Monopoly Allocative

Inefficiency

P0

P1

Q0 Q1

Marginal Cost

DemandA

B C

Quantity

Price

output rises, marginal cost does not.The flatness indicates perfectly elasticsupply (perfectly price-sensitive sup-ply): even a slight increase in the marketprice will elicit a tremendous outpouringof additional quantity, as the price comes

to exceed the marginal cost of most sup-pliers, and even a slight price declinereduces the quantity drastically, as itmakes production unprofitable. Real-world industries are not so extreme, butthe flat supply curve is a good simplifi-cation for looking at any industry withdrastic supply responses.

Figure 2.2 shows what happens whenthere are not many competing suppli-

ers, just one: the monopoly. The supplycurve is not a supply curve, properly speaking. It is the marginal cost curveof the one company. The company would be foolish to charge a price equal tomarginal cost. Instead it will choose a higher price, labelled P0 here, resultingin the quantity Q0.

Consumer surplus is the triangle A above the price P0 and below thedemand curve. Producer surplus is the rectangle B that is above the supplycurve but below the price P0.

CS0 = A

PS0 = BTS0 = A+B

The government can do better than the market byimposing the price ceiling P1. Producer surplus would

fall to zero, since P1 is the minimum price the monopolywould accept to sell its product. Consumer surpluswould become the triangle A+B+C between the P1

price line and the demand curve, Producers have lost area B, but consumershave gained even more, areas B+C.


9/27


10/27

210 Market Failure

off. Even when bargaining is not one-to-one, firms with market power can

find it worthwhile to spend much of their effort on clever pricing scheme toextract extra consumer surplus rather than on producing new surplus for theworld.

A third problem with monopoly is that it might increase production cost.It isnt clear why monopolies should have higher costs. One might think thatfirms in industries so competitive that their survival depends on cost-cuttingwould have lower costs than a monopoly which can survive even if it is fatand lazy, but that logic has a catch. The catch is that a monopoly, like acompetitive firm, prefers high profits to low profits, and so prefers low coststo high. Firms arent literally fat and lazy as people are, and a monopolysshareholders have no incentive to settle for low profits to save their employees

effort. Thus, the cost disadvantage of monopolies is not clear.Yet though the monopolys desire for high profits may be just as great

as the competitive firms, its ability to make profits high might be lower.An example is in how company executives are rewarded or punished. Share-holders of a competitive firm can compare its presidents performance to thepresidents at other firms. A monopoly cannot do that. As a result, thecompetitive firm can punish or reward its executives more effectively than amonopoly.4

In addition, if different firms have different technologies or innovate indifferent ways, keeping all but one firm out of the market will restrict the

opportunity for innovations to spread in the industry. A monopoly may oweits monopoly position not to its superior product and cost but to an accidentof luck or to its talent for excluding other firms from the market. If severalfirms compete, on the other hand, any one of them with a cost advantagewill tend to grow and ideas can diffuse from one firm to another.

The most important kinds of regulation justified by monopoly are publicutility regulation and anti-trust laws. The technology of electricity distribu-tion is such that it is best that one firm provide the service, but important toprevent it from doing so at such a high price the people are discouraged fromusing electricity. In other industries the technology makes the simultaneousoperation of many firms feasible, but regulation is necessary to prevent firms

from making agreements not to compete.

4See Joseph Farrell, Monopoly Slack and Competitive Rigor: A Simple Model, inReadings in Games and Information, Eric Rasmusen, ed., Oxford: Blackwell Publishing(2001) http://www.rasmusen.org/GI/reader/farrell.pdf.
http://www.rasmusen.org/GI/reader/farrell.pdfhttp://www.rasmusen.org/GI/reader/farrell.pdfhttp://www.rasmusen.org/GI/reader/farrell.pdf


11/27

Market Failure 211

2.4: Poor Information

Economists have realized increasingly that solving information problemsis central to a successful economy. The surplus maximization argument forfree markets assumes that everyone in the economy is well-informed aboutthe value of the goods being exchanged. Otherwise, the parties try to takeadvantage of their private information. As with market power, effort goesinto extracting surplus from each other rather into producing new goods. Inaddition the wrong transactions may take place, not just too few transactions.

Information can be imperfect in many ways. Not all of them create mar-ket failure. We would not say that the American economy of 1900 was fullof market failure because people had imperfect information on how to makepersonal computers. Even a well-functioning market is limited by availabletechnology and information about future events. Imperfect information cre-ates market failure when it interferes with the right transactions taking place,not when output is low because of poor technology. Such interference hap-pens in many ways, and has been the subject of a vast scholarly literature.5

Asymmetric information about product quality is one important categoryof imperfect information. If Jones claims he is selling whisky, but Smithcannot tell in advance of the sale whether it is really whisky or is coloredwater, one of two problems arises.

First, if Smith buys colored water, his value is not $15, but $0, and surplushas not been maximized. To be sure, the colored water would have had zero

value even if Jones had kept it, but theyve incurred some transaction cost inmaking the worthless transaction, and since Smith bought the colored waterinstead of making a genuine surplus-increasing trade with someone else, thelost opportunity is a big cost.

Second, if Smith is more sophisticated, he will realize that Joness whiskycannot be trusted because it might just be colored water. Smith will notbuy at all because Joness promises lack credibility. When there are no lawsagainst fraud, honest merchants lose because consumers lack confidence inthe market.

Starting a new business is always difficult, but especially if reputation isthe only basis for consumer trust. In the absence of government regulationof fraudulent new products, innovation is stifled because consumers do not

5 See Eric Rasmusen Games and Information: An Introduction to Game Theory, 4thedition (1st edition, 1989), Blackwell Publishers, Oxford (2005), http://www.rasmusen.org/GI/index.html for references.
http://www.rasmusen.org/GI/index.htmlhttp://www.rasmusen.org/GI/index.htmlhttp://www.rasmusen.org/GI/index.htmlhttp://www.rasmusen.org/GI/index.html


12/27


13/27

Market Failure 213

the context, but let us go through one example. In Figure 2.3, vitamin pills

are sold by a competitive industry with perfectly elastic supply. Informationis poor. Consumers overestimate the value of vitamins, so the demand curvethey use in their decisions has too high a willingness to pay. How valuable agood is to a consumer is partly a matter of personal taste and income, but inFigure 2.3 consumers scientific knowledge is wrong and if they were betterinformed they would not pay as much. Someone willing to pay $9/bottlebased on his mistaken information would only pay $6 if he were told thetruth, someone who is willing to pay $6 would only pay $3, and so forth.

If consumers have good information, then their maximum willingness topay is also their true value of the product. Thus, the demand curvetheir maximum willingness to pay is the same as their value curve

the value they receive from the product once they consume it, given theirpersonal tastes and the other things they are consuming.7 When informationis poor, we need to distinguish between the demand curve and the valuecurve, because they differ. In Figure 2.3, the value curve is always below thedemand curve.

The effect of imperfect information is that we use the demand curve tofind the equilibrium price, but the value curve to calculate the surplus. Thelaissez faire price and quantity are P0 and Q0 in Figure 2.3 because that iswhere quantity supplied and quantity demanded equal each other. At thequantity Q0, however (and remember, it is the quantity traded that is cru-

cial for efficiency, not the price), the price on the value curve is only V0, lessthan the P0 consumers are paying. The true value of the Q0th vitamin pillbottle is only V0, and the consumer is buying it only because he is misin-formed. His surplus is negative it is V0 P0. To find the total consumersurplus, keep in mind that we are looking for the excess of consumer value,given by the value curve, over the price paid, which is P1. For quantities inthe interval between 0 and Q1, consumer surplus is positive area B. Forquantities in the interval between Q1 and Q0, consumer surplus is negativearea -E, because consumer value is less than the price paid. Total consumer

7This is conventionally called the marginal valuation curve, because its height at

each quantity shows the value of having a little more of the good, rather than the totalvalue of consuming that quantity, but Ive shorted the name so it is analogous to demandcurve. We never talk about total demand curve versus marginal demand curve, sowhy should we treat value curves differently in our terminology? (Plus, why add the twoextra syllables of valuation and the implication that it is an estimate rather than a truevalue?)


14/27

214 Market Failure

surplus under laissez faire is B-E. The consumer surplus does not include

areas A+C+D+E. One might call that imaginary consumer surplus, be-cause it is consumer surplus that the uninformed consumers expect to getbut dont actually receive because theyve overestimated the value. Finally,think about producer surplus. Despite the fact that consumers are overpay-ing for vitamins, producer surplus is zero, because the price exactly equalsthe minimum sellers would accept. Seller volume and revenue is greater thanit would be if consumers were well-informed, but seller profit is zero becausesellers bid the price down to their marginal cost.

Figure 2.3

Overestimation of Quality

CS0 = B-EPS0 = 0TS0 = B-E

Suppose the government keeps the price the same(so P1 = P0), but reduces the quantity to Q1. Theconsumer surplus for the units in the interval from 0 toQ1 is still B. No surplus, positive or negative, is earnedfor greater quantities. The producer surplus is still

zero. Total surplus has increased by amount E, so government interventionhas raised surplus.

CS1 = BPS1 = 0

TS1 = B

The regulatory policy was simply to assign thequantity Q1. There is excess demand, however, be-cause consumers still are mistaken about the value of

the vitamins and the government has kept the price atP0. Excess demand results in rationing some con-

sumers are able to buy and some are not. If the rationing is efficient, thatmaximizes consumer surplus as just described. Under inefficient rationingsome consumers with high values for vitamins would fail to find a seller but


15/27

Market Failure 215

some with low values between V0 and P0 would succeed. In that case, the

regulation would still result in inefficiency, possibly even more than underlaissez faire, because high-value consumers with potential positive surpluswould not be able to buy but low-value consumers with negative surpluswould be buying.

This shows why the particular policy remedy matters. If the governmentcan somehow teach everyone the correct information, it does not have toregulate the quantity sold and the excess demand will disappear. Consumerswill use the informed demand curve, and will naturally demand quantity Q0without the need for the government to force it on them.

This whole story of overestimation does depend on consumers being fooled.Such mistakes are unlikely to last long. Soon, consumers will realize they

cant trust producer claims and they will stop buying. This is still marketfailure, however, and perhaps even worse failure, because the market cancompletely dry up because of distrust. Consumers and producers alike willwelcome government intervention if it can prevent false claims.

2.5: Externalities (Spillovers)If someone takes an action which affects someone else but neither party

can compel an exchange of money, we say the action imposes an external-ity. The classic example is when a company sells a product to consumersbut generates pollution that hurts a third party who cannot force consumersor company to pay for the damage. A better word for the effect than exter-nality, would be spillover, but externality has long been the establishedeconomic term. The motivation for the word externality is that the effectis external to the parties and transactions generating it.

Sidebar 2.3Negative Externalities from Death

Land is expensive in Hong Kong, so cremation is standard instead of burial.Even ashes have to go somewhere, though, and most people want to visit the locationinstead of throwing the ashes in the sea (or instead of following the example of thewoman who wanted to be cremated and have her ashes thrown in her ex-husbandsface). Thus, there are public and private columbaria windowless buildings coveredfloor to ceiling inside with small niches. The government predicts that 50,000 newspaces per year will be needed, and in July 2010 it announced the sites for 11 new

public columbaria. The neighbors are unhappy. They worry about traffic, smokefrom the burning of paper offerings, and just plain bad luck. Private columbariaare also being built, but they must comply with zoning regulations. Recently one12,000-niche underground columbarium was seized by the government for being builtin defiance of an official order. (Over My Dead Body, The Economist, p. 33,(August 14, 2010))


16/27

216 Market Failure

Externalities could come up in our running example of Smith and Jones.

Suppose that Smith, after buying whisky from Jones for $10 and drinking it,will throw the bottle onto the sidewalk in front of Browns house, where itwill shatter and cost Brown $20 to clean up.

The transaction between Smith and Jones has still created surplus of $7as far as those two are concerned Smiths value is $15 so he gets $5 sur-plus, and Joness is $8 so he gets $2 surplus. Consumer and producer surplusare not hurt by externalities, as they would be under monopoly or imperfectinformation. The problem is Brown, the third party. External to the trans-action, he suffers a value loss of $20. This loss is a negative externalitybecause it inflicts harm on the third party. The negative externality of $20more than wipes out the gains from trade of $7, so the whisky transaction

reduces total surplus.Just because there is a harmful externality to other people, however, does

not mean that a trade is inefficient. If Browns loss had only been $6, therewould be a negative externality but the transaction would have been surplusmaximizing anyway, since the externality would be less than the gains fromtrade. The usual effect of externalities is not that the entire market shouldbe shut down, but that too many trades take place because even trades thatadd very little to consumer and producer surplus still harm third parties.

Figure 2.4

An Externality

Figure 2.4 shows how output is toohigh when there are negative external-

ities. The supply of newsprint comesfrom a large number of competing pa-per mills, all with the same technol-ogy and costs, so the supply curveis flat. Paper mills are located onrivers, because they use a lot of water,and they return polluted water to theriver. Making one unit of newsprintcreates pollution that harms peopledownstream by amount X= 1, a neg-ative externality. The private cost

is P0 = 3, but the social cost isP0 + X = 4. The private cost is the

cost to the suppliers; the social cost is the private cost plus any third-partycosts.

The laissez faire equilibrium price and quantity are determined only by


17/27

Market Failure 217

the behavior of buyers and sellers, not by the third parties affected by the

externality, so they are P0 and Q0 = 100, where the quantity demanded ofnewsprint equals the quantity supplied. Consumer surplus is A+B+C, andproducer surplus is zero (because of supply being perfectly elastic). We mustgo beyond consumer surplus and producer surplus to calculate the effect onthird parties. The people downstream suffer harm ofX per unit times thequantity Q0. Their surplus is thus X Q0, amount -(B+C+D).

CS0 = A+B+CPS0 = 0Third Party Surplus0 = -B-C-DTS0 = AD

Now let the government regulate byassigning output limits to each firmthat reduce industry output to Q.Consumers will bid the price up toP0 +X, since there would be excess de-

mand at P0. You might wonder whythere isnt excess supply at P = P0 +X. The reason is that the governmenthas limited the supply to the number of licenses issued, so at P = P0 + Xevery seller who is allowed to sell will find a buyer. Consumer surplus fallsto A, and producer surplus rises to B. People downstream still have negativesurplus of -B because of the externality, but it has diminished because of thedecline in output.

CS1 = APS1 = B

Third Party Surplus1

= -BTS1 = A

Total surplus has risen because ofthe output licenses. The free mar-ket resulted in inefficiently high output,

which government regulation corrected.It is unexpected that pollution regula-tion has ended up benefitting the paper

mills, adding B to their surplus, but that is one of the benefits of surplusanalysis it helps companies and consumers realize just what kinds of poli-cies benefit them. I chose the particular pollution control policy carefully:output restriction rather than required pollution control equipment or finesfor every ton of pollution released. In a later chapter we will look at suchpolicies.

Externalities can be seen as a problem of weak property rights. In the

whisky example, Smith shatters the bottle on Browns sidewalk. A solutionwould be for the government to make it clear that although Smith does havethe right to walk on Browns sidewalk, he does not have the right to shatterglass there. The government would also have to enforce the right by makingSmith fear the police too much to break the bottle or forcing him to pay


18/27

218 Market Failure

compensation. If the people downstream of the paper mills owned the river

or the right to clean water, they could make the paper mills pay for theprivilege of polluting the water. Better enforcement of property rights isindeed a good solution to some externalities broken glass on sidewalks,for instance. In the pollution example, however, having all the downstreamvictims enforce the property right is more cumbersome and other policies aremore common.

Positive ExternalitiesPositive externalities are spillover effects that benefit third parties.

Suppose Smith and Jones are neighbors. Smith is deciding whether to pay$500 to plant a tree in his yard. If Smith plants the tree, Jones receives a

benefit of $200 that is, he would be willing to pay up to $200 to have thetree next door. That $200 is a positive externality, a beneficial spillover.

Positive externalities create surplus. We would not make the world a bet-ter place by somehow eliminating Joness enjoyment of Smiths tree. Para-doxically, however, positive externalities are both good in themselves and asource of market failure. The reason is that the market does not generateenough of them.

The problem is that Smith fails to take into account the entire benefitof the redbud when he makes his decision. If Smith would pay up to $450to have the tree, we say that his private benefit is $450, the height of his

demand curve. The social benefit is the private benefit plus any positiveexternalities, which sums to $650 here. The private benefit of $450 is lessthan the $500 cost, so Smith will not plant the tree, but the social benefit of$650 is greater than $500, so surplus maximization says the tree should beplanted.

Smith fails to plant the tree because he makes his decision in isolation,ignoring benefits external to himself. If he and Jones were to talk and makea deal, Jones would be willing to pay him an amount say, $150 thatwould make Smith plant the tree. Why not make the deal, then? MaybeJones thinks Smith is bluffing when he says his value for the tree is less than$500 that Smith will plant the tree anyway, even if Jones refuses to help

pay. Or Smith may be too embarassed to ask Jones for money, because thatmakes him look like a crass, selfish person who isnt willing to beautify hisyard to please his neighbors.

There is a special terminology used for goods with positive externalities.We say that Smiths tree is a nonexcludable good because Smith cannot


19/27

Market Failure 219

exclude Jones from enjoying it. We say that it is also a nonrivalrous good

because when Jones enjoys it that does not impose any extra costs on Smith.A good that is both nonexcludable and nonrivalrous is called a public good.On a small scale, the tree is a public good. On a larger scale, nationaldefense is the classic public good. If citizens eveywhere in the rest of theUnited States except Kansas voluntarily contribute to hire an army to defendthemselves against invasion, the Kansas citizens nonetheless get the benefitsof the protection (so it is nonexcludable), though without increasing the costsof the others (it is nonrivalrous). Telling China it can invade Kansas but notthe rest of the United States is simply not feasible. As a result, we do notexpect to see the market maximize surplus. The rest of the United Statesmust coerce Kansas to pay its fair share of national defense.

Figure 2.5

Positive or Negative?

It can be hard to decide whether anexternality is, on net, positive or nega-tive, What of Figure 2.5? Vince Han-nemanns Cathedral of Junk, is oneof the tourist sites of Austin, Texas.Tourist vans stopping by to see it, butthe neighbors dont like it. After 21 yearsof gradual construction, the city threat-ened to demolish it in 2010 because oflack of a building permit. Whatever the

law may be, would the demolition in-crease surplus, or reduce it?8

Real versus Pecuniary ExternalitiesThe shattered whisky bottle, the water pollution, and the tree in the yard

create real externalities: spillovers such that someones action affects theutility of someone else directly rather than through prices. If the spilloverresults from prices, it is called a pecuniary externality.

If Jones has been regularly selling whisky at $10/bottle to Smith, makinga profit of $2 per bottle, and then Anderson kills Joness sales by sellingat $7/bottle, Anderson has inflicted a negative externality of $2/bottle on

Jones. Anderson has certainly hurt Jones, but it would be very strange ifthis were market failure, because competition is not market failure but the

8A Junk Pile Grows in Texas, but Is It Art? Austin Project Bugs Neighbors, AttractsHoards of Tourists, Ana Campoy, The Wall Street Journal(April 24, 2010) http://goo.gl/dfX6V.
http://goo.gl/dfX6Vhttp://goo.gl/dfX6Vhttp://goo.gl/dfX6Vhttp://goo.gl/dfX6Vhttp://goo.gl/dfX6V


20/27

220 Market Failure

very process by which markets reach optimality. And in fact a pecuniary

negative externality like this does not reduce surplus.Suppose Andersons cost is $6 per bottle. Jones has indeed lost $2 perbottle, but Smith has gained $3 and Anderson has gained $1, so total surplushas gone up, not down, as a result of Andersons accidental harming ofJones.It has risen by $4, the amount by which production has gotten cheaperwhen Anderson with his $6 cost replaces Jones with his $8 cost. A pecuniarynegative externality indeed harms someone, but the harm is either exactlybalanced by a gain to someone else orexceeded, as happened here. Thelosers from new competition are unhappy, and often call for regulation toexclude the competitors who are hurting them, but the harm does not reducetotal surplus. In a well-functioning marketplace, pecuniary externalities are

inevitable and desirable.9

Coordination and Network ExternalitiesA special type of externality arises when what one person does depends

on what he expects others to do. When expectations matter, there mayexist a number of stable configurations of behavior, each with its own set ofexpectations, and some of these equilibria may lead to better results thanothers.

If we look at the situation from before the whisky is produced, Joneswill not spend $8 to produce the whisky unless he expects Smith to buy

it. But Smith will not waste time visiting Jones unless he thinks Jones haswhisky to sell. In one equilibrium, the whisky is produced and traded; in asecond equilibrium, with lower surplus, Smith stays home and no whisky isproduced. This has been suggested as a cause of business cycles; people inthe general economy will not produce goods unless they expect other peopleto produce goods for which to exchange them. One equilibrium has lowproduction and low welfare; another has high production and high welfare.Government jawboning might shift the economy from one equilibrium to theother.

Pessimistic expectations also generate runs on banks. Each depositor isafraid the other depositors are going to try to withdraw their money first,

9On pecuniary externalities, see R. Tresch Public Finance: A Normative Theory(1981)p. 91; J. Viner, Cost Curves and Supply Curves, 3 Zeitschrift fur National-Okonomie(1932), (reprinted in American Economic Association, Readings in Price Theory, (1952)(the origin, so far as I know, of the term pecuniary externality); Allyn Young, PigousWealth and Welfare, The Quarterly Journal of Economics, 27:672686 (August 1913).


21/27

Market Failure 221

leaving none for him, so he runs to the bank to take out his money. When

everybody does that, even an otherwise healthy bank does not have enoughfunds on hand. In one equilibrium, nobody expects a bank run, so with-drawals stay at a normal level and the bank is able to fund them. In a sec-ond equilibrium, everybody expects a bank run, so a run does happen andthe bank cannot pay everyone. Government deposit insurance is intendedto eliminate the bad equilibrium although we have seen in more than onebanking crisis that government bailouts introduce their own problems.

Sidebar 2.4A Medieval Lawsuit

This is like the case of 11 HenryIV, p. 47: one schoolmaster sets up anew school to the damage of an ancientschool, and thereby the scholars are al-lured from the old school to come to hisnew; the action there was held not to lie.But suppose Mr. Hickeringill should liein the way with his guns, and frighten theboys from going to school and their par-ents would not let them go thither, surethat schoolmaster might have an actionfor the loss of his scholars. 29 EdwardIII, p. 14. A man hath a market, towhich he hath toll for horses sold; a man

is bringing his horse to market to sell; astranger hinders and obstructs him fromgoing thither to the market; an action liesbecause it imports damage.

Notes: The action there was held notto lie means the court rejected the law-suit on the grounds that no ones rightshad been violated. Toll for horsessold is the commission the market ownercharged to anyone who sold horses there.

Expectations also matter whenthere are network externalities:a consumer gets more benefit froma good if more other people are us-

ing the same kind of good. Tele-phones are the paradigmatic exam-ple. Having the only telephone inthe world is useless, because theresnobody else to call. When morepeople buy telephones, they be-come more useful because there aremore people to call. Software is an-other example: the fact that mostpeople use the Microsoft Windows

operating system makes it more at-tractive.10

Network externalities can gen-erate market failure through mul-tiple equilibria as bank runs do.Software product A might be bet-ter than product B, but if the ex-pectation is that everyone will useA, that expectation is self-fulfilling.Everyone might prefer a simultane-ous shift to product B, but nobody

wants to be the first to shift.Compatibility between different companies products can also create co-

10On network effects see Oz Shy, The Economics of Network Industries, CambridgeUniversity Press (2001).


22/27

222 Market Failure

ordination problems. If two companies produce a product according to the

same standard, sales of both can increase because of the interchangeabil-ity. The government can be helpful in setting a standard railway gauge or astandard technology for high-definition television.

Much of the coordination function of government is a background func-tion, like protecting property rights, rather than requiring active and contin-ual intervention. Money solves a coordination problem. People wish to tradewith each other, but it is very inconvenient to have to figure out that valueof the goods a person produces in terms of the value of every other good,and very inconvenient to carry around truckfuls of each thing produced foruse in barter. I teach students and write books; would I have to carry booksand students to the grocery store to exchange for pancake mix? Instead, the

government provides money as a unit of account and medium of exchange.

2.6: Market Failure and the SolutionsWe have seen a number of sources of market failure, defects in the market

that can result in total surplus not being maximized. We started with weakproperty rights and contract enforcement. An important function of govern-ment is to clarify who owns what and to protect property against theft anddestruction. A second step is to enforce contracts so that people can tradeproperty without worrying about whether the person on the other side of thetrade will do what he promised.

The rest of the chapter was on the Big Three of market failure: marketpower, imperfect information, and externalities. A firm has market powerif it can affect the market price by how much output it produces. A firmwith market power can restrain its output to drive up the price, but in theprocess it hurts buyers more than it helps itself. Imperfect information cancause many different problems, but the simplest one is that if buyers cannot

judge quality, sellers will be tempted to take advantage of them by sellingshoddy goods. Externalities are spillover effects onto third parties who arenot involved in a transaction. They cause markets to fail because the harmto third parties are involuntary. The third party cannot charge for the harm,and so the external cost of the transaction is ignored by the parties who make

the decisions.By now, you may think that Chapter 1s optimism about market efficiency

was completely misplaced. Dont practically all sellers have at least a littlemarket power? Maybe a farmer cant get away with raising the price of hiscorn, but every small shop can raise its prices and keep most of its customers


23/27

Market Failure 223

for at least a while. Isnt information always imperfect? Sellers know a lot

more about their products than buyers do, and buyers dont know all theprices of all the sellers in the market. Arent externalities pervasive? Noman is an island, as John Donne said.11 What I buy affects me, and therebyaffects my friends and family; every extra ounce of fat imposes a negativeexternality on those who care about my survival. One extra ounce of fat istrivial, I may say as I buy my bag of potato chips (or as I buy my thirdbag of potato chips). But I must still concede that the market at least failsby a little bit to maximize surplus. Economists maintain their beliefs in themarketplace anyway, for two reasons.

First, there are market solutions to market failure. Market power is lim-ited by entry of competitors. Poor information is limited by advertising.

Externalities are limited by voluntary agreements to limit harmful behavior.We will look at these in detail in the various chapters.12

The monetary character of economic transactions limits surplus loss, be-cause where surplus is not maximized, there is profit to be made. The makingof the profit will ameliorate the imperfection, though at a cost. It may notmatter, for example, whether consumers can themselves test the quality ofcar bumpers, because either competing sellers will themselves try to demon-strate quality to obtain competitive advantage, or new businesses will enter(such as the many car magazines one can buy at supermarkets) to sell infor-mation to consumers at a small price. Similarly, the losses from externalities

are limited by the possibility of the third parties making a deal with who-ever is creating the externality. Before we impose government regulation, weshould ask whether market failure is being solved by some market institution.Maybe we do not need the government after all.

The second reason not to give up on the market is a less happy one:the government might do even worse. This is particularly true if the marketfailure is small. Just as there is market failure, so there is government failure,

11No man is an island, entire of itself; every man is a piece of the continent, a part ofthe main. If a clod be washed away by the sea, Europe is the less, as well as if promontorywere, as well as if a manor of thy friends or of thine own were. Any mans death diminishes

me, because I am involved in mankind; and therefore never send to know for whom thebell tolls; it tolls for thee. John Donne, Devotions upon Emergent Occasions, MeditationXVII (1654), http://isu.indstate.edu/ilnprof/ENG451/ISLAND/text.html.

12See The Wall Street Journal, Daniel Michaels and Elizabeth Williamson, Well, HushMy Mouth: Congress Is Moving Against LOUD Ads: After Decades of Complaints, LawMakers Are Yielding to Popular Demand, (December 1, 2010).
http://isu.indstate.edu/ilnprof/ENG451/ISLAND/text.htmlhttp://isu.indstate.edu/ilnprof/ENG451/ISLAND/text.html


24/27

224 Market Failure

and government failure, in fact, is the rule rather than the exception. Chapter

Three will explain.

Review Questions on Market Failure

1. What does market failure mean and what causes it?

2. Why are property and contract rights important?

3. How does market power cause market failure?4. How does poor information cause market failure?

5. How do externalities cause market failure?


25/27


26/27

226 Market Failure

Figure 2.3

Overestimation of Quality


27/27

Market Failure 227

Figure 2.4

An Externality

02 Market Failure

Documents

Transcript of 02 Market Failure