Transcript Chapter 14 THE MARKET MECHANISM: SHORTCOMINGS AND REMEDIES

The Shortcomings
of Free Markets
Contents
● 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
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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
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Externalities
● 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
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Externalities: Examples
● 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
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Externalities and Inefficiency
● 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
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1: Equilibrium of a Firm
with Detrimental Externality
FIGURE
Marginal Cost and Revenue
Marginal
social cost
Marginal
private cost
0
B
A
35
100
Marginal
revenue
Thousands of Tons of Paper
per Year
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Government 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
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Public 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)
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Public 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
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Provision of Public Goods
● 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
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Provision 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
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Resource 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
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Resource Allocation
Between Present and Future
● 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
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Resource Allocation
Between Present and Future
● 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
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Resource Allocation
Between 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.
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Resource Allocation
Between Present and 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.
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Asymmetric Information
● 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
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Asymmetric 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
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Asymmetric Information
● 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
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Rent-seeking Behavior
● 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
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Rent-seeking Behavior
● 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
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Moral 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
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Moral 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
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Principal-Agent Problem
● 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
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Principal-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
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Principals, Agents and Recent
Stock Option Scandals
● 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
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Market 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.
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The Cost Disease of the
Service Sector
● 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
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The 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
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The Cost Disease of the
Service Sector
● 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
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The Cost Disease of the
Service Sector
● 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
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The Cost Disease of the
Service Sector
● 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
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The Cost Disease of the
Service Sector
● 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
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Epilogue: 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
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Epilogue: 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
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The End
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