INFORMATION, MARKET FAILURE AND THE ROLE OF THE GOVERNMENT

Market Failure
Inability of the unregulated market activity to provide desired goods and services at competitive market Exist when market fails to achieve an optimal allocation of resources Factors that limit the market to promote efficient use of resources includes: insufficient information, externalities and public goods

Market Behavior with Imperfect Information

For the most part of our analysis of market behavior has assumed that market participants have full information about product s and resources. For customers, full information involves knowledge about a product s price, quality, and availability. For firms, full information includes knowledge about the marginal productivity of various resources , about the appropriate technology for combining them, and about the demand for the firms product. In reality, reliable information is often costly

Marginal Cost of Search

Individuals gather the easy and obvious information first However, as the search widens, the marginal cost of acquiring additional information increases because: Individuals may have to travel greater distances to check prices and services The opportunity cost of their time increases as they spend more time acquiring information Thus, the marginal cost curve for additional information slopes upward.

Optimal Search with Imperfect Information

Marginal Benefit of Search

The marginal benefit from acquiring additional information is better quality at a given price or a lower price for a given quality The marginal benefit is relatively large at first, but as more information is gathered and people grow more acquainted with the market, additional information yields less and less additional benefits Thus, the marginal benefit curve for additional information slopes downward.

Optimal Search with Imperfect Information

Optimal Search with Imperfect Information

Market participants will continue to gather information as long as the marginal benefit of additional information exceeds its marginal cost optimal search occurs when the marginal benefit equals the marginal cost at point I*. Note that at search levels exceeding the I*, the marginal benefit of additional information is still positive. Note also that at some point the value of additional information reaches zero, Ip. This level of information is identified as perfect information.

Asymmetric Information in Product Markets

The issue of costly and limited information becomes more complicated when one side of the market has more reliable information than does the other side asymmetric information Two types of information that a market participant may want but lack:
One side of the market may know more about characteristics of the product for sale than the other side knows asymmetric information problem involves hidden characteristics

Asymmetric Information in Product Markets

A second type of problem occurs when one side of a transaction can pursue an action that affects the other side but that cannot be observed by the other side Whenever one side of an economic relationship can take a relevant action that the other side cannot observe, the situation is described as one of hidden actions

Hidden Characteristics: Adverse Selection

One type of hidden-characteristic problem occurs when sellers know more about the quality of the product than do buyers, such as the market for used cars The seller of a used car normally has abundant personal experience with important characteristics of that car While buyers have much less information

Hidden Actions: Principal-Agent Problem

In the age of specialization, there are many tasks that individuals do not perform for themselves because others do them better and have a lower opportunity cost This leads to the second problem which occurs because one side of a transaction can pursue hidden actions that affect the other side

Hidden Actions: Principal-Agent Problem

When buyers have difficulty monitoring and evaluating the quality of goods or services purchased, some suppliers may substitute poor-quality resources or exercise less diligence in providing the service

This is called the principal-agent problem

Describes a situation in which one party, the principal, contracts with another party, the agent, in the expectation that the agent will act on behalf of the principal The problem arises when the goals of the agent are incompatible with those of the principal and when the agent can pursue hidden actions

Asymmetric Information in Insurance Markets

In the insurance market, it is the buyers, not the sellers, who have more information about the characteristics and actions that predict their likely need for insurance in the future If the insurance company has no way of distinguishing among applicants it must charge those who are good health risks the same as those who are poor ones

Asymmetric Information in Insurance Markets

This price is attractive to poor health risks, but will seem too high to good health risks, some of whom will choose not to buy insurance

As the number of healthy people who dont buy insurance increases, the insured group becomes less healthy on average rates must rise insurance is even less attractive to healthy people adverse selection tends to make insurance buyers less healthy than the population as a whole

Asymmetric Information in Insurance Markets

The insurance problem is compounded by the fact that once people buy insurance, their behavior may change in a way that increases the probability that a claim will be made This incentive problem is referred to as moral hazard occurs when an individuals behavior changes in a way that increases the likelihood of an unfavorable outcome

Asymmetric Information in Insurance Markets

More generally, moral hazard is a principal-agent problem since it occurs when those on one side of a transaction have an incentive to shirk their responsibilities because the other side is unable to observe them

Coping with Asymmetric Information

There are ways of reducing the consequences of asymmetric information

An incentive structure or an informationrevealing system can be developed to reduce the problem associated with the lopsided availability of information
Lemon laws that offer compensation to buyers of new or used cars that turn out to be lemons

Health insurance companies use a variety of tools

Physical exams and filling out questionnaires Deductibles

Asymmetric Information in Labor Markets

Differences in the ability of labor present no particular problem as long as these differences can be readily observed by the employer That is, if the productivity of each particular worker is easily quantified that measure can be used and serves as a basis for pay

Asymmetric Information in Labor Markets

But because production often takes place through the coordinated efforts of several workers, the employer may not be able to attribute specific outputs to each particular worker An adverse-selection problem arises in the labor market when labor suppliers have better information about their own productivities than do employers, because a workers ability is not observed prior to employment hidden characteristics

Asymmetric Information in Labor Markets

In a labor market with hidden characteristics, employers might be better off offering a higher wage makes the job more attractive to morequalified workers Paying a higher wage gets at the problem of hidden actions by workers

Paying a higher wage to attract and retain more-productive workers is called paying efficiency wages

Externalities
An effect from one activity which has consequences for another activity but is not reflected in market price Two types of externalities are: external diseconomies of production or consumption (negative externality) and external economies of production or consumption (positive externality)

Types of Externalities
External diseconomies of production or consumption refers to the uncompensated cost impost by the firm or an individual on other firms or individuals based on their actions e.g. smoking (consumption) dumping in lakes and rivers of wastes (production)
1.

Types of Externalities
External economies of production or consumption refers to the uncompensated benefits conferred to firms or individuals by the action of one firm or individual e.g. attractive garden in front of his or her house education
2.

Public Goods
Are commodities the consumption of which has to be decided by society as a whole, rather than each individual Public goods have three characteristics.

Three characteristics of Public Goods

They yield non-rivalrous consumption. The consumption of one individual will not deprive others in consuming them. They are non-excludable. If one individual consumes them, it is impossible to restrict others to do the same. They are often non-rejectable. Individuals cannot abstain from their consumption even if they wanted to.

Public Goods
Example of public goods: national defense, public health services, national weather services Public goods are examples of a particular kind of externality; each member must consume the same amount of the good or service.

Role of the Government

Existence of market failure implies a potential role for government intervention or regulation Economic instruments to correct market failure: establishing property rights, imposing taxes and subsidies, and direct regulations. Property right is a legally established title to the ownership and use of resources, goods, or services

Role of the Government

The use of taxes to bring private and social costs of production into agreement is known Pigovian taxation. Pigovian tax is a tax levied to correct the negative externalities of a market activity Regulation legalistic approach that usually involves the setting of standard to be complied with by violators

True or False

Market Failure is the ability of the unregulated market activity to provide desired goods and services at competitive market. Reliable information is often costly for both consumers and producers. Externality is an effect from one activity which has consequences for another activity but is not reflected in market price. Public goods are examples of a particular kind of externality; each member must consume the same amount of the good or service. Existence of market failure does not imply a potential role for government intervention or regulation.