Unit 12: Market, efficiency, and public policy

The logic of Adam Smith’s famous claim, which is based on the invisible hand, is the basis of
the economic model of a perfectly competitive market: Price-taking firms and consumers
implement market outcomes that are Pareto efficient.

But sometimes, this “magic” can fail, and despite being useful sometimes, it is not a
description of how real markets work in general, and therefore not a good guide to public
policy. Two examples of this are the use of pesticides and antibiotics.

Governments provide a system of laws and law enforcement that guarantee property rights
and enforce contracts. Social norms dictate that you respect the property rights of others,
even when enforcement is unlikely or impossible

12.1 Market failure: External effects of pollution

When markets allocate resources in a Pareto-inefficient way, we describe this as a market

failure. When we analyze gains from trade in such cases, we have to consider not only the
consumer and producer surplus, but also the costs or benefits that other parties who are
neither buyers nor sellers may experience. If this happens, there is an externality (or external
effect)

External effect: A positive or negative effect of a production, consumption, or other economic

decision on another person or people that is not specified as a benefit or liability in a contract.
It is called an external effect because the effect in question is outside the contract.

(In a situation where the use of pesticides in a banana plantation has an external effect on
fishermen)

Situations of externalities can be studied through marginal costs:

 Marginal Private Cost: The cost of producing one more unit of a good for the company
responsible for the externality (plantation)
  Marginal External Cost: The cost for a third person/firm of the company profucing one
more unit of a good (fishermen)
 Marginal Social Cost: The sum of the two costs (plantation + fishermen)

The prize of bananas imposed by the owners equals the MPC (BLACK), though this is Paretto-
inefficient. If the company cared about the external damages they are causing to fishermen, or
if they made an agreement, they would choose instead a price that equals MSC, which is a
Paretto-efficient allocation. (ORANGE).

12.2 External effects and bargaining

In order to reach a Paretto-efficient allocation, negotiations can take place. Given that the
second allocation gives more profit than losses, the fishermen will be willing to pay a price to
the owners of the banana plantation.

The minimum acceptable offer from the fishermen depends on what the plantations get in the
existing situation, which is their reservation profit (Loss of profit in BLUE). Likewise, the
maximum the fishing industry would pay is determined by their reservation option. As in the
case of the plantations. It is the sum of the blue and green areas.

GREEN: NET SOCIAL GAIN

BLUE: LOSS OF PROFIT

GREEN + BLUE: TOTAL SOCIAL COST

Coasean bairganing: As making fishermen assume some of the costs of polluting may not be
fair, and given that the two agents have more information than the government does, another
way to minimize the externality is by giving the fishermen a right to give water. The owners of
the plantation would be willing to pay the fishermen some money to give up their right partly,
resulting always in a Paretto-efficient allocation.
Impediments to reach Paretto-efficiency:

 Impediments to collective action: If there are many fishermen and many plantations,
finding someone to represent them is difficult.
 Missing information: Only with information we can calculate the terms of an
agreement between fishermen and plantations.
 Tradability and enforcement: To make an agreement, agents must have certainty that
they can rely in the legal system if the agreement is enforced.
 Limited funds: The fishermen may not have enough money to pay the plantations, so
the externality is nor going to be solved.

12.3 External effects: Policies and income distribution

If a problem of externalities cannot be solved privately, then the government must intervene.
In the case of the conflict between the plantation of bananas and fishermen, three measures
are plausible:

A. Regulation of the quantity of bananas produced: The government could cap total
banana output to the Paretto-efficient allocation. This measure would reduce the costs
of pollution for fishermen, but it would lower the plantation’s profit. It is complex if
the conflict implies a lot of plantations and fishermen.

B. Taxation: Establishing a tax for plantations ensure that they assume the whole
marginal social cost of their actions (Pigouvian tax). This could be also used in the case
of positive externalities (Pigouvian subsidy). The tax revenue collected by the
government is fully charged to the plantations.

C. Enforcing compensation: The government could make the plantations pay for costs
imposed on the fishermen. The tax will be the difference between MSC and MPC, so
the new price is MPC + TAX= MSC. The fishermen are fully compensated, and the
banana plantations’ profits are equal to the true social surplus of their production.

However, if there are alternatives to the externality, the government can promote the use
of different ways of producing, and also firms may have incentives to develop new ways of
producing to avoid the penalty.
 12.4 Property rights, contracts and market failures

It happens very often that the prices of some goods (like bananas) are based on the costs of
production, and excluded costs that their use would inflict on others. As you have seen, the
private cost to the user (how much he paid to acquire the good) fell short of the social cost for
this reason.

Costs inflicted on others (such as pollution and congestion that are worse because you drive to
work) are termed external diseconomies or negative externalities, while uncompensated
benefits conferred on others are external economies or positive externalities.

Externalities can be solved using the Tort law, also known as the law of damages (you pay for
the demage you cause). This model, however, does not enable to capture some external
effects due to their complexity, the lack of information, no legal framework (e.g. pollution,
free-riding, the investment made in a worker that leaves the job…). In these cases where the
Tort law cannot operate, there is a market failure.

12.5 Public goods

A public good is defined as A good for which use by one person does not reduce its availability
to others: Once the good is available at all, the marginal cost of making it available to
additional people is zero. Goods with this characteristic are also called non-rival goods.

Rival: the marginal cost of making it available to additional people is zero

Excludable: Once you have it, you cannot exclude others from using it.
Markets typically allocate private goods. But for the other three kinds of good, markets are
either not possible or likely to fail. There are two reasons: When goods are non-rival, the
marginal cost is zero; and when goods are not excludable there is no way to charge a price for
them.

Market failure in the case of public goods is closely related to the problems of external effects,
absent property rights, and incomplete contracts.

12.6 Missing markets: Insurance and lemon

A common reason for contracts to be incomplete is information asymmetric, that can be seen
in two forms: Hidden actions (exchanges where something cannot be verified) and hidden
attributes (exchanges where an attribute of one of the parties is not known by the other)

Hidden attributes and adverse selection

When you want to purchase a used car, for example, the seller knows the quality of the
vehicle. You do not. This attribute of the car is hidden from the prospective buyer. Hidden
attributes can cause a problem known as adverse selection.

Adverse selection: The problem faced by parties to an exchange in which the terms offered by
one party will cause some exchange partners to drop out.

An illustration of this situation is health insurance: If companies want to make profit, they have
to establish high prices. However, the only people interested in purchasing that expensive
insurance are ill people. This leads to a missing market which fails due to a lack of information.

Moral hazard in the insurance market

Buying an insurance policy may make the buyer more likely to take exactly the risks that are
now insured. This is a problem of moral hazard, similar to the one of labour effort. They are
both principal–agent problems: the agent chooses an that matters to the principal, but cannot
be included in the contract because it is not verifiable.

The problem of moral hazard and hidden attributes are present in the context of externalities:
Some actions provoke externalities that cannot be monitorized, leading to a market failure.
 12.7 Limits to the market

Not all activities are rules by market. In fact, most of them are not: families, government...
Why this happens? 2 explanations:

 Centralized systems are better at some things (firms) while decentralized are better at
others (markets)
 The boundaries of the firm are unknown: People disagree about the appropriate
extent of the market.

The arguments in favour of limiting markets are based on:

 Repugnant markets: Marketing some goods and services—vital organs, or human

beings—violates an ethical norm, or undermines the dignity of those involved.
 Merit goods: It is widely held that some goods and services (called merit goods)
should be available to people independently of their ability or willingness to pay.

Conclusion

Pareto-inefficient market outcomes (market failure) can result from limited competition,
average costs declining with output, or external effects. Externalities occur when some aspect
of an exchange is not covered by an enforceable property right or contract, as a result of
asymmetric or non-verifiable information. Examples include employment, credit, and
insurance contracts (which may be affected by problems of moral hazard and adverse
selection), and public goods and bads (such as knowledge and pollution).

Both Coasean bargaining and Pigouvian taxes and subsidies can improve on market outcomes
in these cases, but both are limited by the same problems of asymmetric and non-verifiable
information that is the reason for the market failure.

Repugnance and other moral objections to exchanging some goods for money, and the
crowding-out effects of monetary incentives, provide reasons why some goods and services
are not allocated using markets.