Unit 9: Market Failure
9.1: Efficiency and inefficiency in markets
Efficiency in economics can mean a lot of different things depending on the context. In this section, we will go through some of the most important types of efficiency that arise in economics. We will then talk about efficiency in free markets and when free markets are and are not efficient.
Types of Efficiency
We have already dealt with two types of efficiency.
• Productive efficiency means that output is being produced at the minimum cost per unit. It basically means that the firm is using efficient production technologies and techniques, and is not wasting scarce resources.
• Allocative efficiency means that the market is set up in a way that maximizes total surplus. In other words, the gains from trade in the market are at a maximum. There is no deadweight loss.
There are two other notions of efficiency in economics that are more general.
• When comparing two outcomes using Hicks-Kaldor efficiency, we evaluate whether the benefits exceed the costs. Outcome A is more efficient than outcome B in a Hicks-Kaldor sense as long as the benefits of switching exceed the costs.
• When comparing two outcomes using Pareto efficiency, we need to look at whether
anyone loses. Outcome A is more efficiency than outcome B in a Pareto sense only if it helps some people and doesn’t harm anyone in the process.
For a practical example, suppose that a city wants to build a new highway, but that building it requires taking land from a resident who doesn’t want to give it up, even if we pay him. The benefits of the project are so massive compared to the cost to this resident that the project surely improves efficiency in the Hicks-Kaldor sense, but the fact is that if even one person is hurt, then the project does not improve efficiency in the Pareto sense. For another humorous example of the Pareto criterion, Google “economics joke golf”.
Markets and Efficiency
One of the points that economists hammer is that, as a general principle, free markets are efficient. The basic idea is that voluntary exchanges have to improve efficiency by definition – they make both the buyer and seller better off. Otherwise the buyer and the seller would not agree to the exchange. Furthermore, all possible gains from trade will be realized in a free market since individuals trade voluntarily. The outcome is efficient – no alternative is possible that is better.
Remember the basic illustration of consumer and producer surplus at market equilibrium.
The market equilibrium at price P* and quantity Q* is efficient. It captures all of the trades for which the price that the buyer is willing to pay (on the demand curve) exceeds the price at which the seller is willing to sell (on the supply curve). Voluntary trading, leading to the market equilibrium, always generates maximum surplus in the market. Any level of trade other than Q* would reduce surplus and reduce efficiency in the market.
He generally neither intends to promote the public interest, nor knows how much he is promoting it. He is led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest, he frequently promotes that of society more effectually than when he really intends to promote it.” In other words, individuals engage in these voluntary trades because it creates consumer and producer surplus for them. But, in doing so, buyers and sellers ultimately reach an outcome which turns out to be the best outcome for society. People acting in their own best interest ultimately make decisions in a way that benefits society as a whole. Nobody knows your business better than you do.
Market Failure
This result is very powerful. Free markets, in general, produce efficient outcomes for society. This is basically because voluntary exchanges improve efficiency and, in a free market, people will on their own exhaust all possible gains from trade.
However, there are important exceptions to this principle. Economists use the term market failure to describe a situation in which the free market does not generate an efficient outcome. Economists have identified four sources of market failure.
• Market Power: The result that free markets are efficient assumes that the market is
competitive. We saw in previous units that, if the firm has market power and can set the price on its own, the market will generally not maximize total surplus. The firm reduces output and sets a high price in order to maximize profit. Doing so reduces consumer surplus and creates deadweight loss, but it increases the firm’s profit.
• Information Problems: The efficiency of the free market outcome implicitly assumes that people know what is being bought and sold. If there is an information problem, the market outcome might not be efficient. For example, people might not be able to observe other people’s actions or the quality of products that they are buying and selling.
• Public Goods: It’s not easy to imagine voluntary exchange creating an efficient outcome for something like building a highway or clean air. The problem is that there’s no market for buying highways or clean air like there is for buying apples or clothes.
We have already dealt with market power in previous units. We saw all of the inefficiencies created when firms with market power set their own prices, in contrast to competitive markets where firms accept the market price. The rest of this unit is about the other three sources of market failure.
Market failure is really important to understand. We all see free markets going wrong – trash in the water, decaying roads and a financial crisis, to name a few examples. Some people think about things like this, throw up their hands, and say that the free market doesn’t work. But the critical point is that we can identify specific sources of market failure, and then think about whether and how we might correct them.
The free market works, basically. When it doesn’t work, don’t blame the market system in general. Rather, try to identify the specific source of market failure. The free enterprise system has done great things for human society – producing more improvements in our standard of living in the last 150 years than in the whole of prior human history combined.
Most mainstream economists – whether left-wing or right-wing – agree that free markets are good in general. This is a uniting theme of pretty much all of economics, outside of some extreme fringes. Markets and free choice are good, but market failure sometimes exists. Most economists don’t disagree with either part of that statement.
Economists do disagree about how serious market failure is and what should be done about it. Conservative, right-leaning economists tend to see market failure as less serious and something that will correct itself over time. They also believe that the government is an inherently flawed institution for mediating market transactions, and that government intervention in free markets might end up leaving things worse off. Liberal, left-leaning economists tend to see market failure as serious and potentially permanent. As a result, they are more willing to support government action to correct it. Nevertheless, for all this disagreement, we should emphasize again the common core belief that markets are good for society. Market failure is an exception, not a repudiation of the entire principle of free choice.
9.2: Information problems
A key assumption that lurks behind our argument that free markets are efficient is that parties are perfectly informed about the transaction. But this may not always be the case. Asymmetric information refers to any situation where different parties have different information. There are two varieties of market failures created by asymmetric information. We will discuss both in this section.
• Adverse selection refers to a hidden characteristic. For example, a seller of a used car knows the quality of the car but the buyer does not. A buyer of health insurance knows how sick or healthy she is, but the seller does not.
• Moral hazard refers to a hidden action. For example, a restaurant manager knows how
hard he is working, but the owner of the restaurant can’t tell. A mechanic knows whether repairs on your car were necessary, but the customer does not.
Adverse Selection and Market Failure
Adverse selection relates to a hidden characteristic in a market. There are two key features that combine to create a market failure associated with adverse selection.
1. Parties with the worst characteristics have the most incentive to participate. For example, people who are unhappy with their used cars are more likely to try to sell them, and people who are sick are the most likely to buy health insurance. The selection into the market is not random. It is adverse.
2. The other side of the market has imperfect information about this characteristic. For example, a buyer can’t determine perfectly the quality of a used car he is buying. A health insurance company can’t determine exactly how healthy or sick someone is before she buys insurance.
The party with the hidden information can be the buyer or the seller. In the case of the used car market, the seller has hidden information about the quality of the car that could hurt the buyer. In the case of the health insurance market, the buyer has hidden information about her health that could hurt the seller of the insurance.
offer insurance for $2000. Who will buy the insurance? The problem is that the healthy customers with less than $2000 in medical expenses will drop out of the market since the premium is too expensive compared to their health care costs. In other words, the selection into the market is not random – it is adverse; the worst customers are the ones who want to buy insurance.
Having lost the healthiest customers, the insurance company is now stuck with a pool of customers who have high medical expenses. They have to raise the premium above $2000 in order to stay in business. But this causes even more people – the healthiest among the remaining customers – to drop out. Now the insurance company has to raise the premium again, causing even more people – the healthiest among the few remaining customers – to drop out. Eventually, we are stuck with really expensive insurance, with only the sickest customers buying it.
In the case of health insurance specifically, this is known as a death spiral. The healthiest customers don’t buy insurance, making the cost of insurance rise, then even more healthy people leave, the insurance gets even more expensive, etc… until the market completely unravels. Adverse selection reduces the size of the market, specifically driving out the best customers.
Adverse Selection in a Used Car Market
Suppose that half of the used cars in a market are good and half of the used cars in a market are bad. The table below shows what a good car and a bad car are worth to the buyer and to the seller.
Value to Buyer Value to Seller
Good Car $10,000 $8000
Bad Car $4000 $2000
If information were perfect on both sides of the market, then the market would work fine. If buyers and sellers both knew which cars were good and which cars were bad, then good cars would be traded for a price between $8000 and $10,000 and bad cars would be traded for a price between $2000 and $4000.
The problem is this. If the buyer offers $7000 for a used car – which seems like a fair price – only sellers with bad cars are willing to sell a car to him. Sellers of good cars value their cars at $8000 and are unwilling to sell their good cars for the $7000 that the buyer offers.
Now, once the buyer figures out that only sellers with bad cars are going to agree to sell him a car, then he’s only willing to pay $4000 for the car. But paying $4000 ensures that the only kind of car traded in this market is a bad car! The good cars are completely driven out of this market because sellers can masquerade bad cars as good cars and the buyer can’t tell the difference.
There are two points to note here. First, the presence of different quality levels does not in and of itself create a market failure. The real source of market failure is the information asymmetry. If everyone knew the quality of the used car or how healthy someone is, then the price would be set accordingly and the market would operate efficiently. The presence of asymmetric information is what causes the market to break down.
Second, adverse selection reduces the size of the market. Specifically, it drives out good quality. People in good health don’t want to buy health insurance in a market where they are charged the same rate as sick people. People with high-quality used cars don’t want to sell them in a market where the value of their car is averaged together with low-quality cars.
The important point is that the resulting equilibrium is inefficient. It is impossible to trade high-quality used cars or to sell insurance to healthy people, even if doing so would be efficient, because of the information asymmetry.
Solutions to Adverse Selection
A few solutions to adverse selection problems present themselves.
• Get better information: Having a used car inspected before purchase or making a health insurance buyer take a physical before she can buy a policy can resolve at least some of the hidden information problem. Note that this is good news for good customers. For example, if an insurance company is allowed to test whether people are smokers or nonsmokers, then the ability to test lowers average rates for nonsmokers.
to protect his reputation. This is one justification for buying brand-name products, generally. A shoe company without a recognizable name doesn’t face much of a consequence if they sell you bad shoes that fall apart after a week. But Nike has an incentive to give you a good-quality shoe, because it damages their brand name if word gets around that they sell low-quality shoes.
• Warranties and consumer protections: Offering a warranty might be a signal to a
customer that a product is high quality. In the case of a car, a seller would not agree to cover repair costs unless he was fairly sure that the car was of high quality.
• Standards and certification: Having a neutral third-party evaluate the quality of the product is a good idea for firms with high quality products. For example, car companies are in full support of having Consumer Reports test the safety of their cars and reporting the results to buyers. Meat and dairy products are certified by neutral government inspectors to be of a certain level of quality.
• Signaling: It is difficult for an employer to tell whether an applicant for a job is smart and hard-working. Further, there is an adverse selection problem because who are stupid and lazy end up looking for jobs pretty often. How then, when you go for a job interview, can you convince your employer that you are the smart and hard-working type? Getting a college degree or a high GPA can be a big help. The reason it helps is that, for a person who isn’t that smart or who is too lazy to put in some work, it’s difficult to obtain a college degree or get a high GPA. According to economists, the value of going to college is not so much that you learn anything important in college. It’s that you are sending a message to your employer that you are smart and able to work hard. Otherwise you never would have never been able to make it through college. Thank your professors when they’re hard on you. It makes your degree more valuable. If everyone can get one, it’s not worth much.
Moral Hazard and Market Failure
Let’s start with a simple story. You go to a doctor because of pain in your fingers. You see on the Internet that there are lots of different drugs that treat your problem, but you don’t know which is the best one for you. Your doctor recommends a drug and your condition improves. Later, you find out that your doctor has a deal with the manufacturer of the drug that he prescribed, and gets a commission every time he prescribes that drug. Did he really recommend the drug because it was the best option for you? Or did he just want his commission?
In a nutshell, this is moral hazard. The problem is a hidden action. The doctor recommends a drug, but you don’t know whether the action that he took is in your best interest or in his best interest. There are two key features that combine to create a market failure associated with moral hazard.
1. Different parties have different incentives with respect to the action in question. For the example above, you want the doctor to prescribe the best drug, but the doctor has an incentive to prescribe a drug from the manufacturer that pays a commission.
2. The action is not perfectly observable to both parties. For the example above, you can’t tell perfectly whether the doctor took an action in your best interest (the right drug for you) or in his own best interest (the drug from the manufacturer that pays a commission).
Moral hazard is an information problem – a poisonous combination of mis-aligned incentives together with hidden action. You have bad incentives to take the action that I don’t want you to take, and I can’t perfectly observe whether you are taking the right action or not.
The general solution to a moral hazard problem is to realign the incentives in a way that encourages the other party to take the actions that you want. In this case, you might think about writing online reviews or threatening to switch doctors if your finger doesn’t get better. That might give the doctor an incentive to recommend the right drug.
Examples of Moral Hazard
We will present several examples of moral hazard, along with what can be done to solve the problem.
One solution is to tie pay to performance somehow. The problem is that observable performance is not always a good indicator of effort. A restaurant manager might work really hard, but the restaurant is unprofitable just because the economy is bad. Conversely, another manager could be really lazy, but the restaurant is always profitable just because the location is good. Performance pay is never perfect, and the owner can never really tell how hard the manager is working, but it’s better than nothing and can provide an incentive for the manager to work hard.
Performance pay is an especially thorny issue for large organizations or for group projects where each individual’s contribution to a group effort is difficult to measure. This is a moral hazard because extra effort by an employee might be efficient for the company, but if nobody notices it and there’s no reward, then it’s not worth it for the employee to expend extra effort.
A second general solution is to go little by little instead of having a long contract. This encourages both sides to keep doing the right thing in order to keep the relationship on good terms.
This example, and the example of the doctor, belong to a class of moral hazard problems called principal-agent problems. These problems deal with the situation of a principal (the owner or the patient) who hires an agent (the manager or the doctor). The principal wants the agent to act in the principal’s best interest instead of in the agent’s own best interest. Electing politicians is always a principal-agent problem. How can we get our elected officials to act in the public’s best interest instead of their own best interest?
Another classic moral hazard problem deals with insurance. People whose losses are insured might take more risks than people without insurance, to the detriment of the insurance company. For example, people with full coverage on their cars might drive faster than people with no insurance. The solution here is to share the risk – raise premiums when drivers get into accidents. This realigns incentives and encourages drivers to drive safely. If insurance companies could perfectly monitor whether people are driving safely or not, they would just adjust rates accordingly. But they can’t, so the best they can do is to raise your rates when you get into an accident.
A similar moral hazard problem arises with health insurance. People with comprehensive insurance might visit the doctor for trivial reasons. The solution here is a co-pay or some kind of cost sharing. This should realign incentives and encourage customers to visit the doctor only when the problem is serious.
only a low percentage. If the real estate agent gets 3%, then putting in a bunch of extra effort to find a buyer willing to pay $10,000 more will only get the real estate agent an extra $300. Might not be worth it for the agent – better to get the quick sell and move on to another house. But if you were selling the house yourself, it might be worth the extra effort to locate more buyers if you could keep the whole $10,000. This is a moral hazard because the real estate agent doesn’t put in maximum effort, like you might want her to. And her effort isn’t perfectly observable.
Who should be responsible when drivers hit animals on the road? If we make drivers responsible for these accidents, then animal owners have no incentive to keep their animals under their control. But if we always make animal owners responsible for these accidents, then drivers have less incentive to drive carefully. When we solve the moral hazard problem on one end, we create a problem on the other end. Take a law and economics class that addresses liability rules to see how the legal system solves this problem.
Another public policy issue that is intricately related to moral hazard is the welfare state, generally. Lots of people agree that a basic responsibility of society is to help people who are in trouble. But benefits that are too generous might discourage people from working hard. Of course, making the rules too strict will leave some people behind who really do need help. This is a really thorny public policy issue – how can we design a system that helps people who legitimately need help but that doesn’t encourage irresponsible behavior and keeps away people who could work but prefer to just collect welfare? For unemployment benefits, specifically, this is why the government limits the time that workers can collect benefits and requires them to demonstrate that they are either enrolled in school or actively searching for work. Otherwise it is too easy to just enjoy collecting unemployment pay rather than the intended purpose of the program, which is to help people who are between jobs and looking for a new one.
Finally, an example from higher education. Professors are evaluated, at least in part, based on course evaluations from students. But this can give professors an incentive to inflate grades to curry favor with students, even though it hurts the institution. This is one reason that universities give tenure to professors – it guarantees them a job, which allows professors to grade students in an honest way without fear that they’ll lose their jobs because some students are unhappy. Of course, permanent tenure creates a new problem that professors with tenure might not have as much incentive to continue working hard. Like the legal liability example, solving a moral hazard problem on one end creates a new problem on the other end. Another solution to the problem is to have a fixed grade budget, and only allow faculty to give a certain number of high grades.
9.3: Public goods
In arguing that free markets are efficient, we assumed that the market for the product actually exists. It’s easy to operate markets for clothes or food – bringing together buyers with sellers. But it’s not so easy to create a market to build a highway or to clean the air of pollution. In this section, we deal with market failures created when it is very difficult practically to set up a market.
Rivalry and Excludability
A good is excludable when it is possible to prevent nonpayers from using the good. Food and clothes are excludable. You can’t leave the store with them unless you pay. A good is nonexcludable when it is impossible or impractical to charge people for using it, thus making it impossible to exclude nonpayers. For example, radio shows are nonexcludable because there is no way to prevent people who don’t donate to the ration station from listening to the program. Local roads are practically nonexcludable since it is not feasible to put up toll collection booths on every street corner. In short, excludable goods are things we can charge people for. Nonexcludable goods are things where it’s infeasible to charge people for using them.
A good is rival when one person’s use of the good prevents others from using it. Food is rival. If I eat a pizza, you can’t eat the same pizza. A good is nonrival when additional users do not preclude other people from benefitting from the same good. A radio show is nonrival since adding more listeners doesn’t prevent anyone else from listening to the same program. A fireworks show is nonrival. It doesn’t decrease my enjoyment if you watch it too. One simple economic way to state this is that a nonrival good is one for which the marginal cost of additional users is zero. There is a fixed cost to run a fireworks show, but once it’s there the marginal cost for someone else to watch it is zero. However, it does cost something to make a pizza for you to eat.
This classification scheme gives us four different kinds of goods.
Rival Non-Rival
Excludable
Private Good Examples: food, clothes,
computers
Artificially Scarce Good Examples: cable TV, computer
program, music file
Non-Excludable
Common Resource Good Examples: fishing in the ocean,
grazing on open pastures
Public Good
Artificially Scarce Goods
Artificially scarce goods are nonrival but excludable. Think about something like a computer program or a music file. These are excludable since the company can charge you to buy a CD or install the software on your computer. However, they are nonrival – once Microsoft develops a new version of Word or your favorite singer produces a new song, it costs the company nothing for someone else to install the software or for someone else to listen to the song. While there is a fixed cost of producing the software or the song, the marginal cost of adding another user is zero.
Since the marginal cost of another user is zero, it follows that the socially efficient price for an artificially scarce good is zero. Even if using Microsoft Word is only worth $1 to you, it is still socially efficient for you to have it because, once the software is developed, it does not cost Microsoft anything for you to install it on your computer. If you don’t get it, then there is $1 of deadweight loss. Of course, we know that Microsoft will not charge a price of zero for the product since they want to maximize profit and they need to recover their up-front fixed cost.
Overall, there is always deadweight loss in markets for artificially scarce goods. The efficient price is zero, but a privately operating firm can never charge a price of zero because it would lose money. So the firm sets price above marginal cost, leading to deadweight loss.
Common Resource Goods
Common resource goods are rival but nonexcludable. Here, think about fishing in the ocean or grazing your sheep on open pastureland. These are rival since, when you catch a fish or when your sheep eat the grass off of a field, your use diminishes the availability of the resource for others. However, they are practically nonexcludable because it is not feasible to charge everyone who catches a fish in the ocean or whose sheep go on open public lands.
Public Goods
A public good is both nonrival and nonexcluable. Think about a radio show or a fireworks show. These are nonrival and nonexcludable. They are nonrival because another person enjoying a radio show or a fireworks show does not prevent anyone else from using them. The marginal cost of additional users is zero. They are also nonexcludable. There is no feasible way to charge people for listening to a radio show or watching a fireworks show, and thus we can’t exclude anyone from enjoying the show, even if he or she doesn’t pay.
Importantly, the term “public good” is not the same as saying that something is provided by the government. The government provides K-12 education, but this is a private good. Attending school is both rival and excludable. Conversely, radio shows – which are public goods – are run by private companies. Economists use the term “public good” to refer to a good that is nonrival and nonexcludable, not to refer to things that the government does.
The Free Rider Problem
National defense is an excellent example of a public good. It is nonrival since the existence of another person in the US does not prevent the military from protecting me. It is also nonexcludable. The military cannot protect some people in the US, but exclude others from protection. Having an army that keeps bad people out of the US can’t protect your house but not your neighbor’s.
Now, suppose that everyone wants national defense and the total amount that people are willing to pay for it exceeds the cost of providing it. In other words, providing national defense is efficient. Why should the government force us to pay, then? Since people want it and are willing to pay, does this mean that we can just forget about the government and set up a market to do it privately?
The answer is no. Consider each person’s individual position. Your own contribution is so small that you personally have basically no impact on the quality of national defense. But, since national defense is nonexcludable, you get to enjoy the benefits even if you don’t pay. Thus, you reason, why should you bother to contribute? Your personal contribution means basically nothing, and you get to reap the benefits even if you don’t pay. This is known as the free-rider problem. Each individual is better off benefitting from public goods but not making a contribution himself.
This is a clear market failure. Even though society wants something and the value is more than the cost of providing it, it can never get done in a private market because of the free-rider problem. A private company has no way to charge anyone for national defense. Thus, here we have an example of a good that would be efficient to provide, but it can’t get done in a free market.
The government can solve this problem and provide efficient public goods because it can force people to pay taxes, eliminating the free-rider problem. This is a practical way to raise money for national defense. The alternative is a private market, but we know in a private market that national defense wouldn’t be provided at all because of the free rider problem.
Efficient Provision of Public Goods
Here is a simple numerical example. Suppose that Anna, Bill and Carrie are neighbors who like for trees to be planted in a park near their house. The trees are public goods. They are nonrival; once planted, they benefit all neighbors. They are also nonexcludable; neighbors get enjoy looking at trees even if they personally didn’t pay for them.
The table below shows the marginal benefit to each neighbor associated with planting additional trees. These are marginal, so it shows the benefit of each additional tree to each neighbor.
Trees MB (Anna) MB (Bill) MB (Carrie)
0 -- -- --
1 180 150 120
2 120 80 80
3 70 50 50
4 60 40 30
5 20 20 10
The table below shows the marginal social benefit of each additional tree. The marginal cost to plant each tree is $100.
Trees MB (Anna) MB (Bill) MB (Carrie) MSB MC
0 -- -- -- -- --
1 180 150 120 450 100
2 120 80 80 280 100
3 70 50 50 170 100
4 60 40 30 130 100
5 20 20 10 50 100
The efficient number of trees to plant is 4. This is the last tree for which the marginal benefit to society exceeds the marginal cost of planting the tree.
But what if the trees are planted and paid for privately by residents?
• Any of the residents would be willing to plant the first tree. The first tree costs only $100 to plant, but gives all of the residents more than $100 benefit on their own. We don’t know who will pay for the first tree. But, if it were not planted, any of the neighbors would be willing on their own to pay to plant it.
• Anna will plant the second tree. Her $120 marginal benefit from the second tree is alone enough to justify planting it.
• The third and fourth trees will not be planted privately. Although the residents together get enough benefit to justify the $100 cost, nobody individually gets enough benefit to pony up the money. And if they try to get together to do it, they’re going to run into a free-rider problem. Each resident would rather just let the other people pay.
Here we can clearly see the market failure. It is efficient to plant the third and fourth trees.
Collectively, the residents get enough benefit to justify paying for them. But individually, no resident gets enough benefit to pay for them on his or her own. So it is efficient to plant four trees, but the private market will only result in two trees planted.
Government Provision of Public Goods
Suppose that 20,000 residents of a town are each willing to pay $10 to see a fireworks show, and that it costs $100,000 to put on the show. It’s clearly efficient for the show to run since the marginal social benefit to the community of running the show is $200,000 but it costs only $100,000 to put the show on.
Of course, the show would likely not be provided privately. A private company has no way to compel people to pay, and there would almost certainly be a free-rider problem.
The solution seems so obvious. If the government just charges everyone a $5 tax, then they can raise the $100,000 for the fireworks show. This is a Pareto improvement, benefitting everyone in the community, because everyone ends up paying $5 for a fireworks show that they were actually willing to pay $10 for. A surplus for everyone in town! The reason that the government can do what a private company can’t is because the government can compel payment for public goods through taxes, and thus the government is in a unique position to eliminate the free-rider problem. A private company can’t do that. This is exactly why the government provides an army and roads, rather than just leaving everyone on his own to decide how much to contribute. The government can eliminate the free-rider problem by imposing taxes.
This is a nice solution in principle, but there are two big problems. First, it’s really difficult for the government to measure how much a public good is worth to people. In practice, the government won’t know the efficient number of trees to plant or the efficient number of roads to build. This leaves the door open to the possibility that the government could end up providing things that cost more than what they’re worth to people.
9.4: Externalities
We have now dealt with three situations in which private markets fail to generate an efficient outcome: market power, information asymmetries and public goods. In this section, we deal with the final source of market failure.
The basic result that the free market is efficient relies on the idea that voluntary transactions between two parties must improve efficiency. After all, a transaction has to make both parties better off in order for them both to agree to it. But what if the activity imposes costs on a third party? In that case, it is possible that an activity might be privately beneficial, but the harm caused to outside parties makes the activity inefficient from the perspective of society.
Externalities Defined
An externality occurs when an activity generates costs or benefits for people who are not involved in the transaction. The key is that externalities don’t go through the price system and are not reflected in market prices. The fact that something has a negative impact doesn’t make it an externality as long as these negative impacts go through the market. Let’s give a few examples.
• More people move to West Chester and rents rise for existing residents – This is not an externality. Although the high rents do have a negative effect on existing residents of West Chester, these residents are themselves involved in the market.
• John manufactures paper and sells it to Mary. Smoke from John’s factory irritates Mary – This is not an externality either since Mary is involved in the transaction. If the smoke is bad enough, she could just stop buying paper from John.
• John manufactures paper and sells it to Mary. Smoke from John’s factory irritates Sarah – Now we have an externality. A private transaction between John and Mary impacts a third party, Sarah, who has nothing to do with the transaction.
Negative Externalities
A negative externality exists when an activity imposes costs on someone who is not involved in the transaction.
The marginal private cost (MPC) of an activity is the cost to the producer of one additional unit. This includes things like labor costs, the costs of materials, etc… The marginal social cost (MSC) of an activity is the cost to society of one additional unit. The relationship is as follows.
𝑀𝑀𝑀𝑀𝑀𝑀 = 𝑀𝑀𝑀𝑀𝑀𝑀 + 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
If there are no externalities, then social cost and private cost are equal. For example, the cost to society when a farmer grows an apple is equal to the cost to the farmer of growing the apple. The farmer pays for the seed and the labor and the fertilizer, and there are no outside costs imposed on anyone else. The cost to society is just the cost to the farmer, and nothing else.
On the other hand, what about paper production? Producing paper is very dirty and generates lots of pollution, causing medical problems, making people repaint their houses, etc… In this case, the private costs of producing paper are the materials and labor that the producer pays for. But the external costs of producing paper are the costs of the pollution, which are not paid by the manufacturer but are imposed on other people. A negative externality means that marginal social cost exceeds marginal private cost.
Specifically, suppose that producing a ton of paper costs the producer $1000 (labor, materials, etc…) but that the pollution costs residents of the adjacent town $500 (medical problems, damage to environment, etc…). While the private cost of producing a ton of paper is $1000, the social cost is $1500 – which includes the $1000 cost to producer and the $500 external cost. In other words, producing another ton of paper costs society $1500.
The problem is that, when making his decision, the manufacturer is only going to consider his own private cost. The $500 in pollution costs imposed on other residents of the town isn’t really his problem since he doesn’t have to pay for it. In other words, when the manufacturer makes a decision about how much paper to produce, he’s only thinking about the $1000 that he has to pay, instead of the full $1500, which is the true cost to society. This leads him to make inefficient decisions since he’s not really thinking about the cost properly. This disparity is the essence of the market failure associated with externalities.
Tons Total Benefit MB Total Cost
(to producers) MPC
0 0 -- 0 --
1 115 115 10 10
2 210 95 30 20
3 285 75 60 30
4 340 55 100 40
5 375 35 150 50
In a free market, the firm will produce 4 tons of steel – the last unit of production for which the marginal benefit exceeds the marginal cost of producing the steel.
Now, suppose that each ton of steel produced also imposes a $60 external cost on the residents of the town because of the pollution it generates. This means that the marginal social cost associated with each unit of steel production is $60 higher than the marginal private cost. To reiterate, the marginal social cost of an activity includes both the private cost to the producer and the external costs.
The table below shows both the marginal private costs and the marginal social costs associated with steel production. The marginal benefit and marginal private cost are taken from the table above. The marginal social cost is $60 higher than the marginal private cost to reflect the pollution.
Tons MB MPC MSC
0 0 -- --
1 115 10 70
2 95 20 80
3 75 30 90
4 55 40 100
The efficient level of pollution is only 2 tons. This is the last unit of production for which marginal benefit exceeds marginal social cost. An efficient decision balances benefits against costs to all
society, not just private costs to the producer.
To summarize, in a private market the steel firm will produce 4 tons of steel. But the efficient level of production is only 2 tons. This is a market failure. The free market outcome is not efficient.
To see what is going on here, think about the third ton of steel. The additional benefits associated with producing the third ton of steel are $75. The cost to society of producing the third ton of steel is $90. So from a social perspective, it is not efficient to produce the third ton of steel – society loses since the costs are greater than the benefits.
However, in a private market, the manufacturer will produce the third ton. He compares the marginal benefit of $75 with the marginal private cost of $30. The producer doesn’t care that the social cost is $90. He’s just comparing the marginal benefit against his own marginal cost of $30. The other $60 cost is externalized. So the producer, acting in a free market, will produce the third and fourth tons since the marginal benefit is greater than his own marginal private cost.
This is exactly the problem with an externality. Firms overproduce in markets where there are negative externalities because part of the costs are externalized onto other parties. The firm does not take account of the full cost when making its decisions. It only thinks about its own costs, not about the social cost, so it overproduces in a free market.
Markets with Negative Externalities
The marginal private cost reflects the cost to the producer associated with producing each unit of output. The marginal social cost is higher than the marginal private cost, to reflect the negative externality.
In the private market outcome, the producer will produce up to the point where the marginal benefit equals the marginal private cost. The producer in a free market only takes into account his own costs.
But the efficient level of output is where marginal benefit is equal to marginal social cost. A private producer will produce past this efficient point because the benefit is greater than his own cost. But, once we take the externality into account, these units are not efficient to produce because the marginal benefits are lower than the marginal social costs.
One way to see this point is by looking at the market outcome. The marginal benefit curve is the demand curve (what consumers are willing to pay), whereas the supply curve reflects the producer’s private costs. The free market output and price equates marginal benefit with marginal private cost. The corresponding market equilibrium price reflects only the producer’s private cost of producing the output. It does not reflect the social cost of producing output. The efficient price is higher, and corresponds to the point where marginal benefit equals marginal social cost.
The deadweight loss resulting from this market failure is shown in the diagram below. It reflects the surplus loss (social cost higher than benefits) for all the units that are inefficient to produce but are produced anyway in a private market.
problem is that the price you pay for gasoline reflects only the producer’s costs of selling gasoline to you. The price does not reflect all of the other social costs associated with driving. When you decide how much gasoline to buy and use, you are really only taking into account the private cost of producing gasoline, not the full cost of your driving to society. Thus, you drive too much.
Note that we are not saying that all driving is inefficient just because there is a negative externality. Using the diagram above, there is still some driving that is efficient. But the amount that you drive in a free market is too high relative to the efficient level.
Government Solutions to Externality Problems
The conventional solution to discourage overproduction in markets with negative externalities is to charge the producer a tax. A tax to discourage overproduction of a good that creates a negative externality has a special interpretation. In the numerical example above, the problem was that there was a $60 external cost imposed on society each time the firm produced a ton of steel. The obvious solution, then, is to charge the firm a $60 tax for each ton of steel it produces. Now the firm’s cost of producing steel is its marginal private cost plus the $60 tax it is forced to pay.
Tons MB MPC MPC + tax MSC
0 0 -- -- --
1 115 10 70 70
2 95 20 80 80
3 75 30 90 90
4 55 40 100 100
5 35 50 110 110
Given the tax, the firm will on its own choose to produce 2 units (the last unit for which the MB is greater than the MPC with the tax), which is the efficient outcome. This kind of scheme is called a Pigouvian Tax – a production tax equal to the externality, which is designed to raise the firm’s marginal private cost up to the level of marginal social cost.
An even more elegant solution that has attracted a lot of attention lately is tradable pollution permits. Briefly, the idea is that the government issues licenses that give firms the ability to pollute, but firms can buy and sell these licenses between themselves. The basic efficiency improvement is that, if Firm A can reduce its pollution cheaply, but it would be expensive for Firm B to reduce its pollution, then Firm A will sell its permits to Firm B. By allowing these trades, society attains the same level of pollution reduction, but at lower cost because the reduction is done by firms that can do it cheaply.
Market Solutions to Externality Problems
Regulatory solutions to externality issues look nice on the chalkboard, but they can be difficult to implement in practice. For example, measuring the true social cost of externality-generating activities is practically impossible. Think about driving. We know that the social cost is higher than the private cost – pollution, risk of accidents, congestion, etc… but actually measuring it in practice would be almost impossible. Thus, when they can work, private, market-based solutions to externality problems are preferable.
According to the Coase Theorem, private negotiation will lead to an efficient solution to externality problems under the following conditions.
• Property rights are clearly assigned (doesn’t matter to whom they are assigned). • Parties can negotiate with each other costlessly.
• Transfer payments can be arranged.
To understand the power of the Coase Theorem, let us start with a simple example. A candymaker and a doctor have offices in the same building. The problem is that, to make candy, the candymaker runs a loud machine which harms the doctor’s business. Running this machine increases the candymaker’s profit by $500, but it reduces the doctor’s profit by $800.
Prior to Coase, economists would have just said that the problem is created by the candymaker and he should be forced to stop running the machine. Coase said that it’s not this simple. If the doctor forces the candymaker to stop running the machine, then in a sense the doctor is creating a problem for the candymaker. Externalities are always bilateral problems, and we have to think about both sides. A neighbor’s dog barking might irritate you, but then again your neighbor probably loves his dog, and getting rid of the dog would create a cost for him.
running the machine (extra profit for the candymaker). What the Coase Theorem says is that this efficient outcome will be reached by private negotiations. The amazing thing is that the parties will reach this efficient outcome regardless of who has the property rights. In other words, whether the law gives the doctor the legal right to stop the machine, or whether the law gives the candymaker the legal right to operate his machine, negotiation will lead the parties to the efficient solution on their own. Let’s see how it works.
• If the candymaker has the property rights (i.e. he can run his machine if he wants to), then the doctor will pay the candymaker not to run the machine. They can agree on any price between $500 and $800 depending on who is the better negotiator. For example, if the doctor pays the candymaker $650 not to run the machine, this is a good deal for both of them. The candymaker more than makes up his lost profit. And the doctor is better off paying the candymaker $650 to stop running the machine, since he would lose $800 if the candymaker runs the machine. The ultimate outcome is that the machine isn’t run.
• If the doctor has the property rights (i.e. under the law he can order the candymaker to stop running the machine), then he will simply order the candymaker to stop running his machine and that will be the end of it. The candymaker might think about paying the doctor to allow him to run the machine, but the most the candymaker would pay is $500. Of course, the doctor would need to be paid $800 to agree. Thus, the ultimate outcome is that the machine isn’t run.
This is the Coase Theorem. It actually doesn’t matter who has the property rights. The outcome is efficient regardless. The only difference is who pays. In the first case, the doctor has to pay the candymaker to stop running the machine whereas in the second case the candymaker suffers the loss of his profits. But this has nothing to do with efficiency; it’s just a matter of a money transfer. The way in which property rights are assigned can affect the distribution of resources, but it does not affect the efficiency of the final outcome according to the Coase Theorem.
If we reverse the numbers, the conclusion would still hold. For example, suppose that the candymaker’s profit rises by $1000 when he can run the machine, but the doctor loses $800 in profit as a result. In this case, the efficient outcome is for the candymaker to run the machine, since the benefits exceed the costs.
• If the candymaker has the property rights, he will run his machine and that will be the end of it. The doctor isn’t willing to pay enough to make him agree to stop.
Again, the efficient outcome – which is that the candymaker ends up running the machine – is reached either way. The difference is just a distributional one dealing with who pays.
The Coase Theorem is beautiful, in principle. The only thing that the law needs to do is assign property rights clearly and make it easy for people to bargain and work out their own problems. No additional information or government action is needed for externality problems to be resolved in an efficient way.
But is this really reasonable in practice? Probably not all the time. There are several barriers to these kinds of negotiations that could keep the Coase Theorem from producing efficient outcomes, like it is supposed to in principle. Here are some of the problems.
• In practice, negotiation might be difficult and costly. Often, these kinds of negotiations involve legal fees and a lot of time wasted. This means that, even if there is an efficient solution that can be reached by negotiation, the costs of negotiation might make it impossible for the solution to be reached. This is particularly true for negotiations involving large numbers of people. Two neighbors might be able to work out a problem involving a dog barking. But it is unlikely that a million residents of a city suffering from pollution can engage in smooth, simple negotiations with a factory about how to solve the problem. Or that everyone who has to breathe second-hand smoke will be able to make a deal with everyone who smokes about how the problem should be solved.
• Property rights may be difficult to assign. Negotiations over clean air or clean water are really difficult because these are nonexcludable public goods. It’s not like I can pay someone to keep pollution out of my own private parcel of air. Air is free-flowing, so we don’t know who is polluting what air and who is breathing which pollution. This makes it difficult to settle property rights questions.
• People often try to negotiate strategically. Using the example above, the candymaker might try to hold out for an unreasonably large sum, which would cause negotiations with the doctor to fall apart.
protector. If the judge rules for the railroad company, then they do nothing and the farmers will move the crops back on their own. If the judge rules for the farmers, then the railroad can pay them to move the crops back rather than installing the expensive spark protectors. The outcome is the same either way. The only difference is who pays. That’s the Coase Theorem at work.
Positive Externalities
A negative externality occurs when an activity creates costs for third parties who are not involved in the transaction. By contrast, a positive externality occurs when an activity creates benefits for third parties who are not involved in the transaction.
Specifically, the marginal private benefit (MPB) of an activity is the benefit of one more unit of the activity to the individual. The marginal social benefit (MSB) of an activity is the benefit of one more unit of the activity to society. We can calculate the marginal social benefit of an activity as follows.
𝑀𝑀𝑀𝑀𝑀𝑀 = 𝑀𝑀𝑀𝑀𝑀𝑀 + 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
For an activity with no positive externality, social benefit and private benefit are equal. For example, when you eat one more apple, the marginal benefit to society is just the marginal private benefit to you since nobody else cares if you eat an apple or not. But for planting pretty flowers in front of your house, the marginal social benefit is greater than the marginal private benefit. You get some private benefit from looking at the flowers, but your neighbors also get some benefit. The social benefit includes your benefit, plus the external benefit to your neighbors.
We can see from a diagram the effect on the market. The marginal social benefit is higher than the marginal private benefit, to reflect the externality.
efficient level of output takes into account all of the benefits of the activity – not just the private benefit – so the efficient level of activity occurs where marginal social benefit is equal to marginal cost.
While activities that involve negative externalities are oversupplied in a private market, activities that involve positive externalities are undersupplied in private markets. Basically, when activities generate positive side-effects, people making private decisions only weigh their own benefits against the costs. But if they also considered benefits to everyone else, then they would engage in higher levels of the activity.
For example, when you plant flowers in your garden, you only consider your own benefits and weigh them against the work and the cost of buying the materials. But if your neighbors really like the flowers, then it might be socially efficient for you to plant more flowers if you took the external benefits to your neighbors into account.
Two important examples of positive externalities are vaccination against diseases and education. When you get a flu shot, you get a benefit from the shot in the form of a reduced probability of getting sick. But other people in society also get a benefit when you get a flu shot because you are in turn less likely to pass the flu on to them. With respect to education, you earn a higher salary when you get a higher level of education, but all society benefits when kids are educated – more educated people are less likely to commit crimes, make better business partners and spouses, and are more likely to invent something to make our lives better.
What’s the government solution to address a market failure resulting from positive externalities? In the case of a negative externality, we can impose a tax that discourages overproduction. In the case of a positive externality, we can pay a subsidy to encourage additional production. This is exactly why it makes sense for the government to provide subsidized (or free) public education. Even though education is a private good, there are huge external benefits to society when kids are educated. Thus, it makes sense to subsidize education to encourage people to get more education even if parents or kids don’t think that the marginal private benefit is enough to justify the costs.
