Sources of Market Failure

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Sources of Market Failure
Session 3
MT214 Technology, Business, and Public
Policy Vanderbilt University School of
Engineering
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The Perfectly Efficient Market(a theoretical
ideal)

• Many buyers and sellers
• No buyer or seller is a price maker
• Products are interchangeable
• No transaction costs
• No entry or exit costs
• Perfect, universal knowledge among buyers and
  sellers

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Departures fromPerfectly Efficient Markets

• Deviation from Economic Ideal
• Deviation from Social Ideals

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Deviation from Economic Ideal

• Insufficient Competition (too few competitors)
• Information Deficiencies
• Externalities (negative and positive)
• Public Goods
• High Entry Barriers
• Mobility Barriers

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Insufficient Competition

• Ideal
• Many competitors
• Free entry and exit (perfect mobility)
• Deviations
• Monopolies
• Oligopolies
• Examples?
• Local utilities
• Microsoft
• Air carriers (?)

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Insufficient Competition (ctd)

• Causes
• Tight patent protection
• Natural monopolies
• Presence of scale economies
• Increasing returns markets
• Results
• Overpricing
• Mediocre products and service
• Fewer choices for consumers
• Reduced incentives for efficiency, innovation

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Information Deficiencies

• Ideal
• All parties have complete perfect knowledge
• Deviation
• One party has more relevant information
  (information asymmetries)
• Nobody has sufficient information
• Examples
• Information asymmetries
• Used cars
• Information deficiencies
• Many high-tech products
• Prescription drugs mechanism of action unclear

Back to Deviations from Economic Ideal
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Information Deficiencies (ctd)

• Causes?
• Inexperienced buyers
• New or poorly understood products
• Lack of full disclosure
• Results
• Suboptimal decisions
• Less profit (often for both parties)

Back to Deviations from Economic Ideal
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Externalities

• Ideal
• Price paid by buyer covers all product costs
• Producer reaps all social rewards of product
• Deviations
• Negative externalities
• Positive externalities

Back to Deviations from Economic Ideal
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Negative Externalities

• Costs that arent incurred by the parties (social
  costs)
• Examples
• Pollution
• Over-fishing
• Airport congestion
• Causes
• (Often) Scarce/finite (inelastic) resource
• Presence of prohibitive transaction costs
• (e.g., policing compliance, collecting fines)
• Results
• Overproduction
• Underpricing

Back to Deviations from Economic Ideal
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Positive Externalities

• Rewards that the producer doesnt fully reap
• Examples
• Any productive activity that is taxed
• Scientific research (often)
• Digital content whose dissemination cant be
  controlled
• Causes
• High transaction costs
• Low enforceability of property rights
• Results
• Underproduction
• Reduced innovation

Back to Deviations from Economic Ideal
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Extreme Case of Positive Externalities Public
Goods

• Ideal
• Every consumer pays full cost of product
• Deviation
• Large class of users pays little to none of the
  cost
• Examples
• Pure Public Good defense, space exploration
• Quasi-Public Good education, libraries, social
  programs

Back to Deviations from Economic Ideal
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Public Goods (ctd)

• Causes
• Nonexcludability (free riders)
• Imperfect pricing mechanisms
• No mechanism to get consumer to pay for the
  benefit
• Result
• Private markets under-produce or dont produce

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High Entry Barriers

• Ideal
• No entry or exit costs
• Deviation
• Entry costs exclude all but the best-financed
  firms
• e.g., pharmaceuticals, car rental, long distance
  telecom (formerly!)
• Entry costs preclude entry entirely
• e.g., space program, nuclear power
• Causes
• Unacceptable or insurmountable entry scale, risk
  or time horizon
• Result
• Insufficient competition
• Private sector doesnt produce

Back to Deviations from Economic Ideal
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Mobility (entry/exit) Barriers

• Ideal
• No barriers to the mobility of products, ideas,
  labor, or capital
• Deviation
• Trade barriers (tariffs, quotas)
• Immigration restrictions (quotas)
• Currency/capital controls (e.g., foreign
  ownership caps)
• Causes
• Protectionism
• Historical traditions (e.g., separate European
  currencies)
• National security concerns (weapons, high-tech
  products)
• Result
• Higher costs, factor shortages, depressed
  economic activity

Back to Deviations from Economic Ideal
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Deviation from Social Ideals

• Recognition that even perfectly efficient markets
  dont produce certain benefits to which people
  are entitled
• Categories
• Morally objectionable exchanges
• Socially important goods
• Procedural fairness
• Distributive justice

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Morally objectionable exchanges

• Examples
• Victimless crimes
• Illicit drugs, prostitution
• Sale of body organs, babies
• Stem cell research (?)

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Socially important goods

• Goods that arent produced in sufficient quantity
  by the private sector
• Examples
• Telecommunications
• universal access
• Internet in every public school
• Medical care
• Access to prescription drugs by Medicare
  recipients

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Procedural Fairness

• Civil rights
• Equality of opportunity vs. pure meritocracy
• Quotas
• ADA, age discrimination laws, etc.
• Equity vs. Efficiency
• Procurement regulations favoring small businesses

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Distributive Justice

• Equality of Result
• Examples
• Executive compensation
• CEO vs. Assembly Worker
• U.S. 5001
• Europe 201
• Labor costs U.S. vs. Offshore
• (Who objects?)