The market does a good job of allocating almost everything we buy and sell: tortas, cell phones, clothing. But imagine a factory that pollutes the river in your community, or a lighthouse that lights the way for every ship without charging them. In those cases the price doesn't tell the whole story, and the outcome stops being efficient. These situations are called market failures, and they explain why the government steps in to intervene in the economy.
What a market failure is
There are four main types. Each has its own cause:
Failure
What happens
Example
Externalities
The activity affects third parties and the price doesn't reflect it
A factory pollutes the river
Public goods
No one can be excluded from using them, so no one wants to pay
The lighting on a street
Asymmetric information
One party knows more than the other
The seller of a used car knows about its hidden defects
Market power
A firm can influence the price
The only pharmacy in town
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Explain what a market failure is and name four of its main types with a one-sentence example of each.
Explain what a market failure is and name four of its main types with a one-sentence example of each.
Externalities: when the price doesn't tell the whole story
The private cost curve (green) is the one the firm sees; the market reaches equilibrium where it crosses demand (Q market). But society also pays for the harm, so the desirable outcome is where demand crosses the social cost (Q social), a smaller quantity. With a negative externality, the market produces too much.
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Distinguish between a negative externality and a positive externality, and classify these cases: smoke from a factory, childhood vaccination, a neighbor's loud music in…
Distinguish between a negative externality and a positive externality, and classify these cases: smoke from a factory, childhood vaccination, a neighbor's loud music in the early hours of the morning, and a botanical garden open to the local neighborhood.
The figure represents the market for a product whose manufacture pollutes: it shows the private cost to producers and the social cost, which also includes the…
The figure represents the market for a product whose manufacture pollutes: it shows the private cost to producers and the social cost, which also includes the environmental damage suffered by third parties.
a) Identify which curve is which and explain the difference between private cost and social cost.
b) Compare the quantity produced by the market with what would be socially desirable and explain the difference.
Correcting an externality: taxes, regulations, and negotiation
There are other ways to correct a negative externality:
Direct regulation or rule: the government sets a limit or bans the discharge (for example, Semarnat's rules on wastewater). It is clear and easy to check, but it applies to all firms equally, even though some can reduce their harm at a much lower cost than others.
Tax: lets each firm decide how much to cut back. Whoever can do it more cheaply cuts more, and the government also collects revenue, although it is hard to measure the exact harm.
Negotiation (Coase theorem): if property rights are clear, the factory and those affected could agree on compensation. In practice it almost never works with many affected people, because negotiating costs too much.
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A paint factory dumps waste into the river: fish die, local farmers lose crops and water treatment is paid for by the municipality. a) Analyze the externality: who…
A paint factory dumps waste into the river: fish die, local farmers lose crops and water treatment is paid for by the municipality.
a) Analyze the externality: who generates it, who suffers from it and why the market alone does not correct it.
b) Compare two solutions: a tax on discharges or a regulation directly banning them.
When the externality is positive, the market produces too little: the buyer pays only for their private benefit and doesn't count the benefit that society receives. The correction is the opposite one: a subsidy or public provision, to bring the quantity closer to the socially desirable one.
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A advocacy group argues in a public debate that childhood vaccination should no longer be free and should instead be funded entirely by users in the private market:…
A advocacy group argues in a public debate that childhood vaccination should no longer be free and should instead be funded entirely by users in the private market: “Each family knows its preferences and should pay the $\$80$ that the dose costs. If the market freely allocates vaccines according to supply and demand, the outcome will be optimal and we will save on taxes”. Epidemiologists warn that at this price, the coverage rate would fall from the current $96\ \%$ to $65\ \%$, whereas herd immunity to curb outbreaks requires at least $90\ \%$.
a) Refute the group's arguments using the concepts of marginal private cost, marginal social benefit, and free-rider behavior. Support your answer with conceptual graphical reasoning.
b) Predict the medium- and long-term economic consequences for the healthcare system and the country's productivity if this free-market proposal were to succeed.
c) Design and compare two avenues of public intervention to achieve a $95\ \%$ vaccination rate: one based on Pigouvian subsidies (free provision funded through general taxation) and another based on a restrictive legal rule (mandatory complete vaccination record to enroll in public and private schools). Assess the efficiency and equity of each.
Lighthouses and national defence are the classic examples of public goods. a) Explain the two characteristics that define a public good. b) Reason why a private firm…
Lighthouses and national defence are the classic examples of public goods.
a) Explain the two characteristics that define a public good.
b) Reason why a private firm would have difficulty selling these services: what does the 'free rider' problem consist of?
Asymmetric information: adverse selection and moral hazard
How does adverse selection happen in used cars? The buyer can't tell a good car from a "lemon" (one with defects), so they are willing to pay only an average price. At that price, the owners of good cars don't want to sell and withdraw, leaving mostly bad cars. The price falls and the quality offered falls with it.
Solutions (from the market or from the law): seller warranties, an inspection by a third-party mechanic, the car's history report, brands with a reputation, and rules like those of Profeco that require truthful information.
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In the second-hand car market, the seller knows whether their car has hidden faults and the buyer does not. a) Explain what this market failure is called and what…
In the second-hand car market, the seller knows whether their car has hidden faults and the buyer does not.
a) Explain what this market failure is called and what consequences it has on prices and the quality of goods offered.
b) Propose two solutions, market-based or legal, that help reduce it.
With market power, the firm produces less and charges more than under competition, and it may neglect quality because the customer has no alternative. The government has several tools to protect consumers:
Competition oversight: in Mexico, COFECE investigates and penalizes monopolies, collusion, and mergers that harm competition.
Price regulation: for example, a price ceiling for a service where there is no alternative.
Consumer protection: Profeco handles complaints and checks prices, quality, and information.
Licenses and openness: allowing new competitors to enter.
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There is only one pharmacy in a village. a) Which market failure does this situation illustrate, and what might happen to prices and the quality of service? b) What…
There is only one pharmacy in a village.
a) Which market failure does this situation illustrate, and what might happen to prices and the quality of service?
b) What instruments does the government have to protect residents? Name two and explain them.
Back to the beginning: the factory that pollutes the river and the lighthouse that no one pays for are market failures because the price doesn't capture the whole cost or benefit. That is why the government steps in with taxes, subsidies, regulations, or public provision.
Summary
Let's practice! 3 medium exercises in this section