Ch6. Market Failure and Government Intervention — Externalities, Public Goods & Information Asymmetry

What Is Market Failure?

Market Failure:
  A situation in which the free market
  allocates resources inefficiently
  → Provides the economic rationale for
    government intervention

Types of Market Failure:
  ① Externalities
  ② Public Goods
  ③ Common Resources
  ④ Monopoly / Market Power
  ⑤ Information Asymmetry

Externalities

Externality: a cost or benefit imposed on a
  third party not involved in a market transaction

Positive Externality (External Benefit):
  Examples: education, vaccination, R&D spillovers
  Social benefit > Private benefit
  Market outcome: under-provision
  Government remedy: subsidies, mandates
    (e.g., Pell Grants, vaccine programs)

Negative Externality (External Cost):
  Examples: factory pollution, second-hand smoke
  Social cost > Private cost
  Market outcome: over-provision
  Government remedy: Pigouvian tax,
    cap-and-trade (e.g., EPA carbon markets),
    command-and-control regulation

Coase Theorem:
  If property rights are clearly defined and
  transaction costs are zero, private bargaining
  can internalize externalities without government
  Limitation: zero transaction costs rarely exist
    in the real world

Public Goods

Public Good Properties:
  ① Non-excludable: cannot prevent non-payers
    from consuming the good
  ② Non-rival: one person's consumption does not
    reduce availability for others

Free-Rider Problem:
  Non-excludability → people consume without paying
  → Private market under-supplies or won't supply
  → Government provides (national defense, public
    parks, basic research, broadcast TV)

Goods Classification:
  ┌─────────────────┬──────────────┬───────────────┐
  │                 │  Excludable  │Non-excludable │
  ├─────────────────┼──────────────┼───────────────┤
  │ Rival           │ Private good │ Common        │
  │                 │ (pizza)      │ resource      │
  │                 │              │ (fish stock)  │
  ├─────────────────┼──────────────┼───────────────┤
  │ Non-rival       │ Club good    │ Public good   │
  │                 │ (Netflix)    │ (nat'l defense)│
  └─────────────────┴──────────────┴───────────────┘

Common Resources and the Tragedy of the Commons

Common Resource:
  Non-excludable + Rival
  Examples: ocean fisheries, groundwater,
    clean air, public grazing land

Tragedy of the Commons (Hardin, 1968):
  Each individual over-uses the common resource
  pursuing self-interest → resource depleted
  below the social optimum
  Real examples: Atlantic cod collapse,
    overfishing in international waters

Solutions:
  Privatization (assign property rights)
  Government regulation (fishing quotas, permits)
  Community management (Ostrom's self-governance)

Information Asymmetry

Adverse Selection (Pre-contractual):
  One party has hidden information before
  the contract is signed
  Classic example: used-car market (Akerlof, 1970)
    Sellers know quality; buyers don't
    → buyers offer average price → good cars
      withdrawn → only "lemons" remain
  Solutions: warranties, certified pre-owned
    programs, Carfax/vehicle history reports

Moral Hazard (Post-contractual):
  After a contract is signed, one party takes
  hidden actions that increase risk
  Example: after buying health insurance,
    person reduces healthy behaviors
  Solutions: deductibles, co-payments,
    performance-based incentives

Principal–Agent Problem:
  Shareholders (principal) vs. management (agent)
  Agent may pursue self-interest over
    shareholder value
  Solutions: stock options, independent boards,
    executive compensation clawbacks

Externality Direction ★★★★★ : Positive externality → under-production → subsidize. Negative externality → over-production → tax or regulate. Memory hook: positive = too little → pay to get more; negative = too much → tax to reduce

Two Properties of a Public Good ★★★★★ : Non-excludable + Non-rival → free-rider problem → market under-supplies → government steps in. Memory hook: public good = non-excludable + non-rival

Adverse Selection vs. Moral Hazard ★★★★★ : Adverse selection = hidden information BEFORE the contract. Moral hazard = hidden action AFTER the contract. Memory hook: adverse selection = pre-contract; moral hazard = post-contract

Practice Questions

Q. How is the Pigouvian tax on factory pollution determined?

The tax is set equal to the marginal external cost (MEC) at the socially optimal output level — the gap between the social marginal cost (SMC) and the private marginal cost (PMC). This forces the firm to internalize the externality, shifting output from the market equilibrium to the socially efficient quantity.

Q. What mechanisms can reduce adverse selection in the used-car market?

① Dealer/manufacturer warranties that signal quality ② Certified pre-owned (CPO) programs with independent inspections ③ Vehicle history reports (Carfax, AutoCheck) that disclose accident and maintenance records — all of these reduce the information gap between buyer and seller, bringing the market closer to efficiency.