Chapter 16 – Market Failures and Government Intervention
The operative choice is not between an unhampered free-market economy and a full
centralized command economy. It is rather the choice of which mix of markets and
government intervention best suits people’s hopes and dreams
When the government’s monopoly of violence is secure and functions with effective
restrictions against its arbitrary use, citizens can safely carry out their ordinary economic
and social activities.
Informal defence of free markets is based on three central arguments
o Free markets provide automatic coordination of the actions of decentralized
o The pursuit of profits in free markets provides a stimulus to innovation and rising
material lining standards
o Free markets permit a decentralization of economic power
Market failure: describes a situation in which the free market, in the absence of
government intervention, fails to achieve allocative efficiency
Externality: an effect on parties not directly involved in the production or use of a
commodity. Also called third-party effects.
Private cost the value of the best alternative use of resource used in production as
valued by the producer
Social cost: the value of the best alternative use of resources used in production as
valued by society
Discrepancies between private cost and social cost occur when there are externalities.
The presence of eternities, even when all markets are perfectly competitive, leads to
allocative inefficient outcomes.
With positive externality, a competitive free market will produce too little of the good.
With a negative externality a competitive free market will produce too much of the
See figure 16-1 pg. 391 for diagram
Rivalrous: a good or service is Rivalrous if, when one person consumes one unit of it,
there is one less unit available for others to consume.
Excludable: a good or service is excludable if its owner can prevent others from
Goods that are both rivalrous and excludable - private goods - pose no particular
problem for public policy.
Goods that are rivalrous and non-excludable are called common-property resources.
They tend to be overused by private firms and consumers. To avoid inefficient exclusions, the government often provides for free non-rivalrous but
excludable goods and services.
Because of the free-rider problem, private markets will not always provide public goods.
In such situations, public good must be provided by government.
The optimal quantity of a public good is such that the marginal cost of the good equals
the sum of all users’ marginal benefits of the good.
o Figure 16-2 pg.396
Private Goods Common-Property Resources
Rivalrous A seat on an airplane Rivers and streams
An hour of legal advice Wildlife
Non-Rivalrous Public Goods
(up to capacity)
Art galleries National defence
Roads Public information
Bridges Public production
Cable or satellite TV signal Regular TV signal
Asymmetric information: a situation in which one party to a transaction has more or
better relevant information about the transaction than the other party
Moral Hazard: a situation in which an individual or a firm takes advantage of special
knowledge while engaging in socially inefficient behavior.
Adverse selection: self-selection, within a single risk category, of persons of above-
Summary of market failures; the following four situations result in market failures and,
at least in principle, provide a rationale for government interventions.
o Firms with market power will charge a price greater than marginal cost. The level
of output in these cases is less than the allocative efficient level.
o When there are externalities, social and private marginal costs are not equal. If
there is a negative externality, output will be greater than the allocative efficient
level. If there is a positive externality, output will be less than the allocative
efficient level. o Common-property resources will be overused by priva