Week 11 study guide
DepartmentEconomics for Management Studies
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Chapter 16 Market Failures and Government Intervention Notes
x the operative choice is not between an unhampered free-market economy and a fully centralized command economy; it is rather
the choice of which mix of markets and government intervention best suits people’s hopes and needs
16.1 Basic Functions of Government
x when the government’s monopoly of violence is secure and functions with effective restrictions against its arbitrary use, citizens
can safely carry on their ordinary economic and social activities
16.2 The Case for Free Markets
x this informal defence of free markets is based on three central arguments:
1. Free markets provide automatic coordination of the actions of decentralized decisions makers.
2. The pursuit of profits in free markets provides a stimulus to innovation and rising material living standards.
3. Free markets permit a decentralization of economic power.
16.3 Market Failures
x market failure (MF) : failure of the unregulated market system to achieve allocative efficiency
x MF describes situation in which free market, in absence of government intervention, fails to achieve allocative efficiency
x market power is inevitable in any modern market economy for at least two reasons: (1) in many industries economies of scale are
such that there is room for only a few firms to operate efficiently, each having some ability to influence market conditions and
(2) in most manufacturing and service industries, firms sell differentiated products and thus have some ability to set price
x externality : an effect on parties not directly involved in the production or use of a commodity; also called third-party effects
x private cost : the value of the best alternative use of resources used in production as valued by the producer
x social cost : the value of the best alternative use of resources used in production as valued by society
x discrepancies between private cost and social cost occur when there are externalities; the presence of externalities, even when all
markets are perfectly competitive, leads to allocatively inefficient outcomes
x with a 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 good
Non – Rivalrous and Non – Excludable Goods
x rivalrous : good/service is rivalrous if, when 1 person consumes 1 unit of it, there is 1 less unit available for others to consume
x excludable : a good or service is excludable if its owner can prevent others from consuming it
x private goods : goods or services that are both rivalrous and excludable
x goods that are both rivalrous and excludable—private goods—pose no particular problem for public policy
x common-property resource : a product that is rivalrous but not excludable
x goods that are rivalrous and non-excludable called common-property resources; tend to be overused by private firms/consumers
x to avoid inefficient exclusion, the government often provides non-rivalrous but excludable goods and services
x public goods : goods or services that can simultaneously provide benefits to a large group of people; also called collective
x because of free-rider problem, private markets will not always provide public goods, which must be provided by government
x optimal quantity of public good is such that marginal cost of the goods equal the sum of all users’ marginal benefits of the good
x asymmetric information : a situation in which one party to a transaction has more or better relevant information about the
transaction than the other party
x moral hazard : a situation in which an individual or a firm takes advantage of special knowledge while engaging in socially
x adverse selection : self-selection, within a single risk category, of persons of above-average risk
1. Firms with market power will charge a price greater than marginal cost. The level of output in these cases is less than the
allocatively efficient level.
2. When there are externalities, social and private marginal costs are not equal. If there is a negative externality, output will be
greater than the allocatively efficient level. If there is positive externality, output will be less than the allocatively efficient level.
3. Common-property resources will be overused by private firms & consumers. Goods will be underprovided by private markets.
4. Situations in which there is asymmetric info—both moral hazard & adverse selection—can lead to allocative inefficiency.
16.4 Broader Social Goals
x even if there are no market failures, government may choose to intervene in markets to achieve broader social goals
x paternalism : intervention in the free choices of individuals by others (including governments) to protect them against what is
presumed to be their own ignorance or folly
A General Principle
x even if free markets generated allocatively efficient outcomes, they would be unlikely to generate outcomes consistent with most
people’s social goals; there is often a trade-off between achieving these social goals and increasing allocative efficiency
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