Chapter 4 · Microeconomics
Microeconomic Objectives and Market Failure
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Key Definitions
- Market failure
- The free market fails to allocate resources efficiently.
- Partial market failure
- Information failure, factor immobility, market dominance, or externalities causing over- or under-production.
- Complete market failure (missing market)
- Public goods that the market fails to provide entirely.
- Public goods
- Goods that are non-rivalrous, non-excludable and non-rejectable; the efficient price is zero.
- Asymmetric information
- One party has more information than another, causing moral hazard and adverse selection.
Core Concepts
Public goods
- Non-rivalrous: one person's consumption does not reduce another's.
- Non-excludable: it is impossible to exclude non-payers.
- Non-rejectable: consumers cannot easily refuse the good.
- Free-rider problem and concealed demand mean the market provides too little.
- The efficient price is zero, for example street lighting.
The negative externality framework (five steps)
- Demand is the marginal private benefit (MPB).
- Supply is the marginal private cost (MPC).
- The free-market output Qe is where MPB equals MPC.
- Marginal social cost (MSC) equals MPC plus marginal external cost (MEC).
- The socially optimal output Qs is where MSC equals MSB; Qe exceeds Qs, so there is overproduction and a deadweight loss triangle, commonly labelled CDE.
Information failure
- Consumers may under- or over-consume goods with imperfect information, creating deadweight loss.
Asymmetric information
- Moral hazard: one party behaves differently because they are insured, for example health insurance leading to overconsumption of healthcare.
- Adverse selection: the quality mix is distorted before a transaction, for example the used-car market or health insurance pools.
Factor immobility
- Occupational immobility: sunset versus sunrise industries, skills mismatch, for example analogue camera workers.
- Geographical immobility: relocation costs, cultural barriers and differences in living standards.
Inequity
- The rich have more dollar votes, so basic needs of lower-income groups can be underserved by the free market.
Diagram Notes
MPB is the demand curve and MPC is the supply curve; the market equilibrium Qe occurs where MPB equals MPC. MSC sits above MPC by the per-unit MEC. The social optimum Qs is where MSC equals MSB. Because Qe lies to the right of Qs there is overproduction, and the area between MSC and MPB over the interval Qs to Qe is the deadweight loss triangle.
A public good cannot be supplied by the market because it is non-excludable and non-rivalrous; the market demand curve is concealed and understated because of free-riding. At a positive price almost nobody buys, so the market outcome is far below the socially efficient quantity.
Real-World Examples
- An aluminium factory polluting the surrounding environment is a negative production externality.
- Health insurance creates moral hazard and overconsumption of medical care.
- The used-car market illustrates adverse selection from asymmetric information.
- Sunset industries (for example analogue cameras) versus sunrise industries show occupational factor immobility.