Market Efficiencies and Failures II Flashcards
(23 cards)
What are 4 main reasons markets can fail to achieve Pareto efficiency?
Imperfect Competition – e.g. monopolies reduce output to raise prices.
Public Goods – goods that are non-rival and non-excludable (like streetlights).
Externalities – side effects on others not reflected in prices (e.g. pollution).
Informational Market Failure – when one party has more or better info (e.g. used car sales).
Mkt. failure type 1: Imperfect competition
Market structures where the assumptions of perfect competition break down. Key features include:
Sellers or buyers have control over prices (market power)
Barriers to entry or exit exist
Leads to too little production and prices that are too high
This causes a loss of efficiency compared to perfectly competitive markets.
Types of Imperfect Competition
Monopoly: markets with a single seller.
Cartels: multiple sellers who collude on price.
Oligopoly: a small number of sellers compete, recognizing they are large enough to affect the price.
Monopolistic competition: a large number of sellers
of differentiated varieties of the same product. Entry/exit costs are low. Each firm has a
‘mini-monopoly’ on its style, flavour or brand.
Monopsony: markets where there is a single buyer.
Natural Monopoly
Happens when one firm can supply the entire market more cheaply than two or more firms could. This is usually because of:
High fixed costs (e.g., building power lines, pipelines, or railroads)
Low marginal costs (it’s cheap to serve one more customer once the infrastructure exists)
Rare case where one seller is better for efficiency — but it still needs regulation or public ownership to prevent abuse.
2 Policy Responses to Natural Monopoly
There are two policy responses to natural monopoly:
Public corporation (e.g. BC Hydro) or regulation (e.g. Fortis)
Monopsony
Opposite of a monopoly:
Instead of one seller dominating the market, there’s one buyer (or a very dominant one).
This buyer has market power — it can influence prices downward because sellers compete to get their business.
Key Feature: Unlike monopolies (which raise prices), monopsonies lower prices — especially wages in labor markets.
Examples of Monopsony:
Rural labor market:
A small town with only one major employer (like a mine or sawmill).
Workers have few or no alternatives, so the employer can offer lower wages.
Policy Responses to Monopsony Power:
Minimum wage laws – Set a legal wage floor.
Unions – Workers band together to bargain collectively.
Fair Trade programs – Ensure producers (e.g. coffee farmers) get a fair price, even if buyers are powerful.
Market failure type 2: Public goods
A public good is non-rival and non-excludable, meaning everyone can benefit without reducing others’ enjoyment, and you can’t easily stop anyone from using it.
non-rival
Means many people can use the good at the same time without interfering with each other’s enjoyment.
non-excludable
Non-excludable means you can’t easily prevent people from accessing or benefiting from the good.
4 types of goods
- Public Goods
- Private Goods
- Club Goods
- Common Goods
Policy Response for types of goods
Private & Club goods: Mostly left to the market
Public goods: Often provided or funded by the government
Common goods: Need regulation or collective management to avoid overuse
Market failure type 3: Externalities
An externality is a side effect of an activity that affects people not directly involved in the transaction — these are called third parties.
Negative Externality
If the side effect is harmful
Air pollution from a factory → affects nearby residents’ health
Noise from airports → lowers neighborhood quality of life
Traffic congestion → your driving slows everyone else down
Positive Externalities
If it’s beneficial, it’s a positive externality.
Vaccination → protects others by reducing disease spread
Beekeeping → bees pollinate nearby crops
Education → creates a more informed and productive society
Mkt. failure type 4: Imperfect Information
Imperfect information leads to bad decisions, lost trust, and inefficient markets.
Especially dangerous when information is asymmetric, causing good products or low-risk buyers to disappear from the market.
Adversion Selection
Adverse selection is a type of market failure that happens when there is asymmetric information — one party (usually the buyer) knows more about their own “type” (e.g. risk level, quality, or intent) than the other.
It occurs before a contract or transaction is made, and the less-informed party (often the seller or insurer) can’t accurately screen or identify who they’re dealing with.
Continuation Value
he value of staying in the game (i.e. making future sales) is called the continuation value.
If the continuation value is high, it’s worth telling the truth to keep your reputation.
Why Reputation Matters
Reputation helps overcome asymmetric information.
If buyers trust a seller’s past record, they’re more willing to pay full value — even when quality is hard to see.
That leads to more honest behavior and more efficient markets.
Moral Hazard
Moral hazard is when people act less carefully or take more risks because they’re shielded from the consequences — like being insured, or expecting a bailout.
Moral Hazard Examples
Car safety (Peltzman Effect): Drivers may drive less carefully in safer cars, assuming airbags or seatbelts will protect them.
Distinction between Moral Hazard and Adverse Selection
Adverse Selection = Happens before the contract (the wrong people enter the deal).
Moral Hazard = Happens after the contract (behavior gets riskier after protection is in place)
