Question Description
Construct a table like the one in Figure 12.13 to analyse the possible market failures associated with the decisions below. In each case, can you identify which markets or contracts are missing or incomplete? You use money that you borrow from the bank to invest in a highly risky project. A city airport increases its number of passenger flights by allowing nighttime departures. You contribute to a Wikipedia page. A government invests in research in nuclear fusion.
| Decision | How it affects others | Cost or benefit | Market failure (misallocation of resources) | Possible remedies | Terms applied to this type of market failure |
|---|---|---|---|---|---|
| A firm uses a pesticide that runs off into waterways | Downstream damage | Private benefit, external cost | Overuse of pesticide and overproduction of the crop for which it is used | Taxes, quotas, bans, bargaining, common ownership of all affected assets | Negative external effect, environmental spillover |
| You take an international flight | Increase in global carbon emissions | Private benefit, external cost | Overuse of air travel | Taxes, quotas | Public bad, negative external effect |
| You travel to work by car | Congestion for other road users | Private cost, external cost | Overuse of cars | Tolls, quotas, subsidized public transport | Common-pool resource, negative external effect |
| A firm invests in R&D | Other firms can exploit the innovation | Private cost, external benefit | Too little R&D | Publicly funded research, subsidies for R&D, patents | Public good, positive external effect |
| An employee on a fixed wage decides how hard to work | Hard work raises employer’s profits | Private cost, external benefit | Too little effort; wage above reservation wage; unemployment | More effective monitoring, performance-related pay, reduced conflict of interest between employer and employee | Incomplete labour contract, hidden action, moral hazard |
| Someone who knows he has a serious health problem buys insurance | Loss for insurance company | Private benefit, external cost | Too little insurance offered; insurance premiums too high | Mandatory purchase of health insurance, public provision, mandatory health information sharing | Missing markets, adverse selection |
| Someone who has purchased car insurance decides how carefully to drive | Prudent driving contributes to insurance company’s profits | Private cost, external benefit | Too little insurance offered; insurance premiums too high | Installing driver monitoring devices | Missing markets, moral hazard |
| Borrower devotes insufficient prudence or effort to the project in which the loan is invested | Project more likely to fail, resulting in non-repayment of loan | Private benefit, external cost | Excessive risk; too few loans issued to poor borrowers | Redistribute wealth; common responsibility for repayment of loans (Grameen Bank) | Moral hazard, credit market exclusion |
| Bank that is ‘too big to fail’ makes risky loans | Taxpayers bear costs if bank fails | Private benefit, external cost | Excessively risky lending | Regulation of banking practices | Moral hazard |
| A monopoly, a firm producing a differentiated good, or a firm with declining AC sets P > MC (Unit 7) | Price is too high for some potential buyers | Private benefit, external cost | Too low a quantity sold | Competition policy, public ownership of natural monopolies | Imperfect competition, decreasing average costs, natural monopoly |
Figure 12.13 Market failures with remedies.
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