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  {  \sc \ref{chap02}:  Market Failure}   \label{s02.0} \\
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{\it ``Government can easily exist without laws, but law cannot exist without government."  } (Bertrand Russell)
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{\small \hfill {\it January 18, 2020 }}\\


 

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\noindent
  {\bf 2.1  Introduction: Markets Work Well} \label{s02.1}

    Markets  work well. In competition with each other, businesses bid down prices to   cost (given
that we include normal profit--- the payment to capital in a competitive market--- as part of cost) and choose the quality that consumers want.  Each
firm's effort to maximize its own    producer surplus and each consumer's effort to maximize his own
consumer surplus leads to   total surplus being maximized,  as if an Invisible Hand \index{
Invisible Hand} pushed the price to just the right level,   where the producer's  marginal cost
equals the  consumer's marginal benefit. If the government uses regulation to impose a different
price or quantity, it can help some people, but only by hurting others more. Rent control\index{Rent
control} can help tenants, but only by costing landlords   more than the tenants gain.

 Our reasoning  for  why markets work   depends, however,  on   assumptions that  while roughly true
for most markets are perfectly true for none  and  sometimes collapse completely.    The
reasoning that producers would bid down prices in competition against each other, for example,
depends  on there being more than one producer. If  there is a  monopoly,  the price is not  bid
down   and the reasoning fails. The reasoning that consumers   buy from the firms that sell the most
cost-effective quality depends on consumers being able to judge quality accurately. If they can't,
high-quality producers will lose out to sleazy competitors.  These are two examples of {\bf market
failure}\index{market failure}: situations where the free market does not maximize surplus.

    Let us return to Chapter 1's single-transaction case as a running example.  Buyer  Brown is willing to
pay up to \$15 for a bottle of whisky and  seller Smith is willing to accept as little as \$8. Our
conclusion   was that the government should allow the transaction to take place  because it benefits
both buyer and seller.  In this chapter that story will be modified in a number of ways, even though
our focus  will remain on surplus maximization, rather than on more direct challenges to the
equilibrium's optimality such as that  Islam forbids   the drinking of alcohol as contrary to God's
will. Even if you accept surplus maximization, however, things can go wrong in the story of perfect
competition, generating  market failure and an opportunity for government action to   increase total
surplus.


\bigskip
%-------------------------------------------------------


\noindent
 {\bf 2.2:  Weak   Property   Rights and   Contract Enforcement }   \label{s02.2}

 A certain amount of government involvement is helpful, perhaps even necessary,  for even laissez
faire  market transactions to take place.  As Chapter 1 noted, if    the government is completely
hands-off,   Brown faces no police    if he steals the bottle of whisky from Smith instead of
paying. Laws against theft are a form of regulation and  a constraint on our liberty,   but   if
Brown can steal the bottle  easily   he will steal it even if his value is less than Smith's,  and
surplus will not be maximized.  Moreover, Smith   uses time, energy and
 resources   to prevent theft  and Brown   uses time, energy, and resources   to overcome that
prevention. Buying and selling create  transaction  costs too,  as do the  courts and police
necessary to suppress theft,  but not as high as theft. The government's police    are  a useful
supplement to Smith's private precautions against theft,  and the mere threat of punishment reduces
Brown's incentive to incur the effort  of stealing.  In practice we see a mix of ways property
rights are enforced, both  private  precautions---locks, alarms, and handguns-- and public
precautions---police, courts, and prisons.\\


    The government does more than provide police and courts: it literally
  ``defines property rights\index{property rights}.'' Not only do courts decide who owns property in
particular cases, but the law also provides standard terminology in the form of   legal definitions.
The definition   may be simple when it comes to bottles of whisky, but    definitions get more
intricate   when it comes to   ownership of corporations, wild animals,  and stolen goods.
 Even for simpler goods, standard definitions make life easier.
 The holder of  a   land title  that says    he owns it  ``in fee simple''\index{in fee simple}
can use the land for his entire life, leave it to heirs, or sell it in fee simple to someone else,
without having to worry about what kinds of rights he has over the land.    Rather than checking the
fine print on the  property deed, he  can rest assured that   he has bought the conventional package
of rights.\footnote{For an economics-oriented discussion of how the government limits the types of
property rights in land, see  Thomas W. Merrill .\index{Merrill}\& Henry E. Brown, \index{Brown}
``Optimal Standardization in the Law of Property: The
Numerus Clausus Principle,'' {\it  Yale Law Journal}  (2000).}

  Particularly important is that   property rules award   ownership to someone who creates something
new.  This is most obvious if someone creates a new physical good. If Smith  distills  whisky using
his own labor and supplies, the natural property rule is to give him ownership of that whisky.
Otherwise, he will not produce it.  The government does not have to give Smith the right to 100\% of
the whisky he produces to give him reasonable incentives, however,  and  very few governments do.
The usual rule is that Smith has the right to keep most  but not all  of what he produces, giving up
some of it  to the government as taxes.


   The property rule for another class of goods is that the producer owns them, but only
temporarily.  This class is {\bf intellectual property}\index{intellectual property}: patent and
copyright.  If someone comes up with a new idea, rather than a new physical object, the government
faces a quandary. If the person has complete and exclusive rights to his idea, he will overcharge
others to use it---the problem of market power that we will discuss later. But if he has fewer
rights, he has less incentive to come up with new ideas.
The compromise  is for the creator to  own  his creation    for  a limited period of  time.   A
patent gives the inventor  of an idea ownership for  20 years,   but after  that  anybody can use
it  for free. Copyright gives the writer of a book exclusive rights for his lifetime plus 70 years.



 \noindent
\begin{center}
\begin{boxedminipage}[l]{.9\linewidth}
\renewcommand{\baselinestretch}{1}

\begin{footnotesize}
\refstepcounter{sidebarcounter} \label{sidebar2.9}
\noindent
{\sc  Box 2.\ref{sidebar2.9}\\
 Self-Help in Property Rights}\\

\hspace*{16pt}``As thugs have been burning, beating, and stealing their way through London, citizens
of that disarmed society had little to defend themselves with as the police were completely
overwhelmed.

 
%\begin{center}
% \includegraphics[width=.7\linewidth]{fig02-koreatown.jpg}
%\end{center}
 

\hspace*{16pt}  Desperate Brits are resorting to shopping online for improvised weapons.  They are
buying Amazon.uk out of baseball bats, billy clubs, and folding shovels.   Yesterday, billy clubs
saw a 41,000\%+ increase in sales, until the item was pulled. Shipping times on their most popular
baseball bat (up over 36,000\%)   slipped to 4-6 weeks.   Today, a   folding shovel  is their new
Sports and Leisure top seller, with sales up 239,000\% in the past 24 hours! \ldots

\hspace*{16pt}During the Los Angeles riots  \ldots the police having been overwhelmed, the Korean
community banded together to defend their stores and lives against the rioters, even though it was
too late for many.  Using Korean-language radio, they called for security volunteers.''\footnote{ \href{http://legalinsurrection.com/2011/08/london-rioters-ran-rampant-over-disarmed-populace/}{
``London Rioters Ran Rampant over Disarmed Populace,''}  {\it Legal Insurrection} blog (2011)
.}

\end{footnotesize}

\end{boxedminipage}
\end{center}
\vspace{16pt}






Still other goods are {\bf common property}.\index{common property} This is different from {\bf
government property}.\index{government property} A parking place with a parking meter is government
property that it leases out to private people for specified amounts of time. A parking place without
a meter is common property. Anybody can use it, the rule being first-come-first-served.  That is
efficient, because in those locations, parking space is so abundant that it isn't worth the
transactions cost to make it into private or government property. If, however, demand increases
enough, it will become efficient to install parking meters and create property rights. This can even
happen if just one person's demand increases enough. In Covina, California  Mark Shoff kept five
unregistered cars in his  driveway plus  43  others   in the   surrounding streets. His neighbors didn't like the looks of that  (the
``externality''\index{externality} cause of market failure) or the loss of places to park. They sent
him notes and circulated a petition. The county responded by
  assigning ``street sweeping days'' to some of the surrounding streets, with ticketing of cars
parked over   72 hours. I don't know what happened, but my guess is that Mr. Shoff was   willing
to drive his cars to new parking spots a block away. After all, it's not good for a car  never to be
driven. But what regulation would  maximize
 surplus? This was an unusual case, and it did need government intervention, but perhaps the unique response was better than writing a new rule.\footnote{
``Resident's Car Collection Frustrates Covina Community:
Residents Say One Neighbor Owns Nearly 50 Cars that Are Parked Everywhere,''
{\it  KTLA News }  (2010).}




%\begin{wrapfigure}[10]{l}{.25\linewidth}
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 % {\sc Figure 2.\ref{fig02-01-covina-car.jpg} \\
 % Parking Spot Property} \\
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% \vspace*{-24pt}
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   Property rights need to be established before buying and selling take place, but the trading
process also needs laws.     Suppose Smith would like for Brown to pay today for a bottle of whisky
that  Smith will deliver tomorrow. Without a law against   breach of contract, Brown
will be reluctant to hand over the money, since Smith could just keep it and not deliver. A  law
must say what happens if Smith violates his promise. The law could be that Smith must refund the
money, or that he must   deliver the bottle or be jailed, or that he must pay Brown  enough   to
make Brown as  happy as delivery would have.    Which of these rules maximizes surplus is not clear,
but   any of them is better than no rule at all.

   What matters most for surplus maximization is that there be clear rules about who owns what, and
that there be high enough penalties \index{penalties}for broken promises. Getting the exact rules
right is  less important, because people can adapt to imperfect rules. But if nobody is quite sure
what the rules are, or who has the power to get what he wants,    total   surplus falls.


 Some people have suggested that private organizations could replace government  in defining and
protecting property and contract rights. People could sign up with one of various competing
``protective organizations'\index{protective organizations}' and pay the organization a yearly fee,
a fee   similar to taxes  but a price rather than a tax.\footnote{See David Friedman,
 \index{Friedman} {\it The Machinery of Freedom,} 2nd edition  (1989) available on the web ungated.}
The idea is intriguing, but   the result would be like having several governments simultaneously
without clarity as to which  organization's law  would   prevail  or what they  would do with their
power.  While the yearly fees might start out being voluntary, what is to prevent a protective
organization from using its police to make them compulsory?

\noindent
\begin{boxedminipage}[c]{\linewidth}
\renewcommand{\baselinestretch}{1}

\begin{footnotesize}
\refstepcounter{sidebarcounter} \label{sidebar2.1}
\noindent
{\sc  Box 2.\ref{sidebar2.1}\\
  The World Bank's  \href{http://www.doingbusiness.org}{ ``Doing Business''} Project}\index{Doing
Business}\\

\hspace*{16pt}  The World Bank is an international agency to promote economic development in poor
countries. One reason some  poor countries stay  poor  while others grow out of poverty is whether
property is protected and contracts enforced.  The World Bank   measured these things across 190
countries. Here are   the May 2019  numbers.  \\
\begin{center}
%  \vspace*{12pt}
 \begin{footnotesize}
\begin{tabular}{lrr rr}
\hline
 	&	 	&	  	&	    &	   \\
	&	  Overall	&	 	Starting a 	& Registering &	 Enforcing  \\
 Country	&	 Rank	&Business	  & Property	&   Contracts   \\
 	&	 	&	  	&	    &	   \\
 \hline
 	&	 	&	  	&	    &	   \\
New Zealand	&	1	&	1	&	2	&	23	\\
Singapore	&	2	&4	&	21	&	1	\\
Hong Kong 	&	5 &	75	&	51	&	31	\\
Denmark	&	4	&	45	&	11	&	14	\\
United States	&	6	&55	&	39	&	17	\\
Mexico	&	60	&	107	&105	&	43	\\
  Nigeria &	131&	105	&183	&	73	\\
Somalia 	&	190	&	188	&	153	&	116	\\
 	&	 	&	  	&	    &	   \\
\hline
\end{tabular}\\
   \end{footnotesize} 
 %\vspace*{12pt}
\end{center}

\hspace*{16pt} The rankings are based on the complexity, time, and cost of the various business
activities.  Below are some of the entries for contract enforcement. \\
\begin{center}
 %\vspace*{12pt}
\begin{tabular}{l rrrr }
\hline
	&   &  & 	   	&   \\
   	        &  Rank &  Score  & 	Time  	& Cost  \\
 Country   & 	& (100 best)& 	  (days)	&   (\% of claim)\\
	&   & 	&   	&   \\
\hline
	&   & 	&   	&   \\
New Zealand& 23  &71.5&	216	& 27.2\\
Denmark&14	& 73.9	&485&23.3\\
United States&17	& 73.4 &	444&30.5\\
Mexico&	43&67.0 &341&	33.0\\
Nigeria&	73	&61.5 &399&	38.9\\
	&   & 	&   	&   \\
\hline
\end{tabular}\\
\end{center}
% \vspace*{12pt}
\hspace*{16pt} Even in the United States,  enforcing a contract is troublesome.  If people know that
the courts will enforce contracts at relatively low cost, however, they will   keep their promises
and actual lawsuits seldom occur.

\end{footnotesize}

\end{boxedminipage}
 
 \vspace{12pt}


 If the government provides clear rules and enforces them honestly, its overwhelming power provides
a background in which people will use voluntary trade instead of deceit or coercion. This benefits
everyone in society, both the strong and the weak.  The strong   have more property to protect and
trade, so they have a clear interest in government protection. The weak have less property, but also
less ability to protect what they do have, so they rely even more on government protection. Think about which neighorhoods call for police help most often--- it the poor neighborhood  that has the most victims in need of help.  Both
strong and weak know that law prevents them from stealing from others, but for both, the benefits
of law outweigh the    infringement on their liberty.


%---------------------------------
\bigskip
%\newpage
\noindent
{\bf 2.3: Monopoly and  Market Power   } \index{Monopoly and  Market Power}   \label{s02.3}

  Government's role in creating property rights and enforcing contracts is  easy to accept. We  so
take it for granted that whoever produces   something      is the owner that we don't think 
rules against  theft are intrusive.   This form of government  regulation  is  more like an
essential part of a   free market   than a restriction. We now come to a  different form of market
failure,  where surplus maximization requires  the government to stop someone from freely deciding
whether to   sell his property. This  form  is market power.


A monopoly  can capture more  producer   surplus, but   at the expense of diminishing  total
surplus. Monopoly welfare losses arise from these inefficient attempts to capture surplus. The loss
may arise either from the attempt to become a monopoly (as in the expense of lobbying the government
for a monopoly), from the attempt to exploit the monopoly, as in the administrative costs of price
discrimination, or from  {\bf the allocative inefficiency  of  monopoly}\index{the allocative
inefficiency  of  monopoly}---the ``triangle loss'' since it shows up as a triangle on surplus
diagrams.

  The easiest way to think about market power is in terms of monopoly, but the problem is broader
than that. A firm  has  {\bf market power}\index{market power} whenever the demand curve facing that
firm individually  is downward sloping instead of flat.  If firm with market power   raises its
price, it loses some but not all of its customers.   In particular, it can raise its price above
marginal cost, which is what creates inefficiency.


In a perfectly competitive market of very small firms selling an identical product, firms do not
have market power.  Any firm that raises its price will lose 100\% of its sales---the demand facing
it is {\bf perfectly elastic},\index{perfectly elastic} perfectly price-sensitive.  This is true
even though the market demand curve slopes down and is not perfectly elastic. The reason is that the
market demand curve shows what happens to quantity demanded when the market price  rises, which
happens when all sellers raise their price simultaneously. The demand curve facing one firm shows
what happens to the quantity demanded  from that one firm if only that firm raises its price. If
just one firm raises its price and all the others do not, that firm loses all of its sales.

 In the real world, almost all firms have market power in the short run,   but if the  demand facing
the firm is sufficiently elastic---that is, sensitive enough to price---then  the firm has so
little choice over its price that we can ignore market power. If a firm would lose 90\% of its sales
if it raised its price 10\% above its competitors' prices, then that firm  does not need to spend a lot
of energy on optimal pricing strategies; it should focus on cost reduction and output decisions.
If the firm has a distinct product or market niche,\index{market niche}  on the other hand, or if it
is literally a monopoly, on the other hand, then it will think about manipulating the price and we
have to  worry about market failure.




Surplus analysis  shows  the size of  a monopoly's allocative inefficiency.  Figure  2.2 shows an industry with a flat supply curve and a downward sloping demand curve. We
will   use   flat supply curves   in this chapter for simplicity, returning to upward-sloping supply
curves in later chapters. A flat supply curve is realistic for many industries, though by no means
all.  It is appropriate when most firms in the industry use the same technology,  so as industry

% \begin{floatfree}
\begin{wrapfigure} {l}{2.4in}
 \begin{minipage}[c]{\linewidth}
\begin{center}
 {\sc Figure 2.\ref{fig2-01-monopoly.pdf} \\
     Monopoly Allocative Inefficiency} \\

 \includegraphics[width=\linewidth]{fig-monopoly.png}
\refstepcounter{figurecounter} \label{fig2-01-monopoly.pdf}
\end{center}
 \end{minipage}
%  \vspace*{- 1.4in}
%\end{floatfree}
\end{wrapfigure}

output rises, marginal cost does not.  The flatness indicates {\bf perfectly elastic supply}
\index{perfectly elastic supply} (perfectly price-sensitive supply):  even a slight increase in the
market price will elicit a tremendous outpouring of additional quantity, as the price comes to
exceed the marginal cost of most suppliers,  and even a slight price decline  reduces the quantity
drastically, as it makes production unprofitable. Real-world industries are not so extreme, but the
flat supply curve is a good simplification for looking at  any industry with drastic supply
responses.



Figure 2.\ref{fig2-01-monopoly.pdf}  shows what happens when  there are not   many competing
suppliers,  just one:  the  monopoly. The supply curve is not a supply curve,  properly speaking. It
is   the marginal cost curve of the one company.  The company would be foolish to charge a price
equal to marginal cost. Instead it will choose a higher price, labelled $P_0$ here, resulting in the
quantity $Q_0$.


 Consumer surplus is  the  triangle A   above the price $P_0$ and below the demand curve. Producer
surplus  is the  rectangle B  that is above the supply curve but below the price $P_0$.
\begin{wrapfigure}{L}{1.4in}
\noindent
$ CS_0 = $ A\\
$ PS_0 = $ B\\
$TS_0 = $ A+B
 \end{wrapfigure}
%\vspace{6pt}



 The government can   do better than the market   by imposing the price ceiling  $P_1$. Producer
surplus would fall  to zero, since $P_1$ is the minimum price the monopoly would accept to sell its
product.  Consumer surplus would become the triangle A+B+C  between the $P_1$ price line and the
demand curve,   Producers have lost area B, but consumers have gained even more, area  B+C.

%\vspace{6pt}
\begin{wrapfigure}{L}{1.4in}
\noindent
$ CS_1 = $ A+B+C\\
$ PS_1 = $ 0\\
$TS_1 = $ A+B+C
\end{wrapfigure}

%\vspace{6pt}

 Reducing the price helps consumers more than it hurts the monopoly because the monopoly's high
price was a deliberate sacrifice of sales to low-valuing customers in order to increase the price
paid by high-valuing customers.  The consumer surplus of the low-valuing customers  falls to zero
(since they don't make a  purchase), but the monopoly doesn't make any profit from them, so the fall
in consumer surplus is a complete social loss.



%---------------------------------------------------
\bigskip



\noindent
{\bf Other Problems Created by Monopoly}

  Allocative inefficiency is not the only problem created by monopoly.
Monopoly profits are a little like the profits from theft, because the process of creating a
monopoly  requires   effort that transfers surplus from one person to another without creating new
surplus---  the  classic article   is titled,   ``The Welfare Costs of Tariffs, Monopolies, and
Theft'' (Gordon Tullock,\index{Tullock} {\it Economic Inquiry}, 5(3): 224--232,  June 1967). Whether
by merging existing firms in an industry, lobbying for a law that knocks out one's competitors, or
illegal violence to scare off other firms, the creator has to spend time and effort  to get his
monopoly.



 In the years around 1900, J. P. Morgan\index{Morgan} exerted his considerable talents to creating
monopolies by giant mergers of existing companies. U.S. Steel \index{U.S. Steel} was his biggest
creation, put together in  a massive deal that   merged Andrew Carnegie's\index{Carnegie}   dominant
steel firm with a number of others.  Carnegie had followed a business strategy of high volume and
low prices, so his departure into the world of philanthropy  ended price wars (he spent  the rest of
his life giving away his  buy-out money to charitable causes).  Morgan's deal was profitable for him
and the steel companies, but it reduced surplus rather than creating it, not just because it raised
the price of steel  but because it consumed the attention of investment bankers who could  otherwise
have been doing  deals  that created surplus instead of moving it around. 

 A second problem with  monopoly is the transactions cost\index{transactions cost} of extracting
consumer surplus. Even if someone has a created a monopoly by driving out all competition, he still
faces the problem of trying to make each consumer pay the maximum possible for a given product. If
Smith is the only seller of whisky to Brown, then the two of them have a bargaining problem in
deciding where the price would be between the \$8 that is the least Smith will accept and the \$15
that is the most Brown will pay. Possibly the entire \$7 will be eaten up by the bargaining costs as
they waste time haggling back and forth; if Brown   spend \$1.90 of his time getting the price \$2
higher, he ends up better off.  Even when bargaining is not one-to-one, firms with market power can
find it worthwhile to spend much of their effort on clever pricing scheme to extract extra consumer
surplus rather than on producing new surplus to sell.

A third problem with monopoly is that it  might increase  production cost\index{production cost}. It
isn't clear why monopolies should have higher costs.  One might think that firms in  industries so
competitive that their survival depends on cost-cutting would have lower costs than a monopoly which
can survive even if it is fat and lazy, but that logic has a catch. The catch is that
a monopoly, like a competitive firm, prefers high profits to low profits, and so prefers low costs
to high.   Firms aren't literally ``fat and lazy'' as people are, and  a monopoly's shareholders
have no incentive to settle for low profits  to save their employees effort. Thus, the cost
disadvantage of monopolies is not clear.

Yet  though the monopoly's desire for low costs may be just as great  as the competitive firm's,
its ability to control costs might be less.  Consider how company executives are
rewarded. Shareholders of a competitive firm can compare  the  company president's performance
to  presidents at   other firms.  A monopoly cannot.    As a result, the competitive
firm can punish or reward its executives   more effectively than   a monopoly.\footnote{See Farrell,
Joseph\index{Farrell}, ``Monopoly Slack and Competitive Rigor: A Simple Model,''  in {\it Readings
in Games and Information}, Eric Rasmusen, ed., Oxford: Blackwell Publishing (2001)
\url{http://www.rasmusen.org/GI/reader/farrell.pdf}.}

 In addition, if different firms have different technologies or innovate in different ways, keeping
all but one firm out of the market will restrict the opportunity for innovations to spread in the
industry.   A monopoly may owe its monopoly position not to its superior product and cost but to an
accident of luck or to its talent for excluding other firms from the market. If several firms
compete, on the other hand, any one of them with a cost advantage will tend to grow  and   ideas can
diffuse from one firm to another.



The most important kinds of regulation justified by monopoly are public utility regulation and
 anti-trust laws. The technology of electricity distribution is such that it is best that one firm provide
the service, but important to prevent it from doing so at such a high price the people are
discouraged from using electricity. In other industries the technology makes the simultaneous
operation of many firms feasible, but regulation is necessary to prevent firms from      making
agreements not to compete.



\bigskip


%----------------------------------
 

\noindent
   {\bf 2.4:  Poor Information  }\index{Poor Information}   \label{s02.4}

   Economists have realized increasingly   that solving information problems is central  to a
successful economy.
The surplus maximization argument for  free markets assumes that everyone in the economy is
 well-informed about the value    of the goods being exchanged. Otherwise,   the parties try to take
advantage of their private information. As with market power, effort goes into extracting surplus
from each other rather into producing new goods. In addition the wrong transactions may take place,
not just too few transactions.



 Information can be imperfect in many ways.  Not all of them create market failure. We would not say
that the American economy of 1900  had market failure because there was imperfect
information  on how to make personal computers.     Even a well-functioning market is limited by
available technology and information about future events.  Imperfect information creates market
failure when it interferes with the right transactions taking place, not when output is low because
of poor technology.  Such interference happens in many ways, and has been    the subject of a vast
scholarly literature.\footnote{\label{Rasmusen89} See Rasmusen, Eric \index{Rasmusen} {\it Games and
Information: An Introduction to Game Theory}, 4th edition (2005, 1st edition, 1989)   for references  (partly available online.}

  Asymmetric information \index{Asymmetric information}about product quality is  one important
category of imperfect information.
  If Smith claims he is selling whisky, but Brown cannot tell in advance of the sale whether it is
really whisky or is  colored water, one of two problems arises.

First,    if  Brown buys  colored water, his value is not \$15, but \$0, and surplus has not been
maximized. To be sure,  the colored water would have had zero value even if Smith had kept it, but
they've  incurred some transaction  cost in  making the worthless transaction, and since  Brown
bought the colored water instead of making   a genuine surplus-increasing trade with someone else,
the lost opportunity is a big cost.

Second, if Brown is more sophisticated, he will realize that Smith's whisky cannot be trusted
because it might just be colored water. Brown will not buy at all because Smith's promises lack
credibility.
  When there are no laws against fraud, honest merchants lose   because consumers lack confidence in
the market.

Starting   a new business is always difficult, but especially   if reputation is the only basis for
consumer trust. In the absence of government regulation of fraudulent new products, innovation is
stifled because consumers do not know whether it is safe and effective.\footnote{See ``Scores of TGI Fridays in New Jersey busted
for selling caramel-colored rubbing alcohol as
top-shelf scotch  in statewide crackdown
dubbed Operation Swill,'' {\it Mail Online} (2013). }


 A related obstacle is that     consumers often do   not know what they want exactly and would like
to delegate this task. Delegating \index{Delegating}to a business is hazardous if  the business
makes a profit from  selling the products it recommends.  The government may have purer motives.
Thus,  the government requires technical safety features on cars, a  minimum level of safety that
consumers rely  on.


  Another large category arises from the difficulty of observing effort, choice of action, and
performance. Recall that one of the problems of a monopoly was in getting an  executive  to make the
right choices when the shareholders cannnot compare him with executives at other firms. The
asymmetric information is that the monopoly's president knows what maximizes profits, but the
shareholders don't, and he will keep his information concealed to avoid   some unwanted task such
as  firing mediocre but well-meaning mid-level executives.  This is known as a {\bf principal-agent
problem}\index{principal-agent problem}, because the principal (the shareholders) cannot control his
agent (the president).


Still another category of imperfect information involves poor information about the markets
themselves. Suppose a market has one hundred competing sellers  but some  consumers  only  know
about  one of them. Those consumers  effectively face a monopoly, because the lucky  seller can get
away with raising its price despite being one of a hundred. When  consumers need  to search for
prices and   learn about different sellers, they may end up buying from the wrong seller or buying
the wrong product.

Imperfect information is also the category under which bad decisionmaking is usually placed. Does a
consumer who buys a magical spell as a cure for cancer    have poor information,  or   is he  just
foolish? Either way, his beliefs about the product are wrong and  he pays more than his true value.
Either way, government regulation could help.     Whether  unethical businesses take advantage of
poor information or poor reasoning, penalties on their   bad behavior raises surplus and  protects
ethical businesses from  competition with the unethical.    Exactly how to regulate, however, may
depend on whether the problem  is ignorance or stupidity.\footnote{My language is, of course,
hyperbolic ({\it Hyperbole}: Saying something in an extravagant or exaggerate way without intending
the listener to take it literally;  a figure of speech.)}  If someone is ignorant, informing him
fixed his problem;  if he is stupid, one may have to make the decision for him.






 Exactly how to apply  surplus analysis to    poor information depends on the context.  Let's  go
through one example. In Figure 2.\ref{fig2-02-info.pdf}, vitamin pills are sold by a competitive
industry with perfectly elastic supply.  Information is poor.  Consumers overestimate the value of
vitamins, so the demand curve they use in their decisions   has  too high a   willingness  to pay.
How valuable a good is to a consumer is partly   a matter of personal taste and income,   but  in
Figure 2.\ref{fig2-02-info.pdf} consumers' scientific knowledge is   wrong  and if they were better
informed  they would not pay as much. Someone  willing to pay \$9/bottle based on his mistaken
information would only pay \$6 if he were told the truth, someone who is willing to pay \$6 would
only pay \$3, and so forth.

 If consumers have good information, then their maximum willingness to pay is also their true value
of the product. Thus, if they have good information their   {\bf demand curve}\index{demand
curve}---their maximum willingness to pay---is the same as their {\bf  marginal benefit curve}\index{value
curve}---the value they receive from the product once they consume it, given their personal tastes
and the  other things they are consuming.  When information is poor, we need to distinguish between
the demand curve and the   marginal benefit curve, because they differ. In Figure 2.\ref{fig2-02-info.pdf}, the
marginal benefit curve is always  below the demand curve.


%\begin{wrapfigure}{L}{2.6in}
%\vspace*{24pt}
\noindent
\begin{minipage}[c]{ \linewidth}

\begin{center}
 {\sc Figure 2.\ref{fig2-02-info.pdf} \\
      Overestimation of Quality} \\

\refstepcounter{figurecounter} \label{fig2-02-info.pdf}
 \includegraphics[width=.6\linewidth]{fig02-03marginal-benefit.png}
\end{center}
\end{minipage}
%\vspace*{-24pt}
%\end{wrapfigure}% \begin{wrapfigure}{L}{1.4in}
\noindent
$ CS_0 = $ B-E\\
$ PS_0 = $ 0\\
$TS_0 = $ B-E\\
%\end{wrapfigure}

The effect of imperfect information is that we   use the   demand curve to find the equilibrium
price, but the marginal benefit curve to calculate the surplus. The laissez faire   price and quantity are
$P_0$ and $Q_0$ in Figure 2.\ref{fig2-02-info.pdf} because that is where quantity supplied and
quantity demanded   equal each other.  At the quantity $Q_0$, however (remember, it is the quantity
traded that is crucial for efficiency, not the price),  the price on the  marginal benefit curve is only $V_0$,
less than the $P_0$ consumers are paying.  The true value of the $Q_0$th vitamin pill bottle is only
$V_0$, and the consumer is  buying it  only  because he is misinformed.   His surplus is negative---
it is $V_0-P_0$.  To find  the total  consumer surplus, keep in mind that we are looking for the
excess of consumer value, given by the value   curve, over the price paid, which is $P_1$. For
quantities in the interval between 0 and $Q_1$,  consumer surplus is positive--- area   B. For
quantities in the interval between $Q_1$ and $Q_0$, consumer surplus is negative---area -E,
because consumer value is   less  than the price paid. Total consumer surplus under laissez faire is
B-E. The consumer surplus does not include areas A+C+D+E. One might call that ``imaginary consumer
surplus,''  because it is   consumer surplus that the uninformed consumers expect to get  but don't
actually receive because they've overestimated the value.   What about producer surplus?  Despite
the fact that consumers are overpaying for vitamins, producer surplus is zero, because the price
exactly equals the minimum sellers would accept. Seller volume and revenue  is greater than it would
be if consumers were well-informed, but seller profit is zero because sellers bid the price down to
marginal cost.




   Suppose the  government keeps   the price the same (so $P_1=P_0$), but reduces the quantity to
$Q_1$. The consumer surplus for the units in the interval from 0 to $Q_1$ is still  B. No surplus,
positive or negative, is earned for greater quantities.  The producer surplus is still zero. Total
surplus has increased by amount E, so government intervention  has raised surplus.


\begin{wrapfigure}{L}{1.4in}
\noindent
$ CS_1 = $  B \\
$ PS_1 = $ 0\\
$TS_1 = $  B
\end{wrapfigure}

       That regulatory policy   was   to assign the quantity $Q_1$  and keep price at $P_0$.  There
is excess demand, however, because consumers still are mistaken about the value of the vitamins and
the government has kept the price at $P_0$. Excess demand results in rationing---some consumers are
able to buy and some are not.    If  the rationing is efficient, that   maximizes consumer surplus
as just described.  Under inefficient rationing    some consumers with   high values  for vitamins
would  fail to find a seller  but  some with low values   between $V_0$ and $P_0$ would succeed.  In
that case, the regulation would still result in   inefficiency, possibly even more than under
laissez faire, if  it happens that high-value consumers with potential positive surplus can't  buy,
but low-value consumers with negative surplus can find a seller.

 This shows why the particular policy remedy matters. If the government can
 somehow teach everyone the correct information, it does not have to regulate the quantity sold and
 the excess demand will disappear. Consumers will use the informed  demand curve, and will naturally
demand quantity $Q_0$ without the need for the government to force it  on them.

 This whole story of overestimation  depends  on consumers being fooled. Such mistakes are unlikely
to last long. Soon, consumers will realize they can't trust producer claims and they will stop
buying. This is still market failure, however, and perhaps even worse failure, because the market
can completely dry up because of distrust. Consumers and producers alike will welcome government
intervention if it can prevent false claims.



%---------------------------------

 \bigskip

\noindent
{\bf 2.5:   Externalities (Spillovers) }    \label{s02.5}

  If someone takes an action  which affects someone else but neither party can compel an exchange of
money, we say  the action {\bf imposes an    externality}\index{imposes an externality}.  The
classic example  is when a company sells  a product to   consumers  but generates pollution that
hurts a third party who cannot force consumers or company  to pay for the   damage. A better word
for the effect than ``externality,'' would be ``spillover'', but ``externality'' has long been the
established economic term.  The motivation for the word  ``externality'' is that the  effect is
external to the parties  and  transactions generating it. 

  

Externalities could come up in our running example of Brown and Smith.
 Suppose that buyer Brown, after buying whisky from seller Smith for \$10 and drinking it,  throws the bottle
onto the sidewalk in front of third party Theodore's house, where it  shatters and cost Theodore \$20 to clean up.


The transaction between Brown and Smith has still  created surplus of \$7 as far as those two are
concerned---Brown's value is \$15 so he gets \$5 surplus, and Smith's  is  \$8 so he gets \$2
surplus.  Consumer and producer surplus are not hurt by externalities, as they would be under
monopoly or imperfect information.   The problem is Theodore, the third party.  External to the
transaction, he suffers a value loss of \$20. This loss is  a {\bf negative externality}
\index{negative externality} because it inflicts harm on the third party. The   negative externality
of \$20 more than wipes out the gains from trade of \$7, so the whisky transaction reduces total
surplus.

  Just because there is a harmful externality to other people, however, does not mean that a  trade
is inefficient.  If Theodore's loss had only been \$6, there would   be a negative  externality  but
the transaction would have been surplus maximizing anyway, since the externality would be less than
the gains from trade.  The usual effect of externalities is not that the entire market should be
shut down, but    that too many trades take place   because even  trades that add  very little to
consumer and producer surplus still harm third parties.

\begin{wrapfigure}{L}{2.6in}
%\vspace*{24pt}
\noindent
\begin{minipage}[c]{\linewidth}
\begin{center}
  {\sc Figure 2.\ref{fig02-basic-externality.jpg} \\
     An Externality}
\refstepcounter{figurecounter} \label{fig02-basic-externality.jpg}
 \includegraphics[width=\linewidth]{fig02-basic-externality.jpg}
\end{center}

\end{minipage}
\end{wrapfigure}



Figure   2.\ref{fig02-basic-externality.jpg}  shows how output is too high when there are negative
externalities.  The supply of newsprint comes from a large number of competing paper mills, all with
the same technology and costs, so the supply curve is flat. Paper mills are located on rivers,
because they use a lot of water, and they return polluted  water to the river.  Making one unit of
newsprint creates pollution that harms people downstream by amount $X=1$, a negative externality.
The {\bf private cost}\index{private cost} is $P_0=3$, but the {\bf social cost}\index{social cost}
is $ P_0+X=4$. The private cost is the cost to the suppliers; the  social cost is the private cost
plus any third-party costs.


    The laissez faire equilibrium price and quantity are determined only by the behavior of buyers
and sellers, not by the third parties affected by the externality,  so
they
are $P_0=3$ and $Q_0=100$, where the quantity demanded of newsprint equals the quantity supplied.
Consumer surplus is  A+B+C, and producer surplus is zero (because of supply being perfectly
elastic).   We must go beyond consumer surplus and producer surplus to  calculate the effect on
third parties. The people downstream suffer harm of $X$ per unit times the quantity $Q_0$. Their
surplus is thus  $-X \cdot Q_0$, amount -(B+C+D).
\begin{wrapfigure}{L}{2.5in}
\noindent
$ CS_0 = $ A+B+C\\
$ PS_0 = $ 0\\
Third Party Surplus$_0 =$ -B-C-D\\
$TS_0 =  A-D $
\end{wrapfigure}

   Now let the government regulate by assigning output limits to each firm that reduce   industry
output to  $Q^*$.  Consumers will   bid the price up to  $P_0+X$, since   there would be excess
demand at   $P_0$.    You might wonder why  there isn't excess supply at   $P=P_0+X$. The reason is
that the government has limited the supply to the number of licenses issued, so at     $P=P_0+X$
every seller who is allowed to sell will find a buyer.   Consumer surplus falls to A, and producer
surplus rises to B.  People downstream still have negative surplus of -B because of the externality,
but it has diminished because of the decline in output.

\begin{wrapfigure}{L}{2.5in}
$ CS_1 = $ A \\
$ PS_1 = $ B\\
Third Party Surplus$_1 = $ -B \\
$TS_1 =  $ A
\end{wrapfigure}

Total surplus  has risen because of the output licenses. The free market resulted in inefficiently
high output,  which  government regulation corrected. It is unexpected that pollution regulation has
ended up benefitting the paper mills, adding $B$ to their surplus,  but that is one of the benefits
of surplus analysis---it helps companies and consumers  realize just what kinds of policies benefit
them.  I chose the particular pollution control policy   carefully: output restriction    rather
than required pollution control equipment or fines for every ton of pollution released. In a later
chapter we will look at  such policies.
\bigskip



Externalities can be seen as a  problem  of   weak property rights.   In the whisky example, Brown
shatters the bottle on Smith's sidewalk.    A solution would be for the government to make it clear
that although Brown does have the right to walk on Smith's sidewalk, he does not have the right to
shatter glass there. The government would also have to enforce the   right  by  making Brown  fear
the police too much  to break the bottle   or forcing  him to pay compensation. If the people
downstream of the paper mills owned the river  or the right to clean water, they could make the
paper mills pay for the privilege of polluting the water.  Better enforcement of property rights is
indeed a good  solution to some externalities--- broken glass on sidewalks, for instance.  In the
pollution example, however,  having all the downstream victims enforce the property right is more
cumbersome and other policies  are more common.
\index{pollution}




\bigskip
%---------------------------------


\noindent
 {\bf  Positive Externalities}


  {\bf Positive externalities}\index{Positive externalities}  are spillover effects that benefit
third parties.   Suppose  Brown and  Smith are neighbors. Brown is deciding whether to pay
  \$500   to plant a redbud    tree in his yard.  If Brown plants the tree, Smith receives a benefit
of \$200---that is,  he would be willing to pay up to \$200 to have  the tree  next door.    That
\$200 is a positive externality, a beneficial spillover.



 Positive externalities create surplus. We would not make the world a better place by somehow
eliminating the positive externality of Smith's enjoyment of Brown's  tree.    Paradoxically,
however, positive externalities  are both   good in themselves and a  source  of    market failure.
The reason is that the market does not generate enough of them.

   The problem is that Brown  fails to take into account  the entire benefit of the redbud  tree
when he makes his decision. If Brown would pay up to \$450 to have the tree, we say that his {\bf
private benefit}\index{private benefit} is \$450, the height of his demand curve. The {\bf social
benefit}\index{social benefit}  is the private benefit plus any positive externalities, which sums
to \$650 here. The private benefit of \$450  is less than the \$500 cost, so Brown will not plant
the tree, but the social benefit of \$650 is greater than \$500, so surplus maximization says the
tree should be planted.



  Brown fails to plant the tree  because he makes his decision in isolation, ignoring benefits
external to himself. If   he and  Smith were to talk  and  make a deal, Smith would be willing to
pay him an amount---say, \$150---that would make Brown plant the tree. Why not make the deal,
then?    Maybe   Smith thinks Brown is bluffing when he says  his value for the tree is less than
\$500---   that Brown will plant the tree anyway, even if  Smith refuses to help pay.   Or Brown
may be too embarassed to ask Smith for money, because that makes him look like a crass, selfish
person who isn't willing to beautify his yard to please his neighbors.

    There is a special terminology used for goods with positive externalities. We say that  Brown's
tree is a {\bf nonexcludable}\index{nonexcludable} good because Brown cannot exclude Smith from
enjoying it. We say that it is also a {\bf nonrivalrous}\index{nonrivalrous} good because when Smith
enjoys it that does not impose any extra costs on Brown.  A good that is both nonexcludable and
nonrivalrous is called a {\bf public good}\index{public good}. On a small scale, the tree is a
public good.  On a larger scale, national defense is the classic public good.
  If citizens  eveywhere in  the rest of the United States except Kansas voluntarily contribute to
hire an army to defend themselves against invasion,   the Kansas citizens nonetheless  get the
benefits of the protection (so it is nonexcludable), though without increasing the costs of the
others (it is nonrivalrous). Telling  China   it can invade Kansas but not the rest of the United
States is simply not feasible. As a result, we do not expect to see the market maximize surplus.
The rest of the United States must coerce Kansas to pay its fair share of national defense.


%\begin{wrapfigure}{L}{2.4in}
% \vspace*{- .2in}
%\noindent
%\begin{minipage}[c]{\linewidth}
%\begin{center}
%  {\sc Figure 2.\ref{fig02-03a-junkpile.jpg} \\
 %   The Cathedral of Junk\\
% Positive Externalities, or Negative?} \\
%\medskip
%\refstepcounter{figurecounter} \label{fig02-03a-junkpile.jpg}
% \includegraphics[width=\linewidth]{fig02-03a-junkpile.jpg}
%\end{center}
%\end{minipage}
 % \vspace*{-.2in}
%\end{wrapfigure}



It can be hard to decide whether an externality is, on net, positive or negative. Vince Hannemann's
``Cathedral of Junk,'' is one of the tourist sites of Austin, Texas. Tourist vans stopping by to see
it,  but the neighbors don't like it. After 21 years of gradual construction,  the city threatened
to demolish it in 2010 because of lack of a building permit. Whatever the law may be, would the
demolition increase surplus, or reduce it?\footnote{``A Junk Pile Grows in Texas, but Is It Art?
Austin Project Bugs Neighbors, Attracts Hoards of Tourists,''  {\it The Wall Street
Journal}  (April 24, 2010).}


\bigskip
%---------------------------------



\noindent
{\bf Real versus Pecuniary Externalities}

  The shattered whisky bottle, the water pollution,  and the tree in the yard   create    {\bf  real
externalities}\index{real externalities}:   spillovers such that     someone's action affects the
utility of someone else   directly rather than   through    prices.
If the spillover results from  prices, it is called a {\bf pecuniary externality}.\index{pecuniary
externality}


If  Smith has been regularly selling whisky at \$10/bottle to Brown, making a profit of \$2 per
bottle, and then Anderson kills Smith's sales by  selling at   \$7/bottle, Anderson has inflicted a
negative   externality of \$2/bottle on Smith because he deprives Smith of that amount of surplus.
Anderson has certainly hurt Smith,  but it would be very strange if  this were  market failure,
because   competition is not market failure but the very process by which markets reach optimality.
And in fact a pecuniary negative externality like this does not reduce surplus.

  Suppose Anderson's cost is \$6 per bottle. Smith has indeed lost \$2 per bottle,  but Brown has
gained \$3  and Anderson has gained \$1, so    total surplus has gone up, not down, as a result of
Anderson's accidental harming of Smith. It has risen by \$2,  the amount by which production has
gotten cheaper when Anderson with his \$6 cost replaces Smith with his \$8 cost.    A pecuniary
negative externality  indeed harms  someone, but the harm is  either  exactly balanced by a   gain
to someone else  or exceeded, as happened here. The losers from  new  competition  are unhappy, and
often call for regulation to exclude the  competitors  who are hurting them,   but  the harm does
not reduce total surplus. In a well-functioning marketplace,    pecuniary externalities are
inevitable and desirable.\footnote{ \label{Tresch}On pecuniary externalities, see  R. Tresch, 
\index{Tresch}  {\it Public Finance: A Normative Theory}  (1981) p. 91; Jacob  Viner, ``Cost Curves and
Supply Curves,'' 3 {\it Zeitschrift fur National-Okonomie} (1932), (reprinted in American Economic
Association, {\it Readings in Price Theory}, (1952) (the origin, so far as I know, of the term
``pecuniary externality''); Allyn Young,   \index{Young} ``Pigou's Wealth and Welfare,'' {\it The
Quarterly Journal of Economics}, 27: 672--686 (August 1913).  }


\begin{wrapfigure}{L}{2.8in}
%\vspace*{24pt}
\noindent
\begin{boxedminipage}[c]{\linewidth}
 \renewcommand{\baselinestretch}{.9}
\begin{footnotesize}
\refstepcounter{sidebarcounter} \label{sidebar2.3}
\noindent
{\sc Box 2.\ref{sidebar2.3} \\
  A Medieval Lawsuit }\\

\hspace*{16pt} ``This is like the case of 11 Henry IV,  p. 47: one schoolmaster sets up a new school
to the damage of an ancient school, and thereby the scholars are allured from the old school to come
to his new; the action there was held not to lie. But suppose Mr. Hickeringill should lie in the way
with his guns, and frighten the boys from going to school and their parents would not let them go
thither, sure that schoolmaster might have an action for the loss of his scholars. 29 Edward III, p.
14. A man hath a market, to which he hath toll for horses sold;  a man is bringing his horse to
market to sell; a stranger hinders and obstructs him from going thither to the market; an action
lies because it imports damage.''



\medskip
{\it Notes:}  ``The action there was held not to lie''  means the court rejected the lawsuit on the
grounds that no   one's rights had  been violated.  ``Toll for horses sold''  is the commission the
market owner charged to anyone who sold horses there.

\end{footnotesize}
\end{boxedminipage}
\end{wrapfigure}


%\renewcommand{\baselinestretch}{1}
%--------------------------------------
\bigskip

\noindent
 {\bf    Coordination   and Network Externalities }

  A special type of externality arises  when what one person does depends on what he expects others
to do.  When expectations matter, there may exist a number of stable configurations of behavior,
each with its own set of expectations, and some of these equilibria may lead to better results than
others.


If we look at the situation from before the whisky is produced,
 Smith will not spend  \$8 to produce the whisky unless he expects Brown to buy it. But Brown will
not waste time visiting Smith unless he thinks Smith has whisky to sell. In one equilibrium, the
whisky is produced and traded; in a second equilibrium, with lower surplus, Browna stays home and no
whisky is produced. This has been suggested as a cause of business cycles; people in the general
economy will not produce goods unless they expect other people to produce goods for which to
exchange them. One equilibrium has low production and low  welfare; another has high production and
high welfare. Government jawboning might shift the economy from one equilibrium to the other.

  Pessimistic expectations\index{Pessimistic expectations} also generate runs on banks. Each
depositor is afraid  the other depositors are going to try to withdraw their money first, leaving
none for him, so he runs to the bank to take out his money. When everybody does that, even an
otherwise   healthy bank does not have enough funds on hand.   In one equilibrium, nobody expects a
bank run, so  withdrawals stay at a normal level and the bank is able to fund them.     In a second
equilibrium, everybody expects a bank run\index{bank run}, so   a run does happen and the bank
cannot pay everyone. Government deposit insurance is intended to eliminate the bad equilibrium,
although we have seen in more than one   banking crisis that government bailouts introduce their own
problems.

 Expectations also matter when there are
  {\bf network externalities}\index{network externalities}:    a consumer gets more benefit from a
good if more other people are using the same  kind of good. Telephones are the paradigmatic example.
Having the only telephone in the world is useless, because there's nobody else to call.  When more
people buy telephones, they become more useful because there are more people to call. Software is
another example:  the fact that most  people use the  Microsoft Windows operating system makes it
more attractive.\footnote{ On network effects see Oz Shy,  \index{Shy}  {\it The Economics of Network
Industries}  (2001).  }

Network externalities can generate market failure  through multiple equilibria  as   bank runs do.
Software product  A  might be better than product B, but if the expectation is that everyone will
use A, that expectation is self-fulfilling. Everyone might prefer a simultaneous shift to product B,
but nobody wants to be the first to shift.

 Compatibility between different companies' products can also create coordination problems.
If two companies produce a product according to the same standard, sales of both can increase
because of the interchangeability. The government can  be helpful in setting a standard railway
gauge or a standard technology for high-definition television.

 Much of the  coordination function of government is a  background function, like protecting
property rights, rather than requiring active and continual intervention. Money solves a
coordination problem. People wish to trade with each other, but it is very inconvenient to have to
figure out that value of the goods a person produces in terms of the value of every other good, and
very inconvenient to carry around truckfuls of each thing produced for use in barter\index{barter}.
I teach students and write books; would I have to carry books and students to the grocery store to
exchange for pancake mix? Instead, the government provides money   as a unit of account and medium
of exchange.





\bigskip



%---------------------------------


\noindent
{\bf 2.6:    Market Failure and  Market  Solutions  } \label{s02.6}

    We have seen a number of sources of market failure,   defects in the market that can result in
total surplus not being maximized.    We started with weak property rights and   contract
enforcement. An important function of government is to  clarify who owns what and to protect
property against theft and destruction. A second step is to enforce contracts so that people can
trade property without worrying about whether the person on the other side of the trade will do what
he promised.



The rest of the chapter was on the Big Three\index{Big Three} of market failure: market power,
imperfect information, and externalities. A firm has market power if it can affect the market price
by how much output it produces. A firm with market power can restrain its output to drive up the
price, but in the process it hurts buyers more than it helps itself. Imperfect information can cause
many different problems, but the simplest one is that if buyers cannot judge quality, sellers will
be tempted to take advantage of them by selling   shoddy goods. Externalities  are spillover effects
onto third parties who are not involved in a transaction. They cause markets to fail because   the
harm      to   third parties are involuntary. The third party cannot charge for the harm, and so the
external cost of the transaction is ignored by the parties who make the decisions.

    By now, you may think that Chapter 1's optimism about market efficiency was completely
misplaced. Don't practically all sellers have at  least a little market power?  Maybe a farmer can't
get away with raising the price of his corn, but every small shop can raise its prices and keep most
of its customers for at least a while. Isn't information always imperfect? Sellers know a lot more
about their products than buyers do, and buyers  don't  know all the prices of all the sellers in
the market. Aren't externalities pervasive?  ``No man is an island,'' as John Donne
said.\footnote{``No man is an island, entire of itself; every man is a piece of the continent, a
part of the main. If a clod be washed away by the sea, Europe is the less, as well as if promontory
were, as well as if a manor of thy friend's or of thine own were.  Any man's death diminishes me,
because I am involved in mankind; and therefore never send to know for whom the bell tolls; it tolls
for thee.'' John Donne, {\it Devotions upon Emergent Occasions}, Meditation XVII  (1654),
\url{http://isu.indstate.edu/ilnprof/ENG451/ISLAND/text.html}.}  What I buy affects me, and thereby
affects my friends and family; every extra ounce of fat imposes a negative externality on those who
care about my survival.
   One extra ounce of fat is trivial, I may say as I buy my bag of potato chips (or as I buy my
third bag of potato chips).  But I must still concede that the market at least fails by a little bit
to maximize surplus. Economists maintain their beliefs in the marketplace anyway, for two reasons.

First,   there are market solutions \index{market solutions}to market failure.  Market power is
limited by entry of competitors. Poor information is limited by advertising. Externalities are
limited by voluntary agreements to limit harmful behavior. We will look at these in detail in the
various chapters. 

The monetary character of economic transactions limits surplus loss, because    where surplus is not
maximized, there is profit to be made. The making of the profit will ameliorate the imperfection,
though at a   cost. It may not matter, for example, whether consumers can themselves test the
quality of car bumpers, because either   competing sellers will themselves try to demonstrate
quality  to obtain competitive advantage, or new businesses will enter (such as the many car
magazines one can buy at supermarkets)   to sell information to consumers  at a small price.
Similarly, the losses from externalities are limited by the possibility of the third parties making
a deal with whoever is creating the externality.
Before we impose government regulation, we should ask whether market failure is being solved by some
market institution. Maybe we do not need   the government after all.

 The second reason not to give up on the market is a less happy one:   the government might do even
worse.  This is particularly true if the market failure is small. Just as there is market failure,
so there is government failure, and government failure, in fact, is the rule rather than the
exception. Chapter Three will explain.

 %-----------------------------
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 \newpage
\vspace{24pt}
\begin{center}
{\sc   Review Questions }
\end{center}
 \begin{enumerate}
\item
What does market failure mean and what causes it?

\item Why are property and contract rights important?

 \item How does market power cause market failure?

\item How does poor information cause market failure?

\item  How do externalities cause market failure?
 \end{enumerate}


 

    \vspace{.5in}
%\cleardoublepage
\begin{center}
{\sc    Readings }
\end{center}
 \begin{enumerate}



\item
\href{http://marginalrevolution.com/marginalrevolution/2008/08/against-intelle.html}  {``Against Intellectual Monopoly,''} Alex Tabarrok, {\it Marginal Revolution}  blog.
 



\item
\href{http://www.nytimes.com/2016/01/19/world/asia/delhi-sleep-economy.html?_r=0}{``Desperate for Slumber in Delhi, Homeless Encounter a ‘Sleep Mafia’,'' }  {\it The  New York Times}.
 

\item
\href{http://www.hoover.org/research/silent-serial-killer}{  ``The Silent Serial Killer,''} Henry Miller, {\it Defining Ideas}.


\item
    \href{http://press-pubs.uchicago.edu/founders/documents/v1ch16s23.html}{``Property,'' } James Madison, {\it National Gazette}, March 29, 1792. 
 


 



\item
\href{http://online.wsj.com/article/SB10001424052748704008704575638850947058366.html}{``Well, Hush My Mouth: Congress Is Moving against LOUD Ads
after Decades of Complaints, Law Makers Are Yielding to Popular Demand,''} {\it The  Wall Street Journal}.




\end{enumerate}


 \end{document}





