G401 October 12, 1998 Professor Rasmusen, Erasmuse@Indiana.edu NOTES ON MARKET FAILURE These notes summarize ideas that we have talked about in various class sessions. They start off the same as the notes on government failure. Suppose Congress is thinking of passing a new law affecting a business. How should we think about the new law? From the viewpoint of the public good, the big question is: IS THE LAW EFFICIENT? which means: Does it help the winners from the change more than it hurts the losers? Even if the law is inefficient, it might still be desirable. A law against abortion, for example, would put abortion clinics out of business, and in easily measurable dollar terms might appear inefficient. The real issues in abortion, however, are not how it affects business, consumers, or workers. From the viewpoint of a business, the big question is WILL THE LAW HELP MY COMPANY? Whether an executive should support a law (e.g., sugar import quotas) which helps his company but hurts the public more is a good and hard ethical question. But he should certainly be cognizant of the law's effect. Whether a law will increase efficiency depends first on whether there is MARKET FAILURE. If there is not, no law is needed. If there is, then a law COULD be helpful, but might still be a bad idea because of GOVERNMENT FAILURE. Markets generally work very well. A good default position is to assume that no government intervention can increase efficiency. If the market price of chocolate ice cream cones is 2 dollars, then price or quality regulation would hurt more than it would help. Some people might benefit if the price were required to be 1 dollar, or 3 dollars, or if only vanilla were legal, but more people would be hurt. Most conceivable regulations are inefficient, even tho some people would argue strenuously for them. But there are major exceptions. Market failure occurs if 1. Information is asymmetric. Suppose the seller knows the ice cream is contaminated, but the buyer does not. The buyer's willingness to pay 2 dollars does not reflect the true benefit to him. 2. The buyer or seller has market power. If the seller is a monopoly, he has purposely restricted the amount of cones sold to increase the price to 2 dollars per cone. If the buyer is a monopsony, he has purposely restricted his purchases to avoid driving the price higher than 2 dollars a cone. In either case, the outcome is inefficient. 3. There are positive or negative real externalities. If people dump half- finished ice cream on the beach, creating messes, that is a negative externality, an extra cost. The ice cream was worth 2 dollars to the buyer, but some innocent beach walker pays an extra 50 cent cost when he steps on the mess left behind. The book lists some other reasons, but they are variants of these. Free riding, for example, is consuming positive externalities without paying for them. The principal-agent problem arises because of asymmetric information-- the principal does not know how hard the agent works or how talented he is, though the agent knows these things. Businesses exist in markets where change are always happening that help some people and hurt others. The ones that are hurt often ask for government intervention. Look for the three sources of market failure above in trying to decide whether regulation really is justified. It's tough to avoid bias when your own company is involved. But remember what the painter Whistler (of "Whistlers's Mother") once said (if I have remembered it right): "Two plus two always equals four, despite the demand of the critic for three and the whine of the amateur for five."