Chapter 15/The Shortcomings of Free Markets
CHAPTER 15
THE SHORTCOMINGS OF FREE MARKETS
Chapter 15 deals in a comprehensive way with a series of market failures. It is the complement to
Chapter 14, which extolled the virtues of free markets; this chapter concentrates solely on their
faults.
CHAPTER OUTLINE
WHAT DOES THE MARKET DO POORLY?
1. Market economies suffer from severe business fluctuations.
2. The market distributes income unequally.
3. Where markets are monopolized, resources are allocated inefficiently.
4. The market deals poorly with the side effects of many economic activities.
EFFICIENT RESOURCE ALLOCATION: A REVIEW
An efficient allocation of resources requires that price equal marginal cost for each
commodity. (P = MC).
EXTERNALITIES: GETTING THE PRICES WRONG
A beneficial externality is an incidental benefit of an economic activity.
Externalities and Inefficiency
When a firm’s activities generate detrimental externalities, marginal social cost (MSC)
exceeds marginal private cost (MPC), and the free market produces too much of the
commodity.
Externalities Are Everywhere
They are found throughout the economy.
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Both market economies and centrally planned economies wrestle with externality problems.
Government Policy and Externalities
Governments can promote efficiency by moving private costs closer to social costs.
PROVISION OF PUBLIC GOODS
When a good is not depleted by repeated use, and when people cannot be excluded from
access to it, it is called a public good.
The private market will underprovide public goods.
ALLOCATION OF RESOURCES BETWEEN PRESENT AND FUTURE
Investments, including investments in human capital or education, necessarily require
understanding the trade-offs between the present and the future.
The Role of the Interest Rate
The allocation between present and future is governed by interest rates that represent the
opportunity cost of money.
How Does It Work in Practice?
Because interest rates are manipulated for many purposes, there is little reason to think that
they represent a good evaluation of the future.
The market tends to devote too many resources to immediate consumption because today’s
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SOME OTHER SOURCES OF MARKET FAILURE
There are some notable omissions from the previous discussion of market imperfections
including:
1. Imperfect Information: “Caveat Emptor”
2. Rent Seeking
MARKET FAILURE AND GOVERNMENT FAILURE
The market has many failures, but remember that it has many strengths as well, and that
governments are also subject to failure.
THE COST DISEASE OF SOME VITAL SERVICES IN THE ECONOMY
Although not strictly a market failure, this often leads to government action that threatens
general welfare.
Deteriorating Personal Services
Personal Services Are Getting More Expensive
The costs of personal services such as education and health care have increased at a much
faster rate than the Consumer Price Index.
Why Are These “In-Person” Services Costing So Much More?
The “cost disease” of personal services stems from their labor-intensive nature.
Uneven Labor Productivity Growth in the Economy
A Future of More Goods, but Fewer Services: Is It Inevitable?
As the society becomes richer, it becomes more difficult, not less, to provide services such as
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Government May Make the Problem Worse
Here the problem is that the market does give the appropriate price signals, but government is
likely to misunderstand these signals and to make decisions that do not promote the public
interest most effectively.
THE ECONOMICS OF AMERICA’S 2010 HELATH-CARE REFORM: THE
DEBATE CONTINUES
The quest for universal care as opportunity costs. Society must decide on its priorities.
PUZZLE RESOLVED: EXPLAINING THE RISING COST OF CANADIAN
HEALTH CARE
Despite attempts at price controls, Canadian health-care costs have risen dramatically
because of the effects of the cost disease of personal services.
THE MARKET SYSTEM ON BALANCE
Although the market mechanism is virtually irreplaceable, the public interest nevertheless
requires considerable modifications in the way it works.
EPILOGUE: THE UNFORGIVING MARKET, ITS GIFT OF
ABUNDANCE, AND ITS DANGEROUS FRIENDS
The market system produces growth and prosperity as no other system has been able to do.
MARGIN DEFINITIONS
Production Possibilities Frontier: a curve that shows the maximum quantities of outputs it is
possible to produce with the available resource quantities and the current state of technological
knowledge.
Resource Misallocation: if it is possible to change the way resources are used or the
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Marginal Social Cost (MSC): the sum of its marginal private cost (MPC) plus the incidental
cost (positive or negative) that is borne by others.
Marginal Private Cost (MPC): the share of an activity’s marginal cost that is paid for by the
persons who carry out the activity.
Marginal Social Benefit (MSB): the sum of its marginal private benefit (MPB) plus the
incidental benefits (positive or negative) that are received by others, and for which those others
do not pay.
Rent Seeking: unproductive activity in the pursuit of economic profit.
Moral Hazard: the tendency of insurance to discourage policyholders from protecting
themselves from risk.
Agents: people hired to run a complex enterprise on behalf of the principals.
Principals: those whose benefit an enterprise is supposed to serve.
MAJOR IDEAS
1. Markets often fail when confronted with externalities and public goods, that is, when
prices are not charged to people who benefit from a product or who impose costs on
others.
2. A detrimental externality occurs when an economic activity incidentally harms others
who are not directly involved in the activity; a beneficial externality occurs when an
economic activity incidentally creates benefits for others.
3. When an activity causes a detrimental externality, the activity’s marginal social cost
(including the harm it does to others) must be greater than the marginal private cost to
those who carry on the activity. The opposite will be true when a beneficial externality
occurs.
4. The market will therefore tend to overallocate resources to the production of goods that
cause detrimental externalities and underallocate resources to the production of goods
that create beneficial externalities. This is one of the Ideas for Beyond the Final Exam.
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5. A public good is defined by economists as a commodity that is not depleted by additional
users. In addition, it is often difficult to exclude anyone from the benefits of a public
good, even those who refuse to pay for it.
ON TEACHING THE CHAPTER
Market failure is an extremely important topic and one that is often given short shrift in many
economics courses. It is imperative for the students to have an understanding of the conditions
under which free markets do not produce socially optimal results.
Chapter 15 is an excellent summary chapter, bringing together a great deal of the material
that has already been covered, or that will be covered in later chapters. For example, the sections
on price distortions can be used to explain why economists are so concerned about the departures
from perfect competition that was covered in Chapter 10. The section on externalities provides
the groundwork for Chapter 16 on environmental economics. The discussion of public goods
leads into Chapter 17 on public finance. Instructors may want to refer to the material in this
chapter frequently throughout the course.
PROBLEMS
1. What type of market failure is involved when:
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a) Shipping companies do not build the lighthouses they need.
b) The effluent from pulp and paper mills pollutes a river.
c) Fossil fuels are depleted rapidly.
d) An individual with a serious medical issue buys health insurance.
e) Ticket prices to string quartet concerts rise.
f) People fail to keep their front lawns neatly mowed.
Solution:
a) Public good—nonexcludable and nonrival in nature
2. In each of these cases, draw a diagram showing the applicable marginal social benefit, the
marginal private benefit, the marginal private cost, the marginal social cost, the
equilibrium output, and the socially optimal output.
a) Megafurnace Company disposes of its wastes in the nearby river when it produces
steel.
b) Marvin Musician plays his amplified keyboard at midnight in the college dorm.
c) Gayle Gardener plants beautiful tulips in the front yard of her house on Main Street.
d) Advanced Semiconductors, Inc. trains its labor force in high-tech skills, after which
time many of its workers take jobs at other firms.
Solution:
3. In each of the cases in Problem 2, should the government take action to bring the actual
output closer to the optimal output? If so, what action?
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Solution: Government should take action to ensure that economy is producing socially
4. Explain why each of the following is or is not a public good (or is an ambiguous case):
a) The U.S. Navy
b) The welfare system in your state
c) The public parks in your community
d) Medical care in your community
e) Downtown street cleaning
Solution: There may be some debate on these examples but for the most part we can draw
the following conclusions. Examples a, b, and e are public goods as these programs are
DISCUSSION QUESTIONS
1. “The market system fails utterly to provide for the future. The adequacy of natural
resources and the quality of the natural environment a hundred years from now depend
upon actions that we are taking now—but because future generations cannot express their
preferences in today’s marketplace, their interests are not represented, and they are being
impoverished.” Discuss.
Suggested Answer: Many observers believe that the market often shortchanges the future,
2. “There is no possibility of productivity improvements in the performing arts. And yet the
costs of performances keep going up because wage rates in general in the economy are
rising, and performers insist upon sharing in that prosperity at least to a small extent.
Therefore the costs of performances keep rising. Paradoxically, the country will soon
become so wealthy that most consumers will not be able to afford any live performances
at all, and our only exposure to the performing arts will come through the electronic
media.” Discuss.
Suggested Answer: Student responses will vary. Cost of performances could also be
rising due to the premium people place upon them. Rising costs could also be a reflection
3. Most people insist upon having some form of health insurance. And yet when they have
health insurance, they have an incentive to use more medical care than they really need,
because the private marginal costs are much lower than the social marginal costs. This is
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one of the reasons for the crisis in health care in the United States today. Can you think of
any ways to alleviate this problem?
Suggested Answer: Student answers will vary. Awareness campaigns, tying premiums to
4. Consumers cannot make optimal choices about purchases unless they are well informed
about the quality of goods in the marketplace. Some people defend corporate advertising
as providing that information. Others argue that advertising really is “disinformation,”
that whatever it conveys to us is certainly not objective information about products. What
is your opinion? Does advertising make the market more efficient?
Suggested Answer: It is a requirement of the market mechanism that consumers and
producers have all the information they need to make good decisions. In this sense,
5. “It is pointless to dwell upon market failures. True, the market sometimes fails to achieve
the optimal outcomes that it would if all industries were perfectly competitive. But it
comes fairly close. Moreover, there is no good substitute for the market. Certainly the
inefficiencies inherent in government intervention are far greater than any problems the
market could create. Whatever its faults, the market is our best guarantee of efficiency.”
Discuss.
Suggested Answer: As a means of achieving efficiency in the production of ordinary
consumer goods and responding to changes in consumer preferences, the market system