CHAPTER 3
Spontaneous Order, Markets, and Market
Failure
CHAPTER SUMMARY AND TEACHING OBJECTIVES
The Prime Directive in economics is the idea that markets are efficient and that they create incentives
for living standards to increase. At times, however, the market outcome is not efficient. This occurs in
cases of externalities, public goods, asymmetric information, and in common property ownership. It is
often argued that government involvement in economic decisions can address market failure. However,
governments often fail too.
IMPORTANT TERMS
Rent seeking the use of government to reallocate wealth and resources and to affect outcomes
Market failures times when the market is unable to allocate resources and/or goods and services
efficiently
Externalities costs or benefits imposed on people who are not part of an economic decision to
purchase a good or service
Public Goods goods people can consume without paying for them
TOPICS AND TEACHING SUGGESTIONS
1. The Prime Directive: Look to the Market
The Prime Directive in economics is the idea that the market efficiently allocates resources and
2. Governance and Government Failure
When markets fail and private solutions cannot be promoted, government is often seen as an
10 Chapter 3: Spontaneous Order, Markets, and Market Failure
ANSWERS TO EXERCISES
1. What does it mean to say that people don’t like the market outcome?
2. Give some examples of rent seeking. If rent seeking is inefficient, will it be competed away?
Why or why not?
3. What is an “externality”? Why might it create a problem for market allocation?
4. Why is it widely accepted that the government is responsible for dealing with externalities?
5. Give an example of an externality between firms, between customers and firm, and between
suppliers and firm?
6. Explain how smoking can simultaneously generate positive and negative externalities. Is there
too much or too little smoking? Explain why smoking bans on bars and restaurants do not
7. Using a tax to correct for an externality means subtracting the private cost of the activity from
the social cost. Who should determine /quantify this social cost, and how should they do it?
What is the analogous approach to externalities within the firm or between firms?
8. “Anyone who tells you that markets left to their own devices always lead to socially
beneficial outcomes is talking utter nonsense.” Do you agree with this statement? Defend
9. Is the government provision of interstate highways a productive use of resources? What
would have occurred had the government not taken responsibility for building and
maintaining highways?
10. What is a public good? Is it necessary for government to provide a public good? Apply your
answer to national defense. Apply your answer to a lighthouse. Could either be privatized?
11. Describe two examples of times when you behaved as a “free–rider”. For each instance,
explain how your behavior may have been different had you had to pay for the good/service
involved. How should these specific “free–rider” problems be rectified? Explain.
12. Suppose a firm has a choice between male and female lawyers and that the two appear to be
identical on paper. Why might the choice of the male be an asymmetrical information
problem?
13. What is adverse selection? What is moral hazard? Give an example of these two problems
14. “Markets tend to favor the party that knows more.” True or false? So if you think you might
know less, how does that change your behavior?
15. Is it necessary to have democracy to have a “free enterprise economy”? Can a free enterprise
economy and totalitarianism coexist?
16. We have all experienced the “co–pay” when it comes to health insurance. We also have had to
choose how large of a deductible we are willing to live with when we purchase auto
17. Why does corruption negatively affect economic growth and standards of living? Why is
corruption like a tax on doing business?
18. Why does corruption tend to arise more when government has a larger role in an economy
than when government’s role is small?
19. A beekeeper, Yung, lives next to an apple orchard. She not only benefits from the bees‘
honey, which she sells, but she also creates a positive externality for her apple grower
neighbor: Yung‘s bees help pollinate the apple trees so the apple grower can grow more
apples. Yung’s total cost and benefit for keeping her bees is the following:
Price per 1000 bees 27 24 23 21 18 15 12
Quantity of bees demanded 1 2 3 4 5 6 7
Quantity of bees supplied 9 8 7 6 5 4 3
a. Ignoring the externality, how many bees will be kept?
b. If the apple grower wants to see 6,000 bees kept, what is the value of the externality?
What would have to happen for the socially optimal (including externality) amount of bees to
be kept?
20. Suppose that an automobile race track is built several miles from a small town. After the
construction is completed it is discovered that the heavy roar from the cars regularly disturbs
the 2,500 local residents between the hours of 10:00 PM and 1:00 AM on summer nights.
Each local resident places a value of $150 on having quiet evenings at home during the
summer concert season. The amphitheater owners could install a retractable roof over the
track that would eliminate the noise at a cost of $350,000. Local residents could install extra
insulation in their homes to soundproof them at a cost of $125 per resident. Suppose that it is
easy for the theater owner and the town residents to reach an agreement that makes them all
better off. If the amphitheater must provide full monetary compensation for any noise
damage imposed on the community, what will the outcome be? If the amphitheater is NOT
required to pay any compensation for any noise damage done to the community, what will be
the outcome?