Unit 10 Market successes and failures: The societal effects of private decisions

10.12 Summary

• For a Pareto-efficient allocation of resources, the marginal social cost of production and consumption of every good must equal the marginal social benefit.
• Where private and social costs or benefits differ, and decision-makers consider only their private interests, the external effects of their decisions result in misallocation (Pareto inefficiency).
• For markets to allocate resources efficiently, prices must reflect marginal social costs and benefits. Market failure occurs if prices send the wrong messages, or if the relevant markets don’t exist.
• If property rights are clearly established, an efficient allocation may be achieved through private bargaining. But this will not happen if, as is typically the case, transaction costs impede bargaining.
• When markets and private bargaining fail, government regulation or taxation may help to overcome the problem. But there are also limitations—such as a lack of important information—on the effectiveness of government policy.
• Public goods are a special case of external benefits. They are non-rival: the marginal cost of supplying an additional user is zero.
• Private firms will not provide a public good efficiently. If the good is excludable, a firm may be able to provide it to fewer than the Pareto-efficient number of consumers by setting a price above marginal cost.
• Shared or open-access resources are non-excludable but at least partially rival. This also leads to misallocation—that is, overuse.
• When relevant information is asymmetric between the parties to an interaction (or is non-verifiable), the contract will be incomplete and the outcome inefficient, because whatever is not covered in the contract is an external effect of one party on the other.
• Examples include the hidden action problem in the labour market when extra effort by the worker is an uncompensated external benefit to the employer.
• Hidden attributes result in adverse selection as buyers or sellers with better attributes withdraw from the market.
• Some goods and services are not allocated in markets because we agree that they are merit goods that should be available to all; or that it would be repugnant for them to be traded for money.