TOPIC INFO (UGC NET)
TOPIC INFO – UGC NET (Economics)
SUB-TOPIC INFO – Public Economics (UNIT 6)
CONTENT TYPE – Detailed Notes
What’s Inside the Chapter? (After Subscription)
1. Introduction
2. Asymmetric Information
2.1. Adverse Selection
2.2. Moral Hazard
2.3. Remedial Measures for Asymmetric Information
3. Public Goods
3.1. The Free Rider Problem
3.2. Efficient Provision of Public Goods: The Samuelson Condition
3.3. Remedial Measures for Public Goods
4. Externality
4.1. Divergence Between Private and Social Cost/Benefit
4.2. The Coase Theorem
4.3. Remedial Measures for Externalities
5. Conclusion
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Market Failure and Remedial Measures: Asymmetric Information, Public Goods, Externality
UGC NET ECONOMICS
Public Economics (UNIT 6)
Introduction
Market failure refers to a situation in which the free operation of a competitive market mechanism fails to allocate resources efficiently, resulting in an outcome that departs from Pareto optimality. Under the conditions specified by the First Fundamental Theorem of Welfare Economics, a perfectly competitive market with complete information, well-defined property rights, and the absence of externalities achieves an efficient allocation of resources. Market failure arises precisely when one or more of these underlying assumptions is violated. The principal sources of market failure conventionally studied are asymmetric information, public goods, and externalities, each of which is examined below along with the theoretical remedies proposed in the economics literature.
Asymmetric Information
The concept of asymmetric information was first analysed by George Akerlof in his 1970 paper titled The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. He considered an example of automobile market.
Asymmetric information exists, when amongst different parties in the trade, unequal information set persists. That is, if we assume there are buyers and sellers in the market, then under asymmetric information, one agent will have greater (or lesser) information than the other.
For example, in the market for second-hand cars, also called the market for lemons, sellers of the second-hand cars have more information about the real value of the car than the buyer. This information asymmetry gives the seller an incentive to sell goods of less than the average market quality. The average quality of goods in the market will then reduce as will the market size.
Moreover, buyer possessing lesser information, often is discouraged to go in trade, as he wants to reduce the risk of buying a damaged car, called a ‘lemon’. Thus the presence of asymmetric information, may result in no trade taking place at all.
In another example, in the market for health insurance, buyer of insurance has more information about his/her status of health than the insurance company selling such policies. More such examples exist in the real world.
The existence and persistence of asymmetrical information cannot be denied and due to it, many markets fail to trade. This simply means, that due to lack of symmetry in information between the parties, they are unable to construct tradable price in the market and without tradable price, trade cannot take place. This way asymmetrical information leads to market failure.
To correct for the market failure resulting from asymmetrical information, one way out is when such asymmetries in information can be nullified, in other words when more equal distribution of information is possible.
For instance, in markets for second-hand cars, some certification or quality accreditation with some years of guarantee from an organisation can help spread information about the true real value of the second-hand car amongst buyers and sellers.
In the market for health insurance, a thorough medical check-up can reveal true status of the buyers’ health.
In the financial market for credit, borrowers borrowing-score can help reveal the actual default rate of the borrower.