Understanding Market Structures, Externalities, and Market Failures

Posted on Jul 4, 2024 in Economy

Define what a positive and negative externality is and provide an example of each.

Negative externalities occur when producers or suppliers impose costs on third parties who are not directly involved in a market transaction. Conversely, positive externalities occur when people who are not directly involved in a market transaction receive benefits from it without having to pay for them.

Here are examples of each:

• Negative Externality: The cost of breathing polluted air.
• Positive Externality: The benefit of having others inoculated against a disease.

What is the moral hazard problem? Given an example of the moral hazard problem and explain why it might lead to an undesirable market outcome and lead to market failure.

The moral hazard problem arises when a person behaves more recklessly after obtaining a contract that shifts the costs of negative outcomes onto another party, such as an insurance company or the government.

For example, a truck driver might start speeding and passing aggressively after obtaining auto insurance. This behavior could lead to a market failure because lenders might start making loans to high-risk firms, knowing that the government will have to bail them out if they go bankrupt.

What is the adverse selection problem? Given an example of the adverse selection problem and explain why it might lead to an undesirable market outcome and lead to market failure.

An adverse selection problem arises when information known to one party to a contract or agreement is not known to the other party, causing the latter to incur major costs.

For instance, individuals in poor health are statistically more likely to buy health insurance. This information asymmetry might lead to market failure. The sorting of people purchasing insurance would become biased toward those with high risks, which is disadvantageous to the insurance company. Consequently, insurance rates would rise so high that many people would be unable to afford coverage.

Why is there a free-rider problem with public goods? Why doesn’t the private sector produce and sell public goods? How can governments overcome the free rider problem?

The free-rider problem exists with public goods due to their characteristics of non-rivalry (one person’s consumption doesn’t diminish another’s) and non-excludability (it’s difficult to prevent people from using the good). Most people are reluctant to pay for something they can obtain for free.

The private sector doesn’t produce and sell public goods because they cannot charge for them effectively, eliminating the profit incentive. Governments, however, can overcome the free-rider problem through taxation. This funding mechanism allows them to provide public goods without relying on voluntary contributions.

A computer company is considering lowering the price of its laptop computer to promote sales. However, it worries that this will reduce desktop computer sales. Given the cross-price elasticity of demand, determine and explain why its concerns are legitimate or not.

The computer company’s concern about reducing desktop sales by lowering laptop prices depends on the cross-price elasticity of demand between the two products. This measure indicates how the demand for one product (desktops) responds to price changes in another (laptops).

• If the cross-price elasticity is positive, laptops and desktops are substitutes. Lowering laptop prices would likely decrease desktop demand, making the company’s concern legitimate.
• If the elasticity is low or negative, it suggests weak substitution or complementarity. The impact on desktop sales would be minimal, alleviating the company’s concern.

Why does a price decrease cause revenue from sales to increase in some circumstances and decrease in others? What does the price elasticity of demand have to do with this?

The impact of a price decrease on revenue depends on the price elasticity of demand, which measures how sensitive quantity demanded is to price changes.

• Elastic Demand: A price decrease leads to a proportionally larger increase in quantity demanded, resulting in higher total revenue.
• Inelastic Demand: The quantity demanded changes by a smaller percentage than the price change. A price decrease will cause revenue to decrease.
• Unitary Elastic Demand: The price change does not affect total revenue, as quantity demanded changes by the same percentage as the price change.

What are some examples of markets that would be considered as Competitive? Monopolized? Oligopolistic? Explain why each is representative of the market structure it exemplifies regarding (i) number of competitors, (ii) type of product sold, (iii) control over sales price, (iv) entry conditions and (v) advertising/promotion.

Competitive Market Example: Agriculture

• Number of Competitors: Many small farmers and producers.
• Type of Product: Relatively homogeneous products (e.g., wheat, corn).
• Control over Sales Price: Limited control; prices determined by supply and demand.
• Entry Conditions: Relatively easy entry due to low barriers.
• Advertising/Promotion: Minimal advertising; products are well-known commodities.

Monopolized Market Example: Water Supply Companies

• Number of Competitors: Typically, a single provider in each area.
• Type of Product: No close substitutes for water.
• Control over Sales Price: Significant control, often regulated by the government.
• Entry Conditions: High barriers to entry due to infrastructure requirements and regulations.
• Advertising/Promotion: Limited advertising, as consumers have no alternatives.

Oligopolistic Market Example: Automobile Industry

• Number of Competitors: A few large firms dominate the market.
• Type of Product: Differentiated products with brand identity (e.g., Ford, Toyota, Honda).
• Control over Sales Price: Some control, but prices are influenced by competition.
• Entry Conditions: High barriers to entry due to economies of scale, technology, and regulations.
• Advertising/Promotion: Extensive advertising to differentiate brands and influence consumer preferences.

Compare and contrast pure monopoly to perfect competition in terms of (i) price, (ii) output, (iii) profitability and (iv) economic efficiency?

Explanation:

• Monopolists have market power and can restrict output to charge higher prices, leading to higher profits but reduced economic efficiency.
• Firms in perfect competition are price takers, selling at market prices. This leads to optimal output and maximum economic efficiency, but minimal long-term profitability due to intense competition.