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Types of Market Failure

This post goes over a quick discussion of the invisible hand, and introduces the invisible foot (kicking you in the ass for believing that markets work :) OR market failure).

There are four basic types of market failure for goods/services or environmental resources:
Externalities, public goods, common property, and hidden information.

  1. Externality: this is the most common case, where an activity has an effect on a third party who is not involved in the activity. Some examples include the student in front of you enjoying a bean burrito (and then polluting your air), a factory polluting a river that others then cannot swim in (who didn't buy the factory's product), and finally your dorm mate listening to music really loud and it annoys you (negative externality) or your enjoy it (positive externality). 
    1. Ecosystem externalities: It is crucial for natural scientists and economists to work together to properly understand these externalities and their effects on humans. For example, mining any type of ore out of the ground can result in forms of pollution or diminished air/water quality that affects people who either did not work for the mining firm or purchase their products.
  2. Public goods: Goods that are non-excludable (anyone can use them at any time), and non-rival (one persons consumption does not affect another's ability to consume). Pure public goods are both non-excludable and non-rival, while impure public goods are one or the other but not both. Allocation of public goods are generally inefficient because of...
    1. Free riding- since a person cannot be excluded from using a public good, each person has an incentive to let someone else provide the good (and therefore not contribute/pay). Examples include public radio and TV, and a variety of government programs such as roads and the military. Note that most "free" radio and TV stations are supported by ads (because people would not donate enough to keep them around) and government programs are supported by mandatory taxes because people in general would not be willing to volunteer monies for the government to then reallocate.
  3. Common Property - Is related to public goods except that the good is rival and therefore can be diminished. Because exclusion is not possible, everybody rushes to consume the good and it is soon depleted. An example may include free donuts at your workplace where everybody rushes to get one before they are gone or grazing lands open to the community. People have an incentive to take advantage of the resource because if they do not, then others may leaving them with nothing. This is also commonly referred to as the tragedy of the commons.
  4. Hidden information - asymmetric information, one party knows more about a good or service than the other party. This becomes an issue when people spend more money on a resource (say a car) then they should because of unscrupulous salespeople. For example, a car dealer may know that the car is a lemon, but they do not share this information with you so you pay more than you should resulting in a deadweight loss to society. Some argue that the financial crisis of 2008 in the US was a result of hidden information, meaning that securities salesman knew that the mortgage backed securities were junk, but still sold them at a premium.

How can some of these market failures be corrected?

Assign property rights: Coase Theorem. We could assign rights to clean air to either the factory owner or the people and they could then trade units of clean air. For example, the people could sell units of air to the factory to pollute, or the factory could sell units of clean air to the people to breathe. The argument is that whoever has the right, trade will commence until the willingness to pay for clean air is equal to the willingness to accept to give up clean air.

Green taxes: incorporate the externality. Focuses on price.

Tradable permits: limit the quantity of the externality. Focuses on quantity.