At Scioto Analysis, our core specialty is microeconomic analysis of public policies. We use this lens because microeconomics provides a framework for understanding how individuals, households, and firms make decisions in response to changing market conditions.
At Scioto Analysis, our core specialty is microeconomic analysis of public policies. We use this lens because microeconomics provides a framework for understanding how individuals, households, and firms make decisions in response to changing market conditions.
One of the most important models we use is basic supply and demand. How people react to changes in market prices can tell us a lot about underlying economic conditions. Understanding these markets is essential.
In a competitive market, the price of a good will eventually reach an equilibrium such that supply equals demand. Given the assumptions of a competitive market, this has the fortunate side effect of maximizing total surplus in the market. In other words, an intervention in the market will result in less overall value existing in the economy.
Unfortunately, perfectly competitive markets don’t really exist in the real world. Because of this, it’s worth understanding what the gaps are between real markets and ideal markets. If we understand why markets aren’t working at maximum efficiency, then we can consider ways to address those issues and create more value for society.
One of the most common and important market failures is the existence of externalities. An externality is some effect that occurs when a good is consumed or produced that affects third parties to a market transaction. Classic examples are pollution from a factory or secondhand smoke from cigarettes.
If an externality is the only market failure, then that market actually does operate completely efficiently for the buyers and sellers who participate. The issue is that because people outside the market are harmed (or helped in some cases) by that market activity, overall wellbeing might actually increase if less of that good was consumed. The private equilibrium does not align with the social equilibrium.
Another important market failure is information asymmetry. This occurs when one side of the market has some private information that allows them to take advantage of the other. A common example of this is a shady used car dealer who intentionally hides defects in order to sell poor cars at high prices.
A less nefarious example of imperfect information is if a market participant is unaware of viable substitutes. A buyer might not know that other sellers of a good might offer better prices or quality, or a seller might not know their product could fetch a higher price if they sold to other clients.
Another significant market failure arises from public goods, which are defined by two key characteristics: they are non-rivalrous and non-excludable. Non-rivalrous means that one person's consumption of the good doesn’t prevent another person from consuming it. Non-excludable means it is impossible or very costly to prevent someone from consuming the good once it has been produced, even if they haven't paid for it.
One example of a public good is a city park. One person walking their dog through the park doesn’t prevent someone else from having a picnic, and it isn’t possible to keep people who don’t help pay for the park’s maintenance from enjoying the greenspace.
Because of these characteristics, public goods are often underprovided by the private market. This is due to the "free-rider problem," where individuals can benefit from the good without paying for it. A private company would struggle to make a profit providing public parks because they can’t reasonably make people pay. As a result, the government typically steps in to provide public goods, funding them through taxes.
One final important market failure is the existence of monopolies. In economic theory, monopolistic firms have the ability to extract greater surplus for themselves at the expense of lower surplus for consumers plus an additional deadweight loss. In other words, they take an extra slice of the pie at the cost of throwing the rest in the garbage.
Because of this, monopolies are generally illegal. However, there are cases where it actually makes sense to allow firms to have monopoly power. These are called natural monopolies, and they occur when the upfront costs of entering a market as a seller are extremely high or where there are significant economies of scale.
The most common example is local utility providers. It would be extremely expensive for more than one company to build a major power plant and transmission infrastructure, so in many places single firms are allowed to manage all the utilities. Where I live in St. Paul, Minnesota, we have Xcel Energy. These firms need to be closely regulated since they don’t have natural competitors to encourage them to act in a socially optimal way.
Market failure is a key consideration for policy analysts like us. They give us guidance for where government can improve markets through tools like taxes, subsidies, public goods provision, and regulation. This provides us with a roadmap for how government and markets can work together to improve social welfare as a whole.