One question that often comes up in my class discussions of market failure and public goods is “Why can’t we just have a global government that intervenes to correct those market failures with global impacts?” The global market failures my students get so worked up about are those arising from common access resources, such as deforestation, over-fishing and global warming, those resulting from information asymmetry, such the global financial crisis of 2008-2009, and the global inequality in the distribution of income and economic opportunity.

What I haven’t ever really considered or explained to my students (until now) is the history of public goods. In the column below, Martin Wolf of the Financial Times’,  tells the history of public goods, which as it turns out, is intimately tied to the history of the modern state as we know it. This column should become a must read for all economic students studying market failure.

From The World’s Hunger for Pulbic Goods – January 24, 2012, Financial Times

What… is a public good? In the jargon, a public good is “non-excludable” and “non-rivalrous”. Non-excludable means that one cannot prevent non-payers from enjoying benefits. Non-rivalrous means that one person’s enjoyment is not at another person’s expense. National defence is a classic public good. If a country is made safe from attack everybody benefits, including residents who make no contribution. Again, enjoyment of the benefits does not reduce that of others. Similarly, if an economy is stable, everybody has the benefit and nobody can be deprived of it.

Public goods are an example of what economists call “market failure”. The point is generalised in the language of “externalities” – consequences, either good or bad, not taken into account by decision-makers. In such cases, Adam Smith’s invisible hand does not work as one might like. Some way needs to be found to shift behaviour; public goods usually involve some state provision; externalities usually involve a tax, a subsidy or some change in property rights…

The history of civilisation is a history of public goods. The more complex the civilisation the greater the number of public goods that needed to be provided. Ours is far and away the most complex civilisation humanity has ever developed. So its need for public goods – and goods with public goods aspects, such as education and health – is extraordinarily large. The institutions that have historically provided public goods are states. But it is unclear whether today’s states can – or will be allowed to – provide the goods we now demand.

The story of public goods goes back to the very beginning of states, which were the result of the agricultural revolution. The latter made populations vulnerable to… “roving bandits”. The answer was the “stationary bandit” – the state. It was not a perfect answer – answers almost never are. But it worked well enough to permit substantial increases in population. The state provided defence in return for taxation. The empires – Rome or China – enjoyed economies of scale in providing security. When Rome collapsed, security was privatised by local gangsters, at huge social cost: this we now call feudalism.

The industrial revolution expanded the activities of the state in innumerable ways. This was fundamentally because of the needs of the economy itself. Markets could not, on their own, provide an educated population or large-scale infrastructure, defend intellectual property, protect the environment and public health, and so on. Governments felt obliged – or delighted – to intervene, as suppliers and regulators, or subsidisers and taxers. In addition to this, the arrival of democracy increased the demand for redistribution, partly in response to the insecurity of workers. For all these reasons, the modern state, vastly more potent than any that existed before, has exploded in the range and scale of its activities. Will this be reversed? No. Does it work well? That is a good question.

Yet consider where we are now. The impact of humanity is, like the economy, increasingly global. Economic stability is a global public good. So, in the era of nuclear weapons, is security. So, in important respects, are control of organised crime, counterfeiting, piracy and, above all, pollution. So, even, is the supply of education or health. What happens anywhere affects everybody – and increasingly so. Unless there is a global economic collapse, an increasing number of the public goods demanded by our civilisation will be global or have global aspects.

Our states cannot supply them on their own. They need to co-operate. Traditionally, the least bad way of securing such co-operation is through some sort of leadership. The leader acts despite free riders. As a result, some global public goods have been adequately – if imperfectly – supplied. But as we move again into a multipolar era, the ability of any country to supply such leadership will be limited. Even in the unipolar days, it only worked where the hegemon wanted to provide the particular public good in question.

I started with economic stability, because the big surprise of the past few years is just how difficult it has proved to provide even this. The point I finish with is far broader. Ours is an ever more global civilisation that demands the provision of a wide range of public goods. The states on which humanity depends to provide these goods, from security to management of climate, are unpopular, overstretched and at odds. We need to think about how to manage such a world. It is going to take extraordinary creativity.

Related posts:

1. From public to private – what’s next, lighthouses?

IB Economists,

For your final quiz on our market failure unit, you will not be sitting in class writing, as usual. Rather, you will answer one of two possible questions in a video dialogue using the software available through the website Xtranormal. Here’s an example of what you will create:

Market Failure Video Quiz
by: welkerjason

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The assignment is as follows:

1. Create a free account on Xtranormal.com or log in using one of your other online accounts.
2. Once logged in, click the “Create” tab.
3. Choose one of the themes for your video. Notice, however, that you have only 300 xp (xtranormal points) to use in the production of your video, so some of the themes you cannot use for free.
4. Once you’ve chosen a theme you can afford to make a video on, choose the question you wish to answer in your video.
5. Think about how to best answer the question in dialogue form. It is recommended that rather than simply answering the question like you would on a written test or quiz, you have your two characters engage in a conversation about the topic. Another suggestion would be to show a simulated transaction in which the main idea of the topic is illustrated.
6. Experiment with camera angles, expressions, gestures, sounds and so on. While your grade will be based wholly on the content of your dialogue, production quality can certainly add to the entertainment value of your video.
7. Keep your video between 4 and 5 minutes in length. Either of the two questions should be able to be addressed in this amount of time. Be sure to preview your video before publishing, otherwise you will spend your xp points and not have enough to make changes later on.
8.  When you have previewed the video and re happy with it, publish it to the Xtranormal site. After it has finished rendering, view your video and copy the embed code, then log into our class Posterous page (zis-economics.posterous.com) and past the embed code into the html screen of a new post. Publish your video on that page for your teacher to see. Make sure you name is included in the post.

The questions: You may chose ONE of the following questions to address in your video:

• Explain, using examples, how market failure may occur when one party in an economic transaction possesses more information than the other party. (10 marks)
• Explain why inequality in the distribution of income within a nation is sometimes considered a market failure and how government policy can help reduce income inequality (10 marks)

Related posts:

1. Market failure versus Government failure – what should we be more concerned about?
2. IB Economics Podcast Assignment – Market Failure Commentary
3. Market Failure and the role of government in the economy ~ an introduction to Environmental Economics

The prevalence of income inequality in free market economies indicates that inequality may be the result of a market failure. Those who are born rich are more likely to become rich, while individuals who are born poor are more likely to live a life of relative poverty. In a “free” market, it is believed, all individuals possess an equal opportunity to succeed, but due to a mis-allocation of resources in a purely market economy, this may not always be the case.

The resources I refer to here are those required for an individual to escape poverty and earn a higher income. These include public and merit goods that those with high incomes can afford to consume, while those in poverty depend on the provision of from the state, including:

• Good education
• Dependable health care
• Access to professional networks and the employment opportunities they provide

Whenever a market failure exists, it can be argued that there is a role for government in regulating the market to achieve a more optimal distribution of resources. When it comes to income inequality, government intervention typically comes in the form of a tax system that places a larger burden on the rich, and a system of government programs that transfer income from the rich to poor, including welfare benefits, unemployment benefits, healthcare for low income households, public schools and support for economic development in poor communities.

Many politicians and some economists like to argue that income inequality is not as evil as many people make it out to be, and that greater income inequality can actually increase the incentive for poorer households to work harder to get rich, contributing to the economic growth of the nation as a whole. Allowing the rich to keep more of their income, in this way, leads more people to want to work hard to get rich, as they will be able to enjoy the rewards of their hard work.

Another common argument is that higher income inequality leads to social and economic disruptions that can slow economic growth and bring an economy into a recession or a depression, since the middle and lower income groups in the nation will not benefit from a relatively equal share of the nation’s output, and over time will see their living standards drop and their overal productivity and contribution to national output decline.

The debate over inequality and what government can or should do about it is at ther root of many other economic debates today. A recent study by the Political Economy Research Institute of the University of Massachusetts, Amherst, provides support for those who support the second argument above. Here are some of the main discoveries from the study, “Searching for the Supposed Benefits of Higher Inequality: Impacts of Rising Top Shares on the Standard of Living of Low and Middle-Income Families”.

Discoveries of the study:

Some believe that increase inequality leads to more growth, others argue that it leads to less growth.

A more interesting question is whether rising income inequality leads to a higher standard of living for everyone in society, or whether standards of living decline for those in the middle as the percentage of total income earned by the top 10% increases.

The study found that the higher the percentage of income earned by the top 10%, the incomes of those in the middle and bottom of the income distribution actually decreases. Not just the percentage of total income, but the actual incomes of these groups falls as the rich get richer.

The popular belief is that reducing taxes on the rich increases the amount of investment in the economy, creating more jobs and helping increase incomes of the middle and lower income households. This theory is sometimes referred to as “trickle down” economics, as the increased incomes and wealth at the top will “trickle down” and raise the incomes of the rest of society as well.

However, actual data shows that a 10% increase in the share of total income earned by the top 10% of income earners leads to a 2% decline in the incomes of households in the middle of the income distribution (based on data for the period between 1979 and 2005).

It’s not just that the rich get richer and the poor get poorer, rather that the rich getting richer makes the poor (and the middle income earners) poorer. This is a breakthrough discovery.

Possible explanations:

• The rich contribute to growth abroad, rather than at home: Rich households’ higher incomes allow them to consume more domestic output and imported goods and services, but it also allows them to save more, which sometimes translates into more investment. But more investment does not always translate into domestic economic growth, since investment is now global. A rich American saving more does not mean American firms will have access to cheaper capital, as domestic savings may fuel investment in emerging markets or elsewhere abroad. Foreign investment resulting from savings among rich Americans counts as a leakage from America’s circular flow of income, leaving less income within America for the middle and low income earners. Essentially, much of the income earned by the rich is saved abroad, contributing to employment and growth overseas, reducing incomes of the middle class at home.
• Reduced support for the provision of public goods: When examining living standards, more than just income must be considered, but also access to education, provision of health care and other public goods such as public safety and security. Richer households are less interested in things like public schools and social welfare programs, as they do not rely on these for their own well-being. Therefore, the richer the top 10% become,  the greater their incentive to work against efforts to fund public education, public health and public safety. The underprovision of these social welfare enhancing goods by govenrment further widens the gap between the living standards of the richest and the middle class. Economist Robert Reich refers to this phenomenon as “the secession of the successful”.
• Wage competition reduces incomes in the middle: Business owners, who make up a large percentage of the richest households in America, increase their own incomes to the extent that they can drive down the wages they pay their employees. In this way a higher share of national income is enjoyed by a smaller proportoin of society. The minimum wage has barely increased over time, and workers have less bargaining power as fewer workers than ever are members of labor unions; this has allowed business owners to pay lower wages over time, concentrating an increasing share of national income in business profits, and less and less in wages for workers.

In the video below, the study’s author shares some of the findings discussed above. Watch the video and respond to the discussion questions that follow.

Discussion Questions:

1. Summarize the argument against a government taking measures to redistribute its nation’s income to reduce the level of inequality between the rich and the poor.
2. Summarize the argument for a government reducing inequality.
3. Popular belief holds that “a rising tide lifts all boats”. In other words, if the total income of a nation is increasing, it does not matter if the rich are enjoying a larger percentage of the higher income than the poor and middle, because everyone is likely to be better off than if total income were not growing at all. Does the study discussed above support this popular view? Why or why not?
4. What measures can a government take to assure that higher national income leads to higher standards of living for everyone in society, including the middle class and the poor? Why might the highest income earners be opposed to such attempts by government?
5. Should government intervene to reduce the level of income inequality in society?

Related posts:

1. How do you support low income workers to reduce inequality? – A Singapore Case Study
2. The role of taxes in income re-distribution – another preview of my textbook
3. Final Market Failure Quiz – IB Economics

This week we’ve been exploring the issues of common access resources and how they give rise to a market failure. The video below illustrates the tragedy of the commons in Indonesia’s fish populations.

The high demand for fresh seafood from Southern China and Hong Kong create demand for Indonesia’s reef fish species. Over the last decade, the fish stocks around the more populated Western islands of the archipelago have all but disappeared, so today fishermen have brought their unsustainable methods to the Eastern islands of Indonesia, using dynamite and cyanide to stun fish, which are then caught live and rapidly transported to the markets in China for consumption. According to some estimates, Indonesia’s fish stocks are declining by 30% per year, a rate at which they will be depleted within the next decade.

This poses several problems for both the consumers and producers of fresh fish. For the Chinese consumers, the increasing scarcity of fish in the next decade will mean rising prices and, eventually, the death of the market altogether. For Indonesian fishermen, the outcome is more dire; a loss of their livelihood as the fish stocks dry up.

This raises the question: Why do fisherman continue to use these unsustainable methods? Of course, in a competitive market with thousands of fisherman, if one individual chooses to fish using sustainable methods (using hook and line, for example), he risks catching fewer fish than the competition using cyanide and dynamite. Fewer fish mean less income and a lower standard of living. The rational thing for each individual fisherman, therefore, is to catch fish using the most productive method available. The tragedy of this is that the highest yielding methods are unsustainable, as the story explains, and before long the fish will be exploited to extinction.

The organization profiled in the video is using education to encourage fisherman to use sustainable methods to catch fish. Unfortunately, I fear this will not be enough to save the wild fish stock of Indonesia. The Indonesian government must intervene in the market to enforce strict catch limits, perhaps employing a permit scheme that would allow fishermen to buy and sell permits to catch a strictly controlled quantity of fish during a fishing season.

As it stands, however, Indonesia’s dwindling fish stocks demonstrate yet another example of the tragedy of the commons. Without clear property rights or management by a government, the common resource of Indonesia’s reef fish will continue to be exploited unsustainably,  leaving future fishing communities with fewer sources of income and future consumers with less variety of fish to consume and enjoy. The resource is over-exploited today, to the gain of today’s consumers and fisherman, at the expense of future generations.

Related posts:

1. The Tragedy of the Commons as a Market Failure

Over the last few weeks in our IB Economics class, we have been studying cases in which markets fail to achieve an efficient, socially optimal level of production and consumption when the private buyers and sellers are left to interact in a free market. Markets fail in many ways; sometimes they produce too much of a good, and sometimes too little is produced. There are some things society would benefit from having more of, while other things society would be better off with less than what is produced by the free market.

When the free market fails to achieve a socially optimal level of output, at which the costs and benefits not just of the individual consumers and producers are accounted for, but all social, environmental and health costs and benefits are weighed as well, the government may be able to improve on the free market outcome by intervening in some way. For example, certain goods deemed beneficial for society are simply under-provided by private firms: Education, infrastructure, public transportation, security, health care… these are all markets in which government often intervenes to increase the provision of the good to society. In other cases, government intervenes to decrease the amount of a good consumed: Cigarettes, alcohol, reckless driving, polluting factories, violence on TV, child pornography, dangerous drugs… in each of these cases governments tend to use taxes, regulation or legislation to reduce the amount of the harmful good available on the market.

Besides the merit (beneficial) goods and the demerit (harmful) goods described above, markets may fail in other ways as well. One notable form of market failure arises due to a phenomenon first articulated by American ecologist Garrett Hardin, who warned of the Tragedy of the Commons. In his 1968 essay, Hardin explained that when there exist common resources, for which there is no private owner, the incentive among rational users of that resources is to exploit it to the fullest potential in order to maximize their own self gain before the resource is depleted. The tragedy of the commons, therefore, is that common resources will inevitably be depleted due to humans’ self-interested behavior, leaving us with shortages in key resources essential to human survival.

Each of the videos below illustrates a different example of the tragedy of the commons. Watch the videos and think about how each applies Hardin’s concept.

Example 1: Thousands of fishermen empty lake in minutes:

Example 2 – Dr. Suess’s The Lorax

Example 3 – Tuna fishing

In each of the videos above, there is a common resource (fish and trees) over which no ownership has previously been established. The resource users (the Malian fishermen, the Once-ler and his family and the tuna boat), all have a strong incentive to maximize their own short term gain by extracting and exploiting the resource as quickly as possible.

• In the Mali fishing hole, the outcome is observable: within minutes the resource is depleted and there are no more fish for for future fisherman to enjoy.
• In The Lorax the result of the Once-ler’s exploitation of the forest is foretold in the beginning of the story when the young boy comes upon the desolate outskirts of his town.
• The tragedy of the commons acts as a warning to the tuna fishing industry, in which there are still tuna surviving in the world’s oceans, but at the rates industrial fishing boats such as the Albatun Tres exploit the resource, it will not be around much longer.

Garret Hardin – the Tragedy of the Commons

Discussion Questions:

1. Hardin refers to Karl Marx’s adage “from each according to his abilities, to each according to this needs.” What does Hardin have against this socialist idea?
2. How does Hardin’s example of a “common pasture” illustrate the tragedy of the commons? How is a common pasture similar to the three examples in the videos above?
3. According to Hardin, what are the only two solutions to the common pasture problem? Which of these solutions do you think would be most socially desirable?
4. Explain Hardin’s claim that “the unmanaged commons cannot possibly work once the population gets above a certain size”. Of the world’s common resources today, what are some examples of common resources that remain unmanaged?
5. Whose responsibility should it be to decide how common resources should be dealt with?
6. Do you agree with Hardin’s claim that “the world cannot possibly live at the American standard of living at its present population size”? Which of his predictions do you think is most likely to occur: Will the American (and Western European) standard of living have to go down or will the number of people in the world have to be reduced? Or is there a third possibility? Discuss.

Related posts:

1. Market failure versus Government failure – what should we be more concerned about?
2. “Global warming is one GIANT market failure”
3. A video and audio introduction to Market Failure

Over the last two weeks our IB Year 1 Economics students here at Zurich International School have been writing, recording, editing, and now publishing their own podcasts. Over the next two days these podcasts, covering several economics issues relating to Market Failure, will be published to the site below. If you have the chance, give them a listen; there are some very high quality examples of economic analysis and commentary here! Enjoy!

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Last year, I argued that Christmas was the most inefficient time of the year due to the large loss of welfare that goes with the tradition of gift giving. This year I will argue that Santa Claus, as the tradition is embraced in the English speaking world, fails to provide children with strong enough incentives to behave nicely, thus resulting in too much naughty behavior, reducing society’s welfare in the months leading up to Christmas. We’ll explore a market-based solution to this market failure,  already being practiced across the European continent, which harnesses the power of incentives to improve children’s behavior, and the overall efficiency of the Christmas holiday.

The lyrics to the popular Christmas song, Santa Claus is Coming to Town, are a warning to little children that they better not act naughty, OR ELSE! Read them and see what I mean:

You better watch out, You better not cry
Better not pout, I’m telling you why
Santa Claus is coming to town
He’s making a list, And checking it twice;
Gonna find out who’s naughty and nice
Santa Claus is coming to town
He sees you when you’re sleeping, He knows when you’re awake
He knows if you’ve been bad or good, So be good for goodness sake!
O! You better watch out! You better not cry
Better not pout, I’m telling you why
Santa Claus is coming to town

“So be good for goodness sake,” a child will say, ” OR WHAT? What are you going to do Santa, if I am naughty? Are you not going to bring me a present that I really want?”

You see, this is the problem with the Santa I grew up with. He is all carrot, and no stick. Humans respond to incentives, and the Santa I grew up with is great at incentivizing nice behavior, but he’s really bad at disincentivizing naughty behavior. Consider the following:

• Santa sees me when I’m sleeping and knows when I’m awake, so he knows when I’ve been bad or good. If I’m good, the implication is that I will be rewarded with wonderful gifts from Santa come Christmas time.
• If I’m bad, however, I will experience no loss whatsoever. While I will not benefit as much as the good children, nothing will be taken away from me. I will be made no worse off by being naughty, rather the degree to which I will be made better off is reduced.

This is a classic incentive problem. Santa provides rewards for good behavior, but fails to dole out punishment for bad behavior. A culture which embraces this benevolent Santa will invariably produce too many naughty children. Such a market failure can be illustrated clearly using benefit and cost analysis:

As economists, we’re always exploring ways to improve efficiency in the markets for different goods, services, and human behaviors. Clearly, in the market above, in which children determine how naughty they will be based on their perceived private benefits and costs of their own behavior, there is a market failure.

Due to Santa’s hollow threat (“…you better watch out!”), children lack a strong disincentive to not act naughtily, and therefore choose to engage in naughty behavior to the extent that overall welfare in society is reduced. The marginal private benefits of naughty behavior are far greater than the marginal social benefits of naughty behavior (let’s face it, acting naughty is FUN!).

So how could Santa better harness incentives and disincentives (both the carrot and the stick) to reduce naughty behavior and increase overall welfare in society, thereby increasing the overall efficiency? Santa must do more than just encourage good behavior; he must also strongly discourage naughty behavior.

Well, as it turns out, the Santa I grew up with is not the only version of Santa Claus in the world, and in fact the Santa known to millions of children all over Europe is one with a fearsome, wrathful side that is not timid about doling out punishment to naughty children. Allow me to introduce the European Santa, and his evil alter-ego, known here in Switzerland by the ominous name Schmutzli (which translates loosely to “dirty face”).

img source: http://www.ricksteves.com

The Swiss news site Swissinfo.ch introduces the character Schmutzli:

This is not the Santa Claus known to English-speaking countries but the Swiss version – who is normally accompanied by a strange-looking individual with a blacked out face.

The Swiss Father Christmas was based on Saint Nicholas, whose feast day was celebrated on Saturday – his Swiss German name, Samichlaus, alludes to that. But the origins of his sinister companion are less easy to make out.

Known as Schmutzli in the German part of the country… Samichlaus’s alter ego usually carries a broom of twigs for administering punishment to children whose behaviour throughout the year has not been up to scratch.

You see, here in Switzerland, and in much of Western Europe, Santa brings gifts for the children who have been nice, but his partner Schmutzli delivers harsh punishments to those children who have been naughty. Schmutzli, who goes by different names in other parts of Europe, is known to throw naughty children in his sack, carry them into the woods, and administer a fierce beating with his birch stick, and for the naughtiest children, to eat them or throw their beaten bodies into a river.

Schmutzli, quite literally, provides the stick to accompany Santa’s carrot. In Europe, children not only receive wonderful rewards from Santa for good behavior, but fierce punishments from Schmutzli for naughty behavior.

From an economic perspective, Schmutzli’s existence increases the efficiency of the Santa character dramatically, and therefore improves overall welfare in society by giving children both an incentive to act nice and a strong disincentive to act naughty, thereby internalizing the negative social costs of naughty behavior. The outcome can be as illustrated as below:

As the graph illustrates, Schmutzli’s presence by Santa’s side come Christmas time forces children, in their decisions regarding naughty behavior, to account for the likelihood that Santa truly “knows when you’ve been bad or good”. For if he does know when you’ve been bad, Santa will unleash Schmutzli, his child-hauling sack and his birch stick on those whose behavior has been more naughty than nice.

Schmutli’s existence in Switzerland’s Santa story internalizes the external costs of naughty behavior among children, and thereby reduces the marginal benefits enjoyed by naughty children, reducing the actual number of naughty children and the size of the deadweight loss they impose on society. Fewer children will act naughty, the externality is reduced, and overall welfare in society improves.

There you have it. The deadweight loss of Santa. If you ever doubted that Economists could find the inefficiency in Christmas, I’ve shown you once again that it is indeed the most inefficient time of the year. By providing a balance of rewards and punishments, Schmutzli’s presence corrects the incentive problem of an always benevolent Santa. Society as a whole should therefore suffer from less naughty behavior among its children.

Once again, a little Economic analysis can help make Christmas more efficient for all!

Related posts:

1. Grinchonomics – or “how the Economist stole Christmas”
2. McJobs in America – under threat!
3. “Opulent in elegance. Bountiful in spirit”

As IB SL and HL students, you will be required to produce, record and post one podcast written and performed by you and a classmate. The purpose of this project will be to strengthen and enhance your ability to explain economic theory, apply it to current real-world issues and evaluate the effectiveness of economic theory to explain what is occurring.As these skills are required to write a successful IB Economic Internal Assessment, the process of producing the podcasts will strengthen the performance of students on their IAs.

NEW: A guide to using Audacity for audio editing

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1. Final Market Failure Quiz – IB Economics
2. Market Failure and the role of government in the economy ~ an introduction to Environmental Economics
3. Market failure versus Government failure – what should we be more concerned about?

Market failures exist all around us. Until you have studied the concept, however, you would probably never know it! Not all market failures are in the form of pollution, however, and in fact many of the goods that are beneficial to society can be pointed to as examples of market failure.

If a good creates external benefits for society beyond those enjoyed by the consumer of the good itself, it is said to create positive externalities of consumption. Condoms are an example of such a good; when an individual uses a condom when having sex, he enjoys several private benefits, such as reducing the chance of becoming infected with a sexually transmitted disease and reducing the likelihood of an unwanted pregnancy. However, the benefits for society of condom use are much greater, and include lower HIV and other STD infection rates, thus a healthier, more productive population, lower birth rates thus less pressure on resources from excessive population growth. These are external benefits of condom use, which means they will not be considered when an individual decides whether or not he will use a condom when engaging in sex.

Using the terminology of market failure, the marginal social benefits of condom use exceed the marginal private benefits. Thus, when left to the free market, the quantity of condoms consumed will be less than the socially optimal quantity. Not enough people will use protection when having sex: birth rates will be higher than desired, HIV infection rates will be higher and society as a whole will bear the costs of unsafe sexual activity.

In India, a developing country where the average woman still has nearly three children in her life, population growth threatens to put increasing pressure on the nation’s resources. Therefore, the country could benefit greatly from increased use of condoms.  The video below demonstrates an attempt by non-governmental organizations to increase awareness among Indian males about the purpose and appropriate use of condoms.

Watch the video and respond to the questions that follow:

Discussion Questions:

1. What approach does the video take to correcting the market failure in the use of condoms?
2. Why is condom use lower than what is socially optimal in India?
3. Is this video an example of a commercial, or is it a public service announcement? What’s the difference?
4. Do you think it will work? How would we know if the video succeeded or failed?

Related posts:

1. A video and audio introduction to Market Failure

One of the most prominent economists of the 20th century was the late Milton Friedman, an ardent free market supporter who remained skeptical of government’s ability to correct market failures through interventionist policies.

I found the talk below interesting. Friedman offers several examples of market failures that have been pointed to as a justification for government intervention, and argues that in fact, government often does not truly know what the right outcome is in most cases. He believes that government failure should be just as much a concern as market failure; and that therefore societal welfare would be best met by finding market-based solutions to the misallocation of resources that sometimes arises under conditions in which externalities exist.

As you watch the video, consider Friedman’s claims regarding the role of government, then post your response to one of the discussion questions below.

Discussion Questions:

1. Is government better able to know the “optimal” quantity of output of different goods and services than private individuals are?
2. Under what conditions would the free market be best able to achieve solutions to market failures such as those described by Friedman?
3. What do you think should be of greater to concern to society, market failure or government failure?

Related posts:

1. Market Failure and the role of government in the economy ~ an introduction to Environmental Economics
2. Market Failure and Bullets
3. “Global warming is one GIANT market failure”

Each of the following videos or audio clips illustrate an example of a market failure. Watch or listen to each and answer the questions that follow:

Story #1: ”Cowboy City”

Story #6: Sweatshops and Story #7: Toxic chemicals (watch up to 11 minutes)

Click here to view the embedded video.

Discussion Questions:

1. Which of the stories above is about public goods, or goods which would not be provided at all if left entirely to the free market? Explain.
2. Which of the stories above is about demerit goods, or ones which would be over-provided by the free market due to their negative effects on the environment or human health? Explain.
3. Which of the stories above is about merit goods, or ones which are provided by the free market, but at a quantity below which is socially optimal due to the fact that they create spillover benefits for society as a whole.
4. Which of the stories describes a good or goods which the government currently regulates the production of? Which goods does government currently NOT regulate the production of?
5. What makes each of the stories above examples of market failure?

Related posts:

1. Market Failure and the role of government in the economy ~ an introduction to Environmental Economics
2. Market failure versus Government failure – what should we be more concerned about?
3. The Tragedy of the Commons as a Market Failure

The tools of economics can be applied to almost any social institution, even the decision of individuals in society whether or not to have children. All over the rich world today, potential parents have decided against having babies, the result being lower fertility rates across much of Europe and the richer countries in Asia, including Japan, South Korea and Singapore. Lower fertility rates have some advantages, such as less pressure on the country’s natural resources, but the disadvantages generally outweigh the benefits.

The story below, from NPR, explains in detail some of the consequences of declining fertility rates in the rich world, and identifies some of the ways governments have begun to try to increase the fertility rates.

The problem of declining fertility rates can be analyzed using simple supply and demand analysis. In the graph below, we see that the marginal private cost of having children in rich countries is very high. The costs of having children include not only the monetary costs of raising the child, but the opportunity costs of forgone income of the parent who has to quit his or her job to raise the child or the explicit costs of child care, which in some countries can cost thousands of dollars per month. Marginal private cost corresponds with the supply of babies, since private individuals will only choose to have children if the perceived benefit of having a baby exceeds the explicit and implicit costs of child-rearing.

The marginal private benefit of having babies is downward sloping. This reflects the fact that if parents have just one or two children, the benefit of these children is relatively high, due to the emotional and economic contributions a first and second child will  bring to parents’ lives. But the more babies a couple has, the less additional benefit each successive child provides the parents. This helps explain why in an era of increased gender equality, families with three or more children are incredibly rare. The diminishing marginal benefit experienced by individual couples applies to society as a whole as well, therefore the market above could represent either the costs and benefits of individual parents or of society at large.

Notice, however, that that the marginal social benefit of having babies is greater than the marginal private benefit. In economics terminology, there are positive externalities of having babies; in other words, additional children provide benefits to society beyond those emotional and economic benefits enjoyed by the parents. The podcast explained some of these external, social benefits of having children: a larger workforce for firms to employ in the future, more people paying taxes, allowing the government to provide more public goods, more workers supporting the non-working retirees of a nation, and more competitive wages in the global market for goods and services. Higher fertility rates, in short, result in more economic growth and higher incomes for a nation.

When individuals decide how many children to have, they make this decision based solely on their private costs and benefits, since the external benefits of having more babies are enjoyed by society, but not necessarily by the parents themselves. Therefore, left entirely alone, the “free market” will produce fewer babies (Qe) than is socially optimal (Qso).

So what are Western governments doing about low fertility rates? The podcast identifies several strategies being employed to narrow the gap between Qe and Qso. In Australia households receive a $1000 subsidy for each baby born. In Germany mothers receive a year of paid leave from work. Here in Switzerland mothers get three months of government paid leave and $200 a month subsidy to help pay for child care after that. Each of these government policies represents a “baby subsidy”. In the graph above, we can see the intended effect of these policies. By making it more affordable to have children, governments are hoping to reduce the marginal private cost to parents, encouraging them to have more children, which on a societal level should increase the number of babies born so that it is closer to the socially optimal level (Qso).

Unfortunately, as the podcast explains, it appears that parents are relatively unresponsive to the monetary incentives governments are providing. This can be explained by the fact that the private demand (MPB) for babies is highly inelastic. Even if the “cost” of having a baby falls due to government subsidies, parents across the Western world are reluctant to increase the number of babies they have.

As we can see in the graph above, a subsidy for babies reduces the marginal private cost of child-rearing to parents. But the MPB curve, representing the private demand for babies, is highly inelastic, meaning the large subsidy has minimal effect on the quantity of babies produced. Without the subsidy, Qe babies would be born, while with the subsidy only Qs are born, which is closer to the socially optimal number of births at Qso, but still short of the number of births society truly needs.

The “market for babies” in rich countries is failing. Because of the positive externalities of having children, parents are currently under-producing this “merit good”. One of two things must happen to resolve this market failure. Either the marginal private costs of having babies must fall by much more than the government subsidies for babies have allowed, or the marginal private benefit must increase. Either larger subsidies are needed, or some moral revival aimed at encouraging potential parents to consider both the private and social benefits of having children when making their decisions.

Don’t you love economics? We make everything seem so logical! And like they say, it all comes down to supply and demand!

Discussion Questions:

1. What makes low fertility rates among parents in the rich world an example of a “market failure”?
2. What are the primary reasons fertility rates are lower in the rich world than they are in the developing world?
3.  What are the economic consequences of lower birth rates? What are the environmental consequences of lower birth rates? Should government be trying to increase the number of babies born?
4. Why have government incentives for parents to have more babies failed to achieve the fertility rates that government wish they would achieve?
5. Do you believe that government can create strong enough incentives for parents to have more babies? If not, what will become of the populations of Western Europe and the rich countries of Asia given today’s low fertility rates? Should we be worried?

Related posts:

1. Market Failure and Bullets
2. “I am the condom friend ever useful to you”
3. Market failure versus Government failure – what should we be more concerned about?

The Global Coal Trade’s Complex Calculation : NPR

Sometimes when I read the news, I wonder what it would be like to NOT understand basic economics, and then I realize how much of what goes on around us can be explained by two simple concepts: demand and supply. The NPR story below talks about how the construction of two proposed coal exporting facilities on America’s west coast could, indirectly, lead to a greener future for America. Listen to the story then read on for more analysis:

China, already the world’s largest coal consumer, continues to build new coal burning electricity plants at an alarming rate. Its appetite for the “black gold” has driven the world price up to $100 per ton, as it has demanded increasing quantities from its own coal producers, but also those in other coal rich areas like Australia and the United States.

However, because of America’s lack of coal transporting and shipping infrastructure, US coal producers have been unable to sell their abundant coal to the Chinese, who are willing to pay 500% the equilibrium price in the US. The US market has remained isolated from the world market, not due to any explicit, government-imposed barriers to trade, rather due to fact that they simply can’t get their coal to the Chinese energy producers who demand it most.

Graphically, this situation can be illustrated as follows:

If the export facilities on the West coast of the US are not constructed, it will remain difficult for US coal producers to sell their output to China at the high price of $100, and the domestic quantity (Q2) will continue to be produced and sold for $20 per ton. But with the new port facilities, US energy producers will now have to compete with Chinese energy producers for American coal, and the US price will be driven up to the world price, since demand now includes thousands of Chinese coal-fired power plants. As the price rises from $20 to $100, the domestic quantity demanded in the US will fall to Q1, as domestic energy producers seek alternative sources of energy, switching instead gas, solar, or wind power.

The irony is that through increasing the ease with which American coal producers can sell their product to China, the US may reduce its own consumption of coal and its emissions of greenhouse gasses. Overall coal production in the US will rise with increased trade, but overall consumption within the US will fall.

Now, this may sound great if you’re the kind of person who thinks only locally. Air pollution will be reduced in the US, health will be improved, our electricity production will be greener and more sustainable. But globally, by making its coal available to China, the US market will contribute to the continued dependence on carbon-intensive energy production, and delay any progress among Chinese energy producers towards a transisttion to greener fuel sources.

The podcast also points out the fact that if the US did undertake the construction of the new coal-exporting facilities, it could be that the current high price of coal will have led to the entrence of several other large coal prodcuing countries into the world market, reducing China’s demand for US coal, reducing the price at which American producers can sell to China and thereby off-setting any domestic environmental benefit that may have resulted from the large decrease in quantity demanded among US producers at the current price of $100 per ton.

The whole conversation about the coal industry is somewhat depressing when the environmental costs of the industry are considered. Another NPR show, Planet Money, ran a story this week about the “gross external damages” caused by the production of coal-powered electricity. They cited a study which found that the damages caused by coal to human health and the environment outweight the benefits enjoyed by society from the generation of cheap electricity by around $10 billion in the United States alone. This means that if the US shut down every coal-powered energy plant in the country immediately, total welfare in the US would increase by $10 billion. There’s no doubt that energy prices would rise, but the gains in human and environmental health would outweight the added costs of electricity generation by $10 billion. If a similar analysis were undertakein in China, I would guess the potential welfare gain of transitioning to alternative energies would be far greater for the Chinese people.

Here’s the chart from Planet Money’s blog showing the net welfare loss of coal-generated electricity and other economic activities in the United States.

*GED = Gross external damages from pollution

Discussion questions:

1. How would the construction of two coal-exporting facilities on America’s West coast ultimately lead to a cleaner environment in the United States? Do you think this prediction is realistic?
2. Who stands to gain the most if the coal-exporting facilities are constructed? Who would suffer? In your opinion, should the facilities be constructed? Why or why not?
3. Interpret the colorful diagram above. What do the green bars represent? What do the yellow and red bars represent? According to the graphic, which type of activity is most harmful to American society? How do you know?
4. True, false, or uncertain. Explain your reasoning. “The burning of coal to make electricity should be completely banned in China, since China is the world’s largest greenhouse gas emitter.”

Related posts:

1. Tit, tat, tariff… China and America’s latest shoving match is underway
2. Supply and demand shifters and the price of pork in China
3. Monopoly prices – to regulate or not to regulate, that is the question!

The following post was written by an AP Economics student at Zurich International School

We all know about market failure on the product side: A good or service is under or over produced in the free market because of externalities that cause the marginal social benefit (MSB) to no longer equal the marginal social cost (MSC). Instead, the good or service is at another equilibrium where the MSB is equal to the marginal private cost (MPC). In such a case, the government may intervene by either taxing or subsidizing the good or service, or even by taking control of production in order to bring the values to the social equilibrium point (MSB=MSC).

Now let’s take a look at how this plays out in the human resources market.

In the human resource market firms tend to pay close to the same salary to people of the same rank or position. This can lead to market failure. An employer might have positive or negative externalities. Their location may be near public transport and in a beautiful location. Or it might be situated right next to a sewage treatment plant. When firms offer the same salary for the same position, their externalities may lead to labor surpluses or shortages, i.e. to market failure.

A firm with negative externalities will have a shortage of workers since the qualified workers can work elsewhere for the same amount. A firm with positive externalities will have a surplus of applicants. The number of people will want to work at such firm will exceed the positions available. The firm could profit from this situation by becoming more selective, accepting only those candidates of superior quality. However, there can also be additional costs to the company if its externalities attract a surplus of applicants. There would be additional costs for processing and reviewing the many applications received. In a world of perfect competition where employee qualifications would be the same, the firm with positive externalities would reduce the wages it offers. This would reduce labor costs and decrease the number of applicants, reducing thus administration costs too. A firm with the negative externalities would have to do the inverse: raise wages in order to increase the number of workers. In reality of course, employee qualifications differ and the firm with positive externalities may get a flood of applications from candidates even those with insufficient qualifications.

There are many examples of positive and negative externalities, not only location. These can range from a positive (or negative) brand to a positive (or negative) reputation in how the company treats employees, such as by having flexible hours or supplying recreational or sporting facilities. When a person is looking for a job, externalities can play a decisive role.

Case Study: John the Consultant

Let us look at John the Consultant as an example. Like most applicants, John is looking for a good salary but he also wants to enjoy his work environment.

John gets three job offers: One from a fairly standard consulting firm, one from a tobacco company, and another from a sports TV network (with great offices with fabulous views).

When he was originally applying, John thought he would jump at opportunity to work at the sports network. The network had been his favorite since he was a child. He loved the thought of working in sports and television.

But then he took a closer look at the actual offers. The sports network offered him a salary that did not even come close to his expectations. The consulting firm’s offer was like its offices: just the standard fare. On the other hand, the tobacco company’s financial offer was mind-blowing.

Why is this so?

The tobacco company’s labor market might look like this:

Here, due to ethical concerns with the product, too few people would be interested in working at the tobacco company if it paid the average wage. Its cost to hire an additional worker (let’s call it the Private Marginal Resource Cost (PMRC)), is higher than the market average (AMRC). This is why it is necessary for the firm to increase wages in order to increase the quantity of labor to the optimal level. To be noticed is that their new quantity of labor is still below the market average. If the firm wanted to raise labor up to the market average, it would have to further increase wages, which would be extremely inefficient since there will be a point at which the cost of the additional workers will outweigh the value they represent.

A sports network company might look like this:

The sports network company, if it offered average wages, would have a surplus of workers. Here the AMRC is higher than the PMRC. In such case, the economically wise action is to decrease wages, thereby decreasing the quantity of labor to the optimal amount. To be noticed again is that its optimal amount is still higher than the market average. If it further decreased wages to reach Q_A there would be a dead weight loss. (Pragmatically speaking, the firm would not hire a surplus of workers; it would stick to Q₂, but even then normal wages would be inefficient, since it could get the exact same quantity of labor at lower wages.)

Now John has the choice of taking less money along with the positive externalities, or more money when there are negative externalities. The externalities turn into opportunity costs. And this creates a dilemma.

Firms have long known the gist of this concept. Most large corporate firms have made serious efforts to increase employee satisfaction in the hope that it will become a positive externality. Yet since the vast majority of employers have done similarly, various types of extra benefits have become standard for the market. However there are still companies that stand out from the rest. For example Google has placed a high priority on creatively generating employee satisfaction and creating a work environment conducive to cooperation and innovation. It has excelled in these domains by so much that their employees are glad to take a lower paycheck than the market average for the privilege of working there.*

Now all this is a prime example of how externalities are corrected through the profit incentive. In contrast to the product market (where a company may not bear the full cost of a negative externality it causes, such as pollution, and government intervention can become necessary), no government interference is usually necessary in the human resource market. There it is the firm that notices and corrects the difference in employee wages in relation to externalities. Most companies have learned to put a price on externalities, and equilibrium is restored.

*As an example, according to the Financial Times Feb 7, 2011, Google now receives an astonishing 75,000 applications a week.

Related posts:

1. Reducing negative externalities – the European market for carbon emissions
2. Shanghai American School and the imperfectly competitive market for international teachers
3. An introduction to consumption externalities from a Singapore perceptive

This post is an introduction to the Academy Award winning documentary, ‘Inside Job’ for introductory Economics students

What do Wall Street investment bankers and used car salesmen have in common? Sometimes, the less their customers know about the products they’re selling, the more profits they both stand to earn. Imperfect information in markets can lead to market failure, and at its core, the failures of global financial markets during 2008 – 2009 was a result of imperfect information.

Last night, the film ‘Inside Job’ won the Academy Award for Best Documentary of 2010. The film focuses on the changes in the financial industry in between 2000 and 2007 that led to an overall increase in the level of risk undertaken by home mortgage lenders, investment banks, and ultimately the broader investment community the banking system serves.

The mis-aligned incentives motivating Wall Street banks and the asymmetry of information between the buyers and sellers of financial products, as well as the creation of new, complex derivative markets that allowed investment banks to bet against the very assets they were assembling and selling off to investors, contributed to the collapse of credit markets in 2007 and 2008 and ultimately a contraction of the level of economic activity worldwide during the “Great Recession” of 2008 and 2009.

The article below is an attempt to introduce the seemingly incomprehensible nature of global financial markets and understand what occurred in them between 2000 and 2007 in the context of an introductory Economics unit on Market Failure.

Imperfect Information as a Market Failure:

Imagine this. You’re in the market for a used car. You go to the used car dealership, speak with a salesman, and he takes you through rows of automobiles, telling you the features of each one and assuring you that each of his cars has been inspected by a third party garage for reliability. You find this re-assuring; after all you wouldn’t want to buy a car that hasn’t passed a basic inspection, since you don’t want it to break down once you’ve driven it off the lot.

After an hour or so of poking around the lot, you pick out the perfect car. A silver 2006 Audi, a great year for Audis, says the dealer. You have his word that it has been closely inspected and is in top notch shape. So you hand over $20,000 for the Audi and drive it off the lot, satisfied with your purchase.

What would you say, however, if you knew that soon after driving off the lot, the very salesman who convinced you to buy that Audi purchased an insurance policy that would pay the salesman $20,000  in the case that it broke down. Would that knowledge have made you question your purchase?

What would you say if you found out that the “third party garage” the salesman used to inspect the car actually followed orders from the dealer himself, and was 100% dependent on that dealer’s business. Therefore, the mechanic was under significant pressure to give each of the cars sent to him a high mark in its inspection. By doing so, the garage mechanic assures that the dealer is able to easily sell cars to the buyers who trust that the mechanic has given an honest appraisal of the car’s mechanical reliability. Since the dealer can sell cars given high inspection marks  for higher prices, the dealer is then able take out insurance policies that pay a greater amount when the car ultimately breaks down.

Would all of this knowledge have made you questions your purchase and the price you paid for your Audi? Chances are, if there had been perfect information in the market for used cars, you, and countless other people, would not have been willing to pay the price you paid for your Audi. Fewer used cars would have been sold, and they would have sold for lower prices. The existence of asymmetric information results in an over allocation of resources towards the market for mechanically unsound used cars.

So what does the story above have to do with the global financial crisis? Believe it or not, the fundamental cause of the near collapse of the global financial system in recent years is almost identical to our story about the used-car salesman, the corrupt garage mechanic, the dubious insurance policies and the sucker buyer, who was stuck driving a crappy car that broke down within days of driving it off the lot.

Financial Market Failure:

Between 2000 and 2007, financial innovation led to unprecedented increases in the availability of low interest loans to millions of low income American households for whom home mortgages traditionally would have been unobtainable. Banks which issued these “sub-prime” loans to households with very poor credit were able to sell them to Wall Street investment banks, which were re-packaging individual home mortgages with  thousands of similar loans from all over the United States into asset-backed securities, a form of bond that could then be sold to an investor to whom the interest payments made by the homeowners would accrue over the lifespans of the mortgages included in the bond.

Investment banks turned to the big credit rating agencies (Standard and Poors, Moody’s), who inspected the make-up of these asset backed securities, declared them investment grade and gave them AAA ratings, essentially giving a thumbs up to the institutional investors who ultimately bought these bonds from the investment banks. An AAA rating assured investors who bought the bonds that they were very safe investments, in essence that they were in “good mechanical order”, just like the Audi you drove off the lot after being told it was in good mechanical order.

The investors who ultimately bought these bonds were not small time investors like you and me, rather they were institutions, such as state pension funds, hedge funds, money market funds, sovereign wealth funds, and so on, who often times used taxpayers money to buy bonds from big investment banks on Wall Street (such as Morgan Stanley, Goldman Sachs and Bear Stearns). These investors were assured by the banks that the bonds were of the highest quality and would therefore earn the investors interest payments for years, even decades. In addition, because of the high ratings given to these bonds by the rating agencies, the investors believed they would always be able to sell the bond if they needed the money back they had originally used to buy it.

The information given to investors was not always correct, however, it turned out that many of Wall Street banks assembling and selling these bonds were also betting against them in a parallel market for derivatives known as credit default swaps.

Here’s the catch… the Wall Street banks that bought millions of low-income Americans’ mortgages (the “sub-prime” type) were just like that used car salesman. They knew the bonds of their creation were of poor quality, but just had to get the investors to believe they were in good mechanical order to “get them off the lot” into the hands of an investor.

And just like the sleazy car salesman, as soon as the banks started selling these bonds to investors, they began taking out insurance policies against them in the case that they should lose their value. An insurance policy that pays out when the value of a bond collapses is called a “credit default swap” (CDS), and the market for these  became a multi-billion dollar industry in which big Wall Street banks bought insurance on the very bonds they created and sold to institutional investors, essentially betting that their own bonds would collapse in value. Of course, none of the investors knew the banks were betting against their own bonds, because this knowledge would have surely wiped out demand for them and led to collapse in business for the Wall Street banks.

The rating agencies inspecting the asset backed securities assembled from bad mortgages were just like the corrupt garage mechanic giving all the 2006 Audis a “thumbs up” to make them easier for the car dealership to sell. By giving sub-prime mortgage backed securities “investment grade” AAA ratings, the rating agencies made it easier for investment banks to sell them to sucker investors for high prices, which in turn enabled investment banks to take out insurance policies (CDSs) against them. And since the rating agencies knew the banks wanted AAA ratings for bonds that should have been given “junk bond” status, the agencies continued to give them the highest rating, since they were dependent on the Wall Street banks for their business.

In the end, just like the 2006 Audi you drove off the lot was of poor mechanical integrity and broke down just days after you dropped $20,000 on it, most of the bonds assembled and sold on to investors by Wall Street banks were themselves of very poor quality. The underlying assets, the sub-prime mortgages themselves, were made to American households who could not possibly pay them back, Americans whose incomes were so low that the monthly payment for the home loan often exceeded the income of the borrower himself.

Ultimately, when sub-prime mortgage borrowers began defaulting on their loans, the Wall Street investment banks that had assembled them into asset backed securities and the institutional investors who bought these bonds found themselves holding trillions of dollars worth of loans that were no longer being repaid. For the banks, however, things weren’t all that bad, because just like the corrupt car salesman, they had taken out hundreds of billions of dollars in insurance on the bonds, which assured that when they finally went bad, the banks, which had passed on most of the bonds to investors, could simply collect the insurance payouts from the issuers of credit default swaps.

Who were the insurance companies stupid enough to insure crappy bonds, you ask? You may have heard of AIG (American Insurance Group). This was the insurance company insuring most of the sub-prime mortgage backed bonds. When all the bonds started to go bad AIG quickly ran out of money as it paid the investment banks out the insurance they owed. When AIG ran out of cash, the US government stepped in and gave AIG $85 billion of taxpayer money in September 0f 2008, assuring that the Wall Street banks with insurance through AIG collected 100% of their insurance money.

Show Me the Market Failure:

So what makes this a “market failure” in the economic sense of the term? Well, the existence of imperfect information in the automobile market led to an over allocation of resources towards the market for used cars. Because the buyers were being duped by the sellers and the corrupt garage mechanics, demand for used cars was too high and the price they were being sold for was too high. With more perfect information, consumers would have demanded fewer cars and they would have been sold for a lower price.

With more perfect information in the financial markets, far fewer investors would have been willing to pay the prices they did for the bonds the Wall Street banks assembled from sub-prime mortgages. Far less credit would have been made available to low income American home buyers. Far fewer sub-prime mortgage loans would have been made, and fewer Americans would have purchased homes that they could not afford in the first place.

In addition, if the institutional investors who were ultimately stuck holding these bonds had known that the investment banks selling them were simultaneously buying insurance policies against them, the investors would have been much more wary about investing in them. Also, if the investors had known that the rating agencies giving the bonds AAA, investment grade ratings were essentially following orders from the investment banks, giving the bonds the high ratings the Wall Street bosses wanted them to get, then the investors would have  been less willing to buy the bonds and less credit would have ended up in the hands of low-income American home buyers.

The market for financial services failed because too many resources were allocated towards the provision of loans to low-income American households. With more perfect information about the value of the under-lying assets included in the bonds being sold by Wall Street banks (the sub-prime mortgages), and with the knowledge that the banks themselves were betting against the bonds they assembled and sold, far fewer investors would have been willing to buy the bonds and far less credit would have been made available to American home buyers.

A market failure exists anytime the free market produces at a level of output greater or less than that which is deemed socially optimal. Given the huge surplus of unsold homes in the United States right now, and the collapse of many institutional investors’ portfolios on whose financial strength hundreds of millions of real people around the world depend for their very livelihoods, it can be safely argued that the imperfect information in the market for mortgage-backed securities (bonds) led to an over allocation of resources towards homes for low income Americans.

Discussion Questions:

1. Why is perfect information needed for a market to be perfectly efficient? How does imperfect information lead to a mis-allocation of resources in a market?
2. In the case of financial markets, what information, if known by those who invested in sub-prime mortgage-backed securities, would have helped correct the market failure and prevented the global financial crisis?
3. Another type of market failure we study in Microeconomics is negative externalities. Did the over-allocation of resources towards home loans for low income households create any negative externalities when the assets backed by the loans ultimately lost their value? What are some of the social costs of too many loans being made to low income borrowers in the early 2000′s?
4. Some argue that the financial crisis was not a market failure, but a regulatory failure, meaning the government failed to notice the actions of Wall Street banks and stop them before they caused a financial crisis? To what extent should the government intervene in the functioning of free markets to assure that information asymmetry does not lead to similar crises in the future?
5. Suggest one regulation the government could have enacted to prevent the over-allocation of capital towards the sub-prime mortgage market?

Related posts:

1. Market failure versus Government failure – what should we be more concerned about?
2. Does the funeral industry represent a market failure?
3. A video and audio introduction to Market Failure