Block 4

Market Failure
 Externalities and
UNIT 7 EXTERNALITIES AND PUBLIC GOODS Public Goods

Structure

7.0 Objectives
7.1 Introduction
7.2 Externalities
7.2.1 Negative Externalities and Inefficiencies
7.2. 2 Positive Externalities and Inefficiencies
7.3 Ways of Correcting Market Failure
7.3.1 Pigovian Tax
7.3.2 Merger and Internalisation
7.3.3 Emission Standards and Emission fee
7.3.4 Missing Market
7.3.5 Private Bargaining and Negotiation: Coase Theorem
7.4 Public Goods
7.5 Public Goods and Market Failure
7.5.1 The Free-rider Problem
7.6 Optimal Provision of Public Goods
7.6.1 The Samuelson–Musgrave Theory
7.6.2 Local Provision of Public Goods: Tiebout Hypothesis
7.6.3 Social Choice Problem: Voting Mechanism
7.6.4 Role of Government in Provision of Public Goods
7.7 Let Us Sum Up
7.8 Some Useful References
7.9 Answers or Hints to Check Your Progress Exercises

7.0 OBJECTIVES
After going through this unit, you will be able to:

x define the concept of Externality;

x illustrate the condition of market failure in the presence of externalities
and public goods;
x describe different mechanisms employed to correct for the market
failures resulting from externalities;

x explain the concept of a Public good;

x discuss solutions/mechanisms ensuring optimal provision of Public

goods;


Market Failure
7.1 INTRODUCTION
Consumption (or production) decisions of an agent affect people not directly
involved in the transactions. Such indirect effects often remain unaccounted
for by the agent creating them. In the previous units, we considered the
cases of markets where negotiations between agents (the buyers and the
sellers) led to optimal (in case of perfect competition) or suboptimal (in case
of imperfect competition like monopoly, monopolistic competition,
oligopoly) allocation of resources. In all these cases we assumed that there
were no unaccounted indirect effects involved. Now we will study the cases
when efficient private allocation may become infeasible. In other words, we
will consider the case when markets fail to clear. The reasons for the market
failure could be— presence of externalities, public goods and asymmetry of
information.

In this unit we will come across the concept of externalities and public
goods. Externality refers to the uncompensated impact of one agent’s
actions on another agent. When the impact is adverse, it is called a negative
externality, and when the impact is beneficial, we have a case of positive
externality.The presence of externality leads to market failure. By market
failure we mean, when market is unable to reach an equilibrium outcome in
price or quantity. As a result, firm may produce too much or too little so that
market outcome is inefficient.

We start with defining what is meant by externality? How does it result in

market inefficiencies and how to rectify them? We proceed by discussing
the concept of a public good. By definition, public goods are defined by the
properties of being non-excludable and non-rival. They are those goods that
benefit all the consumers but which the market either undersupplies or
does not supply at all. The best example of a pure public good is a street
light. The consumption of light from street light is open for all, nobody can
be excluded from its consumption and nobody’s consumption benefit is
reduced by the consumption of other people. In this unit we define the
concept of a public good, and discuss how they are different from private
goods? and what are the problems policy-makers face when trying to decide
how much of public good to provide?

7.2 EXTERNALITIES
Externalities can arise between producers, between consumers, or between
consumer and producers. An externality occurs if a person’s activity, such as
consumption or production, affects the well-being of some other person or
group of persons, for which she(he) or the group has not been
compensated. The term externality comes from the fact that someone
external to the action or transaction is affected by the production or
consumption of the good.

There are two types of externalities: A negative externality occurs if an Externalities and
Public Goods
activity creates costs (harm or discomfort) for uninvolved people. Examples
of negative externalities: Cars and factories generate air pollution that affect
people’s health. Cars entering congested freeways impose time costs on
other drivers, as all cars slow down as a result. Another example of negative
externality is when a steel plant dumps its waste into a river that fishermen
use for their daily catch. More the waste the steel plant dumps into the river
lesser the amount of clean water available for fish breeding and
consequently lower will be the output of the fishermen. It can be seen from
this example that independent action of the steel plant increased the cost to
the fishermen and adversely affected their output for which they are not
compensated. Hence the presence of negative externality leads to the
occurrence of additional costs, which the agent causing it fails to realise. As
a result, in the presence of negative externality there is over-generation of
the activity causing negative externality.

A positive externality occurs if an activity creates benefits for uninvolved

people. Examples of positive externalities include, people who get
vaccinations against a communicable disease reduce other people’s chances
of getting the disease. People who maintain their property well may create
benefits for their neighbours by creating a more pleasing neighbourhood
and increasing property values. In the presence of positive externality,
agents creating it fail to recognise the additional benefits generated by the
activity and hence under-generate it.

Thus, we can say that, production of goods or activities which involve

generation of externalities are not produced at the optimum levels as far as
transaction in a private market is concerned. Private market transactions
will lead to overproduction of goods/activities with negative externalities
and underproduction of goods/activities with positive externalities.

7.2.1 Negative Externalities and Inefficiency

Since the presence of externalities is not reflected in the market price, they
can be a source of market inefficiency. When firms do not take into account
the harms associated with negative externalities, the result is excess
production and unnecessary social costs. To see how negative externalities
affect market outcomes consider the case of a Steel firm and Fishermen. We
assume the Steel firm to be a competitive firm. The production decision of
the steel plant is shown in the Fig. 7.1.


Market Failure

MB

Fig. 7.1: Equilibrium along with Negative Externality

By competitive market we mean that the steel firm takes price as given.
Here the competitive price taken by the steel firm is P1 which is also the
marginal benefit (MB) curve of the firm in competitive market. Now supply
curve of the firm is reflected by the firms’ marginal cost curve, MC. The
optimising firm will produce that quantity of steel where its MB intersects its
MC. In the above figure, this happens at quantity q1. Hence a competitive
steel firm will maximise its profits by producing quantity q1 at the given
price P1. Now let us assume the steel plant dumps waste generated in the
process of steel production in the river that pollutes the river used by the
fishermen to catch the fish. Enhanced pollution level of the river water
negatively impacts fish population in the river and hence the amount of fish
a fisherman is able to catch. Thus, it can be said that production of steel
involves a negative externality which is the additional cost to the society in
the form of loss to the fishermen. This cost is reflected in the above figure as
the marginal external cost (MEC).
The MEC curve is upward sloping indicating a positive relation with the
firm’s output. As production of steel increases, harm to the society
increases. MSC represents the marginal social cost. It is the total cost to the
society given by the sum of MC and MEC. It includes the cost to the steel
firm and to the fishermen for the production of steel. Firms for profit
maximisation equate MC to MB and ignore the costs it incurs to the society
in the presence of negative externality. The social optimal is attained where
MSC is set equal to MB, that is, at q*. Here we can see socially optimal steel
output q* is lower than private optimal at q1.
In Fig. 7.2, it is shown how the presence of negative externality distorts the
optimal outcome of the steel industry and leads to social loss. Considering
that each firm faces similar externality, the steel industry will be facing the
 similar externality. MC1 is the marginal cost in the steel industry and DD is
the demand curve in the steel industry, showing the marginal benefit (MB). Externalities and
Public Goods
The industry will maximise the profits by producing the quantity of steel
where MC1 equates MB.

Fig. 7.2: Social Loss due to Negative Externality

The industry’s private optimal is at quantity Q1 and optimal price P1. Now
again industry fails to internalise the cost of its production activity on fishing
industry. MEC1 depicts marginal external cost of production of steel
industry, which is positively related to increasing output of the steel
industry. MSC1 is the marginal social cost in the steel industry which is the
sum total of MC1 and MEC1 (i.e., MSC1 = MC1 + MEC1). The social optimal is
where MSC1 intersects MB, that is at quantity Q* and price P*. The socially
optimal output of the steel industry should be Q* at price P* compared to
private optimal output of the industry Q1 at the price P1. At the socially
optimal output Q* external costs on the fishermen are internalised in the
production cost.The loss to the society resulting from the excess production
by the industry in the presence of negative externality is shown in the figure
as the shaded triangular region.

The concept of market failure in the presence of externality is due to the

fact that prices undervalue social costs. The private equilibrium of the
industry is at P1, whereas the social optimal for the industry is at P*, where
we can see:

P1 < P*
Hence, we see that in the presence of negative externality the equilibrium
price P1 is too low to include all the cost incurred in the production of steel.
P1 in the above figure reflects the private marginal costs to the firms. It does
not include the costs to the society. In the presence of externality the
market price is not efficiently build to clear the market. Therefore, market

Market Failure fails in the presence of negative externality. In the next section we will show
how market fails in the presence of positive externality.

7.2.2 Positive Externality and Inefficiencies

Positive externality occurs when an agent’s independent action benefits the
other agent’s consumption or production for which the later has not paid.
Here unlike negative externality, the presence of positive externality results
in underproduction of the good or activity. In the case of positive externality
there is existence of external benefit, which an agent fails to recognise and
thus undersupply the good or the activity generating positive externality.
This is referred to as an inefficient allocation. For example, immunisation
prevents an individual from getting a disease along with the positive effect
that the immunised individual getting immunised is not spreading the
disease to others. To understand how market is inefficient in the presence
of positive externality consider Fig. 7.3.

Fig. 7.3: Equilibrium along with Positive Externality

In Fig. 7.3, consider the case of vaccines against a communicable disease. Let
the marginal cost of vaccine be constant and equal to MC. The demand for
vaccine is shown as downward sloping D curve. This demand curve depicts
the marginal benefit to single individual. An individual will optimise his/her
consumption where private marginal benefit equals private marginal
cost(MB=MC). Taking MC to be constant at P1, the private optimal is
attained at quantity q1. Now this private allocation ignored the presence of
an external benefit that vaccines will have on the society in terms of lower
spread of the disease captured by the marginal external benefit (MEB).
Marginal social benefit (MSB) is the sum of private MB and MEB. The social
optimal is given by the quantity q* where MSB equals private MC. Notice in
the Fig. that q* > q1.


So we see that in the presence of positive externality, the market allocation Externalities and
Public Goods
is under-produced than the social optimal and hence market allocation is
called as inefficient and hence we see that in the presence of externality
market fails.
Check Your Progress 1
1) Define externality. How does it leads to market failure?

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2) Is it true that in the presence of negative externality private allocation is

over-provided and in the presence of positive externality it is under-
provided? Explain.

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7.3 WAYS OF CORRECTING MARKET FAILURE

In the previous sections we discussed how market fails in the presence of
externalities. In this section we will be discussing how to correct the market
failure in the presence of externality. Some of the measures are:

7.3.1 Pigouvian Tax

In the presence of negative externality the market allocation is above the
social optimal. To curb the effect of negative externality, one way to correct
market allocation is by introducing output tax. If the firm that generates
externality with production produces more than the socially efficient output
level, then a socially optimal level can be ensured when such a firm is made
to internalise the cost of externality so as to discourage the excess
production beyond the socially optimal level. This can be done my imposing
output tax on the production. Such tax is called Pigouvian tax. Under the
Pigouvian tax, people would face the true cost of generating pollution. This
in turn encourage the creator of the negative externality to reduce the
emissions from production by investing in pollution control equipments,
changing their transport modes, etc. in order to escape Pigouvian tax. One

Market Failure typical problem with imposition of Pigouvian tax is that to charge optimal
tax, optimal level of pollution from the steel industry needs to be calculated.
Consider Fig. 7.4. Private optimal in the presence of negative externality is
q1. When per unit tax ‘t’ is charged on the good produced, the tax increases
the cost of production. Efficient output tax is the one which increases the
cost to equate it to the MSC. Now, the optimal will be given by MC plus tax
equal to MB.The resulting output level of q*(< q1) will be at the social
optimal. Hence market allocation can be made efficient by adding an output
tax on the production in case of negative externality. In the similar lines, a
subsidy is advised in case of a positive externality.

Fig. 7.4: Pigovian Tax

7.3.2 Merger and Internalisation

Another way in which the impact of externality on the market outcome can
be curbed is when the parties involved merge to become a single unit and
internalise the externality. In the case of steel firm and fisherman, this
would mean both of them merging and acting as a single identity.

The waste produced in the production of the steel is dumped in the river
and this adversely affects the fish industry. The steel manufacturers do not
internalise this cost to the society in their private cost of production of steel.
This results in a market outcome that is inefficient and greater than the
social optimal. To persuade the steel producer towards internalisation of
cost to the society because of its action, the two industries (Steel and Fish)
can merge and in this way the externality in the cost of production can be
internalised. There is a definite incentive for the two industries to merge. If
the actions of one affect the other, then they can make higher profits
together by coordinating their activities than by each going alone. The

objective of profit maximisation itself should encourage the internalisation Externalities and
Public Goods
of production externalities. So when the parties involved merge, the total
marginal cost now will also include the external cost of steel production to
the fish industry. Now the merged industries will optimise considering the
social cost instead of private cost. Hence, with the merged industries the
market allocation will be efficient.

7.3.3 Emission Standards and Emission Fee

An emission standard is a legal limit on how much pollutants a firm can
emit. If the firm exceeds the limit, it can face monetary and even criminal
penalties. Consider Fig.7.5 below.

Fig. 7.5: Emission Standard

Suppose the regulatory body set the efficient emission standard at E* (say
equal to 20 units). The firm will be heavily penalised for emission greater
than this level. Now suppose the firm produces emissions greater than this
level. To make sure that the firm follows the emission standard the
regulatory body determines the emission fee. Emission fee is the amount
required by the emitting firm to pay per unit of emission released by its
production activity. Standard emission fee is determined at the intersection
of MEC and MCA curves in the above figure. MEC stands for marginal
external cost, which is the cost the emission causes to the society. MCA is
the marginal cost of abating the emission borne by the firm. It measures the
additional cost to the firm for installing pollution control equipment. MCA
slopes downwards showing that when the emission abatement is high, or
the level of emission is low, higher costs are borne by the firms to abate the
emission. So with low level of emission, required abatement is high and vice
versa. With no abatement cost to the firm, profit maximising firm will
produce emissions equal to 40 units, where marginal cost of abatement is
zero. E* equal to 20 is the optimal emission level, when there is abatement
cost involved and marginal fee of emission is Rs. 30. If the firm lowers the
emissions to somewhere below 20, cost of abatement will be greater than

Market Failure cost to the society and vice versa. Hence we see E* is the optimal emission
level.
However, there are problems associated with this instrument. Firstly, the
government or regulatory authorities often does not possess enough
information regarding the level of the legal emission standards to be set or
the optimal amount of the emission fee to be charged to ensure optimal
generation of emissions. Secondly, cost of enforcing the limits is ignored. For
instance, if the industry emits smoke and the firms have to cut down on
smoke emission by putting filters on the chimneys then this cost should be
taken into account.

7.3.4 Missing Markets

The problem with externalities is that there is no property right and no
market for certain goods. If we take pollution, it may be considered to be an
output of the production process, since both chemical dyes and pollution
are the results of production. However there is no market for pollution (a
bad) and no price for it. This is the problem of missing market. The firms are
the suppliers of pollution. The consumers are the potential buyers and since
pollution is a bad, we can anticipate that consumers will buy this goods only
if they are paid to buy it (the price of a bad will be negative).

Suppose there are two firms 1 and 2. Firm 1 operates in a perfectly

competitive market and produces an output x which imposes a cost e(x) on
firm 2. Assuming per unit price of output sold by firm 1 to be p and cost
function faced by this firm to be c(x), the profits of firm 1 and firm 2 will be
given by:
Firm 1: ߨଵ ൌ ‫ ݔ݌‬െ ܿሺ‫ݔ‬ሻand Firm 2: ߨଶ ൌ  െ݁ሺ‫ݔ‬ሻ
ௗ௖ ௗ௘
We assume ௗ௫
൐ Ͳ, ௗ௫ ൐ Ͳ. Profit maximisation condition led by private
ௗగ
motive would lead firm 1 to produce x such that ௗ௫ ൌ Ͳ ֜ ‫ ݌‬ൌ  ܿ ᇱ ሺ‫ݔ‬ሻ. For
maximising social welfare, socially optimal level of output may be obtained
by optimising profits that takes into account not only the private cost but
also the external cost: ߨௌ ൌ ‫ ݔ݌‬െ ܿሺ‫ݔ‬ሻ െ ݁ሺ‫ݔ‬ሻ, where ߨௌ represents the
profits which takes into account both the private and the social costs. First-
ௗగ
order condition gives: ௗ௫ೄ ൌ Ͳ ֜ ‫ ݌‬ൌ  ܿ ᇱ ሺ‫ݔ‬ሻ ൅ ݁ ᇱ ሺ‫ݔ‬ሻ; where the expression
on the right-hand side is the marginal social costs.

Suppose there is now a market for pollution. If we let the price of pollution
per unit as ߬ǤLet ‫ݔ‬ଵ be the amount of pollution firm 1 wants to sell and ‫ݔ‬ଶ
be the amount of pollution firm 2 wants to buy. The profits of the two firms
now are given by:

‹”ͳǣߨଵ ൌ ‫ݔ݌‬ଵ ൅ ߬‫ݔ‬ଵ െ ܿሺ‫ݔ‬ଵ ሻand Firm 2:ߨଶ ൌ  ߬‫ݔ‬ଶ െ ݁ሺ‫ݔ‬ଶ ሻ

The first order condition are: ‫ ݌‬൅ ߬ െ ܿ ᇱ ሺ‫ݔ‬ሻ ൌ Ͳ and ߬ െ ݁ ᇱ ሺ‫ݔ‬ଶ ሻ ൌ Ͳ


When the demand for pollution equals to supply for pollution: ‫ݔ‬ଵ ൌ  ‫ݔ‬ଶ ൌ Externalities and
Public Goods
‫ ;ݔ‬now we get back to the social optimality condition : ‫ ݌‬ൌ  ܿ ᇱ ሺ‫ݔ‬ሻ ൅ ݁ ᇱ ሺ‫ݔ‬ሻǤ
Since ݁ ᇱ ሺ‫ݔ‬ሻ ൐ ͲǢ ܽ݊݀߬ ൏ Ͳǡ –Š‡’”‹ ‡‘ˆ’‘ŽŽ—–‹‘‹•‡‰ƒ–‹˜‡Ǥ Moreover,
for a market of pollution to exist, there must be property rights in pollution.
Either the polluting firm should have the right to pollute or the polluted firm
should have the right to clean air/water, that is should own clean air/water.
Further the market for certain pollution can be quite thin where there may
be few agents in the market.

7.3.5 Private Bargaining and Negotiation: Coase theorem

We have seen how government regulations (taxes, standards, etc.) can deal
with the inefficiencies that arise from externalities. Such regulations change
a firm’s incentive, forcing it to take into account the external costs due to
externality. Government regulations are not the only way to deal with the
problem of externalities. By assigning well-defined property rights is another
solution to the externality problem. Property right means the legal rules that
state how an economic resource is used and owned. In the example of
fishery and steel firm, if fishery had property rights on the river then it can
legally penalise the steel firm for dumping waste into its property. On the
other hand, had the property right of the river been with the Steel firm, it
could have charged the fishery for polluting less. As per the Coase theorem,
in the presence of well-defined property rights and zero transaction cost of
negotiations between the two parties, the one who cause externality and
the one who is affected by the externality, can result in a socially optimal
outcome. Moreover, the solution works irrespective of whom the property
rights are assigned. An example explaining how in the presence of well-
defined property rights, private players can bargain and come down to
mutual advantageous outcome, where the outcome is efficient irrespective
of the fact how the property rights were initially defined, is discussed below.

Let us consider the example of negative externality involved in case of Steel

industry and Fisheries. Along with the production of Steel, the Steel industry
dumps waste generated in the process of production in the river that
negatively impacts the Fish industry. Let X denote the level of Steel
generated, MB(X) denote the resulting marginal benefit to the Steel industry
from producing X units of Steel, MC1 is the marginal cost or the supply curve
of the steel industry, MEC(X) denote the damage to the Fish industry from
the waste dumped into the river by the Steel industry, and MSC represents
the marginal social cost given by the sum of MC and MEC.


Market Failure

06& 0&

3ULFH
0(& 0&

0(&

0% ; 

2 4  4 ;

Fig. 7.6: Social Optimal Output

It includes the cost to the steel and Fish industry. Steel industry for profit
maximisation would equate MC1 to MB and produce at Q1 ignoring the
costs to the society. On the other hand, social optimal is attained where
MSC is set equal to MB, that is, at Q* (< Q1).

Now we assume, river which was considered a free resource earlier, is

owned by the Fish industry. Fish industry can now charge the Steel industry
for polluting the river. To ensure an optimal production of Steel output, Fish
industry will charge the Steel industry the marginal external cost per unit of
output. This will increase the Steel industry’s marginal cost from MC1 to
MC2 to coincide with the marginal social cost. The Steel output falls from Q1
to Q*, at the socially optimal level of production.
On the other hand, if the Steel industry owned the river, it can charge
(marginal external cost per unit of output) the Fish industry for dumping
less. The socially optimal output of the Steel industry will be same in both
the cases. This way, inefficiency associated with the negative externality can
be taken care of without the need for government intervention when the
externality affects relatively few parties and when property rights are well
specified. Parties can bargain with each other, without costs, and to their
mutual advantage, and the resulting outcome is more efficient, regardless of
how the property rights are assigned.

Private property provides such a mechanism. Indeed, we have seen that if

everything that people care about is owned by someone who can controlits
use and, in particular, can exclude others from overusing it, then there are
by definition no externalities. The market solution leads to a Pareto efficient
outcome. Inefficiencies can only result from situations where there is no
way to exclude others from using something. Of course, private property is
not the only social institution that can encourage efficient use of resources.
For example, rules could be formulated about how much of waste can be

dumped into the river. If there is a legal system along with strict monitoring, Externalities and
Public Goods
to enforce those rules, this may be a cost-effective solution to provide an
efficient use of the common resource. However, in situations where the law
is ambiguous or non-existent, the suboptimal solution can easily arise.
Overfishing in international waters and the extermination of several species
of animals due to overhunting are sobering examples of this phenomenon.
Check Your Progress 2

1) What are the different ways of correcting the market failure resulting in
the presence of negative externality?
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2) How can private bargaining lead to efficient allocation in the presence
of externality?
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7.4 PUBLIC GOODS

Pure public goods, unlike private goods, are by definition non-excludable
and non-rival. Such goods are not optimally provided in the private markets.
These goods have certain characteristics which makes their optimal
provision not profitable for the private players. These characteristics are—
non-rivalry and non-excludability.

Non-excludability means, no agent can be excluded from the consumption

of that public good once it is provided. As a consequence it is difficult or
impossible to charge people for using that non-excludable good. These
goods can be enjoyed without direct payment. Best example would be
National Defence. Once a nation has provided for its national defence, all
citizens enjoy its benefits. A lighthouse and public television are also
examples of goods/service having the characteristic of non-excludability.
This feature goes against that with the private goods that are excludable,
implying, the seller can debar a buyer from consuming a private good. This is


Market Failure done through the pricing of that good (those who do not pay the price, do
not get the goods).
Non-rivalry means consumption of a public good by an agent does not
reduces its availability to the other agents. Accordingly, at any given level of
production, the marginal cost of providing it to the additional consumer is
zero. For example, consider the use of highway (uncongested). Once the
highway is functional and open for public use, if there are 100 cars running
on it, there is no additional cost of providing the highway to 101st car. Hence
an uncongested highway is a non-rivalrous good. Most goods are rival,
especially private goods. This means that if in a market a seller brings 100
units to sell, if an individual buys 5 units, then for the other individual the
available number of units to buy is 95. This is so because there is marginal
cost of production associated with each unit of private good and hence they
have limited production. A good, consumption of which is rivalrous must be
allocated among individuals. A good which is non-rival in consumption can
be made available to everyone without affecting any individual’s
opportunity for consuming them.
Different kinds of goods have different characteristics. Broadly there are 4
categories of the goods,

Rival Non-rival
Excludable Pure Private goods Club goods
Non-excludable Common Resource goods Pure Public goods

Goods that are non-excludable and non-rival are the pure public goods, like,
national defence. Goods that are rival and excludable are the pure private
goods. Goods that are rival but non-excludable are referred to as the
common property resources , like common pasture lands, ground water,
fishing grounds. They are non-excludable as there are no established
property rights on such resources so as to exclude someone from using it.
Rivalrous nature for instance results from the fact that excessive grazing by
one herd of cattle will result in erosion of the land and hence limit its use for
other cattle herders. Goods that are non-rival in consumption but
excludable are called club goods. Club goods are like membership of club.
Membership into a club is non-rivalrous, as the facility of club is open to
everyone but the club can make the entry excludable by charging the
membership fee (or allowing only its members to enjoy certain
programmes/ performances etc).

Public goods are not necessary national: The list of public goods is much
smaller than the list of goods that government provide. For example,
Education is rival in consumption. This results from the fact that as class size
increases, each student gets lower attention. Hence there is positive
marginal cost of providing education to one more child. Likewise charging

tuition fee can exclude some children from enjoying education. Hence, Externalities and
Public Goods
education is provided by local government because it entails positive
externalities, not because it is a public good.

7.5 PUBLIC GOODS AND MARKET FAILURE

To produce the optimal amount of each public good, the government must
know something that it cannot possibly know— everyone’s preferences.
Because exclusion is impossible, nothing forces households to reveal their
preferences. Furthermore, if we ask households directly about their
willingness to pay, their true value might not be revealed. If your actual
payment depends on your answer, you have an incentive to hide your true
feelings. Knowing that you cannot be excluded from enjoying the benefits of
the good and that your payment is not likely to have an appreciable
influence on the level of output finally produced, what incentive do you
have to tell the truth or to contribute?
How does society decide which public goods to provide? We assume that
members of society want certain public goods. Private producers in the
market cannot make a profit by producing these goods, and the government
cannot obtain enough information to measure society’s demands
accurately.

7.5.1 The Free-rider Problem

Provision of public good is often faced with the free-rider problem. Free-
rider problem occurs in non-excludable goods case. Since the provision of
public goods is where sum of marginal benefits equals to the marginal cost
of providing the good, the individuals tend to free ride, that is, they tend to
make use of the public good without making payment for that good.
Moreover, since individuals are made to pay according to their marginal
benefits, they tend to undervalue their marginal benefits so that they have
to pay less. Since it is a collective good, it is often believed by an individual
that someone else will pay for it. Market for provision of public good fails, if
everyone tends to free ride, undervaluing their marginal benefits to the
level that the sum of marginal benefits is lower than the marginal cost of
providing the good and hence no public good is provided. Free riding is one
of the biggest challenges in the provision of public good, as it is very difficult
to judge the true valuation of the public good to the individuals.

Free riding situation bears its resemblance to the Prisoners’ Dilemma game,
though the two are not exactly same. Suppose there are two tenants in a
house who are trying to decide whether to construct a collapsible gate at
the entrance or not. If the gate is constructed, both will enjoy better security
in equal measure. So we may treat it like a public good. Suppose both the
individual earns Rs. 5000 and each value the gate at Rs. 1000 and the cost of
the gate is Rs. 1500, so the joint valuation of the gate exceeds the cost. Once

Market Failure the gate is constructed it will benefit both the tenants. Now the question is
whether to get a gate constructed or not.

Tenant 2
Buy Don’t Buy
ƵLJ ;оϱϬϬ͕оϱϬϬͿ ;оϱϬϬ͕ϭϬϬϬͿ
Tenant 1
ŽŶ͛ƚƵLJ ;ϭϬϬϬ͕оϱϬϬͿ (0, 0)

Here the strategy ‘Don’t Buy’ is the dominant strategy for both the tenants.
So the dominant strategy equilibrium or the Nash equilibrium is mutual free
riding (Don’t Buy, Don’t Buy) leading to suboptimal provision of public
goods. If the tenant 1 decide to buy the gate then the tenant 2 is having the
incentive to free ride and enjoy the better security and vice versa. So there
is a credible threat for both the tenant that the other one will free ride
against his decision to opt for ‘Buy’, which leads to the equilibrium of
mutual free-riding. However here the social optimal situation is one person
take the responsibility to buy the gate and both to enjoy the better security.

7.6 OPTIMAL PROVISION OF PUBLIC GOODS

Now we discuss two solutions to the provision of public goods:

a) When Marginal benefits of the consumers are known as given by the

Samuelson- Musgrave theory, and
b) When Marginal benefits of the consumers are unknown as given under
the Tiebout model

7.6.1 The Samuelson–Musgrave Theory

In the early 1950s, economist Paul Samuelson, building on the work of
Richard Musgrave, demonstrated that there exists an optimal, or a most
efficient level of output for every public good. The discussion of the
Samuelson and Musgrave solution that follows leads us straight to the
thorny problem of how societies, as opposed to individuals, make choices.

As per the theory, an efficient economy produces what people want. Private
producers, whether perfect competitors or monopolists, are constrained by
the market demand for their products. If they cannot sell their products for
more than it costs to produce them, they will be out of business. Because
private goods permit exclusion, firms can withhold their products until
consumers pay in order to consume them. Buying a product at a posted
price reveals that it is “worth” at least that amount to you and to everyone
who buys it.

Market demand for a private good is the sum of the quantities that each
household decides to buy (as measured on the horizontal axis) at each price.

 The diagrams in Fig. 7.7, illustrate the derivation of a market demand curve. Externalities and
Public Goods
Assume that society consists of two people, A and B. At a price of Re 1, A
demands 9 units and B demands 13 units of the private good. Market
demand at a price of Re 1 is 22 (= 9 + 13) units. If price were to rise to Rs. 3,
A’s quantity demanded would drop to 2 units and B’s would drop to 9 units;
market demand at a price of Rs. 3 is 2 + 9 = 11 units. The point is that the
price mechanism forces people to reveal what they want, and it forces firms
to produce only what people are willing to pay for, but it works this way only
because exclusion is possible.

People’s preferences and demands for public goods are conceptually no

different from their preferences and demands for private goods. You may
want fire protection and be willing to pay for it in the same way you want to
listen to a CD. To demonstrate that an efficient level of production exists,
Samuelson assumes that we know people’s preferences.

A B The Market (A+B)

3 3 3

1 1 1
DA DB DA+B
0 2 9 0 9 13 0 11 22
Units of Output Units of Output Units of Output

Fig. 7.7: Optimal Provision of Private Good

Fig. 7.8 shows demand curves for buyers A and B. If the public good were
available in the private market at a price of Rs. 6, A would buy X1 units. Put
another way, A is willing to pay Rs. 6 per unit to obtain X1 units of the public
good. B is willing to pay only Rs. 3 per unit to obtain X1 units of the public
good. Remember, public goods are non-rival and non-excludable. Hence,
one and only one quantity can be produced, and that is the amount that
everyone gets. When X1 units are produced, A gets X1 and B gets X1. When
X2 units are produced, A gets X2 and B gets X2.

To arrive at market demand for public goods, we do not sum quantities.

Instead, we add the amounts that individual households are willing to pay
for each potential level of output. In Fig. 7.8, A is willing to pay Rs. 6 per unit
for X1 units and B is willing to pay Rs. 3 per unit for X1 units. Thus, if society
consists only of A and B, society is willing to pay Rs. 9 per unit for X1 units of
public good X. Likewise, for X2 units of output, society is willing to pay a
total of Rs. 4 per unit.

For private goods, market demand is the horizontal sum of individual

demand curves— we add the different quantities that households consume
(as measured on the horizontal axis). For public goods, market demand is

Market Failure the vertical sum of individual demand curves— we add the different
amounts that households are willing to pay to obtain each level of output
(as measured on the vertical axis).

Fig. 7.8: Optimal Provision of Public Good

Samuelson argued that once we know how much society is willing to pay for
a public good, we need to only compare that amount to the cost of its
production. Fig. 7.9 reproduces A’s and B’s demand curves and the total
demand curve for the public good. As long as society (in this case, A and B) is
willing to pay more than the marginal cost of production, the good should
be produced.

Given the MC curve as drawn in Fig. 7.9, the efficient level of output is X1
units. If at that level A is charged a fee of Rs. 6 per unit of X produced and B
is charged a fee of Rs. 3 per unit of X, everyone should be happy. Resources
are being drawn from the production of other goods and services only to the
extent that people want the public good and are willing to pay for it. We
have arrived at the optimal level of provision for public goods. At the
optimal level, society’s total willingness to pay per unit is equal to the
marginal cost of producing the good.


 Externalities and
Public Goods

Fig. 7.9: Optimal Provision of Public Good

Optimal Provision of Public Goods: The Model

Here we discuss the optimal level of public good that should be produced
and/or provided. Consider an economy with only two goods one public and
one private. Suppose there are two individuals 1 and 2 and their initial
wealth levels are given by ‫ݓ‬ଵ ܽ݊݀‫ݓ‬ଶ . The respective provision for the
public good by individual 1 and 2 be given by ݃ଵ ܽ݊݀݃ଶ ; and let ‫ݔ‬ଵ ܽ݊݀‫ݔ‬ଶ
denote the consumption of private goods by each individual. Let G be the
total amount of public good produced and c(G) be the cost of producing
and/or providing that public good. The agents face the constraint that their
initial wealth cannot exceed their total expenditure on the private goods
and the public goods:

‫ݔ‬ଵ ൅  ‫ݔ‬ଶ ൅ ܿሺ‫ܩ‬ሻ ൌ  ‫ݓ‬ଵ ൅  ‫ݓ‬ଶ

We consider a Pareto efficient provision of the public goods. The provision is
Pareto efficient if agent 1’s utility is maximised given the utility level of
agent 2. Note that both agents consume same amount of the public goods.
The problem can then be written as:

Max ܷଵ ሺ‫ݔ‬ଵ ǡ ‫ܩ‬ሻ™Ǥ ”Ǥ –Ǥ‫ݔ‬ଵ ǡ ‫ݔ‬ଶ ǡ ‫ ܩ‬subject to ܷଶ ሺ‫ݔ‬ଶ ǡ ‫ܩ‬ሻ = ܷଶ ‫ כ‬and 

‫ݔ‬ଵ ൅  ‫ݔ‬ଶ ൅ ܿሺ‫ܩ‬ሻ ൌ  ‫ݓ‬ଵ ൅  ‫ݓ‬ଶ
The Lagrangean function is given by:
ࣦ = ܷଵ ሺ‫ݔ‬ଵ ǡ ‫ܩ‬ሻ ൅  ߣଵ ሼ(ܷଶ ‫ כ‬െ  ܷଶ ሺ‫ݔ‬ଶ ǡ ‫ܩ‬ሻሽ + ߣଶ {‫ݓ‬ଵ ൅  ‫ݓ‬ଶ െ ‫ݔ‬ଵ െ  ‫ݔ‬ଶ െ ܿሺ‫ܩ‬ሻ}
First-order conditions for optimisation are:
డࣦ డ௎
డ௫భ
ൌ  డ௫భ െ  ߣଶ ൌ 0 (i)
భ

డࣦ డ௎
డ௫మ
ൌ  െߣଵ డ௫మ െ  ߣଶ ൌ Ͳ (ii)
మ

డࣦ డ௎భ డ௎మ
డீ
ൌ డீ
െ ߣଵ డீ
െ  ߣଶ ܿ ᇱ ሺ‫ܩ‬ሻ ൌ Ͳ (iii)
డࣦ
డఒభ
ൌ ܷଶ ‫ כ‬െ ܷଶ ሺ‫ݔ‬ଶ ǡ ‫ܩ‬ሻ ൌ Ͳ (iv)
డࣦ
ൌ ‫ݓ‬ଵ ൅  ‫ݓ‬ଶ െ  ‫ݔ‬ଵ െ  ‫ݔ‬ଶ െ ܿሺ‫ܩ‬ሻ ൌ Ͳ (v)
డఒమ 
Market Failure డ௎
From (i) we get ߣଶ ൌ డ௫భ . Then from (i) and (ii) by eliminating ߣଶ we get
భ
ങೆభ
ങೣభ
ߣଵ ൌ  ങೆమ .
ങೣమ

Substituting these values in (iii) we get:

డ௎భ డ௎మ
డீ
൙డ௎భ + డீ
൙డ௎మ ൌ  ܿ ᇱ ሺ‫ܩ‬ሻ
డ௫భ డ௫మ

In other words the condition for optimal provision of public goods can be
ଵ ଶ
written as: ‫ீܴܵܯ‬௑ ൅  ‫ீܴܵܯ‬௑ ൌ  ‫ீܥܯ‬

i.e., The sum of the marginal rates of substitution between the private good
and the public good for the two individuals must equal the marginal cost of
providing the public goods. This condition is known as the ‘Samuelson Rule’.
If we interpret MRS as the marginal willingness to pay, then the Pareto
efficiency condition can be interpreted as sum of the willingness to pay must
be equal to the cost of providing an extra unit of public goods.
If the efficiency condition is violated, it can be shown that at least one
individual can be made better off and nobody is made worse off. Suppose
for example the sum of the MRS is less than the marginal cost. Let MCG = 1
ଵ ଵ ଶ ଵ ଵ
and ‫ீܴܵܯ‬௑ ൌ ଶ ǡ ‫ீܴܵܯ‬௑ ൌ ଷ. Then agent 1 would be willing to accept Rs. ଶ
worth of the private good for the loss of Re 1 of the public good and agent 2
ଵ
would be willing to accept Rs. ଷ worth of the private good for the loss of Re 1
of the public good. Suppose we reduce the amount of the public good by Re
1. Then we can compensate the two agents by giving them Rs. 5/6 worth of
the private good and still have Rs. 1/6 worth of private good left to be
distributed to the two individuals and make them better off. Thus if the sum
of the MRS between the private good and the public good for the two
individuals is less than the MC, less of the public good and more of the
private goods should be provided.

7.6.2 Local Provision of Public Goods: Tiebout Hypothesis

In 1956, economist Charles Tiebout made this point: To the extent that local
governments are responsible for providing public goods, an efficient market-
choice mechanism may exist. Consider a set of towns that are identical
except for police protection. Towns that choose to spend a great deal of
money on police are likely to have a lower crime rate. A lower crime rate will
attract households who are risk-averse and who are willing to pay higher
taxes for a lower risk of being a crime victim. Those who are willing to bear
greater risk may choose to live in the low-tax/high-crime towns. Also, if
some town is efficient at crime prevention, it will attract residents— given
that each town has limited space, property values will be bid up in this town.
 The higher home price in this town is the “price” of the lower crime rate.
According to the Tiebout hypothesis, an efficient mix of public goods is Externalities and
Public Goods
produced when local prices (in the form of taxes or higher housing costs)
come to reflect consumer preferences just as they do in the market for
private goods. What is different in the Tiebout world is that people exercise
consumer sovereignty not by “buying” different combinations of goods in a
market, but by “voting with their feet”, that is by choosing among bundles of
public goods provided and tax rates charged by different towns and
participating in local government.

7.6.3 Social Choice Problem: Voting Mechanism

One view of government, or the public sector, holds that it exists to provide
things that “society wants.”A society is a collection of individuals, and each
has a unique set of preferences. Defining what society wants, therefore,
becomes a problem of social choice— of somehow adding up, or
aggregating, individual preferences.

In social goods it is difficult to calculate the true valuation of the individual’s

marginal benefits. One such solution to the free-rider problem is given by
the mechanism of voting. When individuals vote, they show their
preference. Voting is commonly used to decide allocation questions.
Although voting is assumed to be a genuine solution to the allocation issues,
often it leads to inconsistent results. According to Arrow’s impossibility
theorem, no system of aggregating individual preferences into social
decisions will always yield consistent, non-arbitrary results. Most important
problem with voting outcomes is that when preferences for public goods
differ among individuals, any system for adding up, or aggregating, those
preferences can lead to inconsistencies. In addition, it illustrates just how
much influence the person who sets the agenda has. Another problem with
majority-rule voting is that it leads to logrolling. Logrolling occurs when
congressional representatives trade votes, agreeing to help each other to
get certain pieces of legislation passed. Recent work in economics has
focused not just on the government as an extension of individual
preferences but also on government officials as people with their own
agendas and objectives. That is, government officials are assumed to
maximise their own utility, not the social good.

7.6.4 Role of Government in Provision of Public Goods

There is no question that government must be involved in both the
provision of public goods and the control of externalities. No society has
ever existed in which citizens did not get together to protect themselves
from the abuses of an unrestrained market and to provide for themselves
certain goods and services that the market did not provide. The question is
not whether we need government involvement. The question is how much
and what kind of government involvement we should have.


Market Failure Critics of government involvement correctly say that the existence of an
“optimal” level of public-goods production does not guarantee that
governments will achieve it. It is easy to show that governments will
generally fail to achieve the most efficient level. There is no reason to
believe that governments are capable of achieving the “correct” amount of
control over externalities. Markets may fail to produce an efficient
allocation of resources, but governments may make it worse. Measurement
of social damages and benefits is difficult and imprecise. For example,
estimates of the costs of acid rain range from practically nothing to
incalculably high amounts.
Just as critics of government involvement must concede that the market by
itself fails to achieve full efficiency, defenders of government involvement
must acknowledge government’s failures. Many on both sides agree that we
get closer to an efficient allocation of resources by trying to control
externalities and by doing our best to produce the public goods that people
want with the imperfect tools we have than we would by leaving everything
to the market.
Check Your Progress 3
1) Define public goods. How they different from pure private goods?

………………………………………………………………………………………………………………
………………………………………………………………………………………………………………

………………………………………………………………………………………………………………
………………………………………………………………………………………………………………

………………………………………………………………………………………………………………

2) Why does market fail in presence of public good?

………………………………………………………………………………………………………………
………………………………………………………………………………………………………………

………………………………………………………………………………………………………………

………………………………………………………………………………………………………………
………………………………………………………………………………………………………………

3) Explain Samuleson-Musgrave solution to optimal allocation of a public

good.
………………………………………………………………………………………………………………

………………………………………………………………………………………………………………

………………………………………………………………………………………………………………

………………………………………………………………………………………………………………

 Externalities and
7.7 LET US SUM UP Public Goods

Often when we engage in transactions or make economic decisions, the

impact of it falls on the second or third parties that we the decision makers
have no incentive to take account of. These are called externalities. When
external costs are not considered in economic decisions, we may engage in
activities or produce products that are not “worth it”. When external
benefits are not considered, we may fail to do things that are indeed “worth
it”. The result is an inefficient allocation of resources. A number of
alternative mechanisms are employed to control for externalities: (1)
government-imposed taxes and subsidies, (2) private bargaining and
negotiation, (3) legal remedies such as injunctions and liability rules, (4) sale
or auctioning of rights to impose externalities, and (5) direct regulation.

In an unfettered market, certain goods and services that people want will
not be produced in adequate amounts. These public goods have
characteristics that make it difficult or impossible for the private sector to
produce them profitably. Public goods are non-rival in consumption
(meaning, their benefits fall collectively on members of society or on groups
of members), and/or their benefits are non-excludable (that is, it is generally
impossible to exclude people who have not paid from enjoying the benefits
of public goods). An example of a public good is national defence.
Theoretically, there exists an optimal level of provision for each public good.
At this level, society’s willingness to pay per unit equals the marginal cost of
producing the good. To discover such a level, we would need to know the
preferences of each individual citizen. According to the Tiebout hypothesis,
an efficient mix of public goods is produced when local land/housing prices
and taxes come to reflect consumer preferences just as they do in the
market for private goods. Because we cannot know everyone’s preferences
for public goods, we are forced to rely on imperfect social choice
mechanisms such as majority rule. The theory that unfettered markets do
not achieve an efficient allocation of resources should not lead us to
conclude that government involvement necessarily leads to efficiency.
Governments also fail.

7.8 SOME USEFUL REFERENCES

x Mankiw,N. G, Principle of Microeconomics, (2007) 4th edition,
Thomason Higher Education , USA
x Varian H.R, Intermediate Microeconomics, (2010), W.W. Norton and
Company,
x Case K.E., Fair R.C and Oster S.M, Principles of Economics (2012) 10th
edition. Pearson Education, USA
x Anindya Sen, Microeconomics: Theory and Applications, 2007, OUP.


Market Failure
7.9 ANSWERS OR HINTS TO CHECK YOUR PROGRESS
EXERCISE
Check Your Progress 1

1) Refer Section 7.2 and answer.

2) Refer Sub-sections 7.2.1 and 7.2.2.

Check Your Progress 2

1) Refer Section 7.3 and answer.

2) Refer Sub-section 7.3.2 and answer.

Check Your Progress 3

1) Refer Section 7.4 and answer.

2) Refer Section 7.5 and answer.

3) Refer Sub-section 7.6.1 and answer.


 Asymmetric
UNIT 8 ASYMMETRIC INFORMATION Information

Structure

8.0 Objectives
8.1 Introduction
8.2 Asymmetric Information
8.3 Adverse Selection
8.3.1 Market for ‘lemons’
8.3.2 Market for Labour
8.3.3 Market for Insurance
8.3.4 Market for Credit
8.4 Solution to Asymmetric Information- Signalling and Screening
8.4.1 Signalling
8.4.2 Screening
8.5 Moral Hazard
8.5.1 Principal-agent Problem
8.6 Let Us Sum Up
8.7 Some Useful References
8.8 Answers or Hints to Check Your Progress Exercises

8.0 OBJECTIVES
After going through this unit, you will be able to:
x explain the concept of asymmetrical information;
x discuss how asymmetrical information leads to market failure;
x describe market solutions to the problem of asymmetric information;
x define the problem of moral hazard resulting in the presence of
asymmetric information; and
x understand principal agent problems.

8.1 INTRODUCTION
In a perfect competitive market structure, one of the key assumptions
defining the market is that of complete and symmetric information among
the parties involved in the transaction. That is, we assumed no seller knows
more about a product’s characteristics than a buyer, and no buyer knows
more about the product’s costs than a seller. Such an assumption is
unrealistic due to the fact that in real life, one party to a transaction often
has more information than another about the characteristics of the good or

Market Failure service to be traded. This condition is referred to as that of asymmetric
information.

For instance, the seller of a product usually knows more about the quality of
the good than the buyer; workers usually know more about their abilities
than the potential employers; in the market for second-hand cars, sellers
have more information regarding the true status of the car than the buyer;
in the financial market, the creditor has relatively lesser information about
the default risk of the debtor than the debtor himself; and in the health
insurance market, the insurance company has lesser information about the
health status of the individual than the individual himself. These are some of
the common examples of the presence of asymmetrical information.

As per the first welfare theorem of Economics, perfect competition leads to

a Pareto efficient allocation of resources. A key assumption for the theorem
to hold is that all the information related to the trade in the market should
be equally observed by all the agents involved. When such assumption fails
to hold, that is, when information is asymmetric with one agent possessing
more information related to the trade than other agent(s), prices are
distorted and we do not get a Pareto efficient allocation of resources. This is
referred to as the situation of market failure. The present unit will discuss
the concept of asymmetric information; how does it lead to market failure
and how equilibrium is attained in the presence of asymmetric information.

8.2 ASYMMETRIC INFORMATION

The concept of asymmetric information was first analysed by George Akerlof
in his 1970 paper titled dŚĞ DĂƌŬĞƚ ĨŽƌ Η>ĞŵŽŶƐΗ͗ YƵĂůŝƚLJ hŶĐĞƌƚĂŝŶƚLJ ĂŶĚ
ƚŚĞ DĂƌŬĞƚ DĞĐŚĂŶŝƐŵ. 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,
 Asymmetric
they are unable to construct tradable price in the market and without
Information
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.

8.3 ADVERSE SELECTION

Asymmetric information exacerbates inefficiencies. One reason behind why
presence of asymmetric information leads to market failure is due to
adverse selection. Adverse selection refers to a situation when parties
gaining from the presence of asymmetric information are more likely to
enter into a trade than the parties suffering from information asymmetries.
In our examples mentioned in the previous section, if buyers of the second-
hand cars cannot distinguish good cars from bad ones, sellers may be
inclined to sell only lemons (bad-quality cars). If insurance companies have
difficulty in evaluating applicants’ health status, they may end up serving
high-health risk policyholders and may not be able to harness the cross
subsidies from the low health risk policyholders and thus may not be able to
breakeven due to high insurance claims from the high risk clients. If the
potential employers have trouble assessing the abilities of workers, they
may end up employing poorly qualified workers. In each of these examples,
the informed parties, viz. second-hand car sellers, insurance buyers,
workers, are more willing to trade when trading is less advantageous to the
uninformed parties, viz. second-hand car buyers, insurance companies, and
potential employers, respectively. This phenomenon is known as adverse
selection. When the affected uninformed parties realise that they face
adverse selection, they may become reluctant to even come forward for
trade, causing a market failure.

Let us discuss a few of these examples which lead to adverse selection and
market failure in detail.

8.3.1 Market for ‘lemons’

Let us consider a market where buyers and sellers have different
information regarding the quality of the product offered for sale. Consider a
market where there are 100 sellers and 100 buyers for used cars. Everyone
knows that all the used cars are not of same quality and there is 50 per cent 
Market Failure chance of getting a car in good condition (‘Plums’) and 50 per cent chance of
getting a car in bad condition (‘lemons’). However, the owner of the cars
know the actual quality of the car, but the buyers have no clue about which
one is plum and which one is lemon. Moreover it is not easy to verify the
quality of car from the market.

Let the owners of the lemon want to sell it at Rs. 1,00,000 and the owners of
the plums want to sell at Rs. 2,00,000. Let the buyer of the car is ready to
pay Rs. 2,40,000 if the car is a plum but Rs. 1,20,000 if the car is a lemon. If
there is no problem in verifying the quality of car from the market, then the
lemons will be sold at some price between Rs. 1,00,000 to Rs. 1,20,000 and
the plums will be sold at some price in between Rs. 2,00,000 to Rs. 2,40,000.
Since buyers cannot observe the quality of car to be purchased, they will
have to guess about the quality of an average car. Given that there is only 50
per cent chance of getting a plum (i.e., a car is equally likely to be a plum or
a lemon), the expected value of the car for a typical buyer is:
ଵ ଵ
‫ܧ‬ሺ‫ܤ‬ሻ ൌ  ଶ ൈ ʹͶͲͲͲͲ ൅  ଶ ൈ120000 = Rs. 1,80,000.

However, at that price the owner of the lemons will be only willing to sell
the car (because ‫ܧ‬ሺ‫ܤ‬ሻ ൌRs. 180000 >‫ܵ(ܧ‬௅௘௠௢௡ )ൌRs. 100000) but not the
owner of the plums (because ‫ܧ‬ሺ‫ܤ‬ሻ ൌ •Ǥ180000 <‫ܵ(ܧ‬௉௟௨௠ )ൌRs. 200000).
The price that the buyers are willing to pay for an average car is less than
the price that the sellers of plum expect from the transaction. So at a price
of Rs. 180000, only lemons would be offered for sale. Even though the price
at which buyers are willing to buy plums exceeds the price at which sellers
are willing to sell them, no such transaction for plums will take place. This is
the problem of market failure. In an extreme case, if the buyer was certain
that he would get a lemon, he would not be willing to pay Rs. 1,80,000 for it.
The equilibrium price then would have settled somewhere between
Rs. 1,00,000 to Rs. 1,20,000. For this price range market would have been
segregated, for sellers of plums would not offer their cars for sale.

There is an externality problem between the sellers of plums and lemons,

which result in the market failure. When an individual is trying to sell lemons
he affects the buyers’ perception on the quality of average car in the
market. This lowers the price that the buyers are willing to pay for an
average car in the market. This further discourages the sellers of plums. This
is an externality problem. Thus in the presence of information asymmetry, if
too many low quality items are offered for sale, it changes the buyers’
perception (and dampens the willingness to pay) on the average product,
and thus making difficult for the sellers of high quality items to offer their
products in the market.


 Asymmetric
8.3.2 Market for Labour Information

Now consider market for labour in Fig. 8.1. Let us represent the number of
workers on the horizontal axis and monthly wages on the vertical axis. The
figure shows demand curves for high- and low-ability workers when
workers’ abilities are observable to the potential employers, labelled as DH
and DL respectively. The figure also shows the supply curves for high- and
low-ability workers labelled as SH and SL respectively. The higher the
monthly wage, more the high-ability workers are willing to accept
employment.

Wages per month

SH
SL
12000 DH

6000 DL

2000

200 400 500 1000 Workers

Fig. 8.1: Market for Labour

Using this figure, we show how asymmetries exist in the labour market.
Usually workers have greater knowledge about their abilities than their
potential employer. We assume here that workers are paid according to
their abilities.

Initially we assume the ideal market situation where the potential employer
can easily differentiate between a high-ability and a low-ability worker.
Accordingly, a high-ability worker will be paid where curve DH intersects SH.
The number of high-ability worker employed will be 500 and they will be
paid a monthly wage of Rs. 12,000. The equilibrium for low-ability worker is
where curve SL intersects DL, that is, at 400 low-ability workers paid a
monthly wage of Rs. 6000 per month. Low-ability workers are paid lower
than the high-ability workers when the labour market is in equilibrium. In
this case, we do not face a situation of asymmetric information, as the
abilities of the workers to be hired are common knowledge. Thus, the
employer can easily differentiate between a high-ability and a low-ability
worker.

Now consider the case when we have a situation of asymmetric information

in the labour market. That is, the abilities of the workers to be hired are not
the common knowledge anymore. For this refer Fig. 8.2. 
Market Failure
Wages per month
SH
SL
B C
12000 DH

A E
6000 D

D
4000 DL
F

2000

300 400 500 600 900 1000 Workers

Fig. 8.2: Deadweight loss under Market for Labour

Given that there is information asymmetry, the potential employer is not

able to distinguish between the high- and low-ability workers. So for the
employer the demand for labour is depicted by the demand for an average
worker. Thus following Fig. 8.2, D represents the demand for an average
worker which is given by the average of low-ability and high-ability workers.
DH represents demand for high-ability workers and DL is the demand for
low-ability workers. Let curve S represents the total supply of high- and low-
ability workers together. Curve SH and SL are the supply of high-ability and
low-ability workers, respectively. Thus in the presence of information
asymmetry, the labour market equilibrium is defined by the intersection of
the S and D curve, depicting the total employment of labour in the
equilibrium as 900 workers. Out of 900, the existing 400 low-ability workers
should be paid a monthly wage of Rs. 4000, while the existing 500 high-
ability workers should be paid a monthly wage of Rs. 12,000. This would be
the feasible outcome when the quality of labour was observable. But since
in this case ability of labour cannot be distinguished, 900 workers in the
market are paid a uniform monthly wage of Rs. 6000. This is due to the
presence of asymmetric information to the potential employer about the
abilities of the workers. As a result of this, a high-ability worker is underpaid
and a low-ability worker is overpaid. This will discourage a high-ability
worker from participating in the labour market. At Rs. 6000 per month, only
300 high-ability workers will participate (as shown by the intersection of SH
with D curve). As low-ability workers are overpaid, they will be encouraged
to participate more in the market. So instead of 400, 600 low-ability workers
participate in the labour market in the equilibrium at the monthly wage of
Rs. 6000 (as shown by the intersection of SL with D curve).

In the market, ideally if no asymmetry in information is present, there were

total 900 workers employed, out of which 400 were low-ability and 500
high-ability workers. In the presence of asymmetric information, there 300

 Asymmetric
high-ability and 600 low-ability workers.This shows that quality of the labour
Information
in the market dropped due to the presence of the asymmetric information.
This is known as the situation of adverse selection. Potential employers
would have hired 500 high-ability and 400 low-ability workers when there
was no asymmetric information, but they ended up hiring 600 low-ability
and 300 high-ability workers. Hence, the market has become adverse due to
the presence of asymmetric information.

Deadweight loss due to asymmetric information:

In Fig. 8.2, area ABC represents the deadweight loss due to lower hiring of
high-ability workers and area DEF represents the deadweight loss resulting
from hiring too many of low-ability workers. In the above case we saw that
in the labour market equilibrium, with the presence of asymmetric
information, fraction of high-ability workers will be smaller than it would
have been in the first best scenario (without any information asymmetry)
where the potential employers would able to identify abilities of the
workers before hiring. Because of asymmetric information, low-ability
workers drive high-ability workers out of market. This phenomenon is an
important source of market failure.

8.3.3 Market for Insurance

Huge asymmetric information exists in the market for insurance. For
instance, in the case of health insurance, the maximum and true information
about one’s own health is known only to the person himself or herself. The
insurance company often suffers from the lack of information about the
person’s real health status. People facing high health or disability risk (and
old in age) would prefer buying a fat medical insurance, so that their
medical bills can be taken care of. While healthier (and younger) people
facing a lower health risk, generally do not need much insurance and hence
they would prefer to buy insurance which are attractive to them in terms of
premium and insurance cover. If the insurance company sells insurance to
proportionately more sick or old people, then it may not be sustainable for
them to run business because it won’t be able to draw the benefit of cross
subsidies from the healthy (and young) clients. The insurance company will
incur huge costs of frequent claims and may find it difficult to breakeven. In
such cases the profit maximising company may withdraw from the market.

In the presence of asymmetric information, it is difficult for the insurance

company to segregate individuals facing high health risk from the ones
facing a lower risk. This leads to the problem of adverse selection in the
market for health insurance. If the pricing or the insurance contract (defined
by the amount of yearly/monthly premiums and amount of insurance
benefit in case of sickness) is uniform for both the healthy and sick
individual, then it may induce a relatively stricter clause (over priced) for the
healthy individual and relatively easier clause (under priced) for the sick
individual. This situation is similar to ‘market for lemons’. In such a scenario,

Market Failure the healthy individuals may have disincentive to buy insurance while sick
individuals may have high incentive to buy insurance. Adverse selection will
prevail as individuals applying for insurance will now consists more of the
sick people than healthy people, leading to insurance company losing out
profits. This will lead to market failure in insurance market.

8.3.4 Market for Credit

Similar problem of asymmetric information exists in the market for credit. In
market for credit, the borrower has more information about his true credit
worthiness as compared to the lender. In other words, it is often difficult for
the lender to judge the true credit worthiness of the client. Choosing a
wrong client would mean greater risk of default and hence larger losses to
the lender. As in the case for market for ‘lemons’, low quality or risky
borrowers are more likely to enter the credit market for credit than high
quality or safe borrowers. This forces the lending interest rates based on the
average default risk to go up further, which in turn may induce the safe
borrowers to withdraw from the market and may increase the client profile
of lenders by more risky borrowers. This leads to the problem of adverse
selection in the credit market.

8.4 SOLUTION TO ASYMMETRIC INFORMATION-

SIGNALING AND SCREENING
8.4.1 Signalling
The existence of asymmetric information often leads to the problem of
adverse selection and this leads to market failure. Now what to do when
asymmetric information is prevalent? One way in which the buyer and seller
can deal with this problem is through market signalling. The concept of
market signalling is where the buyer or the seller signals the other
uninformed party, to increase their information about the product in trade.

To see how market signalling works, let us consider the case of asymmetric
information in the labour market. In the labour market where high- and low-
ability workers are present and are not easy distinguishable, employing
somebody can be very costly to the potential employer. If an employer hires
a low-ability worker for a job requiring high-ability, he will be in severe loss.
In such a case ŵĂƌŬĞƚ ƐŝŐŶĂůůŝŶŐ works great. The high-ability worker can
signal the employer about his abilities, which stand out amongst all the
other low-ability candidates. Signals could be in the form of better resume,
being highly qualified, education level, showing good etiquettes, speaking in
decent language, etc. These mechanisms are often used by the high-ability
worker to signal the potential employer about his (her) potential and makes
sure the employer credit him (her) with a high quality tag.


 Asymmetric
8.4.2 Screening Information

Presence of asymmetric information provides incentives to the parties

concerned to communicate with each other. In the previous sub-section we
came across how informed parties (workers) provide information to the
uninformed parties (the potential employer) to make up for the
asymmetries in the information. There, the informed parties initiate
communication by signalling about their hidden type to the uninformed
parties. There is another way to take care of the information asymmetries,
which is when uninformed parties initiate communication by conducting a
test either for the informed parties or the goods those parties seek to trade.
For instance, in the market for second-hand cars, the potential buyer of a
second-hand car can learn about its quality by getting it checked from a
mechanic or learn about the accident record of the car. Similarly, a life
insurance company can gain information regarding the health of an
insurance policy applicant by obtaining the applicant’s medical records,
contacting his current physician, or subjecting him to a physical
examination. Another common way of implementing screening is by
designing and offering different contracts for the different types of agents
with hidden information, instead of offering one homogenous contract. In
this way each agent’s type gets revealed.

There is one significant difference between signalling and screening. In

signalling it is the more informed party that initiate the communication,
whereas in screening the communication intended to make up for the
information asymmetries is initiated by the less informed.

Check Your Progress 1

1) Define asymmetrical information? How does asymmetrical information

lead to market failure?

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2) How does ŵĂƌŬĞƚĨŽƌůĞŵŽŶƐ turn into adverse selection?

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Market Failure 3) What is solution to the problem of adverse selection?

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8.5 MORAL HAZARD

Moral hazard is also a result of asymmetric information where asymmetry
arises due to hidden action by agents such that the action of one party is not
observed by the other party in trade, which in turn affects the benefits of
the latter. For example, in the case of the insurance market, an insured
individual’s risk of death or disability may increase in the post insured stage
because of his unhealthy lifestyle including smoking, excessive drinking, or a
lack of exercise. However, the insurance company is likely to have difficulty
in monitoring his behaviour and adjusting its premiums accordingly.

Moral hazard often arises in the labour market since employers cannot
monitor the behaviour and efforts of their employees completely. This
causes inefficiency with employees exerting less effort than the employer
would consider required. Moral hazard is also prevalent in big corporations,
where individual managers may take actions that further their own interests
at the expense of the company, which we discuss in the next section. In
general, moral hazard occurs when a party to a transaction takes hidden
actions that remain unobserved by its trading partner and that affect the
benefits or payoff of the latter.

A simple illustration explaining moral hazard associated with asymmetric

information problem and how it leads to increase in the costs is as follows.
Consider a case of night security guard in a company. Since the duty is for
the night, nobody observes the actions of the security guard. This in turn is
incentive enough for the guard to shirk, that is, not guarding properly.
Suppose he frequently sleeps during his duty hours as he knows his actions
are not observed. As a result of this, one night the company suffers a break-
in, leading to huge costs to the company. This is due to the presence of
moral hazard in the guard’s hidden behaviour which the firm is unable to
observe. Thus the presence of asymmetric information leads to market
failure.

8.5.1 Principal-agent Problem

We often study a simplified model with only one agent on either side of the
market to understand asymmetric information problems. The agent who
 proposes the contract is called the principal and the agent who either
 Asymmetric
accepts or rejects the contract is called the agent. The existence of moral
Information
hazard too occurs because of the principal and agent. Agents are the
individuals employed by the principal to achieve principal’s objective. In the
presence of information asymmetries, often preferences of the principal and
agents are not aligned and agents tend to pursue their own goals rather
than the goals of the principals. For instance, the employee (or the agent)
on duty has incentive to shirk effort, which his employer (or the principal)
fails to observe.

Common examples of a principal-agent relationship include corporate

management (agent) and shareholders (principal), politicians (agent) and
voters (principal), or brokers (agent) and markets— buyers and sellers
(principals). Consider a legal client (the principal) wondering whether their
lawyer (the agent) is recommending protracted legal proceedings because it
is truly necessary for the client's well-being, or because it will generate
income for the lawyer. Similarly a surgeon advising a patient for an
expensive knee replacement surgery may be because of genuine
requirement of the patient or because it is profitable for the surgeon. In fact
the problem can arise in almost any context where one party is being paid
by another to do something with the agent having a small or non-existent
share in the outcome.

Moral hazard problem arises where parties have different interests

and there exists information asymmetries with agent having more
information than the principal. In such a case, principal cannot directly
ensure that agent is acting in their (the principal's) best interest, particularly
when activities that are useful to the principal are costly to the agent, and
where elements of what the agent does are costly for the principal to
observe. Often, the principal may be sufficiently concerned at the possibility
of being exploited by the agent that they choose not to enter into the
transaction at all, when it would have been mutually beneficial: a
suboptimal outcome that can lower welfare overall. The deviation from the
principal's interest by the agent is called agency costs. Principal-agent
problem can be found both in private enterprises and public enterprises.
One way to correct for the principal-agent problem is by making an effective
incentive mechanism, wherein the agent can be tied with some share in the
profits so that the agents and the principal’s objectives are aligned together.
For example, giving managers (agents) some share in the company’s equity
so that they do not shirk on their full potential in their duty.

Check Your Progress 2

1) Define Moral hazard. What does it lead to?

....................................................................................................................

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Market Failure 2) What is meant by the principal-agent problem? What leads to principal-
agent problem? How can that be corrected?

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8.6 LET US SUM UP

The present Unit discussed the market condition when one of the key
assumptions of perfect competition given by full and symmetric information
among the agents involved in trade does not hold. Asymmetric information
exists when in a two-party trade one party has greater information than the
other party.It leads to market failure with one reaching an inefficient
allocation of resources. Such an inefficient solution results due to adverse
selection that arises when there exist asymmetric information. In adverse
selection the high quality goods or worker leave the market and market
essentially consists of low quality goods or workers. Examples of markets
suffering from asymmetric information are— market for used cars, health
insurance market, market for credit, market for labour, etc. There is
deadweight loss to the society in the presence of asymmetric information,
as efficient allocation of resources is not happening. One solution to achieve
equilibrium in the presence of asymmetrical information is through market
signalling or screening. The Unit proceeded with describing the problem of
moral hazard that exists when one agent tries to shirk as the other agent is
not able to observe former’s actions. In such a case the agent pursue his/her
own goals rather than the goals of the principal.

8.7 SOME USEFUL REFERENCES

x Mankiw, N. G, Principle of Microeconomics, (2007) 4th edition,
Thomason Higher Education , USA
x Bernheim B.D and Whinston M.D, , Microeconomics, (2009), Tata
MacGraw Hill, New Delhi
x Varian H.R, Intermediate microeconomics, (2010), W.W. Norton and
Company,
x Stiglitz J.E and Walsh C. E, Principles of microeconomics (2010), W.W.
Norton and Company


 Asymmetric
8.8 ANSWERS OR HINTS TO CHECK YOUR PROGRESS Information
EXERCISES
Check Your Progress 1

1) Refer Sections 8.2 and 8.3 and answer

2) Refer Sub-section 8.3.1 and answer
3) Refer Section 8.4 and answer

Check Your Progress 2

1) Refer Section 8.5 and answer

2) Refer Sub-section 8.5.1 and answer


Market Failure
GLOSSARY

Constant Returns : Constant Returns prevails when the

proportionate increase (decrease) in input(s)
leads to the increase (decrease) in output in
the same proportion.
Contract Curve : It is the locus of the tangency points of the
isoquants representing the two goods in the
Edgeworth box.
Diminishing Returns : Diminishing Returns prevail when the
proportionate increase (decrease) in all the
input(s) results in the less than proportionate
increase (decrease) in output.
Efficiency : The economic state in which all the resources
are optimally employed and all economic gains
are fully exhausted such that any change to
assist someone will harm another.
Full Employment : Is a condition when all the productive
resources of the economy are fully employed.
Equity : The state of distribution where all agents get
the equitable share of the pie.
First Welfare : The first welfare theorem ensures that a
Theorem perfect competitive equilibrium is Pareto
efficient.
General Equilibrium : General equilibrium theory explains the
functioning of economic markets as a whole. It
is concerned with the equilibrium in all the
markets simultaneously.
Increasing Returns : Increasing Returns prevails when the
proportionate increase (decrease) in all the
input(s) results in the more than proportionate
increase (decrease) in output.
Isoquant : An isoquant shows different combinations of
two inputs that can produce a constant level of
output.
Marginal Rate of : Slope of an isoquant. It gives the amount at
Technical Substitution which one input is reduced for an additional
unit of another input while producing the same
level of output.
Pareto : It is the state of allocation of resources such
Efficiency/Optimality that no one can be made better off without
making someone else worse off.
Pareto Inefficient : State of resource allocation such that there is a
possibility to make someone better off without
making anyone else worse off.

 Asymmetric
Partial Equilibrium : Partial equilibrium explains the concept of
Information
economic equilibrium of a single market,
holding all other factors and markets constant.
Perfect competition : It is a market form with large numbers of
informed buyers and sellers all of whom are
price takers.
Production : Given the resources and the state of
Possibility/ technology, it depicts different combinations of
Transformation curve two goods that can be produced by fully and
efficiently employing all the resources of the
economy.
Second Welfare : Second welfare theorem states that any Pareto
Theorem efficient allocation can be rationalised as
competitive market equilibrium.
Aggregation of : It is the way of depicting individual
Preferences preferences into social preferences.
Benthamite Social : It is a social welfare function which is derived
Welfare Function from aggregation of individual utility functions.
It is represented as ܹሺ‫ݑ‬ଵ ǡ ǥ ǥ Ǥ ǡ ‫ݑ‬௡ ሻ ൌ σ௡௜ୀଵ ‫ݑ‬௜
Bergson-Samulseon : Also known as individualistic welfare function,
Social Welfare it is given by ܹ ൌ ܹሺ‫ݑ‬ଵ ǥ Ǥ Ǥ ǡ ‫ݑ‬௡ ሻ, where ‫ݑ‬i
Function (with ŝ = 1…Ŷ) represent individual utility
functions which are ordinal and are a function
of whatever it may be that provides individuals
with utility or satisfaction.
Efficiency in Product : It refers to Pareto efficiency in production and
Mix exchange.
Isowelfare Curve : The curve depicts combination of utility of two
individuals which gives same level of welfare.
Overall Efficiency : It means efficiency in product mix. A Pareto
efficient allocation in production and
exchange.
Rawlsian Social : It is also known as Minimax social welfare
Welfare Function function:
ܹሺ‫ݑ‬ଵ ǡ ǥ ǥ Ǥ ǡ ‫ݑ‬௡ ሻ ൌ ‹ሼ‫ݑ‬ଵ ǡ ǥ ǥ Ǥ ǡ ‫ݑ‬௡ ሽ.It takes
into consideration welfare of the worse off
agent.
Social Welfare : Social welfare function is the aggregation of
Functions individual utility functions. It depicts social
welfare as a function of individual preferences.
Utility Possibility Set : Utility possibility set depicts the utility set of
two individuals.
Utility Possibility : The curve or the boundary of utility possibility
Frontier set is known as utility possibility frontier. It
consists of all Pareto efficient allocations.

Market Failure
Value Judgements : It refers to the concept of beliefs of individuals
about what is good and what is bad.
Welfare Economics : It is a branch of economics which is concerned
with the overall social welfare of the economy.
It aims at developing economic policies and
target different welfare problems and issues.
Value judgement plays an important role in
welfare economics.
Consumer Surplus : Difference between the total amount
consumers are willing and able to pay for a
good and the total amount that they actually
pay.
Deadweight Loss : A loss of economic efficiency that is generated
by an economically inefficient allocation of
resources within the market.
Economies of Scale : Cost advantage in terms of fall in the long-run
average cost experienced by a firm when it
increases its scale of production.
Inverse Demand : Inverse of demand function expressed in the
Function form of price as a function of quantity
demanded P(Q).
Lerner’s Index : A measure of monopoly power, it measures
௉ሺொሻିெ஼
the price-cost margin, as is given by ௉ሺொሻ

Natural Monopoly : Occurs when one firm (because of possession

of unique raw material, technology, or other
factors) can supply market's entire demand for
a good or service more efficiently than two or
more firms can.
Price Discrimination : A pricing strategy which involves charging
different consumers different prices for the
identical good or service.
Price Elasticity of : A measure of responsiveness of demand for a
Demand product to its own price.
Producer Surplus : Difference between the amount the producer
is willing to supply goods for and the actual
amount received by him.
Allocative Efficiency: : Efficiency resulting when resources are
allocated in such a manner that society is as
well off as possible. This results when output
is produced to the point where the marginal
benefit to society from a unit just equals the
marginal cost of producing that unit. Perfect
competition ensures allocative efficiency by
producing where price equals marginal cost,
 whereas under both monopoly and
 Asymmetric
monopolistic competition, price is marked-up
Information
over marginal cost due to which allocative
efficiency is not ensured.
Deadweight Loss : The loss of social welfare measured in terms
of the sum of producer and consumer surplus
when the equilibrium outcome is not
achievable or not achieved. Both monopoly
and monopolistic competition create
deadweight loss by producing lower output
and charging a higher price than what a
competitive market would produce and
charge.
Economic Profit : Difference between a firm's total revenue
and the sum of its explicit and implicit costs,
also called the supernormal profit.
Excess Capacity : A distinctive feature of monopolistic
competition, it is given by the increase in the
current level of output that is required to
reduce unit costs of production to a
minimum.
Imperfect : Competition is said to be imperfect when one
Competition or more characteristic features of a perfect
competition (viz. homogeneous products,
many sellers and buyers, perfect information,
no barriers to entry and exit, no government
intervention) does not hold.
Incumbent Firm : A firm which is already operating in a market.
Minimum Efficient : The output level at which the internal
Scale economies of scale have been fully exploited
so that the long-run average cost is
minimised. It is also known as the output
range over which a producer achieves
productive efficiency.
Non-price Competition : Sellers competing on factors other than price,
which include, aggressive advertising,
product innovation, better distribution, after-
sale services, etc.
Normal Profits : Also called zero economic profit, it equals the
difference between the firm’s total revenue
and total cost.

Productive Efficiency : Efficiency achieved when production is

undertaken without waste, that is, at the
minimum cost. Perfect competition ensures 
Market Failure productive efficiency, while both monopoly
and monopolistic competition do not.
Selling Cost: : Expenses incurred for promotion of a
differentiated product and increasing the
demand for it.
Cartel : A direct formal agreement among competing
Oligopolist with the aim of maximising joint
profit and reducing uncertainty.
Collusion : An agreement whether explicit or tacit
among the rival firms to coordinate on
various accounts such as price, market share,
etc.
Dominant Firm : A firm which accounts for a significant share
of a given market than its next largest rival.
Fringe Firms : Group of firms where each firm possess an
insignificant market share and are therefore
price takers.
Nash Equilibrium : Mutually best response strategy, where each
player is doing the best it can given the
strategies of all the other players, so that
nobody has a unilateral incentive to deviate
from their own strategy.
Oligopoly : A market structure characterised by a small
number of firms that operate with a lot of
interdependence.
Reaction Curve : Also called best-response function, is the
locus of optimal (profit-maximising) actions
that a firm may undertake for any given
action chosen by a rival firm.
Tacit Collusion : Collusion where rival firms agree upon a
certain strategy without putting it in as a
formal agreement or spelling out the strategy
explicitly.
Backward Induction : A method to solve for a subgame perfect
Nash equilibrium. Under this method, we
start with solving for the optimal strategy at
the "end" of the game tree, and work "back"
up the tree.
Dominant Strategy : A strategy for a player that yields the best
payoff no matter what strategies the other
players choose.
Dominant Strategy : Dominant strategy equilibrium results when
Equilibrium every player has a unique best strategy,
independent of the strategies played by
others.

 Asymmetric
Dominated Strategy : A strategy for a player that is outperformed
Information
by another strategy which is at least as good
no matter what other players choose.
Game Tree : A directed graph whose nodes indicate
players making a choice. Branches originating
from the node indicate a particular choice
made by a player. At the end of the tree we
have the associated payoffs.
Mixed Strategies : A probability distribution that assigns to each
available action a probability of being
selected.
Nash Equilibrium : Mutually best response strategy. It is the set
of strategies, such that no player has
incentive to deviate from his or her strategy
given what the other players are doing.
Sequential Move Game : A game in which players act at well-defined
turns, and have some information on what
the other player(s) did at previous turns.
Simultaneous Move : A game in which all players act at the same
Game time, and thus have no information on the
actions of the others in the same turn.
Subgame : A subset of a game that includes an initial
node (independent from any information set)
and all its successor nodes.
Subgame Perfect Nash : A strategy profile which is a Nash
Equilibrium equilibrium of every subgame of the original
game.
Arrow’s Impossibility : As per Geanakoplos, according to the Arrow’s
Theorem impossibility theorem, “Any constitution that
respects transitivity, independence of
irrelevant alternatives and unanimity is a
dictatorship.”
Coase Theorem : Developed by Ronald Coase, as per this
theorem, in the presence of externalities,
existence of proper property rights with the
parties involved lead to an efficient outcome
regardless of which party owns the property
rights, as long as the transaction costs
associated with bargaining are negligible.
Externality : A cost or benefit of an economic activity
experienced by an unrelated third party.
Free-rider Problem : A type of market failure that arise when an
individual may be able to obtain the benefits
of a good without contributing to the cost of
it provision.

Market Failure
Logrolling : Agreeing to trade votes and support each
other’s favoured initiatives.
Marginal Private Cost : Change in the producer's total cost resulting
(MPC) from the production of an additional unit of a
good or service.
Marginal Social Cost : Sum of marginal private cost faced by
(MSC) producers of the good and the marginal
external cost faced by the party not involved,
such as environmental or social costs, arising
from a good’s production.
Market Failure : An economic situation defined by an
inefficient allocation of goods and services in
the free market.
Non-excludable Good : A good for which it is not possible to prevent
consumers who have not paid for it from
having access to it.
Non-rival in : A good whose consumption by one
Consumption Good consumer does not prevent simultaneous
consumption by other consumers.
Public Goods : Goods that are both non-excludable and non-
rivalrous in that individuals cannot be
excluded from using it, and where use by one
individual does not reduce availability to
others.
Social Choice Theory : The study of collective decision processes
and procedures.
Adverse Selection : Originally defined in the insurance theory, to
describe a situation where the information
asymmetry between policy-holders and
insurers leads to a situation with policy-
holders claiming losses that are higher than
the average rate of loss considered to set
premiums.
Asymmetric : Occurs when one party to an economic
Information transaction possesses greater material
knowledge than the other party.
Market for Lemons : In America, ‘lemon’ is used as a slang
denoting a bad quality car. In the presence of
asymmetric information, bad cars tend to
drive out good cars from the market, leaving
behind a Market for lemons (bad cars).
Moral Hazard : A situation arising as a result of asymmetric
information in which one party gets involved
or consider entering in a risky event after it
has struck a deal involving covering of the
 risky situation by the other party.
 Asymmetric
Principal-agent : Arises when one party (principal) delegates
Information
Problem an action to another party (the agent), and
there exists information asymmetries
between them.


 
620(86()8/%22.6
1) Hal R Varian, Intermediate Microeconomics, a Modern Approach, W.W.
Norton and Campany/Affiliated East-West Press (India), 8th Edition,
2010.
2) C. Snyder and W. Nicholson, Fundamentals of Microeconomics,
Cengage Learning (India), 2010.
3) Salvatere, D. Microeconomic Theory, Schaum’s Outline Series, 1983.
4) Pindyck, Robert S. and Daniel Rubinfield, and Prem L. Mehta (2006),
Microeconomics, An imprint of Pearson Education.
5) Case, karl E. and Ray C. Fair (2015), Principles of Economics, Pearson
Education, New Delhi.
6) Stiglitz, J.E. and Carl E. Walsh (2014), Economics, viva Books, New
Delhi

188

MPDD/IGNOU/P.0.4K/July, 2021
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THE PEOPLE'S
UNIVERSITY
BECC-108
School of Social Sciences
Indira Gandhi National Open University
INTERMEDIATE
MICROECONOMICS • II

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ISBN: 978-93-91229-68-9