The Science of Everything Podcast - Episode 19: Market Failure

Episode Date: June 15, 2011

A discussion of the principal circumstances in which markets do not produce an optimal outcome. After formally defining market failure, I discuss the ‘big four’ market failures of market power, externalities, public goods and asymmetric information. I conclude with a brief look at transaction costs. Recommended pre-listening is Episode 12: The Price System.

You're listening to The Science of Everything podcast, episode 19, market failure. This episode continues on from the analysis of market performers that we conducted in episodes 12 and 16, so it might be good idea to have listened to those first, because you'll get more out of this one. In this episode, we look at situations when markets fail to produce optimal outcomes, hence market failures. So first I'll define exactly what a market failure is because there is a specific definition, and then I'll look at the canonical big four examples of market failure, which are market power or monopolies, externalities, public goods, and asymmetric information. And then at the end, I just want to take a brief look at transaction costs,

which are not exactly the same as the other four examples of market failure, but I think are still very relevant to this analysis. Also, I want to say that in this podcast, I'm just going to have a very brief introduction to each of these areas or examples of market failure. probably in the future I'll do a separate podcast on each of these and have a more detailed look at the ways that they can be rectified or improved. But here I just want to introduce the basic idea to you. So first of all, what is a market failure?

Well, in economics, the term market failure has a very precise meaning. It does not simply mean a dissatisfaction with market outcome. So if we see some outcome or some situation that has occurred in the economy that we don't like, say people are producing and selling music that we don't like or magazines we don't like, or some people are much richer than others and we don't like that, or something along those lines. That is not a market failure, at least not in the economic sense. Market failure refers to the situation when left to its own devices, the market does not allocate resources efficiently.

So what does that mean? What does efficiently mean? Well, efficiently, or efficiency in economics also has a precise meaning, which is that of the concept of Paretoefficiency. named after Pareto, we came up with the idea. You are at a state of Pareto efficiency if it is impossible to make any one person or group better off without making at least one person worse off. Or, to put it another way, if it is possible to make at least one person better off without making anyone else worse off, then you are not at a state of Paretoefficiency.

So market failures mean that we move away from a state of Pareto efficiency, because resources are allocated in such a way that it is possible to make some people better off without making anyone else worse off, therefore we do not have an efficient outcome. So this means that, for example, things like unemployment and income inequality are not necessarily market failures, because if some people are much richer than others, it's not clear that there's any way to rectify that without making some people worse off, and so therefore, by definition, is not a preto inefficient outcome. That doesn't mean that income inequality is not an important topic, and I'll do a podcast on that in the future. It just means it's not necessarily a market

failure in the same way, so I won't be talking about it in this podcast. And I just wanted to make that clear because sometimes when people cover or talk about market failure, they include income inequalities and poverty there. And it's not really legitimate to do that because they're quite different concepts. And market failures are important because when they exist, there's a potential role for the government to introduce policies or programs that could potentially improve outcomes for the community and the economy, etc. Although, as I'll point out briefly in some, in these cases, the fact that there is a market failure, is a necessary but not sufficient condition for government intervention because government intervention doesn't always make things better. It can actually make things worse. Okay, so having defined market failure, let's look at the four big ones in turn. We'll start with market power. Market power

exists when one buyer or seller in a market, or multiple buyers or sellers in the market, have the ability to exert significant influence over the quantity of goods traded or and or the price at which they are traded. So in perfectly competitive markets, all market participants, buyers and sellers have no market power. They have no say on the price or on total quantities that are sold. They are assumed to be price takers where they just see the price and trade at that price. Examples of that in the real world of things like the market for oil or for wheat, milk, things like that, where there are so many buyers and sales that no individual really has much of an influence on the price. You just have kind of have to take the price that there is.

Another way of looking at that is the only way that a single individual or individual firm can influence the price is if they buy a lot or sell a lot or have a big stake in the market. But if there are lots and lots of other players of similar size to you, then you trading twice as much as you did or nothing is not going to make much of difference to the price, and so you don't really have any power over the price. So because large numbers of buyers and sellers kind of reduce the price of any single buyer on seller, that means that market power generally only exists when there are a small number of buyers. That's called a monopsony when there's only one buyer or an oligopsony when there's only a few buyers. That's relatively rare. It generally

only occurs when the government is the buyer or something, and it's a sole buy, like defense hardware, for example. More commonly, though, there are, market power also exists when there are a few sellers. So a single seller is called a monopoly. If you have two sellers, it's a duopoly, a few sellers, an oligopoly. You may have heard those terms before. An example of monopoly might be if the government owns the postal service and it's the only postal service, then it has a monopoly. So whenever you have a monopsony or a monopoly or oligopoly, then that buyer or seller, so we'll talk about the case of monopoly just to be, to simplicity. So when you have a monopoly, that seller is not constrained by competition between other sellers. So they can charge kind of whatever price they like just by altering the quantity that they're willing to sell.

Now, why does this necessarily lead to an inefficient outcome? Well, the reason is because under a perfectly competitive market, which is the kind of the situations we're talking about in podcasts, 12 and 16, prices will be equated to the marginal cost of production, which means that the marginal benefit that you get from a unit of production is equal to the cost of producing that production, and that's the situation you want. If the marginal benefit of an additional unit of production

was greater than the marginal cost, then that means that producing an extra unit would yield a total benefit to society or whoever is getting that, and therefore you should produce it. On the other hand, if marginal costs of production exceed marginal benefits, then you should cut back on production because by reducing production, you would cut costs by more than benefits would be reduced, and so you would be better off. So clearly, those two situations are going to reach equilibrium

or balance each other out when marginal costs equal marginal benefits. That's a general principle in economics. You should always do things, anything, whatever it is, until a situation where marginal benefits equal marginal costs. and that's really just common sense. Now, the thing is, under a perfectly competitive market, that happens automatically through prices. So basically, prices will continue to rise

until they reach marginal costs because consumers will be willing to pay a certain amount of money for the good, and the amount of money they're willing to pay depends on the marginal benefit that they get from them, and so the price will be certain to go to at least marginal cost, as long as the marginal benefit that people get from the good exceeds marginal cost at some level of output.

otherwise none of the good will be produced at all because the marginal benefits is just not enough to cover marginal cost but marginal but the price is never going to exceed marginal cost in a perfectly competitive market because if it did then new sales could enter the market they could produce at marginal cost and sell at the price and make a profit and therefore people will keep entering the market

until the price is driven down to the marginal cost and therefore no one's earning a profit or a net profit and therefore you're actually equilibrium and that's what we talked about in previous podcast. Now that only happens in a perfectly competitive market. If you only have one or a few sellers, the price is not equated to marginal cost, and therefore you do not get the efficient outcome. Remember, the efficient outcome, the amount of production we want is when marginal cost equals marginal benefit, and therefore price is what equates those two. When

marginal cost equal marginal benefit, then price is equal to both of them, and that the price brings them together, and that's what generates the efficient outcome. In imperfect competition, that does not work. Now, why doesn't it work? Well, the reason is, under imperfect competition, marginal costs generally don't change. That is, to the producer or the seller of the goods, marginal costs are presumably the same of producing whatever it is. But the marginal revenue to that firm changes.

So that's the amount of extra money that they get from selling an extra good, the marginal revenue at the margin. Under perfect competition, marginal revenue is simply equal to the price, because whatever, if they sell an extra good, if the firm sells an extra good, they will receive revenues equal to the price of that good, and that's it. Selling an additional good will not change the price, because by definition, in a perfectly competitive market,

you don't have any market power. You have no ability to change the price, and so whatever you sell doesn't affect the market price, and so marginal revenue is just the same as price. However, under imperfect competition, marginal revenue has two components. So when an imperfectly competitive, say a monopoly, when that monopoly sells an extra unit, they receive extra marginal revenue equivalent to the price

at which they sell the extra good. so that's fine, that's the same as under a perfectly competitive market. However, and this is the key difference, under an imperfect competition, the monopoly, in order to sell the extra unit, it has to lower the price that it charges on that unit, and also on all previous units. Now, that's based on the assumption that they can only charge a single price, and they can't charge different prices for different units,

and that's often the case. So if the monopoly wants to sell extra units of production, they have to lower the price, because otherwise people won't be willing to buy the extra goods at the existing price. That's just the fact of the downward-sloping demand curve. The more expensive something is the less people want to buy. If the firm wants to sell more, they have to reduce the price in order to sell those extra units. And if you assume they can only sell all the goods at the same price,

then they will have to reduce the price on all previous units that they sell as well. And so there's a trade-off there. the monopolist gets an extra revenue equal to the new price times however many extra goods they sell. However, they lose revenue equal to the change in price, the reduction in price, times however many units they were selling before. So there's a trade-off there. And that means that marginal revenue for the monopolist or the imperfectly competitive firm is always going to be less than it is for a perfectly competitive firm.

Because the perfectly competitive firm does not face that trade-off. The perfectly competitive firm can sell extra units at market. price, that's the same, but they do not face any loss on existing units. Because, remember, we've said that they have no market power, which means that selling extra units will not change the price for them. They don't have the market power to do that. The monopolist does, and in fact, has to reduce the price in order to sell the extra units. That's the key difference. And so in the case of perfectly competitive markets, there is no trade-off in marginal revenues. So marginal revenues, what they are, and price will reach the market-efficient level to equate marginal benefits and marginal costs.

the imperfect competition on the monopoly, the marginal revenue of the firm will always be less than price or always be less than the, than it should be under a perfectly competitive market, because of that effect of having to give up higher prices on previous units of output. And if marginal revenue is less than the price, then that means the firms will supply less than they would under a perfectly competitive market output. It's somewhat easier to explain this if you have a diagram, if you use one of those supply demand diagrams. So maybe if you're having trouble understanding what I'm saying, look up.

monopoly supply demand diagram or something like that on Google Images and have a look at the diagram and you'll sort of see what I'm saying. The basic idea is that if a monopoly has market power, it pays to produce less because by restricting the output, you can charge a higher price and increase your profits. But the trouble is when you do that, you move away from the perfectly competitive equilibrium output and therefore you reduce total efficiency. And by reducing total efficiency, basically what means we're giving up opportunities for production and trade that could benefit society as a whole, that could increase total surplus, as economists would say. So it's good for the monopolist to restrict output, but it's bad for

the society as a whole. It's bad for consumers, but we can also tell that the benefit to the monopolist will be less than the loss to consumers because we have not reached the Pareto-optimal output. Okay, so that's the problem with market power or monopolies. What can be done about it? Well, the basic idea, sort of the original idea is that the government could just provide these sorts of things. So if goods tend to, if a certain good tends to be a natural monopoly so that it consistently gets monopolized by a single firm, then the government could provide it. An example of that might be railways or telephones or electric power or something like that. Whether those particular examples are natural monopolies or not is a separate question. But that's one possibility that government could provide it directly and charge a lower price than the monopolist would and so prevent the loss.

Another way of doing it is for the government to introduce antitrust laws, which force large companies to break up or prevent merges between larger companies and try and prevent other anti-competitive practices and so on. One problem with legislation like that, it's very hard to tell when any particular action is anti-competitive or when a firm is too big and so on. And sometimes by restricting, for example, by restricting firms from merging or restricting an existing firm from expanding, you could actually make consumers worse off and make society worse off by preventing, what is actually an efficient trade or an efficient action from taking place. So it's very hard to tell when a market is actually anti-competitive or whether it's just needs economies of scale or something like that. And there are also, whenever the government gets involved in things like this, political incentives come into play.

So maybe the firm is not actually a monopolist or it's not actually abusing its position. Because to take attention there, it is possible for a monopolist actually to not, to still charge the perfectly competitive equilibrium price. It's just that it has an incentive not to. However, it may be the case that the monopolist is constrained by outside forces to charge that low price. The government could force them to, or they could be forced by outside competition. So suppose that you have a monopoly on selling something, but you face the potential of other firms coming in and competing with you to sell that goods.

So basically, in order to maintain your monopoly position, you have to sell at quite a low price and large quantity, and therefore you're basically producing the market efficient outcome anyway, even though you are monopoly. And that's what we would expect in a perfectly competitive market. If there are monopolies, we would expect them to be fairly competitive, because otherwise they would risk attracting new entrants who would compete away their profits. However, there are situations where there are so-called barriers to entry,

which prevent firms from entering like that, and therefore allow the monopolies to restrict production and increase price, and therefore increase their profits with impunity. Patent laws, legal barriers, high fixed costs of production, or ownership of unique natural resources, those sorts of things can produce that effect. But anyway, as I was saying, so it is possible for monopolies to be fine or to still produce the efficient outcome, or it is possible for firms to get bigger and still not actually do anything anti-competitive. And it's not very easy for the government to distinguish

those situations. There's a lot more to say about market power, but that's some of the basics there. And that's one of the more complicated of the market failures, I would say, to understand. So the other ones will hopefully be a little bit simpler if you had trouble getting your head around that. The second one that I'm going to talk about is externalities. are costs or benefits that arise from an economic transaction. So an economic transaction is just buying or selling of something or production of something. Costs or benefits arising from an economic transaction

that are born or received by parties not involved in the transaction. That is third parties. So externalities can be positive or negative. A positive externality means it's an external benefit. So someone else benefits from the transaction who's not involved in the transaction. Negative externality is the reverse. It's a cost, an external cost on someone not involved in the transaction.

So just to reiterate this concept of an economic transaction, in an economic transaction, basically you have a buyer and a seller, party one and party two. A third party would be someone who is neither the buyer nor the seller or not directly attached to them in any way. They're just someone else. If they are affected by said transaction, then we say that the transaction has externalities.

Now, those effects could be positive. They could be good things. They could be benefits that the third party receives, or they could be costs and therefore negative externalities that the third party bears. The existence of externalities will result in either too much or too little production of the goods and services that are producing the externalities, and therefore, once again, we move away from the efficient outcome. So why should that be the case? Why should an external cost lead to too much or too little production? Well, basically, the reason is that when a person decides how much of a good to produce, or how much to consume, for that matter, they generally, in an economics we assume, and it's also a fairly reasonable assumption for most cases, that they only take into account their own personal costs and benefits.

how much does it cost for them to produce it and how much will they get from selling it, or what's the benefit that they get from consuming it and how much does it cost for them to pay for it, to buy it? That's what they take into account. They do not take into account any external costs or benefits that consuming it or producing it may entail. So a good example of this is a firm producing steel. So when deciding how much steel to produce, it has to factor in labour costs, capital costs and other inputs, and it has to pay for those at the appropriate market price. And so those costs will be fully reflected in the market price of steel, the cost of labour and capital and all that.

However, if the firm produces pollutions into the atmosphere in making the steel, those costs do not have to be paid for by the firm. It can just put out as much pollution as it likes, it doesn't have to pay for it. And therefore, it will not factor in those costs of pollution when deciding how much steel to produce, and also when deciding what price to charge for its steel. And so the price of steel incorporates labour and capital. That's fine. But it does not incorporate the cost of the pollution generated in making the steel, because that cost was external. the firm didn't have to consider it, and so it doesn't, it's not incorporated into the price. And so that means in a situation where you have negative externalities, you'll get overproduction,

because when deciding how much to produce, remember, I said that the efficient outcome will occur when marginal benefits of production equal marginal costs of that production. So in the case of a negative externality, marginal benefits are the same as what they always were, but marginal costs are actually higher than was thought or than is being considered because of those extra costs. And so if you have higher marginal costs, you should have a higher price to incorporate that and also have a lower total, lower total output or consumption of the good, reflecting the higher marginal cost versus marginal benefit trade-off. On the other hand, if you have a positive externality, then marginal cost is the same, marginal benefits go up.

And therefore, you should, you'll actually get less production of the good than you should have in an efficient equilibrium. An example of a, so the most common example of an externality is pollution, which is a negative externality, but there are a major. many, many different examples of externality. Another example of a positive externality is a flower garden or a park or something like that that looks nice. When the person is deciding how many flowers to plant in their garden, they probably don't consider the benefits that other people get from enjoying their flowers, and so that's a positive externality that they don't consider,

and therefore they plant too few flowers. Now, the government can remedy externalities by taxing subsidies that cause negative externalities, and then subsidizing activities that produce positive externalities. and that if the tax is placed at the right level, and that's a big gift because it's not always easy to know what the right level is, but if the tax is placed at just the right level, then the government can ensure that the efficient or optimal output of the goods is produced, or you have the efficient allocation. And that works because suppose you have a negative externality, say the pollution, that means that marginal costs are higher than the firm is considering in making their production choices.

If the government then introduces a tax on production of steel that's just equal to the size of the pollution costs, then the firm, when they're deciding how much to produce, will look at, you know, labor and capital and all those existing costs, and then they'll add on the tax as well, and consider that as a cost as well, because that's what they have to pay when deciding how much to produce. And so if that tax is set at the same level as the negative external costs of the pollution, then it will be as if the steel firm was considering the cost of the pollution, their production choices, and then you'll get to the efficient outcome. So, taxing an external cost, like a pollution tax or a carbon tax, for example, does not actually directly, in a sense, get rid of the externality. The externality is still there. It just forces firms or consumers to act

as if they were incorporating the cost of the externality in making their choice. And the same thing works for a subsidy. It's that if you subsidize an activity, you pay someone to do it, so the government could theoretically subsidize people to plant flowers in their guns, and if the subsidy was placed at the right level, it would be roughly equal to the benefit that people would get from looking at the nice flowers. And so when the person was deciding how many flowers to plant in their garden, they would incorporate their own personal benefits from doing that. Plus, they would incorporate the money they're going to get from the government. And that amount of money, once again, if it's at the right level, will be equal to the benefits that other people

are going to get from seeing the flowers. And therefore, when the person's deciding how many flowers plant, it'll be as if they incorporate the benefits that other people get from seeing the flowers. And so they'll produce the plant the right number of flowers. They'll produce the efficient outcome. Of course, implementing those taxes and subsidies can often be very difficult. And then there's the trouble of political incentives whereby everyone, if you're going to subsidise people who produce positive externalities, all of a sudden, every industry is arguing that they're producing positive externalities, whether they really are or not. And so there are various problems with that, as there is with everything. Okay, so that's externalities. Now we're going to move on to market failure

number three, public goods. Public goods exists when the provision of a product or service for one person or for one group of people means that it is available at everyone else to no extra cost, or at least it is available to a significant additional group at no extra cost. So there are two essential concepts to understand when you're talking about public goods. These are non-excludability and non-rival. Public goods have to be non-excludable and non-rival. You have to satisfy both of those criteria to be a public good. So what do these things mean? Non-excludability. means that it is impossible to exclude anyone from consuming the good that you have just produced. A classic example of this is defence. So if you produce a defence force to defend your country,

you can't really defend some people in the country without defending other people. I guess you could defend half of the territory of the country, but that's not quite the same thing. You can't defend half of the people in a given area, not the other half of the people in a given area. It's not physically possible. Another example is when you produce a new idea or invention. It's not really easy to prevent people from knowing that thing as well. You can exclude people from, say, accessing the physical documents or computer program or whatever that you've got, but you can't really exclude them from possessing the idea itself if they have some physical means of obtaining it. So this idea of non-excludability is a little bit vague because it relates to what's physically or technologically possible,

and things that were non-excluable in the past may actually become excludable in the future if we have new technologies that allow us to do that. And there's also degrees of excludability and things like that that confuse the issue. But that's the basic idea that you can't prevent other people from consuming it once. you've made it. Non-rival is the other criteria. Non-rival means that one individual's consumption of the good does not subtract from anyone else's consumption of that good. So effectively, you only need to make it once, or only need to make a certain amount of it, and then everyone can benefit. Defense is another really good example of this, because if you defend a country, you've defended the country, and everyone in that country gets the benefit of the defense, that's the non-exclutability part,

but the benefit that I get from being defended does not detract from the benefit that you get from being defended. So if an extra, say, 100 people move into the country, they are not going to detract from the amount of defence benefit that everyone else gets in the country. Of course, you could say that if a million extra people moved into the country, then maybe that would affect the amount of defence that you had to have. So once again, there are degrees of rival, how rival something is, but still the basic idea is that one person's consumption does not detract from another person's consumption. Now, the opposite of a public good is a private good. private goods are excludable and rival.

So, excludable meaning that you can prevent anyone from consuming it. Rival means that when one person consumes it, it's not available for someone else. So an ice cream loaf of bread, a seat in a cinema, a classic examples of that. One ice cream consumed by one person means that that's one ice cream that another person cannot consume, so it's rival, and you can prevent someone from consuming your ice cream by not selling it to them or not allowing to have it. So things like that are excludable and rival. But public goods are non-excluable and non-rival. It's actually an interesting conundrum because it's actually good in a sense that things are non-includable and non-rival,

particularly non-rival at least, because non-rival means that you only need to produce it once and then everyone benefits. So it seems it would actually want things to be non-rival. And non-excludable, well, that's a little bit if you're fier, but still it means that if one person gets it, everyone gets it. So it's sort of fair in that sense. So you might think that non-excluble and non-rival is actually a good thing. And it sort of is in that sense. But there's a problem. The problem with goods that are public goods, non-excluble and non-rival, is the problem of free.

writing. Basically, if you cannot exclude anyone from consuming the good when you produce it, then everyone is going to want to wait for everyone else to produce it. So, for example, let's consider the situation of a lighthouse. A lighthouse is another good example of a public good. Each ship captain wants there to be a lighthouse because they don't want their ship to run a ground or to miss the port or whatever. So it's in their interest to have a lighthouse. However, a lighthouse is basically non-excludable because once it's there, every ship can benefit. you can't really prevent a ship's captain from not using the lighthouse. Not very easily anyway.

And so every ship captain wants there to be a lighthouse, but they also say, well, I know that everyone else wants there to be a lighthouse too, and I know that once someone else builds a lighthouse, I'll be out of benefit from it. So I prefer just to wait for someone else to build the lighthouse and then benefit from it rather than having to pay for it myself. And so everyone says to themselves, and everyone waits for everyone else to build the lighthouse,

and the lighthouse never gets built. I mean, that's an extreme example. In other cases, it might just be that you get a suboptimal, production of the good. So you get a short, lousy lighthouse, or just not enough lighthouses or something like that. Or you get some defence, national defence, but just not enough, not very good, or something like clean air and information goods like inventions and software development or other examples of public goods. You might get some of those under a free market, but just not enough, because everyone's trying to free ride on everyone else. Just sit back and wait for everyone else to produce it. And that's

the non-exclusability problem. The non-rivalous problem comes into play because if the good was rival, then, like, you might not be able to prevent someone from consuming it, but if you've already consumed it by the time they get there, because it's rival, then it doesn't matter so much. There'll still be no free-riding problem if that happens. So goods have to be non-excluable and non-rival in order for this public goods problem to really play out in the way we describe it here.

Now, if one of those criteria is met but not the other one, so if you're excludable but non-rival or non-rival, or excuse me, and rival but non-excutable, there are different problems associated with that. Those are not public goods, they're not private goods, they're sort of somewhere in between. And I'll talk about those later. I don't want to complicate the situation for now,

but just understand that those are separate criteria, and one can be fulfilled without the other being fulfilled, but you need both of them in order to be a public good. So we expect public goods to be provided at suboptimal levels, so not enough of them in a free market or a perfectly competitive market. And so one potential way of avoiding that is just to have the government provide them directly for free or for a highly subsidized price. So the government builds a lighthouse and then everyone benefits.

The government provides national defense and everyone benefits, and then the government just taxes everyone to collect a contribution, to providing the good. That I think is one of the sounder arguments in favour of government intervention. Lots of people make different arguments in favour of government intervention, often on the basis of some sort of market failure. Some of them, I think, are more tenuous than others. This one is a pretty solid one, because that would be efficient in a sort of economic sense. However, of course, like anything else, it has its own problems. For example, there are adverse political incentives associated with the provision of any good. Whenever the government's spending lots of money on anything,

you've got political problems. So maybe the person who gets the contract to build the lighthouse is not actually the person who would build the best or cheapest lighthouse, it's the person who's friends with the local senator or something like that. That certainly happens. And lots of more subtle factors. Another problem with government provision of public goods is that there's often a lack of motivation to innovate or to be effective or to provide good customer service and things like that. If a private firm doesn't innovate, doesn't provide good customer service and so on, it might be able to get away with that for a while, but eventually it's going to lose business to someone to a competitor and go out of business or lose a lot of profits at least.

But if the government's the only person providing that, then it's probably not going to have the same constraints placed on it to perform well, especially because the constraints would, the political pressure might come on them to improve their performance, but there are so many other factors that affect, you know, whether a government wins or loses an election that, you know, a lousy postal service, even if it's really bad, may not actually tip the balance, and so the government just doesn't have much of incentive to do anything about it. Another way to do with public goods is to try and introduce property rights to make the goods excludable and rival, or at least one of those two things.

So one example would be pollution permits. The natural environment or a clean air, probably a better example, clean air is a public good. Because if one person has clean air, then kind of everyone does. And the one person benefiting from clean air doesn't really take away anyone else benefited from clean air. I suppose the air you actually breathe is air that someone else can't breathe, but there's so much of it that really, if the air is clean, there's enough for everyone. So clean air is a public good.

However, if you introduce pollution permits, you've sort of made it into private and excludable because you can now exclude people from polluting by not selling the permits and one permit for one person is clearly one permit less for someone else so it's rival in that sense fishing zones in the ocean might be another example generally the ocean has been a public good so anyone can just fish how much they like wherever they like and that leads to overfishing and depletion of fishing stocks however if you divide up the ocean into segments and say this person has full and sole rights to fish this area and another person has full and soul rights to fish in this area and so on then you've made them rival and excludable. That comes back to the issue of sort of what counts as being rival and

excludable because it's not easy to divide up the ocean like that. You can't really fence the ocean and different ways have been tried to attempted to do this and really it comes down to a technological institutional issue of how feasible is it to do that. And so there's no clear demarcation between what's sort of rival and what's not, what's excludable and what's not. It's a relative question of degrees. But still the concept of public goods is a very valid and important one. Okay. So that leads us on to our fourth and final of the big for market failures, and that's asymmetric information. Information asymmetry just means sort of inequality of information that people have. It's when one party to a transaction has more

information or better information about the transaction or the good being sold or bought or whatever it is than the other party does. Often it's the seller who knows more about the product than the buyer, but it doesn't have to be the case. So, classic example here is the market for lemons, used car salesman, they know that the car is dodgy, the buyer doesn't know that the car is dodgy, or what's wrong with the car, and so there is asymmetric information there. Another example would be things like drugs or medical care or anything that involves a lot of technical expertise. The person selling the drug or providing the medical care knows or should know or could well know, at least, whether it works or how effective it is or how useful it's going to be.

The person buying it may not know. They may not have the expertise to know that or just the ability to access that information. So once again, there is an asymmetric information there. Another example occurs in the case of workers. The worker, in this case is the seller, they're selling their labor. They know how qualified they are, how much experience they have, how hard they're going to work, etc. The employer doesn't. At least not directly. They may look at things like their grades or previous work experience on their resume or other things like that to as signals that indicate the real performance and abilities of the worker, but they don't know them for sure. So there's asymmetric information there as well. So why might asymmetric information be a problem? The reason is it

prevents consumers and producers from making fully informed decisions and therefore could distort, well, will distort market allocations to suboptimal levels. It's sort of similar to the issue of external costs. So you can think of it like this. When you have externalities, that means that there's a cost that one imposes on someone else that one ignore. So you ignore a cost that's imposed on someone else. In the case of asymmetric information, you ignore a cost or a benefit that you impose on yourself. Now, why would you do that? Well, the only reason you do that is if because you don't know about it. So you ignore a cost, say, if you buy a used car that is poor quality, you might have ignored the cost of buying that car, say extra cost of servicing, or maybe just overstated the benefit

of buying the car, because you were ignorant of information which would have led you to reassess the cost of benefits. So in the case of asymmetric information, you're ignoring costs of benefits but that apply to yourself, or maybe they'd apply to the other partner in the transaction. And obviously, that's going to lead to market allocations which are not optimal, because you're making decisions based on information that's actually wrong. Now, regulation that requires people to disclose information about products or places restrictions on dangerous or defective goods and so on can address this type of market failure, can provide that information. Another way to overcome asymmetric information is by the use of brand names and reputation. So it's often thought that

the content of a brand name is just total waste. It's just a way for the big company to charge a high price for their good and earn more money. But it's not actually total waste. It serves a purpose. The purpose is that if you buy a brand name, if you buy McDonald's or Nike or whatever, you know you're getting a quality product, or at least a product of a certain quality. I mean, you may know that you're getting a low quality product, but at least you know what you're getting. If you buy from a brand name that you don't have no familiarity with or just from some random person, you don't have that reputation, you don't have that information there. So brand names convey information about the quality of the product you're buying based on your past performance

and what other people have said about their brand and so on. So brand names are actually worth a lot for companies to maintain because they can charge a much higher price based on their good brand name than if they were just selling a generic product. So that means that it's very much in the interest of large corporations to protect their brand. And that's why they spend so much on advertising. That's why they're so worried about their public image and reputation and so on. And that's why, for example, Nike goes to so much effort to sort of clean up its image in terms of the, you know, shoes being produced in sweatshops and so on and having detailed inspections and so on is what they do. It doesn't mean that these sorts of corporations can't do nefarious things or can't

exploit consumers in some ways. However, it certainly means that it's in their interest to minimize those sorts of things and minimize the public, maximize the public perception of the goodness of their organization because their brand name is very valuable because it overcomes asymmetric information. If everyone had perfect information, then brand names would be useless because you'd know the quality of the product, what the quality of the product was anyway. Another way of avoiding asymmetric information problems is through consumer advocacy and consumer choice organizations, which can investigate the quality of the product for you and therefore provide consumers with more information.

Final thing I want to talk about briefly are transaction costs. Transaction costs are just costs that are incurred in the act of making an economic transaction. So that's buying or selling, basically. They include things like the costs of finding out information about who sells what or what consumers want. The energy and time taken to actually go there to actually physically produce the thing, or not producing, to actually physically buy the thing, things like that. Time waiting in line, the effort of paying, all those sorts of things involved in the actual

transaction itself. High transaction costs in that sense may make it very difficult to discover opportunities for mutually beneficial trade and then even if you know about them make make it very expensive and difficult to actually engage in them. Now this is not exactly a market failure in the sense of the four previous ones that we discussed because a transaction cost is a real cost. And so if you knew that you could benefit from buying some good, if you could just somehow buy it with no transaction costs, then that's one thing. But that's not the real world. The real world is you actually you have to engage in the transaction, therefore the transaction cost is an intrinsic part of the transaction that you're engaging in. And so it's perfectly rational and in fact perfectly

efficient for people not to engage in transactions that have very high transaction costs. That's not really, it's not the same as a public good or an externally. It's not moving you away from an efficient outcome. All it's doing is the transaction cost essentially moves away from the best outcome that you could imagine, but not the best outcome that's actually reachable in practice. However, it's still kind of, transaction. transaction costs are still kind of relevant because you can change transaction costs by changing the market structure or by changing the legal institutions that underpin market transactions. For example, the government could introduce regulations or remove regulations even or provide

the good directly or something like that in order to reduce transaction costs. So, for example, it's possible for people to provide public goods by just engaging in a contract, an agreement between themselves. So for example, suppose, remember all those sailors that I talked about or ship captains who wanted there to be a lighthouse but didn't want to pay for it just by themselves? Well, they could all come together and sign a contract whereby they all contributed a certain portion of the cost of the lighthouse and then it was built. That would achieve the optimal outcome in that case. The trouble is that that act of coming together and arranging the contract and so on is expensive.

There are lots of transaction costs associated with that. It may be cheaper for the government to just build the thing in the first place. That in itself will have transaction costs, of course, you know, getting the bill passed and so on. But the transaction costs may be substantially lower in that case than if the ship captains had to agree to it with themselves. Depending on the way you've organized the market and depending on the extent of government intervention, you can affect the size of transaction costs. And so it's sort of relevant to the question of market failures as well. Okay, well, that's all that I wanted to cover in this podcast.

As I said, there's plenty more to say about all of these topics, but that's for future podcasts. I hope you have enjoyed this episode and learned something from it. Please email me with any suggestions or feedback that you may have or post a review on iTunes. Really, particularly would like more feedback from listeners to know why you listen to this podcast. as opposed to other podcasts and what I could do to make the podcast better and more distinctive because there are plenty of other good science podcasts out there and I really intend to fill a particular niche in providing more in-depth information about specific topics and not just sort of discussions or interviews on news articles, which is what most science podcasts that I'm

familiar with do. So your feedback in that regard will be most appreciated. So thanks for listening and I'll speak to you next time.