“Economics 101” -Is Government Intervention necessary in Markets? Training Session 5 Mar 2014

Why are Markets good? Problems in Markets Is Government Intervention beneficial?

Why are Markets good?

Markets are mechanisms through which scarce resources are allocated. Free markets create equilibrium (that is beneficial to all) Why equilibrium is good

Problems with Markets.

1. Externalities An externality is when I make a trade with you, but it has some accidental effect on other people who weren't involved in the trade. (e.g. Environmental Damage) Is there a way to solve externalities without Government Intervention? – Possibly, but it is likely to be difficult Hard to boycott or have entire community action Often these problems are more wide spread than just immediate area

2. Coordination Problems Coordination problems are cases in which everyone agrees that a certain action would be best, but the free market cannot coordinate them into taking that action. A self-interested person has some incentive to sign a pact to make everyone do something beneficial, but in many cases has a stronger incentive to wait for everyone else to sign such a pact but opt out himself. This can lead to an undesirable equilibrium in which no one will sign such a pact. Bargaining Power

3. Irrational Choices Old-school economics assumed choice to be "revealed preference": an individual's choices will invariably correspond to their preferences, and imposing any other set of choices on them will result in fewer preferences being satisfied. There is growing evidence from behavioral economics that seemingly trivial alterations in the way decisions are presented can substantially affect choices. Should Governments protect people from irrational choices?

4. Lack of Information In order for consumers to be able to make the right decisions, they need to have perfect information about everything However, this clearly doesn’t happen in the real world. So, Governments intervene to protect individuals by ensuring that products are of a certain standard, and label how they work or what went in to them. However, sometimes there are insurmountable cases of information asymmetry (where one party has information, and the other party doesn’t, and that information is very important to the transaction). The two most interesting cases are moral hazard and adverse selection, and something like health insurance gives a good example of both.

Moral Hazard Moral hazard occurs when, by protecting an individual against some bad outcome, it leads to behaviour that actually may increase the likelihood of that bad outcome occurring. If you have top notch health insurance, and know you will be covered no matter what happens, then you are likely to be less careful with your health, meaning you may in fact be more likely to get sick

5. Monopolies Monopolies are inefficient Can charge what they want when they have control over the market Generally we don’t have debates about monopolies or oligopolies, but the principles are useful to consider – issues about market power and relative competitiveness do come up in other debates, particularly when considering labour debates such as minimum wage, labour union or right to strike debates.

Government Intervention

Inefficient – Private sector faces competition and aims to maximise profit – Government has different incentives – accountability that often leads to large amounts of bureaucracy Lobbying Are market failures really market failures or are they markets correcting itself?