ASRJC Theme 2B Market Failure Lecture notes 2025

THEME 2: Firms’ Strategies and Market Failure Anderson Serangoon Junior College Economics Department A 1 THEME 2: FIRMS’ STRATEGIES AND MARKET FAILURE SYLLABUS CONTENT (H3)

THEME 2: Firms’ Strategies and Market Failure Anderson Serangoon Junior College Economics Department A 2 THEME 2: FIRMS’ STRATEGIES AND MARKET FAILURE CHAPTER 1: MARKET FAILURE 1. QUASI-PUBLIC GOODS A. ISSUE OF COMMON RESOURCES (THE TRAGEDY OF THE COMMONS) AND SIGNIFICANCE OF CLEARLY-DEFINED PROPERTY RIGHTS - COASE THEOREM AND TRADEABLE PERMITS B. CLUB GOODS 2. UNCERTAINTY AND ASYMMETRIC INFORMATION A. UNCERTAINTY AND ATTITUDES TO RISK B. EFFECTS OF UNCERTAINTY AND ASYMMETRIC INFORMATION ON THE DECISIONS MADE BY ECONOMIC AGENTS C. STRATEGIES AND POLICY MEASURES TO ADDRESS PROBLEMS OF RISK AND UNCERTAINTY, AND ASYMMETRIC INFORMATION Anderson Serangoon Junior College JC2 H3 Economics 2025

THEME 2: Firms’ Strategies and Market Failure Anderson Serangoon Junior College Economics Department A 3 1. Quasi-Public Goods In H2 Economics, students would have learnt the concepts of public goods, in the form of pure public goods which are both non-rivalrous and non-excludable. However, many goods thought of as public goods are actually quasi-public goods, i.e., near-public goods that only exhibit one of the distinguishing characteristics. A useful introduction of quasi-public goods and how they are related to pure public goods can be found in a paper by the Local Government Forum (2008) of New Zealand, titled "Local Government and the Provision of Public Goods". The following paragraphs and the summary table (Table 2–1) have been adapted from this paper. Table 2–1: Characteristics of goods and services Rivalrous in consumption Excludability of consumption Low Medium High Low Public Goods: Street lightings, traffic signs, parks, reserves and civil defence service Low-use roads, footpaths and cycle ways Common Resources: Wild fish in the sea, wild herbs in the forest, and fertile pastures Medium Flood control service Sports grounds High-use roads High Club Goods: Museums and galleries (during non- peak periods) and private golf clubs Public libraries, swimming pools, indoor recreation facilities and public venues Private Goods: Airports, public transport service, clean drinking water, rubbish disposal service, car park lots, cinemas and housing There are various categories of quasi-public goods that only exhibit one of the distinguishing characteristics of a public good. For example, goods depending on infrastructure of fixed capacity (such as roads) can become so congested at a certain level of use that one additional person’s consumption will affect the ability of others to make use of them. In this case, a high-use road becomes rivalrous in consumption. The list of public goods depends on the feasibility of excluding

THEME 2: Firms’ Strategies and Market Failure Anderson Serangoon Junior College Economics Department A 4 non-payers and the transaction costs of charging for services. If it is technologically feasible and economical to charge for such services (e.g., through electronic road pricing), it may become excludable in consumption. Flood control services, although non-rivalrous in consumption, are excludable at a reasonable cost. For these services, it is feasible to recover costs from the sector of the community that benefits from them since it is a very localised service that benefits a small group residing in the area. It is thus possible to exclude other non-paying users because of their geographical distance from the community. Quasi-public goods such as club goods are excludable but non -rivalrous in consumption. A common example of club goods are private clubs and museums. Users can be charged by paying membership fees or purchasing entrance tickets. Museums are largely empty during off-peak periods and are considered to be non-rivalrous in consumption. Whether a good is rivalrous in consumption can vary across localities according to factors such as population size and level of use. For example, a specialised museum or art exhibition that brings together rarely seen items from around the world to the local population may be oversubscribed and, hence, become rivalrous in consumption. A. Issue of common resources (the tragedy of the commons) and significance of clearly-defined property rights Common resources are goods/services that are non-excludable (difficult to stop non-paying individuals from consuming) and rivalrous (an extra user diminishes the quantity of the good/service). Some examples of common resources include clean water, trees in the rainforests and fish in the sea. The tragedy of the commons “The Tragedy of the Commons” is an influential article written by Garrett Hardin (1968) who uses a metaphorical story to illustrate the dilemma faced by individuals when presented with common resources. In this story, there are a large number of herders sharing a common plot of land (the commons) and they are all entitled to let their cows graze on the land. Each herder gains income and satisfaction from rearing an extra cow. However, the damage done to the land is shared by all the herders. To the individual herder, the amount of income and satisfaction he gains outweighs the damage done (as the burden is shared by all) and it will be in his interest to keep rearing more cows. The net effect of each individual herder behaving in his own self-interest is that the land is over-grazed and eventually damaged beyond repair. The tragedy of the commons is actually a variant of the classic prisoner’s dilemma situation; the twist being that there are multiple players instead of just two. In a simplified example, let us consider only two players: Herder A and Herder B. Rearing an extra cow gives a herder $1, but

THEME 2: Firms’ Strategies and Market Failure Anderson Serangoon Junior College Economics Department A 5 the damage the extra cow does to the land is worth $1.20. However, the damage done to the land is shared between the two herders (-$0.60 each). If both herders rear an extra cow, each will bear $1.20 of damage to the land but only gain $1, resulting in a payoff of -$0.20. The respective payoffs and chosen strategies are presented in Figure 2–6 below. Herder B Don’t Rear Rear Herder A Don’t Rear $0, $0 −$0.60, $0.40 Rear $0.40, −$0.60 −$0.20, −$0.20 Figure 2–6: The Farmer’s Dilemma As can be seen from the above figure, the Nash equilibrium occurs when both herders choose to rear an extra cow each. If one thinks of the cost to the land as a long-run cost and the gain from rearing the cow as an immediate gain, the (Rear, Rear) outcome becomes even more likely. We thus arrive at a situation where they are collectively worse off because each herder chooses to act in his own self-interest. Ideally, they would be collectively better off in the long run if both choose not to rear the extra cow. In “The Tragedy of the Commons”, there are more than two herders behaving in their own self- interests. We thus have a multi-person prisoner’s dilemma; this ultimately causes the land to be destroyed as each person thinks that the damage he is doing is being shared by the rest. Suppose we have 100 herders and we use the payoffs from our two-person example – the total damage done to the land would equal to 100 × −$1.20 = −$120. The net damage (total damage minus the benefit of rearing extra cows) is 100 × $1 + 100 x −$1.20 = −$20. Therefore, the greater the number of herders, the greater the damage done to the land. Revisiting the Fallacy of Composition The tragedy of the commons is a classic example of the fallacy of co