1. Market Failures
The normative theory of market-failure predicts that regulation will be instituted
to improve economic efficiency and protect social values by correction market
imperfections. Six types of market-failures are explained here: Natural monopoly,
Externalities, Public Goods, Asymmetric information, Moral hazard, Transaction cots. Anyone
of these six failures legitimates regulation.
Natural Monopoly
A monopoly is natural if one firm can produce a given set of goods or services at lower cost than
can any other number of firms. A natural monopoly results when costs are decreasing in the scale
of a firm (economy of scale) or in the scope of its products or services (economy of scope). In
natural monopoly situations the monopolists will raise his costs and tariffs because he lakes
incentives for efficiency and is interested in the maximization of profit.
Before concluding that regulation is warranted under the natural monopoly rationale, two
questions must be answered. The first is whether there are any natural monopolies, and if there
are, whether significant economic efficiency or social welfare would be gained by regulation.
Economies of scale and scope certainly exist over some sets of goods and services, but these
economies can be exhausted at output levels that allow more than one supplier to persist in the
market. Empirical studies indicate, for example, that the large electric power plants in the United
States have exhausted the achievable economies of scale. A natural monopoly can also result if
having more than one supplier would result in an uneconomical duplication of facilities. Local
electricity distribution systems within cities may remain a monopoly to avoid duplicate sets of
distribution wires. This rationale does not necessarily apply in the telecommunications industry,
since cable television and wireless communications systems provide alternatives to the local wire
connections.
If there is a natural monopoly, it does not necessarily follow that there is substantial economic
inefficiency. First, if entry into the industry is easy, the threat of potential competition may limit
the extent to which an incumbent monopolist can restrict output (and raise prices). Second a
monopolist may choose to use a pricing policy, involving fixed charges and a low unit price,
which can both increase profits and benefits consumers. Third, if there are a number of possible
suppliers of a monopoly service, competitive bidding for the right to be the monopolist can be
used to lower the supply price and increase economic efficiency. Similarly, an alternative to the
regulation of the electric power industry is for communities to own the local distribution system
and bargain with power companies for the supply of electricity.

2. Externalities
For information in Hebrew on Externalities double-click here
Private market activities create so-called spillovers or externalities. They include any cost or
benefit not accounted for in the price of goods or services. A positive externality exists when a
producer cannot appropriate all the benefits of the activities it has undertaken. An example
would be research and development that yields benefits to society (e.g., employment in industry)
that the producer cannot capture. Thus, the producer's incentive is to under-invest in the activity
unless government subsidized or protect it. With positive externalities, too little of the good in
question is produced. With negative ones too much is made. Negative externalities such as air
pollution occur when the producer cannot be charged all the costs. Since the external costs do not
enter the calculations the producer makes, the producer manufactures more of the good than is
socially beneficial. With both positive and negative externalities, market outcomes need some
kind of regulation to be more efficient.
Public Goods
For information in Hebrew on public goods double-click here
A pure public good is one whose consumption by one person does not reduce its availability for
others. When a person consumes a private good such as an apple, it is not available for
consumption by others. When a person consumes a good such as national defense or a radio
broadcast, however, the amount of the good available for consumption by others is not
diminished.
For some public goods, such as national defense, bridges, and roads, government provision is
customary. Public provision, however, does not imply that a good has the characteristics of a
public good. Many goods, such as public housing, food stamps, and solid-bank programs, are
provided by government for redistributive purposes rather than because they are public goods.
Also, public goods can be supplied by the private sector. Radio and television broadcasts are
provided by private enterprises subject only to non-economic regulation.
A fundamental problem with either private or public provision centers on the "revelation of
preferences" for public goods. If those who benefit from a public good are asked to contribute an
amount reflecting their valuations, an individual may decide to free ride on the payments of
others. Because of the free-rider problem, public provision may be warranted. This, however,
does not resolve the problem of determining the public's aggregate valuation of the good and
thus whether it should be supplied. If individuals could be excluded from consuming the public

3. good the revelation and free-rider problem could be resolved - at least in principle. For example,
not allowing satellite-dish ownership free reception of cable television induces customers to pay
for the service.
Fire protection has the properties of a local public good is typically supplied by municipalities
and paid for by the taxes of the beneficiaries. It can be provided privately, though, if exclusion
can be practiced. Tim Emerson of Illinois learned this the hard way when his nearly completed
house caught fire from a space heater. He called the Taylorville firefighters. They responded to
his call. When they got to the house, they asked if the house were covered by the fire protection
plan. Emerson, who had not paid the $25 fee, said, "No". The firefighters asked if there were
anyone inside. When Emerson replied "No", they drove away, letting the house burn to the
grounds.
Asymmetric Information
If people have different (private) information at the time they act, markets may not perform
efficiently, even when there are advantageous trades that could be made. Akerlof presents an
example of a sued car market in which each seller knows the value of the car she/he wants to sell
but the buyers known only the probability distribution of the values of the cars that might be
offered for sale. There is a potential buyer who is willing to buy each used car, but the buyer
cannot through causal inspection determine the value of any particular used car offered for sale.
All he knows is that the car might be a lemon or might be of high quality.
Because of this asymmetry of information, the maximum amount the buyer is willing to pay is
the average of the values of the cars believed to be offered for sale. Because buyers will only pay
the average value, those potential sellers who have high-quality car then find that the amount
buyers are willing to pay is less than the values of their cars. They thus will not offer their cars
for sale. … This is clearly inefficient, because for every used car there is a buyer who wishes to
buy it if he only knew the true value.
This phenomenon also occurs when sellers have incomplete information about customers.
Insurance is, in principle, to provide coverage for individuals with similar risk characteristics.
When those characteristics cannot be readily assessed, however, people with quite different risks
are placed in the same pool. The higher risk individuals then have an incentive to buy insurance,
which can drive up the price of insurance a cause some low-risk individuals not to buy insurance.
Insurance companies respond to this adverse reaction by requiring a physical examination for life
insurance and basing auto insurance rates on accident and traffic citation records and on the
number of years of driving experience.
When market participation havincomplete information and acquiring information is co, markets
may not function efficiently. The mandated provision of information through regulation may
then be warranted. Regulation may not be warranted in all situations involving asymmetric
information, however. Information has value, so there is a demand for it. In the used car
example, a potential buyer may take the car to a mechanic for inspection. More generally,

4. individuals may invest in information acquisition or hire agents who are more knowledgeable
than they are.
Information, however, can remain under-supplied because it is the self-interest of its possessor
not to supply it. Manufacturers are understandably reluctant to release negative information
about potential hazards associated with their products because doing so may reduce demand.
Consequently, consumers may be poorly informed about hazards. Similarly, an employee may be
incompletely informed about possible health and safety hazards in the workplace. In such
situations, the liability system may serve as partial alternative to regulation.
Moral Hazard
Moral hazard refers to the presence of incentives for individuals to act in ways that incur costs
that they do not have to bear. For example, in medical care, a fully insured individual has an
effectively unlimited demand for medical care, since she/he doesn't bear the cost of the care they
receive. In addition, the individual may not have the proper incentive to take socially efficient
preventive measures, since she/he knows that the cost of any illness or accident will be covered
by insurance. Similarly, the provision of federally funded flood insurance encourages people to
live in areas prone to flooding and can lead to socially inefficient local decision.
Regulation is one response to moral hazard problems, but regulation can also cause moral hazard
making regulation itself less effective. In a controversial article Peltzman argued that the
automobile safety regulation induced drivers to take more risks, thus reducing the effectiveness
of mandatory safety standards.
The principal means of dealing with moral hazards is to structure incentives so that the induced
behavior is taken into account. In the case of medical insurance, co-payments can be required
and reimbursement limits imposed. Moral hazard can also be addressed by monitoring the
behavior of individuals to increase the likelihood that they take proper care. Fine for not wearing
a set belt is an example of monitoring.
Transactions Costs
Market failures can also result from costs associated with making market transactions. To the
extent consumers and producers incur costs in becoming informed about market opportunities
and completing market transactions, markets will not perform efficiently. Regulation to reduce
those transactions costs then can improve efficiency. For example, in the auto industry global
auto emissions standards can enhance efficiency, as auto producers would not have to produce
different models for different states.

5. As an example, a common problem in markets is the incentive for sellers to shirk on the quality
of the goods or services they sell. When quality can only be observed through use, a seller may
have an incentive to shirk. As long as a high quality good is more costly to produce than a low-
quality good and a consumer cannot tell the difference until after it is purchased, the seller's
strategy can be to cut back on quality.