CHAPTER 5: ECONOMICS OF ORGANIZATIONS

Organizational Economics delves into the intricacies of transactions and resource

management in a company. It employs diverse theories like agency theory, transaction cost
economics, and property rights theory to discern the fundamental drivers of critical decisions
and actions within an organization.

Reasons to Expand an Enterprise.

● Enterprises frequently diversify their offerings, adjuchasting to numerous factors that
impact transformations in their product or service composition. Such adjustments can
entail broadening the range to expand the company or curtailing by discontinuing
particular offerings. The same factors can stimulate decisions in either direction.
● Market Demand: Fulfilling augmented demand for pre-existing products or services or
penetrating unexplored markets.
● Economies of Scale: As the scale of operations increases, businesses can achieve
cost efficiencies and lower their average costs.
● Competitive Advantage: By expanding their operations, businesses can increase their
market share, which in turn can lead to increased profits and revenue. Additionally,
larger companies often have more bargaining power with suppliers and can negotiate
better prices for raw materials, which can further reduce their costs and increase their
competitiveness.

Classifying Business Expansion into Value Chains.

Involves analyzing the stages of a product's production process to identify areas where value
can be added and efficiency improved.
Generic Value Chain for a Manufactured Good
● Extraction of raw materials
● Processing of raw materials
● Creation of parts
● Assembly of parts into manufactured units
● Retail Sale of manufactured units
Classification of Business Expansions
Horizontal Integration.
This type of integration can help businesses achieve economies of scale, reduce costs, and
increase market power by consolidating operations and resources. Horizontal integration can be
achieved through mergers and acquisitions, partnerships, or internal expansion, and is a
common strategy used by businesses to increase their competitiveness.

Vertical Integration.
When a firm expands its operations by integrating production activities upstream or downstream
in the value chain. This can reduce transaction costs, improve supply chain coordination, and
increase bargaining power. It can be achieved through mergers, partnerships, or internal
expansion and is a popular strategy for improving competitiveness and profitability. Double
Marginalization can occur in vertical integration when both upstream and downstream firms
have market power and charge markup prices. This can result in higher prices for consumers
and lower profits for both firms. Vertical integration can help reduce this phenomenon by
improving coordination and reducing transaction costs.

Alternative to Vertical Integration.

When considering alternatives to vertical integration, firms can address concerns about risk and
reliability through carefully constructed agreements with suppliers or buyers. Long-term
exclusive dealer agreements and resale price maintenance clauses can mitigate uncertainties
related to continued exchanges and future prices. Coordinated schedules, like just-in-time
systems, help reduce the need for large inventories. However, forming such agreements can be
challenging, especially when one party holds private information, leading to adverse selection
and potential free rider problems. Despite these alternatives, firms may ultimately opt for vertical
integration to avoid these complexities.

Conglomerate Merger.
A conglomerate is a type of business that operates in multiple different industries. By
diversifying in this way, it can better withstand difficult economic conditions in any one industry.
Moving money from one business to another within the conglomerate is easier and cheaper
than seeking outside funding. It's true that conglomerates often have some divisions that are
profitable operations in mature markets, referred to as "cash cows," and other businesses that
have great potential but require significant investment. The profits made from the cash-cow
businesses can fund the growth of the other businesses. Another argument in favor of
conglomerates is that companies with talented management staff may be capable of excelling in
more than one type of business.

Transaction Costs and Boundaries of the Firm.

Large corporations may face challenges as they grow too large or diversified, leading to
complex management structures. The expansion can result in diseconomies of scale and scope
due to increased management complexity. Different business cultures within conglomerates can
be difficult to synchronize. Transaction Cost Economics Theory explains when a firm should
expand, break apart, or sell business units based on transaction costs—costs involved in
internal and external exchanges.
● External Exchange - occurs when two separate businesses are involved.
● External Transaction Costs - the costs to create and monitor this agreement.
● Internal Transaction Costs - the costs to plan and coordinate these internal exchanges.
Ronald Coase's Coase hypothesis suggests that firms should expand as long as internal
transaction costs are lower than external transaction costs for the same exchange.

Cost Centers versus Profit Centers.

Large vertically integrated companies often adopt either a cost-center or profit-center approach
for their divisions. In a cost-center design, divisions aim to minimize costs to contribute to overall
profitability, potentially leading to quality and innovation concerns. In contrast, a profit center
approach treats each division as a business with its own revenues and costs, encouraging
managers to focus on creating value by improving both efficiency and product quality.

Transfer Pricing.
Transfer pricing involves setting prices for intercompany exchanges. The profit center model
treats divisions as autonomous businesses. The transfer price, negotiated or market-based,
enhances pricing, and efficiency, and simplifies accounting. Companies may optimize prices for
market conditions or tax benefits. If the transfer price is higher than the external market price,
buying divisions may find external purchases cost-effective. Conversely, if the external market
price is higher, selling divisions may maximize profit by selling externally.

Objectives of Transfer Pricing

 1. To facilitate optimal decision-making.
2. To provide a basis for measuring divisional performance.
3. To motivate the different department heads to improve their performance and that of their
departments.

Employee Motivation.
● The traditional approach to motivating employees in a division or small business
focused on organizational design and behavior. It involved employees agreeing to
employment terms, including salary, wages, and benefits, and then following
management direction within human resource policies for hours and work conditions.
Ensuring good performance was primarily achieved through supervision,
encouragement, and feedback.
● In the new perspective on employee motivation, individuals are seen as independent
contractors, akin to decision-making units. Employees enter into employment based on
their belief that it optimally utilizes their productive abilities, resembling the
microeconomic view of consumers maximizing utility for their households.
● The classical approach to wage setting suggests that an employee's wage should align
with the marginal revenue product of their effort. However, if the wage barely reflects the
value of the employee's efforts and there's a competitive job market, the employee may
lack motivation to work at full capacity or avoid behaviors harmful to the firm since they
can earn a comparable salary elsewhere if dismissed.
● An efficiency wage, set above the marginal revenue product, motivates employees to
be productive and stay in their jobs. The incentive to retain employees is valuable to the
firm, avoiding transaction costs linked to finding and hiring new staff.
● The economic perspective considers the principal-agent problem in employee
contracts, where the employer (principal) hires an employee (agent). This issue arises
when the agent's motivations may not align with the employer's due to limited monitoring
and information. Evaluation discrepancies exist, as the employer assesses based on
contribution to profit, while the employee evaluates based on effort.
● The informativeness principle advises incorporating performance measures reflecting
individual employee effort into employee contracts.
● A significant contribution to employee motivation is the concept of signaling. Employers,
facing uncertainties during hiring, often protect against risk by offering lower
 compensation due to imperfect assessments of applicants and the potential for adverse
selection.

Manager Motivation & Executive Pay.

In businesses where managers aren't owners, the principal-agent problem arises in the
relationship between executive management and shareholders. Executives, hired by the board
of directors to act as agents for shareholders, are primarily rewarded through salaries and
bonuses, even though the expectation is to manage the corporation in the shareholders'
long-term interests.

Multiple Theories for High Executive Salaries.

High executive salaries are explained by theories highlighting the scarcity of talent, the need for
value-based rewards, compensation for personal risk, and the application of the "Tournament
theory" in large enterprises with competitive executive teams.

CHAPTER 6: MARKET EQUILIBRIUM AND THE PERFECT COMPETITION MODEL

Assumptions of the Perfect Competition Model.

The perfect competition model is built on five assumptions:
1. In a market with numerous buyers, each representing a small fraction of total purchases,
a buyer is a price taker. Their decision has minimal impact on the market price, and
they assume the price is given. The buyer then decides on the quantity to purchase for
the utility of their household.
2. In a market with many sellers, each having a negligible impact on total purchases,
sellers act as price takers, assuming their production decisions don't influence the
market price. They decide on the quantity to produce, aiming to maximize profit based
on the assumed given market price.
3. Market firms have the freedom to enter or exit, with non-sellers entering if the market
is attractive and current sellers discontinuing if it's unattractive. Existing firms may adjust
their production levels based on changing conditions.
4. All sellers in the market offer a homogeneous good, implying that buyers are indifferent
to the seller as long as they charge the same price.
 5. Buyers and sellers in the market have perfect information, understanding of production
capabilities, accessing resources, and are aware of all prices charged by other sellers.

Operation of a Perfectly Competitive Market in the Short Run.

In a perfectly competitive market with homogeneous goods and perfect information, exchanges
converge to a single price. Buyers, aware of all seller prices, choose the lower-priced option,
leading all sellers in the market to settle at the same price.

● In Chapters 2 and 3, we explored firm demand curves. In the perfect competition model,
where sellers are price takers and have minimal impact on the market, the observed
demand curve is flat. This implies that sellers can produce and sell any quantity within
their production limit for the next period, while the price remains constant.

● In Chapter 2, the shutdown rule reveals that certain firms operate at an economic profit
due to unaccounted sunk costs, leading to varying short-run profits. Despite a constant
market price, not all firms can justify staying unless they adjust production to align with
more successful operators when replenishing fixed costs.
 ● In the short run, a perfectly competitive firm aims for the output quantity with the highest
profits or, if profits aren't achievable, the lowest losses. This scenario involves firms
producing with one fixed input and incurring fixed production costs.

Perfect Competition in the Long Run.

● In the long run, a producer has sufficient time to implement changes to its processes. In
the short run, differences in size and production processes among firms in the market
may exist, prompting any firm intending to stay in the market to adjust its operations to
mirror those of the most successful firms.
● However, when all firms adopt the same processes, the potential for positive economic
profits diminishes. If one firm achieves higher profit by reducing prices, others are
compelled to follow or exit the market. This cycle repeats as firms lower prices to gain
sales, leading to a collective decrease in economic profits as competitors match the
reduced prices.
● In theory, competition, homogeneous goods, and perfect information drive firms to
continuously match and undercut prices until all remaining firms achieve zero economic
profit. In the long run, perfect competition necessitates that all firms reach a Minimum
Efficient Scale, representing the lowest production rate to minimize average costs per
item.

Firm Supply Curves and Market Supply Curves.

Demand Curve
The demand curve illustrates how individuals or a group of consumers adjust their purchasing
with changing prices, while producers may also alter their sales in response to market price
fluctuations. In the short run, firms should operate if they can attain an economic profit,
increasing production until marginal cost equals marginal revenue, especially in the scenario of
a flat demand curve where the firm's marginal revenue is equivalent to the market price.

The optimal operating level for a firm in response to market prices is determined by shutting
down if the price is too low for economic profit, operating at the maximum level if the price
exceeds the marginal cost at maximum short-run production, and otherwise, operating at the
level where the price equals the marginal cost. Figure 6.3 in a perfectly competitive market
illustrates the relationship between average cost, marginal cost, and the firm's supply curve. The
optimal quantity supplied corresponds to the segment of the marginal cost curve above the
shutdown price level, up to the point of maximum production, where the firm operates at the
maximum production level if prices exceed the marginal cost.

Firm Supply Curve

This curve segment, known as the firm supply curve, mirrors the demand curve and depicts
sellers' optimal responses to market prices. Unlike demand curves that typically slope
downward, firm supply curves generally slope upward, indicating firms' willingness to increase
production with higher market prices to enhance profitability. Seller firms may have distinct firm
supply curves due to variations in capacities and production technologies.

Market Supply Curve

Examining all firm supply curves to determine the total quantity provided at any given price
yields the market supply curve, which generally slopes upward. Market supply curves reflect
both firms' willingness to increase production for improved profitability and their readiness to
emerge from short-run shutdowns when prices improve.

Market Equilibrium.
Market equilibrium is the point of agreement between sellers and buyers in terms of quantity
and associated price. This equilibrium is reached when the market demand curve intersects with
the market supply curve on the same graph.
The market demand curve shows the maximum price buyers are willing to pay for a given
quantity of the market product, while the market supply curve indicates the minimum price
suppliers would accept to provide a given supply of the market product.

● Perfect Competition Model: All buyers and sellers in the market are price-takers.
● Adam Smith, often considered the first economist, wrote "The Wealth of Nations" in the
18th century. In this treatise, he explained the prosperity in Europe due to expanded
commercial trade and the Industrial Revolution, introducing the metaphor of the invisible
hand to describe the unseen forces of self-interest impacting the free market.
● When the price is not at the equilibrium level, sellers will notice an imbalance between
supply and demand, leading some to experiment with other prices. If the price falls
below the equilibrium level, the supplied quantity will be inadequate to meet the
demand.
● When the market price is higher than the equilibrium price, sellers will initially
increase production rates. However, they will realize that buyers are unwilling to
purchase all available goods. Consequently, some sellers may contemplate a slight price
reduction to facilitate the sale of goods that might otherwise remain unsold.
● The process begins with a successful attempt to encourage more demand, leading to a
lower price. Sellers, forced to accept this lower price, may reduce production or shut
down, contracting the total market supply. This cycle may continue until the price
reaches equilibrium with the quantity demanded, but in real markets, achieving
equilibrium is more of a dynamic target influenced by various factors like climate
changes and unexpected events, causing constant fluctuations in market price and
quantity.

Shifts in Supply and Demand Curves.

DEMAND CURVE
● A shift of the Demand Curve (DC) to the Right or Upward results in Higher Equilibrium
Prices and Quantity.
● A shift of the Demand Curve (DC) to the left or downward results in Decreased
Equilibrium Price and Quantity.
SUPPLY CURVE
 ● When the supply curve shifts upward or to the left, a higher equilibrium price and lower
equilibrium quantity
● When the supply curve shifts downward or to the right, results in a lower equilibrium
price and higher quantity

WHY IS PERFECTION COMPETITION DESIRABLE?

In a simple market under perfect competition, equilibrium occurs at a quantity and price where
the marginal cost of attracting one more unit from one supplier is equal to the highest price
that will attract the purchase of one more unit from a buyer.

MONOPOLISTIC COMPETITION
- uses the same assumptions as the perfect competition model with one difference: The
goods sold may be heterogeneous.

- This means that while all sellers in the market sell a similar good that serves the same
basic need of the consumer, some sellers can make slight variations in their version of
the goods sold in the market. Example: selling cars that are in different colors or different
shapes.

CONTESTABLE MARKET MODEL

The contestable market model alters a different assumption of the perfect competition model:
the existence of many sellers, each of which is a barely discernable portion of all sales in the
market.

Firm Strategies in Highly Competitive Markets

PERFECT COMPETITION MODEL

The perfect competition model allows some firms will do better than others in the short run by
being able to produce a good or service at a lower cost, due to having better cost management,
production technologies, or economies of scale or scope.

COST LEADERSHIP
A firm sets out to become the low-cost producer in its industry. It prescribes that firms need to
continually look for ways to continue to drive costs down. They may include the pursuit of
economies of scale, proprietary technology, preferential access to raw materials, and other
factors.

CHAPTER 7: FIRM COMPETITION AND MARKET STRUCTURE

WHY PERFECT COMPETITION USUALLY DOES NOT HAPPEN

Perfect competition is seldom realized in real-world markets due to factors such as a limited
number of sellers, imperfect product homogeneity, information asymmetry, and barriers to entry
and exit, which disrupt the ideal conditions of perfect competition.

Monopoly
Refers to a market structure where a single seller or producer dominates the entire industry,
controlling the supply of a particular product or service.

Market power possessed by sellers

-the main deterrent to a highly competitive market.
Monopoly
-considering the strongest form of seller market power.
Monopolist
-the only seller in Monopoly.

OLIGOPOLY AND CARTELS

In an oligopoly, multiple sellers, recognizing their impact on market price, may have significant
market power, resembling a monopolist. A cartel, an extreme form of oligopoly, operates with
member firms selling at the same price and producing volumes aligned with the same marginal
cost, theoretically resembling a monopolist's operation.

Cartels, like monopolies, are often deemed harmful, and governments typically do not tolerate
them due to illegal collusion. Members may be tempted to increase production to profit
individually, risking retaliation and potentially leading to lower market prices and reduced
economic profits for all cartel members if discovered.
PRODUCTION DECISIONS IN NONCARTEL OLIGOPOLIES
Oligopolies, characterized by limited sellers and significant market sales, differ from perfect
competition and cartels. Optimal production levels are challenging to determine due to
uncertainties about competitors' responses, impacting market supply and price. The Bertrand
and Cournot models attempt to explain oligopolistic behavior, considering factors like firms
anticipating prices, adjusting production levels, and the influence of a "leader" firm.

SELLER CONCENTRATION
Refers to the degree to which a few firms dominate a significant share of economic activity,
encompassing total sales, assets, or employment. In oligopolies, sellers can restrict competition
by eliminating rivals, impeding new entries, or collaborating with other market power-holding
sellers to maintain elevated prices compared to a market with intense price competition.

NUMERICAL MEASURES OF MARKET CONCENTRATION

Concentration Ratios
● Are easy to calculate and easily understood.
● It is the result of sorting all sellers on the basis of market share, selecting a specified
number of the firms with the highest market shares, and adding the market shares for
those firms.
CR’s shortcomings
● The number of firms in the ratio is arbitrary.
● The ratio does not indicate whether there are one or two very large firms that clearly
dominate all other firms in market share or whether the market shares for the firms
included in the concentration ratio are about the same.

HERFINDAHL-HIRSCHMANNINDEX
● An alternative concentration measure.
● Computed by taking the market shares of all firms in the market, squaring the individual
market shares, and finally summing them.

COMPETING IN TIGHT OLIGOPOLIES: PRICING STRATEGIES

Pricing Strategies Used By Firms In Monopolies And Tight Oligopolies:
Deep Discounting
Deep Discounting involves setting prices below cost or a competitor's average cost to potentially
drive the competitor out of the market, enabling the initiating firm to gain a larger market share
and leverage increased market power for higher prices and profits.

Limit Pricing
A limit price ensures a small profit for existing firms, but new entrants, forced to match this price
for market competition, will incur losses.

Yield Management
Yield management aims to secure higher prices from customers willing to pay more, creating
challenges for competitors by lacking a known, fixed price to compete against.

Durable Goods
Monopolies and oligopolies selling durable goods like cars or televisions can implement a form
of first-degree price discrimination by initially setting a high price and offering variations over
time.

Competing in Tight Oligopolies: Nonpricing Strategies

Advertising
Advertising is a crucial tool in tight oligopolies, enhancing a firm's product visibility and brand
recognition, which is essential for successful competition in markets where brand strength plays
a pivotal role.

Excess Capacity
Firms typically plan for sufficient capacity to support production volume, often resulting in some
excess capacity due to variations in actual production. Additionally, the uncertainty in future
demand may lead firms to invest in capacity that is never fully utilized.

Reputation and Warranties

Firms often leverage advertising to emphasize their reputation for delivering quality products
and may use warranties, with the scope of warranty coverage becoming a competitive factor, as
seen in the diverse offerings in the automobile industry.
Product Bundling
Firms can gain a competitive edge by bundling complementary products, allowing consumers to
purchase multiple items together at a reduced cost, particularly effective when competitors find it
challenging to replicate the bundled offering.

Network Effects and Standards

In markets with network effects, where the value of a product to a buyer is influenced by the
number of other buyers, industry standards become crucial. Firms may align with specific
standards to compete effectively, and alliances may form to enhance success through network
effects.

Buyer Power
In markets with a few powerful buyers, such as a monopsony, buyers can influence market price
and quantity. Buyer power becomes most pronounced when there is a single buyer, enabling
them to push prices down to the minimum necessary to induce sellers to produce the last unit,
especially if sellers lack market power.
● Price Negotiation
● Product Specifications
● Market Entry And Exit
● Quantity Demands
● Bargaining Leverage

CHAPTER 8: MARKET REGULATION

Free Market Economies Vs. Collectivist Economies
● The stability of a society depends on its members accessing needed goods and
services. In modern times, governance, often through laws and agencies, replaces
authority figures. Societies favoring centralized control are called collectivist
economies, with communism advocating for this approach to meet citizens' needs.
● Societies relying on markets for goods and services are known as free market
economies. Countries tend to lean towards either a more free-market or collectivist
approach, with none being purely one or the other.
Similarities of Free Market Economy and Collectivist Economy
● Both free market and collectivist economies share similar economic elements, involving
consumers, producers, goods, services, money, and labor, with the common goal of
producing according to market demand.
Difference Between a Free Market Economy and a Collectivist Economy
● A free market economy relies on decentralized market forces, while a collectivist
economy emphasizes centralized authority in managing the creation and distribution of
goods and services.
● In a nutshell, a free market economy prioritizes profit maximization, considers consumer
preferences, and encourages innovation, but may lead to unhealthy competition,
unemployment, and inequality. On the other hand, a collectivist economy focuses on
social and macroeconomic objectives, government-driven production decisions without
considering consumer preferences, and controls business practices to reduce unhealthy
competition, unemployment, and inequality.

Welfare Economics
A sub-field of economics that focuses on evaluating the performance of markets.

Two of The Criteria Used to Assess Markets

EFFICIENCY
● VILFREDO PARETO
○ Pareto Efficiency refers to an economic outcome where no exchange can be
modified to make one party better off without making another party worse off.
● PURE PARETO EFFICIENCY
○ An ideal rather than a condition that is possible in the complex world in which we
live.
● INSTANCES WHERE EFFICIENCY IS NOT FULFILLED
○ Waste in markets occurs when potentially valuable resources are left unused or
underutilized, suggesting an opportunity to reconfigure exchanges for mutual
improvement without causing harm to any party.
EQUITY
● No Simple Principle for Equity
○ Fairness in the distribution of goods and services is a key concern, with
perspectives varying on whether it should prioritize individuals with greater
 talents or those who work harder, while some emphasize access to basic goods
and services as a reasonable expectation for all citizens.
○ Widespread concern about the inequitable distribution of goods and services can
lead to political pressure on those in power or even political unrest.
○ Inequity issues are typically seen as macroeconomic problems, addressed
through wealth transfers like income taxes and welfare payments rather than
direct intervention in goods and services markets.

Circumstances in which Market Regulation may be Desirable

The Generic Types of Market Failure
Generic types of market failure include concentration-related market failure, externalities where
parties not involved in transactions are impacted, issues arising from the presence of free riders,
and failures caused by poor decisions due to insufficient information or understanding.

Regulation to Offset Market Power of Sellers and Buyers.

In Chapter 7, we explored the negative consequences of market power, particularly in
monopolies and monopsonies, leading to disruptions in price and quantity. This not only raises
equity concerns but also results in a net loss of total social surplus. Seller competition,
promoting lower prices and increased consumer surplus, is crucial for product differentiation and
innovation. Antitrust laws aim to prevent monopolies and tight oligopolies, with measures of
market concentration used to oppose mergers or buyouts. Predatory pricing and collusion are
illegal practices addressed by laws, while regulations may support small competitors or
intervene in critical markets to ensure fair pricing and quantity.

Natural Monopoly
In industries with a high minimum efficient scale, a single seller may achieve the lowest average
cost, resulting in a natural monopoly. However, the monopoly position could lead to exploitative
practices. Responses include public agency provision or regulating the private firm as a public
utility, ensuring fair prices through regulatory approval. Regulated monopolies aim for a balance
between private operation and consumer benefits, with regulatory agencies incentivizing
innovation or cost-cutting by allowing firms to retain some surplus in exchange for lower rates.
Externalities
Externalities occur when parties beyond the buyer and seller are significantly affected by the
exchange, without participating in the negotiation. The quantities sold and prices charged may
not reflect the impacts on these external parties.
Positive Externalities
● Spillover effects refer to the transfer of benefits from research and development or
worker training in one firm to other products, firms, or future employers. These effects
stimulate additional economic activity beyond the immediate market, benefiting external
entities.
Negative Externalities
● Externalities in market exchanges include pollution of air or water affecting individuals
unrelated to the buyer or seller, harm or death to others due to the exchange, and
disruptions like noise or congestion causing inconvenience. Additionally, externalities
may involve the degradation of natural habitats.

Regulation of Externalities: Legal and Economic

Legal measures in markets involve sanctions that prohibit or restrict market activities, impacting
the volume of transactions and participants. Governed by the government, these measures
incur transaction costs, and excessive legal restrictions may create inefficiencies by denying
surplus value to buyers and sellers that outweigh the benefits to other parties.

Externalities Taxes
Externality, or external cost, refers to indirect costs or benefits experienced by an uninvolved
third party due to the activities of another party, with the third party lacking control over these
effects. Governments often use taxes as an economic instrument to address externalities,
imposing taxes on goods causing negative externalities like pollution. The optimal tax aims to
cover the marginal externality damage, but determining the correct level can be challenging,
leading to potential inefficiencies in market improvement.

Regulation of Externalities through Property Rights

Ronald Coase
● Ronald Coase conducted groundbreaking research on the impact of transaction costs
and property rights on business and society. His influential paper, "The Problem of Social
 Cost" (1960), introduced the Coase Theorem, which became a fundamental concept in
economic theory.
● Firms could treat the right to impose negative externalities as a tradable asset, selling it
to another firm willing to pay more. This approach, seen in "cap and trade" programs like
those addressing greenhouse gas emissions, allows firms to evaluate the economic
value of retaining or selling their rights based on opportunity costs, potentially influencing
operational decisions or encouraging a shift to cleaner technologies.

High Cost to Initial Entrant and the Risk of Free Rider Producers
Market failures due to free riders can occur when initial entrants bear high startup costs and
face uncertainty, potentially leading to inadequate returns if new entrants benefit without
contributing to startup costs. Regulatory measures, such as ensuring initial entrants receive a
high enough price and volume guarantee, patents, exclusive operating rights, and government
subsidies, aim to address this problem and incentivize innovation, especially in industries with
high initial costs and risks.

Public Goods and the Risk of Free Rider Consumers

Public goods present a challenge because their cost to a seller may exceed what an individual
buyer is willing to pay, yet the collective value to beneficiaries surpasses the purchase price.
The dilemma arises in determining an optimal price, as the marginal cost of serving an
additional benefactor can be nearly zero, suggesting a theoretical pricing of zero. However, this
is impractical, leading to market failure. Examples include government-built dams with entry fees
and digital copies of books and music, where low marginal costs raise concerns about free
riders.

Market Failure Caused by Imperfect Information

Imperfect Information
It can be due to ignorance or uncertainty. If the market participant is aware that better
information is available, information becomes another need or want. Information may be
acquired through an economic transaction and becomes a commodity that is a cost to the buyer
or seller. Useful information is available as a market product in forms like books, media
broadcasts, and consulting services.
8 Major Causes of Market Failure
1. Incomplete Markets
Markets for certain things are incomplete or missing under perfect competition. The absence of
markets for such things as public goods and common property resources is a cause of market
failure.
2. Indivisibilities
The problem of divisibility arises in the production of those goods and services that are used
jointly by more than one person.
3. Common Property Resources
Imperfect Markets Common ownership when coupled with open access, would also lead to
wasteful exploitation in which a user ignores the effects of his action on others. Open access to
the commonly owned resources is a crucial ingredient of waste and inefficiency
4. Imperfect Markets
Any economic market that does not meet the rigorous standards of the hypothetical
perfectly—or purely—competitive markets.
5. Asymmetric Information
Consumers may be ignorant about quality and utility of this anti-pollution device. In some cases,
information about market behaviour in the future may be available but that may be insufficient or
incomplete.

6. Externalities
The presence of externalities in consumption and production also lead to market failure.
Externalities are market imperfections where the market offers no price for service or disservice.

7. Public Goods
Public goods are both non-excludable and non-rivalrous. Moreover, environmental quality is
generally considered as a public good and when it is valued at market price, it leads to market
failure.
8. Public Bad
There are also public bads in which one person experiencing some disutility does not diminish
the disutility of another, such as air and water pollution.
Insurance
- is an example of product where the insurance company assumes the risk of defined
uncertain outcomes for a fee. Still, there remain circumstances where ignorance or risk
is of considerable consequence and cannot be addressed by an economic transaction.
Moral Hazard
- a situation in which one party to a contract has an incentive to act dishonestly or
recklessly because it does not bear the full cost of its actions
Sarbanes-Oxley Law
- Created following the Enron crisis, places requirements on the conduct of corporations
and their auditing firms to try to limit the potential for moral hazard
Defective Product
- may be produced and sold because the safety risk is either difficult for the buyer to
understand or not anticipated because the buyer is unaware of the potential.

Limits of Market Regulation

Regulation requires expertise and incurs expenses
Regulators are agents who become part of market transactions representing the government
and people the government serves.

Capture Theory Of Regulation

- postulates that government regulation is actually executed so as to improve the
conditions for the parties being regulated and not necessarily to promote the public’s
interest in reducing market failure and market inefficiency