Market Failures and Transaction Costs
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Market Failures and Transaction Costs

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Which of the following describes market failure in the context of resource allocation?

  • An inefficient allocation of resources leading to potential economic value loss (correct)
  • A state of equilibrium where supply meets demand perfectly
  • Efficient distribution of goods with maximum consumer satisfaction
  • Limited competition resulting in higher prices with better services

    • Which of the following is NOT considered a source of market failures?

  • Negative externalities
  • Public good provision
  • Information asymmetry
  • Customer loyalty programs (correct)

    • What role does transaction cost play in market interactions?

  • Transaction costs are irrelevant in the presence of perfect information
  • Transaction costs only occur in the presence of monopolies
  • Transaction costs increase market efficiency by streamlining negotiations
  • Transaction costs represent frictions that can hinder negotiation between parties (correct)

    • In the context of transaction costs, which type has the highest cost for unique products?

    <p>Search costs</p> Signup and view all the answers

    Which of the following exemplifies a negative externality?

    <p>A factory polluting a river impacting local fisheries</p> Signup and view all the answers

    Which outcome is associated with bounded rationality in economics?

    <p>Limited cognitive capabilities impacting choices</p> Signup and view all the answers

    Which concept relates to the situation where parties do not have complete information during negotiations?

    <p>Bargaining costs</p> Signup and view all the answers

    What is a potential remedy for market failures?

    <p>Implementing regulations to promote competition</p> Signup and view all the answers

    Which of the following correctly identifies a market failure caused by credence nature of financial services?

    <p>Structural mispricing due to adverse selection</p> Signup and view all the answers

    What distinguishes credence goods from experience goods?

    <p>Credence goods require costly information for quality assessment even after use.</p> Signup and view all the answers

    What common issue does 'churning' in investment advice typically result from?

    <p>Information asymmetry between clients and brokers.</p> Signup and view all the answers

    What might result from withheld private information in financial transactions?

    <p>Moral hazard due to opportunistic behavior</p> Signup and view all the answers

    Which of the following is a key condition leading to adverse selection?

    <p>Unobserved characteristics of products or individuals.</p> Signup and view all the answers

    Which source of transaction costs is associated with the 'lock-in effect'?

    <p>Information asymmetry</p> Signup and view all the answers

    What is a primary reason for the high specification costs in credence goods?

    <p>Structural contract incompleteness.</p> Signup and view all the answers

    What is a consequence of transaction-specific investment features in financial services?

    <p>Heightened risk of underinvestment</p> Signup and view all the answers

    What can happen if an owner of a good mistakenly believes they are performing better than they actually are?

    <p>They may create opportunities for churning by brokers.</p> Signup and view all the answers

    How does bounded rationality contribute to market failures?

    <p>It restricts individuals' decision-making abilities under complex circumstances.</p> Signup and view all the answers

    How does pre-contractual information asymmetry contribute to market breakdown?

    <p>It creates an inability to effectively evaluate risk and quality.</p> Signup and view all the answers

    Which of the following describes negative externalities in financial markets?

    <p>Benefits accruing to a third party without compensation</p> Signup and view all the answers

    Which aspect primarily characterizes experience goods?

    <p>Their quality can only be determined through extended use.</p> Signup and view all the answers

    What type of transaction cost can arise from a natural monopoly or cartel?

    <p>Market power</p> Signup and view all the answers

    Which of the following aspects is least likely to contribute to transaction costs in financial markets?

    <p>High levels of consumer education</p> Signup and view all the answers

    What is a negative consequence of financial advisors being paid through commissions?

    <p>They may prioritize their own earnings over client interests.</p> Signup and view all the answers

    Which of the following best describes Kaldor-Hicks efficiency in the context of market failures?

    <p>Total economic value can increase despite some individuals losing out.</p> Signup and view all the answers

    How does the concept of opportunism relate to transaction costs?

    <p>It increases search costs due to hidden agendas.</p> Signup and view all the answers

    What is a primary characteristic of public goods that contributes to market failures?

    <p>They are non-excludable and non-rivalrous.</p> Signup and view all the answers

    Which of the following statements about negative externalities is correct?

    <p>They result in a decrease in societal welfare when ignored.</p> Signup and view all the answers

    What role does information asymmetry play in the context of market power?

    <p>It can lead to the formation of cartels by enabling collaboration.</p> Signup and view all the answers

    Which situation exemplifies Knightian uncertainty as a source of market failure?

    <p>Investors are unable to predict future stock prices accurately.</p> Signup and view all the answers

    In the context of transaction costs, which aspect typically increases bargaining costs?

    <p>The presence of multiple negotiating parties.</p> Signup and view all the answers

    Which challenge directly emerges from bounded rationality in economic decision-making?

    <p>Decision-makers often fail to consider all available alternatives.</p> Signup and view all the answers

    What is a primary characteristic of credence goods that differentiates them from experience goods?

    <p>Quality cannot be assessed even after normal use.</p> Signup and view all the answers

    How does 'churning' in investment advice typically affect customers?

    <p>It leads to increased commissions for brokers without regard to customer objectives.</p> Signup and view all the answers

    What outcome is most likely to occur as a result of adverse selection?

    <p>Market breakdown due to unobserved characteristics.</p> Signup and view all the answers

    What is a significant consequence of high specification costs in credence goods?

    <p>Greater difficulty in evaluating the risks associated with the goods.</p> Signup and view all the answers

    What can result from an owner's mistaken belief in their performance level with regard to credence goods?

    <p>Potential for unnecessary recommendations or products.</p> Signup and view all the answers

    What role does information asymmetry play in the context of adverse selection?

    <p>It enables one party to gain a competitive advantage.</p> Signup and view all the answers

    What is a primary driver for the high costs associated with credence goods?

    <p>Complexity of assessing quality without prior use.</p> Signup and view all the answers

    What can excessive buying and selling of securities (churning) by brokers lead to for the customers?

    <p>Increased transaction fees and expenses.</p> Signup and view all the answers

    What type of market failure is primarily associated with the credence nature of financial services?

    <p>Structural mispricing due to adverse selection</p> Signup and view all the answers

    Which of the following correctly identifies a source of information asymmetry in financial transactions?

    <p>One party's superior knowledge of costs and benefits</p> Signup and view all the answers

    Which statement best describes the 'lock-in effect' in the context of transaction-specific investments?

    <p>It creates dependence on a specific provider, hindering movement to alternatives</p> Signup and view all the answers

    What is a consequence of bounded rationality in economic decision-making?

    <p>Inability to process all available information leading to suboptimal choices</p> Signup and view all the answers

    Which factor is a consequence of negative externalities in financial markets?

    <p>Market distortions that negatively affect third parties</p> Signup and view all the answers

    Which of the following is a potential outcome of information asymmetry due to withheld private information?

    <p>Increased likelihood of opportunistic behavior by one party</p> Signup and view all the answers

    What market situation can arise from the presence of information asymmetry?

    <p>Adverse selection leading to mispriced financial products</p> Signup and view all the answers

    Which of the following best describes 'Knightian uncertainty' in the context of transaction costs?

    <p>Unpredictable risks that cannot be quantified or mitigated</p> Signup and view all the answers

    Study Notes

    Market Failures

    • A market failure occurs when the allocation of resources through the market is not efficient, leading to a loss of economic value.
    • Key sources of market failures include information asymmetry, public good provision, negative externalities, Knightian uncertainty, market power, and bounded rationality.
    • Transaction costs are any direct or indirect friction that hinders negotiation between parties.
    • Opportunism, where individuals act in their self-interest, is a central factor in transaction cost analysis.
    • Three main categories of transaction costs:
      • Search costs: High for unique goods/services and low for standard ones.
      • Bargaining costs: Not all information is public, leading to higher costs when private information is involved.
      • Enforcement costs: Higher with simultaneous exchanges, complexity, and multiple agents.

    Information Asymmetries

    • Information asymmetry arises when one party in a transaction has more information than the other.
    • Three key sources of information asymmetries in financial services:
      • Credence nature of financial services: Leads to structural mispricing (adverse selection).
      • Withheld private information: Leads to opportunism and strategic behavior (moral hazard).
      • Transaction-specific investments: Leads to the lock-in effect and underinvestment (hold-up).
    • Credence goods: Quality cannot be ascertained even after normal usage, requiring additional costly information. Examples include financial products, car repair services.
    • Churning: Excessive buying and selling of securities by a broker, driven by commissions rather than the customer's investment objectives. This is a misuse of fiduciary responsibility.

    Adverse Selection

    • Pre-contractual information asymmetry.
    • The inability to evaluate risk leads to market breakdown.
    • Key conditions for adverse selection:
      • Unobserved characteristics of the product/service/individual.
      • Divergence of interests between parties.
      • The ability of one party to withhold information.

    Market Failures

    • A market failure occurs when resources aren't allocated efficiently in a market economy, resulting in a loss of economic value.
    • Key sources of market failures:
      • Information asymmetry
      • Public good provision
      • Negative externalities
      • Knightian uncertainty
      • Market power
      • Bounded rationality

    Transaction Costs

    • Transaction costs are frictions that hinder negotiation between parties.
    • Categories of Transaction Costs:
      • Search costs: High for unique goods, lower for standardized items.
      • Bargaining costs: Information asymmetry increases costs, more parties can create collective action problems.
      • Enforcement costs: Costs rise with complexity, multiple agents, and lack of simultaneous exchange.
    • Transaction-specific investments (Williamson 1975) and vertical integration (Williamson 1979) are influenced by transaction costs.

    Sources of Transaction Costs

    • Information asymmetry
    • Public good provision
    • Negative externalities
    • Knightian uncertainty
    • Bounded rationality
    • Market power (e.g.natural monopoly or cartel)

    Information Asymmetries

    • One party to a transaction has more information than the other, creating an informational advantage.
    • Three sources of information asymmetry in financial markets:
      • Credence nature of financial services: Difficult to evaluate quality, leading to structural mispricing (adverse selection).
      • Withheld private information: Opportunistic behavior and moral hazard arise when information is hidden.
      • Transaction-specific investments: Lock-in effects and underinvestment (hold-up) occur when investments are specific to a transaction.

    Credence Goods

    • Search goods: Quality can be determined before purchasing. - Example: Pen, book, table, style of dress.
    • Experience goods: Quality is assessed after use.
      - Example: Durable goods like cars.
    • Credence goods: Quality is difficult to assess even after use because it requires additional costly information. - Example: Financial products and car repair services.
    • **Financial products require: **
      • Advice
      • Risk-signaling mechanisms
      • Specification costs (due to incomplete contracts and high transaction costs).

    Adverse Selection

    • Information asymmetry before a contract is signed, impacting risk/quality assessment.
    • Can lead to market breakdown.
    • Conditions of Adverse Selection:
      • Unobserved product/service/individual characteristics.
      • Divergent interests between parties, with one gaining an advantage by withholding information.

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    Lecture 2 Market Failures PDF

    Description

    Explore the concept of market failures and the critical role of transaction costs in economic transactions. Learn about sources of market failures such as information asymmetry and negative externalities, and the implications they have on efficiency and economic value. This quiz provides insights into the categories of transaction costs and their impact on negotiations.

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