include all the costs related to making sure that the other party upholds the terms of the deal struck. These costs can vary greatly depending on the governing legal system in the country. Companies in common law nations tend to employ a larger number of lawyers than companies in civil law countries, as the built-in structure of the legal system allows more room for interpretation, thus making more work for the legal professionals. This means that the common law systems inherently tend to incur higher transaction costs than civil law systems.
Externalities
An externality is a cost that is put on a third party to a transaction that is neither the buyer nor the seller. Positive externalities cause a benefit to a third party, while negative externalities cause a cost to a third party. Consumer externalities occur as a result of a consuming behavior, while producer externality is a result of production.
The economic problem with externalities is that the additional costs and benefits occur to third parties, so on their own, decision makers frequently ignore them. This means that in case of a negative externality, the private cost of production or consumption is lower than the social cost. Negative externalities lead to overproduction or overconsumption, as part of the cost is borne by others.
In case of a positive externality, the private benefit of the production or consumption is lower than the social benefit. For example, when one decides to vaccinate their child, they consider the fact that their child has a lowered risk of infection—and ignore the positive externality of increased protection that vaccination conveys to other children. Positive externalities lead to underproduction or underconsumption, as part of the benefit is realized by others.
Externalities distort the market mechanism, eliminating the surety that markets guarantee efficient production and consumption. Because externalities lead to overconsumption, underconsumption, overproduction, or underproduction, it is beneficial from the standpoint of a society to try to mitigate or eliminate the effects of externalities. This is called internalizing the externalities.
From about 1930 to the end of World War II, courts aggressively put the costs of externalities onto the party receiving the benefit. A cost-benefit analysis became popular after that which asked whether society was better off with the third party bearing the externality. Chapter 3 explains this in detail.
Public Goods
A public good is one where use by one person cannot be excluded by another person and where there is no rivalry between users. Excludability focuses on whether it is feasible to block certain people from using the resource or not. Rivalry focuses on whether there is competition among consumers for the given good. Material in the public domain is free for anyone to use as one wishes. Since the public good is free, there is no market mechanism that can control its use.
As the table below shows, this defines four distinct kinds of goods. The most common are the private goods, and most products fall into this category. Goods where there is no rivalry, yet consumers are still excludable, are called club goods. The name signifies that (ideally) the members of a club are in no rivalry with each other (if the club is sufficiently well-endowed), but they have the chance of limiting access to others. Living at a country club is an example of this behavior. A more common example is the use of a given software. Buying Microsoft Office, does not reduce the number of available Microsoft Office packages for another, yet others can be excluded from the consumption of the product through the mandatory on-line registration process. Club goods have artificial scarcity. The lack of rivalry means they are available in great abundance but are kept scarce to keep their price up and/or to retain exclusivity.
| Rivalry | No rivalry | |
| Excludable | Private goods most normal products like clothes, beverages, etc. | Club goods golf courses, parks, software artificial scarcity |
| Non-excludable free-rider problem | Common-pool resources fish in a fishery, grass in a pasture negative externality | Public goods (air, defense) |
Common-pool resources have the opposite limitation. They represent some scarce resource, but it is problematic to exclude people from their consumption. Because of this, an overuse of the resource materializes (as everyone considers it a “free” resource), and the overuse can lead to depletion altogether.
The free-rider problem is shared among common-pool resources and public goods. Since consumers cannot be excluded, it is very hard to incentivize them to pay anything for the good or service.
Market Structures
Perfect competition assumes that there are many small sellers in the marketplace. There are three market structures that disrupt that assumption: monopoly, oligopoly, and monopolistic competition.
A monopoly is a market structure where a single entity controls the supply. A monopsony is a market structure where a single entity controls the demand. In either case, the market participant is never in competition with anyone else, and its only concern is the demand curve (in case of monopolies) or the supply curve (in case of monopsonies). Based on its own costs, it can pick a production level or a consumption level and set a price on the demand curve or supply curve that will maximize its own profit, without having to fear competitive pressures. This generally leads to both higher prices and lower quantities produced, compared to the theoretical ideal of the perfect competition.
Monopolies form for a variety of reasons. Mainly, it can be difficult, excessively costly, risky, or impossible for new firms to enter the market. For instance, there can be limited access to physical resources or lack of an economy of scale.
In situations like this, the consumer might face either monopoly-like conditions (apparently discreet firms, who coordinate their pricing strategies), or actual monopolies, such as when firms in a given industry agree to not compete with each other within the same geographical area. Cases like this are called local monopolies. Notable examples in the United States are local telephone and Internet companies. Looking at the US market as a whole, it seems oligopolistic but in reality, carriers engage in “parallel conduct” by operating next to one another while not actually competing directly.14
Finally, since being a monopoly can result in extra profit, firms aim to become one whenever possible. When a firm seeks to a benefit from the government by its lobbying efforts instead of providing land, labor, capital or innovation, that is known as rent seeking behavior. In an economic sense, these resources are wasted, as they are not spent to increase the output of society. Instead, they are used to increase the gain of one company at the expense of other companies and consumers. This frequently reduces total output.
Monopolistic competition works like a perfectly competitive industry, but it lacks the homogeneous products requirement. These are far more common than perfectly competitive industries, as consumers cherish variety and are thus willing to pay higher prices for goods if they have a selection. Differentiation is the process where firms choose to ensure that their product is distinct (or perceived to be distinct by the consumers) from those of their competitors.
In a monopolistically competitive market, there is no single big market with many small producers and consumers. Instead, there are many miniscule markets with tiny pseudo-monopolies as suppliers and a big shared batch of consumers, who consider all of the little sub-markets as perfect substitutes. Slight price and perceived-quality changes can drastically alter the demand among such suppliers.
Oligopoly is a very common market structure, where a small number of large firms dominate the market. This is the general outcome of capitalism’s drive for increasing concentration in pursuit of economies of scale—industries that cannot crystallize into a monopoly remain governed by a few powerful entities.
The economic analysis of oligopolies is significantly more complicated than that of other market structures. While companies