Question

What is market failure? Argue for or against the following statement: A free, unregulated market in medical care is the optimal arrangement for the United States. Hint: Be sure to define what is market failure and recall the arguments of Ken Arrow.

Answer 1

The statement is incorrect.

Medical care leads to positive externality in consumption. This causes underproduction of the good in market outcome, since marginal social benefit (SMB) will lie to the right of marginal private benefit (PMB) by the amount of external benefit. This is an instance of market failure where the market solution fails to maximize efficiency.

If the government intervenes in the market by offering a subsidy (equal to the per-unit external benefit), MPB curve shifts rightward to MSB (by amount of the external benefit), leading to efficient outcome and removing the deadweight loss (DWL) caused by the externality.

In following graph, market outcome is at point A where PMB intersects PMC with market price P0 and market output Q0. Efficient (optimal) outcome is at point B where SMB intersects PMC with higher (efficient) price P1 and higher (efficient output) Q1.

Unless internalized, this positive externality causes a DWL of area ABC, which can be removed by a per-unit subsidy of BD.