Risk aversion may stimulate activity that in well-functioning markets smooths out risk and communicates information about risk, as in markets for insurance, commodity futures contracts, and financial instruments. Financial economics or simply finance describes the allocation of financial resources. It also analyzes the pricing of financial instruments, the financial structure of companies, the efficiency and fragility of financial markets, financial crises, and related government policy or regulation.
Some market organizations may give rise to inefficiencies associated with uncertainty. Based on George Akerlof's "Market for Lemons" article, the paradigm example is of a dodgy second-hand car market. Customers without knowledge of whether a car is a "lemon" depress its price below what a quality second-hand car would be. Information asymmetry arises here, if the seller has more relevant information than the buyer but no incentive to disclose it. Related problems in insurance are adverse selection, such that those at most risk are most likely to insure (say reckless drivers), and moral hazard, such that insurance results in riskier behavior (say more reckless driving). Both problems may raise insurance costs and reduce efficiency in driving otherwise willing transactors from the market ("incomplete markets"). Moreover, attempting to reduce one problem, say adverse selection by mandating insurance, may add to another, say moral hazard. Information economics, which studies such problems, has relevance in subjects such as insurance, contract law, mechanism design, monetary economics, and health care. Applied subjects include market and legal remedies to spread or reduce risk, such as warranties, government-mandated partial insurance, restructuring or bankruptcy law, inspection, and regulation for quality and information disclosure.
Market failure
Main articles: Market failure, Government failure, Information economics, Environmental economics, and Agricultural economics
A smokestack releasing smoke
Pollution can be a simple example of market failure. If costs of production are not borne by producers but are by the environment, accident victims or others, then prices are distorted.
The term "market failure" encompasses several problems which may undermine standard economic assumptions. Although economists categorise market failures differently, the following categories emerge in the main texts.
Information asymmetries and incomplete markets may result in economic inefficiency but also a possibility of improving efficiency through market, legal, and regulatory remedies, as discussed above.
Natural monopoly, or the overlapping concepts of "practical" and "technical" monopoly, is an extreme case of failure of competition as a restraint on producers. The problem is described as one where the more of a product is made, the greater the unit costs are. This means it only makes economic sense to have one producer.
Public goods are goods which are undersupplied in a typical market. The defining features are that people can consume public goods without having to pay for them and that more than one person can consume the good at the same time.
Externalities occur where there are significant social costs or benefits from production or consumption that are not reflected in market prices. For example, air pollution may generate a negative externality, and education may generate a positive externality (less crime, etc.). Governments often tax and otherwise restrict the sale of goods that have negative externalities and subsidize or otherwise promote the purchase of goods that have positive externalities in an effort to correct the price distortions caused by these externalities. Elementary demand-and-supply theory predicts equilibrium but not the speed of adjustment for changes of equilibrium due to a shift in demand or supply.
In many areas, some form of price stickiness is postulated to account for quantities, rather than prices, adjusting in the short run to changes on the demand side or the supply side. This includes standard analysis of the business cycle in macroeconomics. Analysis often revolves around causes of such price stickiness and their implications for reaching a hypothesized long-run equilibrium. Examples of such price stickiness in particular markets include wage rates in labour markets and posted prices in markets deviating from perfect competition.
Macroeconomic instability, addressed below, is a prime source of market failure, whereby a general loss of business confidence or external shock can grind production and distribution to a halt, undermining ordinary markets that are otherwise sound.
A woman takes samples of water from a river
Environmental scientist sampling water
Some specialised fields of economics deal in market failure more than others. The economics of the public sector is one example, since where markets fail, some kind of regulatory or government programme is the remedy. Much environmental economics concerns externalities or "public bads".
Policy options include regulations that reflect cost-benefit analysis or market solutions that change incentives, such as emission fees or redefinition of property rights.
Public finance is the field of economics that deals with budgeting the revenues and expenditures of a public sector entity, usually government. The subject addresses such matters as tax incidence (who really pays a particular tax), cost-benefit analysis of government programs, effects on economic efficiency and income distribution of different kinds of spending and taxes, and fiscal politics. The latter, an aspect of public choice theory, models public-sector behavior analogously to microeconomics, involving interactions of self-interested voters, politicians, and bureaucrats.
Much of economics is positive, seeking to describe and predict economic phenomena. Normative economics seeks to identify what economies ought to be like.
Welfare economics is a normative branch of economics that uses microeconomic techniques to simultaneously determine the allocative efficiency within an economy and the income distribution associated with it. It attempts to measure social welfare by examining the economic activities of the individuals that comprise society.
Macroeconomics
Macroeconomics examines the economy as a whole to explain broad aggregates and their interactions "top down," that is, using a simplified form of general-equilibrium theory. Such aggregates include national income and output, the unemployment rate, and price inflation and subaggregates like total consumption and investment spending and their components. It also studies effects of monetary policy and fiscal policy.
Since at least the 1960s, macroeconomics has been characterized by further integration as to micro-based modeling of sectors, including rationality of players, efficient use of market information, and imperfect competition. This has addressed a long-standing concern about inconsistent developments of the same subject.