4.

Market Failure and Externalities

5-9 July

Anderton: unit 20, pgs 110-112 Powell: 5.2, pg 98

Anderton: unit 21, pgs 113-119 Powell: 5.3, pgs 99-103
Anderton: unit 22, pgs 120-123 Powell: 5.4, pgs 104-108
Anderton: unit 23, pgs 124-128 Powell: 5.5, pgs 108-114
Learning objectives
• To understand the concept of market failure
• To discuss the various types of market failure using appropriate
examples and graphs
Market failure
Market failure
• Market failure occurs when markets do not function efficiently or
equitably.

• Markets can fail in one of two ways:

• Partial market failure – markets may lead to the underproduction or
overproduction of certain goods.
• Complete market failure – markets may not exist (missing markets) leading to
no production of goods and services
Market failure – types
• Types of market failure
• Externalities
• Public goods
• Merit goods
• Demerit goods
• Information failure /
asymmetric information
Type of market failure: externalities
Externalities
• Externalities are the costs and benefits imposed on third parties who
are not directly related to a transaction.

• Negative externalities bring undesirable impacts on third parties;

positive externalities bring desirable impacts on third parties.
Externalities
• Positive externalities are spillover benefits generated in the
production and received in the consumption of goods and services.
Externalities
• Negative externalities are spillover costs generated in the production
and received in the consumption of goods and services.
Externalities
• Negative externalities in production exist when social costs exceed
private costs (MSC>MPC)

• Positive externalities in production exist when private costs exceed

social costs (MPC>MSC)

• Private costs – cost of production/activities to individuals and firms

• Social costs – cost of production/activities to individuals and firms,
and to the rest of society
Externalities
• Negative externalities in consumption exist when private benefits
exceed social benefits (MPB>MSB)

• Positive externalities in consumption exist when social benefits

exceed private benefits (MSB>MPB)

• Private benefits – benefits received by individuals and firms only

• Social benefits – benefits received by individuals and firms, and to
the rest of society.
Externalities – examples
Negative externalities in production Positive externalities in production

A supermarket decides to redevelop a derelict

industrial site for a new store, but at the same time
cleans up pollution on site, improves road on site, and
A chemical plant dumps waste into a river to subsidizes construction of some social housing next to
minimize costs. MSC>MPC. the new store. MPC>MSC.
Externalities – examples
Negative externalities in consumption Positive externalities in consumption

When a child is immunised against chickenpox, the

A person who smokes harms the health of others likelihood of an unimmunised child in the local area to
in the same room. MPB>MSB. contract chickenpox is less. MSB>MPB.
Externalities
• In a free market, production will
take place where MSC=MSB
• MPC = MPB
• However, in a society, the socially MPC=MPB
optimal level of production is
where
• MSC = MSB

X X
• Unfortunately, externalities cause
inequalities between MPC and
MSC, or MPB and MSB. Socially optimal level of output Free market level of output
MSC=MSB MPC=MPB
Anderton: pg. 116, figure 3
Negative externalities in production
MSC>MPC
 Negative externalities in production
MSC>MPC

DWL (deadweight welfare loss) to society if

production is at free market level of output
Anderton: pg. 115, figure 1 Anderton: pg. 116, figure 4
Positive externalities in production
MPC>MSC
 Positive externalities in production
MPC>MSC

Welfare gain to society that could be achieved if

output increases to socially optimal level of putput

Anderton: pg. 115, figure 1 Anderton: pg. 116, figure 5

Negative externalities in consumption
MPB>MSB
 Negative externalities in consumption
MPB>MSB

DWL (deadweight welfare loss) to society if

production is at free market level of output
Anderton: pg. 115, figure 1 Anderton: pg. 116, figure 7
Positive externalities in consumption
MSB>MPB
 Positive externalities in consumption
MSB>MPB

Welfare gain to society that could be achieved if

output increases to socially optimal level of putput

Anderton: pg. 115, figure 1 Anderton: pg. 116, figure 6

Anderton: unit 21, page 114, question 2 on externalities (diagrams should be MPB/MSB etc.)
Type of market failure: public goods
Public goods
• Public goods are non-rivalrous and non-excludable.
• Non-rivalrous – one’s consumption (of a good) does not reduce the amount
available for others to consume. Also sometimes referred to as non-
diminishable/non-exhaustible.
• Non-excludable – once the good is provided, no one can be excluded from
consumption or benefitting.

• E.g. of public goods

• Clean air, roads, street lighting
Public goods
• The problem with public goods: free rider problem
• Consumers who pay for public goods find it unfair that other consumers who
do not (need to) pay and could still enjoy (equal levels of) consumption of
those public goods.
• Thus, there is no incentive for the free market to supply them.
Market supply = 0, or what can be referred to as ‘missing market’. This
constitutes a complete market failure.
• Which explains why the state provides public goods, not the free market.
Type of market failure: merit goods
Merit goods
• Merit goods are goods beneficial to consumers than they realise.

• E.g. of merit goods are education and healthcare.

• Merit goods tend to be underprovided due to imperfect information

which can be classified into: (see next section)
• Information failure
• Asymmetric information
Merit goods
• Merit goods generate positive externalities in consumption.

• However, these goods are not consumed at socially optimal levels;

there is underconsumption of such goods in society.

• Thus, there is market failure where the market fails to account for
social benefits and achieve that socially optimal level of output.
 Merit goods may exist because they are positive externalities in consumption, leading to underconsumption
of the good in a free market. This is because the free market demand curve is to the left of the demand curve
if all benefits were to be taken into account.

Anderton: pg. 126, figure 1

Type of market failure: demerit
goods
Demerit goods
• Demerit goods are goods harmful to consumers than they realise.

• E.g. of merit goods are cigarettes, alcohol, drugs

• Demerit goods tend to be overprovided due to imperfect information

which can be classified into: (see next section)
• Information failure
• Asymmetric information
Demerit goods
• Demerit goods generate negative externalities in consumption.

• However, these goods are not consumed at socially optimal levels;

there is overconsumption of such goods in society.

• Thus, there is market failure where the market fails to account for
social costs and achieve that socially optimal level of output.
Demerit goods may exist because they are negative externalities in consumption, leading to overconsumption
of the good in a free market. This is because the free market demand curve is to the right of the demand
curve if both the positive and negative benefits associated with consumption were to be taken into account.

Anderton: pg. 126, figure 2

Type of market failure: information
failure / asymmetric information
Information failure / asymmetric information
• Information failure (or gap)
• Where information is not available or not clear.
• Or, individuals who know about this information but choose to ignore.
• Asymmetric information
• Where information exists, but is not shared between any two parties.
• Or, one of the parties knows more than the other party.
 Buyers posses imperfect information, overestimating the benefits of buying a good.
The result is that the actual demand curve is to the right of the demand curve where they have perfect
information. AB too much is bought, leading to a misallocation of resources.

Anderton: pg. 120, figure 1

Information failure / asymmetric information
• E.g. of information failure
• Not disclosing important harmful effects on packaging of cigarettes – thus can
lead to underestimating of costs of smoking
• Not spreading/advertising important benefits on vaccination – thus can
underestimate benefits
• E.g. of asymmetric information
• Second-hand car market – where buyers have no perfect/complete
information about quality of prospective cars, but sellers have.
• Child does not see the long-term benefits of education, therefore truant from
school. If allowed, child will devote too few resources to education
(misallocation).
• Asymmetric information can thus lead to misallocation of resources and
market failure, and potentially collapse of the said markets.
Summary
In summary,
• Market failure
• Types of market failure
• Externalities
• Public goods
• Merit goods
• Demerit goods
• Information failure / asymmetric information
• Relevant graphs
Questions
• Anderton: unit 21, page 114, question 2 on externalities (diagrams
should be MPB/MSB etc.)
• Anderton: unit 21, page 119, data response “Sugar”, questions 1 and
2 on externalities
• Anderton: unit 22, page 123, data response “Smoking”, all questions
on asymmetric information, market failure and government
intervention
• Anderton: unit 23, page 124, question 1 on public goods
• Anderton: unit 23, page 125, question 2 on merit goods
• Anderton: unit 23, page 127, question 3 on demerit goods
• Anderton: unit 23, page 128, data response “Television viewing”,
questions 1 and 2 on public goods
Anderton: unit 21, page 119, data response “Sugar”, questions 1 and 2 on externalities
Anderton: unit 22, page 123, data response “Smoking”, all questions on asymmetric information,
market failure and government intervention
Anderton: unit 23, page 124, question 1 on public goods
Anderton: unit 23, page 125, question 2 on merit goods
Anderton: unit 23, page 127, question 3 on demerit goods
Anderton: unit 23, page 128, data response “Television viewing”, questions 1 and 2 on public goods