Market Failures and Externalities

Principle of Economics #7: Governments can sometimes improve market outcomes. Markets do many things well. With competition and no externalities, markets will allocate resources so as to maximize the surplus available. However, if these conditions are not met, markets may fail to achieve the optimal outcome. This is also known as "market failure".

In previous analysis, we assumed that all goods consumed or produced have been private, in the sense that one individuals consumption or production of a good does not affect the other. When our actions impact on those not directly involved, an externality exists. As one individual's behaviour increases or decreases, another's satisfaction or profit changes as well. It can have a positive or negative effect on a third-party not directly involved with the buyer or seller of the transaction. These costs (or benefits) are not included in the cost curve faced by the decision makers. Examples of externalities:
y y y y

A smoker annoys others with second hand smoke. A gardener delights a neighbour with his beautiful garden. A pulp mill pollutes the air and water in town. A perfume wearer gives a friend an allergic reaction.

Negative Externalities
When economic agents not directly involved, negative externalities can exist, such as pollution. A free market tends to over-produce the good which produces a negative externality, and under produce those with positive externality. If we include costs borne by everyone, then we get social costs, which are the total costs of production no matter who bears them. We say that the total cost is equal to private costs plus external costs. Differences in exchange rates are governed by forex trading markets. Negative externalities result in a lower free-market output. In order to make the market produce the optimal amount, we must impose a tax. This is called "internalizing the externality", and forces those involved to account for external costs. There are also externalities in "consumption", when consumption has costs for persons other than those actually consuming the product. Examples of these are cigarettes and second-hand smoke, and drinking alcohol and car accidents.

Externalities (positive and negative) . then the private market can always solve the problem of externalities. and encourage such activity.parties through negotiation can agree as to how to regulate the externality Coase Theorem If parties can bargain without cost over the allocation of resources. it was argued that the source of the externality should be penalized. and more of the good should be produced than will occur in a free market. such as education. Earlier before Coase. Some create benefits to those not directly involved. Voluntary organizations . irrespective of how the law assigns responsibility for damages. since it will have positive externalities to everyone else. Moral codes and social sanctions 2. there could be an under investment in research. This can be remedied by either private arrangements or public policy. Another method is to allow patents to give monopoly rights to new inventions for a period of time. Some have argued that governments should subsidize research and development. There are many different types of market failure: 1. Internalization . Without this method. the social value is greater than the private value Solution to Externalities Externalities lead to an inefficient quantity of production and consumption. In this case.when activities with complementary externalities are merged into one firm. It can allocate resources efficiently. Contracts . thus eliminating the externality 4. Market Failure Definition of Market Failure: This occurs when there is an inefficient allocation of resources in a free market.Positive Externalities Not all externalities are negative. Positive externalities in production means that social cost is less than private cost. It is now recognized that the party that can deal with the externality at least cost should do exactly that.charitable groups. where new inventions benefit those beyond the inventors. lobby groups 3. Such is the case with "technology spillover". Externalities can be dealt with by: 1. There may also be positive externalities in consumption.

wage and price controls. externalities. especially microeconomists. Market failures can be viewed as scenarios where individuals' pursuit of pure self-interest leads to results that are not efficient ± that can be improved upon from the societal point-of-view. Social benefit: is the total benefit to society = Private Marginal Benefit (PMB) + External Marginal Benefit (XMB) Social Cost: is the total cost to society = Private Marginal Cost (PMC) + External Marginal Cost (XMC Definition of Social Efficiency: This occurs when resources are utilised in the most efficient way.[4] Market failures are often associated with information. there exists another conceivable outcome where market participants' overall gains from that outcome would outweigh their losses (even if some participants lose under the new arrangement). But either way. if a market failure exists the outcome is not pareto efficient. bailouts. Mainstream neoclassical and Keynesian economists believe that it may be possible for a government to improve the inefficient market outcome. and possible means to correct such a failure when it occurs.2.[3] but the concept has been traced back to the Victorian philosopher Henry Sidgwick.[1][2] The first known use of the term by economists was in 1958. 5. 7.e. some types of government policy interventions. may also lead to an inefficient allocation of resources. subsidies.[5] or public goods. 6. imperfect market outcomes with or without government interventions. i. 3. such as taxes.[10] . and regulations. (SMB) Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. non-competitive markets. The existence of a market failure is often used as a justification for government intervention in a particular market. Merit and De merit goods Public Goods Monopoly Power Inequality Factor Immobility Agriculture Key Terms in Market Failure y y y Externalities: These occur when a third party is affected by the decisions and actions of others. while several heterodox schools of thought disagree with this. (sometimes called government failures). 4. However. That is. there is sometimes a choice between imperfect outcomes.[8] Such analysis plays an important role in many types of public policy decisions and studies.[6][7] Economists. including attempts to correct market failure. This will occur at an output where social marginal cost (SMC) = Social Marginal Benefit.[9] Thus. are often concerned with the causes of market failure.

goods can display the attributes of public goods[11] or commonpool resources. such as monopolies. oligopoly. if the agent does not implement perfect price discrimination. when a firm is producing steel. as in the development of inventions that may spread freely once revealed. however. the market equilibrium will no longer be Pareto optimal.] Markets are institutions . the actions of agents can have externalities. but the rights to use them in particular ways for particular amounts of time. oligopsony. while markets may have significant transaction costs.[11] The monopoly will use its market power to restrict output below the quantity at which the marginal social benefit is equal to the marginal social cost of the last unit produced. A market is an institution in which individuals or firms exchange not just commodities. Second. and externality According to mainstream economic analysis. such as where a researcher cannot capture enough of the benefits from success to make the research effort worthwhile. monopoly. it absorbs labor. the marginal social cost of the last unit produced will exceed its marginal social benefit.[11] More steel will be produced than would occur were the firm to have to pay for all of its costs of production. or informational asymmetry.[11] monopsonies. the market price for steel will fail to incorporate the full opportunity cost to society of producing. In a monopoly. and if it is not forced to pay for the use of this resource.[11] Hence.[11] Finally. This can lead to inefficiency due to imperfect competition. and these costs will be reflected in the market price for steel. A related issue can be the inability of a seller to exclude non-buyers from using a product anyway.[2] y y y First. [.[11] If the firm also pollutes the atmosphere when it makes steel. which can take many different forms. some markets can fail due to the nature of certain goods. all of these situations can produce inefficiency. it must pay for these in the appropriate markets. More fundamentally.[edit] Causes See also: public goods. capital and other inputs. and a resulting market failure.[2][11] In general..[2] For example. a market failure (relative to Pareto efficiency) can occur for three main reasons. or the nature of their exchange. or whether competitive or technological change will undermine it over time. cartels. allowing them to block other mutually beneficial gains from trades from occurring.[11] Consequently.. so as to keep prices and profits high. or other conditions important to the market.[11] In this case. As Hugh Gravelle and Ray Rees put it. monopsony. This can cause underinvestment. agency problems.[11] An issue for this analysis is whether a situation of market power or monopoly is likely to persist if unaddressed by policy. For instance.[5][11] which are innate to the methods of production. then this cost will be borne not by the firm but by society. agents in a market can gain market power. the underlying cause of market failure is often a problem of property rights. the market equilibrium in the steel industry will not be optimal. or monopolistic competition.

then the resulting distribution can be inefficient. and the costs associated with doing so. Both the democratic accountability of these regulations and the technocratic expertise of the economists play an important role here in shaping the kind and degree of intervention. or equity. This analysis follows the lead of the neoclassical school. applying it to Walrasian models of general equilibrium in order to deal with failures to attain full employment. If a given system of rights does not fully guarantee these at minimal (or no) cost.[13] Traffic congestion is an example of market failure.which organize the exchange of control of commodities. they propose going beyond the common idea of having the government charge a fee for the right to pollute (internalizing the external cost. Many social democrats and "New Deal liberals". so they view market failures as a very common problem of any unregulated market system and therefore argue for state intervention in the economy in order to ensure both efficiency and social justice (usually interpreted in terms of limiting avoidable inequalities in wealth and income). this falls into two generalized rights ± excludability and transferability. Neoliberals follow a similar line. and other ways of making the driver include the social cost in the decision to drive.[2] Other common examples of market failure include environmental problems such as pollution or overexploitation of natural resources.[12] Nonetheless. views still differ on whether something displaying these attributes is meaningful without the information provided by the market price system.[2] [edit] Interpretations and policy The above causes represent the mainstream view of what market failures mean and of their importance in the economy.[8] This form of analysis has also been adopted by the Keynesian or new Keynesian schools in modern macroeconomics. and relies on the notion of Pareto efficiency[14] ± and specifically considers market failures absent considerations of the "public interest". agents' control over the uses of their commodities can be imperfect. for instance by selling or leasing a commodity. . or the non-adjustment of prices and wages. Typically. Some remedies for market failure can resemble other market failures. congestion pricing. For example. Solutions for this include public transportation. creating a disincentive to pollute) to allow polluters to sell the pollution permits.[7] As a result. have adopted this analysis for public policy. since driving can impose hidden costs on other drivers and society. Excludability deals with the ability of agents to control who uses their commodity. toll roads and toll bridges. because the system of rights which defines that control is incomplete. and for how long ± and the related costs associated with doing so. Transferability reflects the right of agents to transfer the rights of use from one agent to another. often focusing on "market-oriented solutions" to market failure: for example. citing definitional concerns. where the nature of the control is defined by the property rights attached to the commodities. the issue of systematic underinvestment in research is addressed by the patent system that creates artificial monopolies for successful inventions.[7] Considerations such as these form an important part of the work of institutional economics.

objections also exist on more fundamental bases." although the notions of market efficiency and perfect competition can be redefined as to include the analytical framework of the Austrian School (praxeology) . This failure of government is seen as the result of the inherent problems of democracy and other forms of government perceived by this school and also of the power of special-interest groups (rent seekers) both in the private sector and in the government bureaucracy. However. and forms the basis of the theoretical argument against the existence of market failures. because the costs of government failure might be worse than those of the market failure it attempts to fix. and give identical results.[16] This definition of efficiency differs from that of Pareto efficiency. as to attain their goals or needs. Beyond philosophical objections. and Marxian economics [edit] Public choice Economists such as Milton Friedman from the Chicago school and others from the Public Choice school. [edit] Austrian Many heterodox schools disagree with the mainstream consensus. Advocates of laissez-faire capitalism. Austrian school. many Marxian economists would argue that the system of individual property rights is a fundamental problem in itself. Israel Kirzner states: Efficiency for a social system means the efficiency with which it permits its individual members to achieve their individual goals. something the government has great difficulty detecting. Conditions that many would regard as negative are often seen as an effect of subversion of the free market by coercive government intervention.[17] [edit] Marxian Finally. such as that of equity. Austrians argue that the market tends to eliminate its inefficiencies through the process of entrepreneurship driven by the profit motive. or correcting. these two definitions agree. or Marxian analysis. inefficiency arises when means are chosen that are inconsistent with desired goals.[15] The Austrian analysis focuses on the actions that individuals make. and so would not be considered a market failure by mainstream economics.Objections See also: Government failure. Colloquial uses of the term "market failure" reflect the notion of a market "failing" to provide some desired attribute different from efficiency ± for instance. high levels of inequality can be considered a "market failure". providing that the conditions of the first welfare theorem are met. such as economists of the Austrian School. argue that market failure does not necessarily imply that government should attempt to solve market failures. yet are not Pareto inefficient.[2] In addition. and . a further issue is the practical difficulty that any single decision maker may face in trying to understand (and perhaps predict) the numerous interactions that occur between producers and consumers in any market. argue that there is no such phenomenon as "market failures.

[edit] . but based upon need as determined by society expressed through the community. This is different from concepts of "market failure" which focuses on specific situations ± typically seen as "abnormal" ± where markets have inefficient outcomes. would say that markets have inefficient and democratically-unwanted outcomes ± viewing market failure as an inherent feature of any capitalist economy ± and typically omit it from discussion. Marxists. preferring to ration finite goods not exclusively through a price mechanism.that resources should be allocated in another way entirely. in contrast.

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