Market Failure

Pareto Efficiency
Pareto efficiency is an economic state where resources are allocated in the most efficient manner.
Pareto efficiency is obtained when a distribution strategy exists where one party's situation
cannot be improved without making another party's situation worse. Pareto efficiency does not
imply equality or fairness. (Investopedia)

Market failure: This occurs when the interaction of demand and supply in a market does not
lead to *Productive or *Allocative Efficiency

*Productive efficiency: This refers to using the least possible amount of scarce resources to
produce a particular amount of produce

*Allocative Efficiency: This refers to producing those products that are most wanted by
consumers given the costs of production

Reasons for market failure:

1. Public goods
2. Merit and Demerit Goods
3. Externalities
4. Asymmetric Information: Adverse selection and moral hazard
5. Imperfect market

Types of goods
Public goods: these are goods that bar no one from consumption (non-exclusive) and the
consumption of the good by one consumer does not impede another consumer from consumption
(Non-rivalrous). E.g. National Defence, Lighthouses, Roadways (*Quasi-public Goods)

*Quasi-public goods: These are goods that are intermediate between public and private goods.

Private goods: These are goods that bar some consumers from consumption mainly through
price and there is a limited quantity to be consumed. Therefore private goods are exclusive and
rivalrous.

Merit and Demerit goods: Merit Goods are those which offer benefit to the society for e.g.
Education , Healthcare and Affordable Housing, which if the market was left on its own it would
under-produce these goods. Demerit Goods are those goods which are more harmful to society
than not, for e.g. Tobacco and Alcohol. If the market was left on its own it would over produce
these goods.

Externalities
Externalities represent the external costs and benefits of any productive activity. These can be
classified as:

A. Production Externalities(positive and negative) -This exists when an external cost or

benefit arising from production must be borne by someone other than the producer of the
good
B. Consumption Externalities(positive and negative) –This exists when an external cost or
benefit arising from the consumption of a good must be borne by someone other than the
consumer of the good

Costs and Benefits

Marginal Social Cost: the sum of the marginal private costs and the marginal external costs

MES= MC+MEC

Marginal external cost: The cost of producing additional units of output borne by individuals
other than the product of the good or service

Marginal social benefit: The sum of the marginal private benefit and the marginal external
benefit.

MSB=MB+MEB

Marginal Benefit: The benefit of producing an additional unit of output that is borne by the
producer.

Marginal External Benefit: The benefit of producing an additional unit of output that is borne
by individuals other than the producer of the good or service.
Asymmetric Information
When individuals do not have the correct information when making transactions, distorted or
wavered decision will be made: there are two types market failures due to asymmetric
information:

1. Moral Hazard- Hidden actions or morally hazardous behaviour by one party in a

transaction, very popular in the insurance industry.
2. Adverse Selection- This occurs when asymmetric information arises from a hidden
attribute of a good or service. Applies to sales where the sellers or the buyers know more
than the other about the good.

Intervention
When the market does fail, the task is left up to the government to intervene. The government can use
many methods to stimulate the market from a point of failure to recovery.

The government can implement measures to control market failure such as:

- Regulations
- Anti-trust policies
- Taxation
- Privatisation and deregulation in some industries to offset cost and other factors
- State ownership of resources
- Subsides to firms to spur on production
- Legislation
- Market creation(tradable permits)

Government intervention according to many economic theorists can be detrimental if the government
does not allow the natural market to settle problems on its own. Many times as governments intervene
some consumers may suffer. But there are benefits to government interventions as many consumers
and producers who have been affected my market intervention do reap the benefits from some of the
actions of government aforementioned.

In the Caribbean our smaller economies are heavily reliant on government intervention but the private
sectors should be given leverage and support where needed.
Private Sector Intervention
When the private sector is allowed a hand in market failure intervention, they have many methods they
can use. According to this course they can use:

- Corporate Code of Conduct

- Corporate Social Security
- Voluntary Agreements
- Corporate Ethics