MARKET FAILURE:

-market failure exists when the market forces of demand and supply fail to supply the quantities of
products that society requires at prices which reflect their marginal utilities. It results in allocative
inefficiency where there is under-production or over-production of a product.

PRIVATE COSTS:
-they are internal costs that fall on someone who generates an economic activity and they are incurred
by producers and consumers. For producers, they are production costs such as cost of raw-materials,
labour costs, rentals, etc. For consumers, it is the amount they pay for the product.

PRIVATE BENEFITS:
-they are internal benefits realised by someone who generates an economic activity and they are
enjoyed by producers and consumers. For producers, it is the revenue they get from selling their
products and for consumers, it is the satisfaction they enjoy from consumption of a product.
**private costs and private benefits go through the price mechanism and as a result, they have a
price attached to them**

EXTERNALITIES:
-Refer to spill-over effects, i.e., cost and benefits to 3rd parties. They affect other people who are not
directly involved in the production or consumption of a product. There are negative and positive
externalities.
Negative externalities are costs suffered by 3rd parties from production or consumption of other
people. They exist when there is a divergence between social costs and private costs. Negative
externalities result in over-production or over-consumption of a product. Examples include, passive
smoking, noise from industries.
Positive externalities are benefits enjoyed by 3rd parties from production or consumption of other
people. They exist when there is a divergence between social benefits and private benefits. Positive
externalities result in under-production or under-consumption of a product. Examples include; other
people using a road constructed by a producer for easy transportation of inputs and finished products,
a neighbour benefiting from the scenery of his neighbour’s garden of flowers.

SOCIAL COSTS:
-refers to total costs to the society.
Social costs = Private costs + Negative externalities
When there are no negative externalities, then social costs = private costs

SOCIAL BENEFITS:
-refers to total benefits to the society.
Social benefits = Private benefits + Positive externalities
When there are no positive externalities, then social benefits = private benefits

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 SOCIALLY EFFICIENT/ SOCIALLY OPTIMUM OUTPUT:
-achieved when Marginal Social Benefit (MSB) = Marginal Social Cost (MSC)
MSB refers to a change in social benefits resulting from production of an extra unit of a product
MSC refers to a change in social costs resulting from production of an extra unit of a product

-Qs is the socially optimum output level where SMB = SMC.

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 MARKET FAILURE AND
GOVERNMENT INTERVENTION:
-market failure exists when SMB is not equal to SMC

CAUSES OF MARKET FAILURE & GOVERNMENT

INTERVENTION:
(1) Existence of negative externalities from production:
-negative externalities result in over-production of a product. Output being produced is more than the
socially optimum output level.

-private firms will seek to maximise profits and will produce output where Marginal private benefit =
marginal private cost (MPB = MPC) which is Q1. However, the socially optimum output is Qs where
MSB = MSC. Therefore, there is over-allocation of resources over-production of the product.
-government can impose a tax on the firm producing a product causing the negative externality and
that tax should be equal to the externality. The tax will therefore shift the supply curve (MPC)
upwards until it coincides with the MSC.
-however, it may be impossible to determine the level of the negative externality and the amount to
impose as the tax.
-government can also pass legislation which prohibits the dumping of industrial waste in rivers and
request the polluting firms to install technologies which reduce emissions. However, firms may find it
costly to buy and install such technologies.

(2) Existence of positive externalities from production:

-there is under-production of products which cause positive externalities.

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-private firms will seek to maximise profits and will produce output where Marginal private benefit =
marginal private cost (MPB = MPC) which is Q1. However, the socially optimum output is Qs where
MSB = MSC. Therefore, there is under-allocation of resources under-production of the product.
-government should give a subsidy equivalent to AB such that the supply curve (MPC) shifts towards
MSC thereby increasing output. However, it increases government expenditure.

(3) Existence of negative externality from consumption:

-there is over-consumption of goods with negative externalities, e.g., passive smoking from those who
smoke cigarettes.

-socially optimum level is Qs which is below the actual consumption level.

-government can carry out advertising campaigns such as anti-smoking campaigns to discourage
consumers from buying those goods such that the demand curve (MPB) shifts downwards towards
MSB. However, this increases government expenditure
-government can also pass legislation which requires producers of de-merit goods like alcohol and
cigarettes to inform consumers about the harmful effects of their products. The idea is to reduce
demand of such goods. However, some of these goods are addictive such that a great number of
people may still consume them
-government can also ban their consumption in public places to limit the effects on 3rd parties.
However, the government may face challenges in effecting such measures

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-government may introduce excise duty on such goods to make them more expensive thereby
reducing their demand as well as ban them altogether. However, as already alluded to, some of these
goods are addictive.

(4) Non-provision of public goods:

-public goods are non-excludable such that they are not provided by private firms since private firms
have a profit motive. Therefore, the government should intervene and provide them for free for
collective use since no-one is prepared to pay for them. Such goods include street-lighting and
national defence. However, this increases government expenditure which may lead to a budget deficit.
Government may also be forced to increase taxes thereby over-burdening the tax-payer

(5) Under-provision of merit goods:

-Merit goods have positive externalities but under a free market economy, they are under-provided,
such as health care and education. They may also not be afforded by some members of the society.
-for example, consumption of education benefits not only people who receive it, but the society also
benefits from more productive workforce, reduces unemployment, higher economic growth and low
crime rates.
-government can intervene by providing free education and free health care of offering them at low
and affordable prices. This can be done through government owned schools and hospitals. However,
this again increases government expenditure.
-government can also pass legislation which makes education compulsory to a certain age or level.

(6) The existence of imperfect competition (monopoly and oligopoly) which

results in productive inefficiency and allocative inefficiency:
-the firms charge a price greater than marginal cost and they do not operate at the minimum point of
their average cost curves.
-government can intervene by introducing price controls. However, price controls have a lot of
undesirable effects in the economy such as promotion of black markets and unemployment.
It can also pass anti-monopoly legislation.

(7) Lack of information:

-this may result in consumers paying a high price for a product unaware that it is cheaper elsewhere.
-Producers may use outdated and inefficient production methods unaware of the existence of new and
advanced technology.
-people may remain unemployed unaware that there are job vacancies somewhere. Employers may
also fail to get employees with shills they require yet they exist elsewhere.
-government can set up information centres which are updated regularly and job centres which
provide information about job vacancies in an economy. However, these centres have to be manned
and gathering the necessary information may be costly to the government.

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 DEADWEIGHT WELFARE LOSS (DWL):
-DWL exists when MSB>MSC or MSB<MSC. It is caused by externalities. This is because a profit
maximising firm will operate where MPB=MPC as it does not consider the externalities that it may
cause. However, the socially optimum output level is where MSB=MSC.
Deadweight loss caused by positive externality from production:

-a profit maximising firm will produce output Q0 where MPB=MPC. However, the socially optimum
output level is Qs where MBS=MSC. At output Q0, MSB > MSC indicating DWL. An increase in
output from Q0 to Qs would improve social welfare.
-Triangle ABC is the DWL.
Deadweight loss caused by negative externality from production:

-a profit maximising firm will produce output Q0 where MPB=MPC. However, the socially optimum
output level is Qs where MBS=MSC. At output Q0, MSB > MSC indicating DWL. An increase in
output from Q0 to Qs would improve social welfare.
-Triangle ABC is the DWL.

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COST-BENEFIT ANALYSIS (CBA):
-CBA is a decision making tool that can be used as an investment appraisal technique, i.e., it can be
used to decide whether it is worthwhile or not, to invest in a proposed project. It is mostly used by the
government although private firms can also use it.
-for example, it can be used when deciding whether or not to construct a dam, a road, to exploit a
discovered mineral deposit, to train workers, to buy advanced technology, etc.
-it involves identifying expected social benefits and social costs associated with the proposed project.
Social benefits include private benefits and positive externalities and social costs consist of private
costs and negative externalities and their values are determined. The expected values are then
discounted to determine their present values in order to take into account the time value of money. If
the value of expected SB exceed the expected value of SC, then the project will go ahead but if the
value of expected SC exceed the expected value of SB, then the project will not be carried out.
Example: The government wants to decide whether or not to construct a dam. The following are
examples of SB and SC associated with dam construction.

SOCIAL BENEFITS:
-water supply to the community, employment creation during dam construction, fishing from the dam,
irrigation using water from the dam, electricity generation, improved roads, revenue from tourists.

SOCIAL COSTS:
-labour costs, fuel costs, cost of buying or hiring equipment, displacement of people, exhumation of
graves, homes destroyed, loss of farmland, break-up of social ties.
All the SB and SC should be assigned values which will then be compared.

USES OF CBA:
(1) Decisions are made on what is best for the society as it also considers externalities from the
proposed project and not just private benefits and private costs.
(2) Although information gathered and used in CBA may not be 100% accurate, it enables logical
thinking and decisions are made with some element of confidence rather than just depending
on guesswork.
(3) Information from CBA is easy to understand and interpret and to see how a particular
decision was reached.

DRAWBACKS:
(1) Not ideal for appraising projects in the private sector as private firms usually consider private
benefits and private costs and ignore the externalities they cause when making their decisions.
The reason is that they are profit motivated.
(2) Difficult to assign values to externalities as they do not go through the price mechanism and
therefore, they do not have values attached to them. As a result, externalities may be over-
valued or under-valued.
(3) It may be difficult to include all affected parties such as animals even though they are also
affected by the project.
(4) Those carrying out CBA may manipulate the figures for a favoured option.
(5) Experts may need to be hired for CBA which may be costly

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