Market Failure

When the price mechanism fails to take into account all the costs and/or benefits of providing and/or
consuming the good, the market will fail to supply the socially optimal amount

● The competitive forces of supply and demand will not produce quantities of goods
where the prices reflect the marginal benefit (utility) of consumption - this, in turn,
leads to over-/under consumption of the good, i.e. allocative inefficiency

Reasons for market failure

Most markets are NOT successful, and the government intervenes to some degree

● Perfect markets are socially efficient, they are operating at Pareto optimality in which
no one can be made better off with someone being made worse off (zero-sum)
● Consumer surplus is maximized
● P=MC where MSC=MSB
● In the real world, markets are not perfect; MSC does not equal MSB and market
failure occurs
● This is because of externalities, underprovision of merit goods, the overprovision of
demerit goods, a lack of public goods, and imperfect markets
● If the free market is left to its own devices, Pareto market failure will occur
● Inefficient Producers: producers do not produce where the average costs are at a
minimum
● Therefore they are using more resources than they need to
● Positive and Negative externalities: an externality is an effect on a third party that
is caused by the consumption and/or production of a good or service
● There are four types of externalities

●
Positive Consumption Externality
●

Negative Consumption Externality

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Negative Production Externality

● Short-term and long-term environmental concerns, with reference to
sustainable development
● Lack of public goods: public goods are goods whose total cost of production does
not increase with the number of consumers

Public goods are:

1. non-rivalrous (consumption by one consumer will not reduce the amount available for other
consumers in the market, i.e. they do not have to compete to obtain the good/service)
2. non-excludable (no consumer is excluded from consuming such good/service)

● The classic example is national defense

● Other examples: street lights, roads
● Public goods will not be provided by the market
● Underprovision of merit goods: if left to their own devices, merit goods (a private
good that society considers under-consumed, often with positive externalities) will be
underprovided
● These are goods and services which have a positive effect on society like
education, healthcare, and sports centers
● Overprovision of demerit goods: if left to their own devices, demerit goods (a
private good that society considers overconsumed, often with negative externalities)
will be over provided
● These are such things as prostitution, alcohol, and cigarettes
● To discourage these demerit goods the government creates: negative advertising,
tax on the goods, or bans them altogether
● Abuse of monopoly power: imperfect markets such as oligopolies and monopolies
restrict output in an attempt to maximize profit
● Thus, MSB is not equal to MSC / MSC is equal to MR

Possible government responses

● Legislation: antitrust legislation can be brought in an attempt to break monopoly

power and collusive oligopolies
● Legislation to make high school attendance mandatory
● Ban smoking in restaurants
● Direct provision of merit and public goods: governments can control the supply of
goods that have positive externalities by supplying a high amount of education, public
roads, parks, libraries, etc.
● Taxation: place an excise tax on the sale of tobacco products or alcohol to
discourage consumption
● This will internalize some of the external costs (i.e., smokers will pay for their
secondhand smoke through the tax)
● Subsidies: reduce the cost of university education because it has beneficial
externalities
● The price will be reduced to reflect the benefits society attains through the
education of individuals
● Tradable permits: tradable permits are permits allowing a firm to produce a given
amount of pollution
● There is limited supply for how much pollution a firm can produce so if a firm
would want to pollute more it has to purchase tradable permits from other firms
● A Carbon Tax (taxing consumption that causes pollution, such as fossil fuels)
achieves the same result
● In both cases, firms and individuals are motivated to reduce costs by reducing
environmental damage
● Extension of property rights: a form of privatization to privatize certain non-private
goods
● e.g., lakes, rivers, beaches => create a market for pollution and charge people if
they want to pollute something
● Advertising to encourage and discourage consumption: by the government to
ensure the socially optimum level of consumption is being achieved
● International cooperation among governments: in the case of acid rain, for
example, international cooperation among governments is necessary in order to
reduce its occurrence