Market Failure 2020

Platinum Business Academy
No 106, S D S Jayasingha Mawatha,

Kohuwala, Sri Lanka Edexcel Unit1 (IAL)
Market Failure
When markets do not provide us with the best outcome in terms of efficiency
and fairness, then we say that there exists market failure. In a free market
economy price mechanism allocates resources, prices and profits are the signals
for allocation of resources. Misallocation of resources will take place if prices
and profits do not reflect true costs and benefit to society.
Market failure occurs whenever freely-functioning markets operating without
government intervention, fail to deliver an efficient allocation of resources and
the result is a loss of economic and social welfare. Market failure exists when
the competitive outcome of markets is not satisfactory from the point of view
of society. This is usually because the benefits that the free-market confers on
individuals or businesses carrying out an activity diverge from the benefits to
society as a whole.
Types of market failure
1. Externalities
a) Negative externality
b) Positive externality
2. Moral hazards
3. Missing markets
a) Public goods
b) Merit goods
4. Lack of information
5. Factor immobility
1
Wasim Imtiasz
BA (Hons) Middlesex University (UK), CIMA passed finalist, ACCA Finalist, Edexcel Dual
HND in Business & Management + Business & Human Resources (UK)
6. Speculation and market bubbles
Externalities
Externalities are common in virtually every area of economic activity. They are
defined as third party (or spill-over) effects arising from
the production and/or consumption of goods and services for which no
appropriate compensation is paid. Externalities can cause market failure if
the price mechanism does not take into account the full social costs and social
benefits of production and consumption.
This causes market failure due to misallocation of resources leading to too much
or too less being produced in the market. Externalities can and do result in the
market mechanism producing the wrong quantity of goods and services so that
there is a loss of social welfare
Negative externality
Negative externalities occur when production and/or consumption
impose external costs on third parties outside of the market for which no
appropriate compensation is paid. In other words when firms or individuals
underestimate their cost they end up over producing this result in negative
externality.
Examples
• Smokers ignore the unintended but harmful impact of toxic ‘passive smoking’
on non-smokers
• Acid rain from power stations in the UK can damage the forests of Norway
• Air pollution from road use and traffic congestion
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• The social costs of drug and alcohol abuse
• External costs of scraping the seabed for supplies of gravel
❖ Private cost
❖ External cost
❖ Social cost
Negative externality diagram Production
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MPC-
MSC-
MB-
MPB-
MSB-
Diagram explanation
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Demerit goods
De-merit goods are thought to be ‘bad’ for you. Examples include the costs
arising from consumption of alcohol, cigarettes and drugs together with the
social effects of addiction to gambling. The consumption of de-merit goods can
lead to negative externalities.
This is a concept connected with negative externality as it brings about harm to
the third party as well as the society. The excess consumption can be defined in
two ways.
1. People lack information regarding the harm on themselves and the society
thus consume more
Diagram 1
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Explanation
2. Individual consumption harms third party thus increasing the total cost for
the society.
Positive externality
There are many occasions when the production and/or consumption of a good or
a service creates external benefits which boost social welfare. In this note we
consider the idea of positive externalities and the market failure that can
result if the market under-consumes or under-provides these sorts of products.
This exist when a good or a service is underprovided or under consumed as the
free may fail to value the correctly during the course of pricing
Examples
• Social benefits from providing milk to young schoolchildren
• External benefits from vaccination / immunisation programmes
• Social benefits from restoration and use of historic buildings
• External benefits from improved training and education
• External benefits from development of renewable energy sources
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❖ Private benefit
❖ External benefit
❖ Social benefit
Positive externality diagram Consumption
Diagram explanation
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Merit goods
Merit goods create a divergence between the private and social costs and
benefits of production and consumption leading to the risk of market failure.
Merit goods are those goods and services that the government feels that people
will under-consume, and which ought to be subsidised or perhaps provided free
at the point of use so that consumption does not depend primarily on the ability
to pay for the good or service.
Who provides merit goods?
It is important to realise that it is not simply the government (or public sector)
that supplies merit goods. Both the state and private sector provide merit
goods & services. We have an independent education system and people can buy
private health care insurance.
The under consumption and under production of merit goods can be explained in
two ways
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1. People lack information about the importance hence under consume (demand
less)
Diagram 1
Explanation
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2. When individuals consume merit goods benefit is accrued to the third party
thereby it increases the total benefit.
Diagram 2
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Cost Benefit Analysis

When there’s a divergence between private and social benefit and private and
social cost it said to be a situation of market failure. CBA is a tool used by the
economists to ensure that right choice of action is made in major projects. This
method differs from the methods used by private sectors such as project
appraisal.
CBA has traditionally been applied to big public sector projects such as new
motorways, by-passes, dams, tunnels, bridges, flood relief schemes and new
power stations. Our example later considers some of the social costs and
benefits of the new Terminal 5 for Heathrow airport.
Because financial resources are scarce, CBA allows different projects to be
ranked according to those that provide the highest expected net gains in social
welfare - this is particularly important given the limitations of government
spending.
The basic principles of COBA can be applied to many other projects or
programmes. For example, -public health programmes (e.g. the mass
immunization of children using new drugs), an investment in a new rail safety
systems, or opening a new railway line. Another example might be to use COBA
in assessing the costs and benefits of introducing congestion charges for
motorists in London. Or the costs and benefits of the New Deal
programme designed to reduce long-term unemployment. Cost benefit analysis
was also used during the recent inquiry into genetically modified foods.
Note –
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The steps involved in the process of Cost Benefit Analysis
1. Identification of all the costs and benefits that arises out of any project.
2. Assigning monetary values for the costs and benefits
3. Checks the future viability, acceptability and feasibility of the project
4. Final decision with higher costs or benefits
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Criticisms involved in CBA
➢ In determining all the costs and benefits involved in a project
➢ In determining monetary values especially in situations where there’s no
market value
❖ Distributional consequences: Costs and benefits mean different things to
different income groups - benefits to the poor are usually worth more (or
are they?). Those receiving benefits and those burdened with the costs of a
project may not be the same. Are the losers to be compensated? To many
economists, the equity issue is as important as the efficiency argument.
❖ Social welfare is not the same as individual welfare - What we want
individually may not be what we want collectively. Do we attach a different
value to those who feel “passionately” about something (for example the
building of new housing on greenfield sites) contrasted with those who are
more ambivalent?
❖ Valuing the environment: How are we to place a value on public goods such as
the environment where there is no market established for the valuation of
“property rights” over environmental resources? How does one value
“nuisance” and “aesthetic values”?
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❖ Valuing human life: Some measurements of benefits require the valuation of
human life – many people are intrinsically opposed to any attempt to do this.
This objection can be partly overcome if we focus instead on the probability
of a project “reducing the risk of death” – and there are insurance markets
in existence which tell us something about how much people value their
health and life when they take out insurance policies.
❖ Attitudes to risk – e.g. a cost benefit analysis of the effects of genetically
modified foods
Annual Benefits £ million

Health benefits (reduced absenteeism) 70 – 140
Health benefits (reduced costs of healthcare) 4
Health benefits (averted deaths from second-hand smoke amongst 21
employees)
Health benefits (reduced uptake, particularly new young employees) 550
Health benefits (smoking cessation) 1600
Safety benefits (damage, deaths, injuries) 57
Safety benefits (cost to fire services) 0.2
Safety benefits (administration costs) 6.3
Cost savings to NHS from smoking cessation Not estimated
Cleaning costs and damage to equipment avoided 100
Production gains 340 – 680
Total 2700 - 3100
Annual Costs £ million

Production losses (smoking breaks) 430
Losses to continuing smokers (loss of satisfaction) 155
Losses to quitters (loss of satisfaction) 550
Losses to the Treasury 1145
Total
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Missing markets
Missing markets is the concept connected to public goods. Public good is
considered as a market failure because of the free rider problem. Private
sector is always profit oriented therefore public goods are not provided by the
private sector since they cannot charge for it. If every individual waits till it’s
provided by another person it will never be provided, therefore the government
provides it.
The existence of public goods imply that resources are not utilised efficiently
which is desirable for the society. In other words private sector is not making
efficient use of resources therefore it becomes a market failure.
The problem arises with public goods is not whether it’s too little or too much
provided, the problem is whether it will be provided at all.
Public goods are of two types as given below
1. Pure public goods
a. 100% non-exhaustible (non- rivalry)
Consumption of a public good by one person does not reduce the availability of a
good to everyone else – therefore we all consume the same amount of public
goods even though our tastes and preferences for these goods (and therefore
our valuation of the benefit we derive from them) might differ
b. 100% non-excludable
The benefits derived from the provision of pure public goods cannot be confined
to only those who have actually paid for it. In this sense, non-payers can enjoy
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the benefits of consumption at no financial cost to themselves – this is known as
the “free-rider” problem and it means that people have a temptation to consume
without paying.
Note - There are relatively few examples of pure public goods. Examples of
public goods include flood control systems, some of the broadcasting
services provided by the BBC, public water supplies, street lighting for roads
and motorways, lighthouse protection for ships and also national defence
services.
2. Quasi-Public Goods
Most public goods are non-pure public goods – these are also known as quasi-
public goods. The main reason is that we can find ways and means of excluding
some groups from consuming them. A quasi-public good is a near-public good i.e.
it has many but not all the characteristics of a public good. Quasi-public goods
are
a. Semi-non-rival - up to a point, extra consumers using a park, beach or
road do not reduce the amount of the product available to other
consumers. Eventually additional consumers reduce the benefits to other
users. Beaches become crowded as do parks and other leisure facilities.
In certain cases fencing a beach or a park and charging an entrance fee
can exclude people. Ex – Viharamadevi park ;)
b. Semi-non-excludable: it is possible but often difficult or expensive to
exclude non-paying consumers. E.g. fencing a park or beach and charging
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an entrance fee; building toll booths to charge for road usage on
congested routes
Private Goods
A private good or service has three main characteristics:
1. Excludability - Consumers of private goods can be excluded from consuming
the product by the seller if they are not willing or able to pay for it.
2. Rivalry- With a private good, one person's consumption of a
product reduces the amount left for others to consume and benefit from -
because scarce resources are used up in producing and supplying the good or
service.
3. Rejectability- Private goods and services can be rejected - if you don't like
the soup on the college or school menu, you can use your money to buy
something else
Factor immobility
This is mainly concerned with the immobility of labour, this can further
classified in to two
1. Geographical immobility
2. Occupational immobility
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Geographical immobility
This occurs when personals are reluctant to change place of work due to the
following factors.
a) Reluctance to leave behind family and friends
b) The financial cost involved in moving home, including cost of selling the
house and other expense.
c) Huge regional variation of house prices/rent
d) Differences in cost of living between regions.
How to overcome this problem?
Occupational immobility
Reluctance and inability to move from one job to another, this mainly occurs due
to workers having specific skills and education level. This leads to mismatch
unemployment
Note –
How to overcome this problem?
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Imperfect market information

All of us experience information deficit which will often lead to misallocation of
resources, which results in market failure.
This occurs when people have inaccurate, incomplete, uncertain and
misunderstood data which leads to wrong choice.
Eg1
Eg2
Eg3
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Advertising Some advertising, such as small ads in newspapers or notifications
for sale on sites such as eBayR, increases information for buyers. It makes
them aware of what is on offer in the marketplace. However, most advertising is
persuasive advertising.
It is designed to change attitudes on the part of the buyer. As such, attempts
to increase information failure on the part of the buyer to the benefit of the
seller. For example, a soap powder advert might attempt to persuade buyers
that a particular brand is better at cleaning clothes than another. A car advert
might link owning the car with increased status for its owner.
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Moral Hazard
Moral hazard occurs when insured consumers are likely to take greater risks,
knowing that a claim will be paid for by their cover
The consumer knows more about his/her intended actions than the producer
(insurer)
If more people have access to health insurance for example, behavioural
changes arising from moral hazard might lead to a substantial rise in health
insurance payouts.
Moral hazard has also been applied to the controversial issue of bank bailouts
for if a bank knows that there is a good chance it will get emergency financial
support when it encounters problems, employees of the bank might be tempted
to take increased risks.
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Adverse selection occurs whenever asymmetrical information — information
known to one party but not the other — makes it difficult for potential trading
partners to distinguish between high-risk and low-risk transactions. This
problem is particularly endemic to insurance markets
Richmond Fed
Adverse selection
A good example of adverse selection is in the health insurance insurance market.
People most likely to purchase health insurance are those who are most likely to
use it, i.e. smokers/drinkers/those with underlying health issues
The insurance company knows this and so raises the average price of insurance
cover
This risks pricing healthy consumers out of the market, meaning that only high
risk individuals gain insurance – this is clearly a market failure
One interpretation of adverse selection is that "we tend to trust the people we
shouldn't!"
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Moral Hazard is a term used to describe a situation in which an individual or
organisation is protected from the consequences of their actions. They know
that someone else will have to deal with any problems that occur. As a result,
there is no incentive to take the normal precautions and act sensibly, which may
result in unnecessary risk-taking and subsequent failure.
This was the situation for many banks around the time of the financial crisis in
2008.Banks that had acted carelessly and built up massive debts were saved
from collapse by the government, which intervened because, if they had not,
there was a risk that the whole economy would suffer. On an individual level,
people with access to free healthcare are less likely to look after themselves
than others who have to pay for any health treatment. It has been argued that
welfare benefits prevent some people from not actively seeking work or
retraining if they lose their jobs.
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“any situation in which one person makes the decision about how much
risk to take, while someone else bears the cost if things go badly.”
Speculation and Market bubbles
A bubble exists when the price of something is driven well above what it should
be, usually due to the behaviour of consumers.
A bubble is said to happen when the prices of securities or other assets rise so
sharply and at such a sustained rate that they exceed valuations justified by
fundamentals, making a sudden collapse likely (at which point the bubble
“bursts”). Typically this is seen in property markets where housing valuations
can rise to unsustainable levels relative to income or long-run average prices.
Speculative demand driven by positive price expectations has the effect of
amplifying market demand and driving prices higher - especially when supply is
restricted and unresponsive to short-term price movements.
Bubbles are common in other asset markets such as for stocks and bonds. And
increasingly we find that world commodity prices exhibit bubble tendencies with
high levels of volatility in the prices of foodstuffs, oil and natural gas and
metals.
The bursting of a bubble - such as a collapse in property prices - can have
important demand-side effects on wealth, confidence and aggregate demand
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The US housing bubble burst dramatically in the mid-2000s as the sub-
prime sector of the market collapsed. Houses that cost tens of thousands of
dollars were being sold for just a few hundred by 2010. In the UK, the housing
market is still rising with many first-time buyers unable to afford even a small
property. In china, there is the strange sight of ‘ghost cities’, vast modern
urban developments left empty when the mass migration of people from country
to town began to reduce. Many developers have gone bankrupt, leaving entire
housing developments and infrastructure empty.
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Platinum Business Academy

No 106, S D S Jayasingha Mawatha,

for allocation of resources. Misallocation of resources will take place if prices

and profits do not reflect true costs and benefit to society.

Market failure occurs whenever freely-functioning markets operating without

government intervention, fail to deliver an efficient allocation of resources and

individuals or businesses carrying out an activity diverge from the benefits to

Types of market failure

defined as third party (or spill-over) effects arising from

the production and/or consumption of goods and services for which no

appropriate compensation is paid. Externalities can cause market failure if

benefits of production and consumption.

there is a loss of social welfare

Negative externalities occur when production and/or consumption

appropriate compensation is paid. In other words when firms or individuals

• Air pollution from road use and traffic congestion

• External costs of scraping the seabed for supplies of gravel

Negative externality diagram Production

social effects of addiction to gambling. The consumption of de-merit goods can

lead to negative externalities.

This is a concept connected with negative externality as it brings about harm to

thus consume more

result if the market under-consumes or under-provides these sorts of products.

This exist when a good or a service is underprovided or under consumed as the

• Social benefits from providing milk to young schoolchildren

• External benefits from vaccination / immunisation programmes

• Social benefits from restoration and use of historic buildings

• External benefits from improved training and education

• External benefits from development of renewable energy sources

Positive externality diagram Consumption

benefits of production and consumption leading to the risk of market failure.

will under-consume, and which ought to be subsidised or perhaps provided free

to pay for the good or service.

Who provides merit goods?

private health care insurance.

thereby it increases the total benefit.

Cost Benefit Analysis

benefits of the new Terminal 5 for Heathrow airport.

Because financial resources are scarce, CBA allows different projects to be

welfare - this is particularly important given the limitations of government

The basic principles of COBA can be applied to many other projects or

programmes. For example, -public health programmes (e.g. the mass

immunization of children using new drugs), an investment in a new rail safety

in assessing the costs and benefits of introducing congestion charges for

motorists in London. Or the costs and benefits of the New Deal

programme designed to reduce long-term unemployment. Cost benefit analysis

The steps involved in the process of Cost Benefit Analysis

2. Assigning monetary values for the costs and benefits

3. Checks the future viability, acceptability and feasibility of the project

4. Final decision with higher costs or benefits

Criticisms involved in CBA

➢ In determining all the costs and benefits involved in a project

➢ In determining monetary values especially in situations where there’s no

❖ Distributional consequences: Costs and benefits mean different things to

economists, the equity issue is as important as the efficiency argument.

❖ Social welfare is not the same as individual welfare - What we want

individually may not be what we want collectively. Do we attach a different

the environment where there is no market established for the valuation of

“property rights” over environmental resources? How does one value

“nuisance” and “aesthetic values”?

This objection can be partly overcome if we focus instead on the probability

health and life when they take out insurance policies.

❖ Attitudes to risk – e.g. a cost benefit analysis of the effects of genetically