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Market failure

Sources of market failure

1. Positive and negative externalities

2. Public goods
3. Merit and demerit goods
4. Monopoly

In economics, market failure refers to a situation when the market forces of

demand and supply fails to achieve an efficient allocation of resources in an
economy. In other words, there is a misallocation of resources by the market.

Put alternatively, market failure exists when a free market left to its own devices
and free from any form of government intervention fails to make the optimum use
of scarce resources. This implies that the market in the absence of any government
intervention fails t deliver what is expected. Some goods may be over provided
implying that too much of resources are being devoted while some underprovided
implying that too few resources and some goods may not be provided by the
market (public goods). Thus, resources are not being allocated to the best
possible way of the market. As a result, the need for the government intervention
is being justified.

In fact, one of the microeconomic objective of the government is to control or

correct market failure.

Characteristics of public good

1. Pure Public good

Public goods are also known as collective consumption goods and are not provided
at all by the free market. Instead they are provided by the government and are
financed out of taxation or from government borrowing. Examples of public goods
include national defence, lighthouse or street lightning amongst others.

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A pure public good has got 2 main features:

1.It is non- excludable(cannot ban someone to consume).Non excludability means

that it is not possible to exclude non-payers from consuming the public good once
it becomes available. Put alternatively, this mean that once the good has been
provided for a consumer, it is impossible to stop all other consumers from
benefiting.

2.It is non- rival

This implies that there is no competition among users to benefit from the product.
Furthermore, the increase in consumption by some users does not reduce the
amount left to others.

Examples of pure public goods are: defense, public road, lighthouse,

streetlighting.

2. Quasi public good (not 100% public)

This refers to goods that have some but not all of the characteristics of a
public good. An example is a sandy seaside beach. Such beach is available to all
those who wish to use it so that it appears to be non excludable. However, it is
possible to think of ways of excluding consumers and a good example would be a
privately owned beach.

Also, the beach can be non rival up to a certain point. For example, if the beach
become crowded, space limited, it may reduce the enjoyment of coming users.
Thus, it will be viewed as a quasi public good.

Another example is that of a toll road whereby anyone not paying the toll can be
excluded from consuming the product. It is also possible that the road becomes so
much congested that the benefits of the last user is not the same as that of the first
user.

Why are public goods a source of market failure?

Public goods are a source of market failure because if left to the market, such
goods will not be provided because of the free rider problem associated with the
non excludability characteristic of the good. This means that, if a consumer or

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user provides such a good at his own cost, he cannot exclude another user from
benefiting. Thus, the user may free ride at anytime and at zero cost. Also, a price
cannot be charged for such a product as it would be impossible to exclude those
who have not paid for the product.

Put alternatively, the benefits derived from pure public goods cannot be confined
solely to those who have paid for it. Indeed non payers can enjoy the benefits of
consumption at no financial cost.[free rider problem]

Thus, it is difficult for the market to provide such a type of good as it is difficult to
control and can be unprofitable. This explains why the government may intervene
and provide such a type of goods to members of the public and finance it out of
taxation.

Private goods:

Private good is an economic term that refers to a specific type of good which has
the characteristics of rivalry and excludability. They are also known as economic
goods since they have a cost in terms of the resources used and are scarce so that a
price is charged when private goods are used and consumed. A private good or
service has two defining characteristics:

Excludability:

A private good is an economic good which is excludable, that is it is possible to

prevent people who have not paid for the good to benefit from it. This is
normally done through charging a price and it implies that non-payers would be
excluded from the consumption of a private good. Once a private good has been
purchased by one person, it cannot then be consumed or purchased by others.

Excludability gives the seller the chance to make a profit. When goods are
excludable, the owners can exercise property rights.

Rivalry:

A private good is a good where the consumption of the good by a consumer

diminishes what is available to others and there is competition among users to
benefit from the good. If one order and enjoy a pizza from Pizza Hut, that pizza
is no longer available to someone else. With a private good, one person’s

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consumption of a product reduces the amount left for others to consume and
benefit from because scarce resources are used up in supplying the good or service.

Due to its features of excludability and rivalry, effective demand for private goods
is registered in the market where people who are willing to pay will obtain the
goods. Thus, there is an economic incentive for private producers to supply
the good through the market and make a profit. The fact that private goods are
excludable implies that a price can be charged so that entrepreneurs will produce
the good in pursuit of profit.

Free goods

Free goods are goods that are not scarce and have zero opportunity cost. Free
goods have no prices and no factors of production are required to produce them.An
example is rainfall.

Merit goods

A merit good is a good which is socially desirable or has got positive externalities
associated with its consumption or for which social benefits exceed private
benefits. In other words, the consumption of such a product benefits not only the
recipient but also society. Examples of merit goods include education, health,
inoculation amongst others.

Generally, consumers do not fully realize the benefit of such products at the time
of consumption due to information failure/ lack of information: either they do
not have the right information or they simply lack some relevant information
about benefits associated with consumption of such goods both for themselves
and for society. Thus this type of good is underconsumed due to information
failure.

For example,the individuals who make decision much education about how to
receive do not fully appreciate how much benefits will be received by being well
educated.

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Merit goods are therefore the outcome of imperfect information held by

consumers.In principle,the ever increasing information available to consumers
[through campaigns, use of internet,labelling amongst others]should enable them to
take rational decisions that maximise consumer welfare.When this happens, the
market works efficiently, if not, there will be an inefficient allocation of resources.

Specific examples of information failure are:

.where consumers are not aware of the benefits or the harmful effects of
consuming a particular product.
.where product packaging makes claims that are misleading or inaccurate
.where persuasive advertising makes claims that are misleading or inaccurate

As well as information failure, a further reason for the underconsumption of merit

goods is low income. Consumers may recognize the benefits of merit goods but
lack the disposable income to be able to afford to buy the goods in the quantity
they would like or not at all.

This explains why merit goods are provided by the government for those who are
thought to need them.

Furthermore, merit goods are also underprovided by the market because the
market does not take into account the externalities associated with as its objective
is to maximize profits..
This can be shown in the following diagram:

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Q – under provision by the market by firm(implies that too few resources are being
devoted towards production of this type of good)
Q1 – level of output desired by society/ socially optimal level of output/
allocatively efficient level of output.

To encourage greater consumption of merit good, the government may:

i. Provide subsidies to firms
ii. Direct provision of such type of good.
iii. Provide some information about its benefit
iv. Make consumption of such type of goods compulsory.

Demerit goods

Demerit goods is a good which is socially undesirable or have negative

externalities associated with its consumption. In fact,at the time of consumption,
the user does not fully realize its costs due to lack of information/ information
failure/ .Such products can be overvalued by people as they may fail to realize the
harmful effects associated with. For e.g. cigarettes and alcohol, junk food.

Consumers may be ignorant of the harmful effects of demerit goods on themselves

and on others. They might be indifferent, choosing not to care. A good example in
high income countries is the rise of obesity due to overconsumption of fast food
and high sugar drinks, particularly in low income households.

Thus, demerit goods are overconsumed due to information failure.

Furthermore, if left to the market, demerit good will be overprovided because the
market does not take into account the negative externalities associated with
consumption of such products as its objective is to maximize profit rather than to
maximize welfare of the society.

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over provision by the market( too much resources are being devoted towards
production of this type of good)
Q- firm
Q* - level of output desired by society/ socially optimal level of output.

To discourage consumption of a demerit good, the government may:

i. Impose a tax(indirect) on the product
ii. Provide information about the harmful effects associated with the
consumotion of such type of goods.
iii. Set regulations.

Thus, with demerit goods, there is likely to be overproduction and

overconsumption largely because these are goods that are habit-forming, are
relatively cheap and readily available.

Exercise:J016 P2Q2

(a) Use examples to illustrate the difference between private goods and public
goods, and explain why only private goods will be supplied in a free market
economy. [8]
(b) ‘The factor enterprise and the free working of the price mechanism always
ensure a satisfactory outcome for consumers even when imperfect information
exists.’
Discuss this view. [12]

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Intro: Externalities

Externalities refer to third party effects of an economic activity on society. Thus

mean that the economic activity is not only affecting the producer and the
consumer but also a third party. Put alternatively, an externality is said to arise of a
3rd party (someone not directly involve in the activity is not affected by the
decisions and actions b y others). It can also be defined as the spill-over of activity
effects of an economic effect on the society. Consumption and production decision
are not likely to take into account all the effect on society. Externalities can affect

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the welfare of people whether it is positive and negative. In fact not all costs and
benefits are reflected in market prices. As a result, the level of consumption and
production may not maximize economic welfare.

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