MARKET FAILURE

Introduction
and
reasons for market failure

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 Public Goods Xtics
Learning objectives:
1. Why the market fails? What is market failure (definition)?
2. Six reasons or circumstances under which the market fails (highly examinable as
major).
3. Characteristics of public vs private goods.
4. Why would these characteristics lead to market failure?
5. Critically examine why the market fails when public goods.
6. Solutions to market failure in case of public goods.
7. Optimal provision of public goods (Samuelson’s conditions) and its numerical
modelling applications (highly examinable as major).

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 Market failure: Summary hints
• 1. Under certain conditions, the competitive market results in a Pareto
efficient resource allocation. When the conditions required for this are
not satisfied, a rationale for government intervention in the market is
provided. In certain respects, markets misallocate [i.e. overproduce or
underproduce] or lead to people having little income to live on.
• 2. Government is required to establish/define and enforce property
rights and enforce contracts. Without this, markets by themselves
cannot function. E.g. over-grazing of land bc no one has property rights
(PRs) over it; PRs not well defined in common housing so price not
accurate/reflective. Loan default contracts, incentive to run away with
others’ investment, etc.
• 3. There are six reasons why the market mechanism may not result in a
Pareto efficient resource allocation (Pareto inefficient): failure of
competition, public goods, externalities, incomplete markets,
information failures, and unemployment. These are known as market
failures.
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 Market failure: Introduction
• 4. Even if the market is Pareto efficient, there may be two further grounds for government
action.
• First, the competitive market may give rise to a socially undesirable distribution of income.
• Second, some believe that individuals, even when well informed, do not make good judgments
concerning the goods they consume, thus providing a rationale for regulations restricting the
consumption of some goods, and for the public provision of other goods.
• 5. Though the presence of market failures implies that there may be scope for government
activity, it does not imply that a particular government program aimed at correcting the market
failure is necessarily desirable. To evaluate government programs, one must consider not only
their objectives but also how they are implemented.
• 6 The normative approach to the role of government asks, how can government address market
failures and other perceived inadequacies in the market’s resource allocation? The positive
approach asks, what is it that the government does, what are its effects, and how does the
nature of the political process (including the incentives it provides bureaucrats and politicians)
help explain what the government does and how it does it?

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 Market failure
• Introduction:
• Adam Smith posits that in competitive markets, an individual
pursuing private gains would promote the common (public)
good. This is the root of market efficiency.
• We have so far studied the circumstances under which
competitive price/market mechanism would lead to an efficient
or Pareto optimal allocation of resources.
• The conditions required (including the specification of
technology and/or revelation of preferences, perfect competitive
market assumptions) are more stringent than those likely to exist
in the real world.
• We’re going to demonstrate even in a single market, there are
circumstances under which the market would produce nothing
(e.g. in the case of public goods), produce inefficient results
(under-produce or over-produce what is socially optimal as in
the case of externalities).
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 Market failure
• In circumstances when the market is unable to produce efficient
results, it is termed market failure. Market failure is most likely
to be associated with resources which have non-existent
markets (eg. public goods) or inefficient/incomplete markets
(eg. externalities). You should be able to distinguish non-existent
markets from incomplete markets! and how market failure
unfolds in them.
• Market failure is the inability of the competitive market
mechanism to efficiently produce socially optimal quantities of
goods and services or efficiently allocate resources.
• Put differently, Market failure is the inability of the competitive
market mechanism to efficiently allocate resources. Efficient
allocation of resources implies that goods and services are
produced at socially optimal levels.
• In principle, whenever markets fail government intervention can
enhance welfare depending on some SWF.
• Market failure issues are of prime interest for two reasons: The
market prices do not necessarily reflect social marginal benefits
(sMB) or costs (sMC); and market profitability does not
necessarily reflect net social benefits.
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 Rationale for Market failure
• Broadly, Market failure occurs because:
➢Competition is imperfect (Imperfect Competition). For
example, someone may have monopoly power, oligopolistic
cartels, etc.
➢Producers or consumers may impose a cost on or confer a
benefit to other producers or consumers without paying for
the cost or charging for the benefit, that is, there are
production or consumption externalities.
➢The process produces a public good for which it is
impossible or undesirable to levy a charge.
➢Markets are incomplete (Incomplete markets). They do not
extend infinitely far into the future, and they do not cover
all risks.
➢Information is incomplete and imperfect (Information
asymmetry).
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 Explanation of Market failure Situations
• Failure of competition (Imperfect Competition)
• For markets to result in Pareto efficiency, there must be perfect competition; perfect
competition conditions must also work absolutely. But in reality, there abound
monopolies (1 firm + several buyers), oligopoly (few large firms +several buyers),
monopolistic competition (several firms producing slightly differentiated product
and different prices), natural monopoly (where it cheaper for a single firm to
produce entire output instead of several smaller firms producing part of it,
imperfect information (where a firm raises prices but does not lose all of its
customers, firms in strategic behaviour/cartels with threats to cut down prices to
discourage entry (e.g. OPEC), Govt patents to firms to innovate, etc. These are
imperfect competition and firms have influence on prices.
• First-best theorem requires perfect competition (no influence on prices but only the
market) to produce Pareto efficiency. Not some competition.
• Therefore, market may fail under such circumstance because for a competitive
market MR=MC=P but in a monopoly or imperfect competition (oligopoly) for
instance, MR=MC<P or P>MC=MR which leads to under-allocation of resources.
• This makes competition imperfect, and the market will fail.
• Consumer surplus reduces in this market failure because of influence on prices. 8
 Explanation of Market failure Situations
• Incomplete markets
• Whenever private market fails to provide a good or service even though the cost of
providing is less than what individuals are willing to pay, this is referred to as
incomplete market (because complete market would provide all goods and
services for which the cost of provision (e.g. GHS40) is less than what individuals
are willing to pay (e.g. GHS 50)). Why this phenomenon?
• Because the market believes that there are certain risks which have been hidden or
under-estimated but will pop up in the future which will cause them to make
losses in the long run. Hence though the cost is lower today than what those
individuals are paying, in future, the costs will be higher than what they pay today
to cover that future costs.
• Examples are loan provision (under-estimated risk of default by loan applicants)
and health insurance (under-estimated risk of high illness or over-consumption of
health care far and above the amount paid).
• When private market produces this, it takes on huge risks and hence charge higher
rates: e.g. microfinance, private health insurance.
• So health insurance is often provided by govts or if markets, then at a very high
premium. 9
 Market failure
• Information asymmetry
• When markets are generally incomplete, they are also likely to be associated with
information asymmetry- (a situation whereby there is imperfect information i.e.
information available to one set of market participants is not the same as
information available to the other set of market players).
• This gives rise to moral hazard and adverse selection problems which increase
risks in the market.
• Moral hazard is a situation when information about actions is hidden from one
party to a transaction and only becomes apparent after a deal or agreement.
Health insurance, used car sale, loan contracts, etc.
• Adverse selection occurs when knowledge about the characteristics is hidden to
from one party to a transaction and therefore makes the market tilts towards
high-risk clients rather low risk. The two problems generally leads to
misallocation of resources in the market.
• Example: high illness parties can buy low illness insurance and consume more
than what they paid as premium.
• Info asymmetry can lead to market failure in insurance policy. E.g.:
• Provider contemplating charging high premium to a firm, the firm will not insure;
charging lower premium means firm will buy but the policy provider will lose; and
this dilemma make market fail.
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 Market failure
• Increasing returns to scale, risk and uncertainty
• There are markets that require huge capital outlay to start and
thereby enjoy significant increasing returns to scale which have
the tendency to push small firms out of entering or producing in
such markets due to risk, uncertainty and the long time it takes
to break-even.
• Meanwhile market efficiency implicitly requires that firms’
technologies should exhibit constant or decreasing returns to
scale.
• A market with increasing returns to scale will have large firms
producing at a lower cost hence charge a lower price which
might not resonate with small firms’ production cost structures.
• The market may end up being a monopoly. Eg: Airlines, railways,
and utilities generally.
• Govt intervention to break the monopoly or to make such govt
production with social welfare in mind.
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 Government intervention in Pareto efficient economy
• Even if the economy is Pareto efficient, two further arguments for
govt intervention:
• 1. Income distribution: Efficient market makes allocations based on
factor endowments and this brings a lot of income inequality issues.
Utilitarian SWF! Govt intervention to redistribute in what is fair and
line with development goals. Taxes and subsidies to achieve this.
• 2. Individuals may not act in their own best interests. Even fully
informed consumers may make bad decisions (bounded rationality
too). E.g. Smoking even though bad; use of seat belts;
• Government intervention: compel individuals to consume merit
goods like seat belts, basic educ. Goods that the govt compels
individuals to consume are merit goods.
• View that govt should intervene because it knows what is in the best
interest of individuals is paternalism.
• View that government should not interfere in the choices of
individuals is libertarianism.
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Formative assessment question (FAQ):

• Explain four distinct reasons for market failure in

developing economies and justify government
intervention in those respects.
• Due in 2 weeks time (strictly)

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 Market Failure

•PUBLIC GOODS

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 Public Goods Xtics
Public goods:
• Goods that will either not be supplied by the market or supplied in insufficient quantity. Eg.:
• All goods provided by the private sector or the private market share one important feature: the
provider of the good can charge those who wish to consume it thru exclusion and make a profit in
the process. Not every good shares these xtics however.
• A broad category of goods exists (public goods) for which charging is impossible or undesirable.
The private sector usually shies away from producing public goods. If it does produce them, it
produces too little of them based on only payment.
• Some goods exhibit a property that they simultaneously provide benefits to more than one
individual at the same time (they are jointly consumed eg. defense, law enforcement, radio and
television, streetlights, flood control, clean air). Once they can be jointly consumed, they are said
to be non-rivalry in consumption. Thus, one individual’s consumption of the good does not
reduce the benefits simultaneously accruing to other individuals. Thus, the MC for an additional
individual enjoying the good is zero. It cost nothing for extra consumers
• It doesn’t make economic sense for exclusion, if the good is non-rivaled because MC of added
consumer is zero. Hence, charging for non-rival goods is inefficient since P=MC=0.
• Besides, the use of public goods may be non-excludable. Thus, it may be difficult, impossible or at
least very costly to exclude particular individuals from the consumption or use of the existing
output of a public good.
• If a particular good has both xtics, it is referred to as a pure public good and if only one xtic is
present is referred to as impure public goods (eg commons and club goods are impure public
goods). Impure public goods can have congestion (partial rivalry) and for that matter the
opportunity cost of allowing more use of the public good, or the reduction in the benefits to those
already consuming it is called a congestion cost. 15
Private vs. Public Goods Matrix
Exclusion Non-Excludability
Rivalriness Private goods: Impure public good:
(E.g.: cars, etc) Commons (eg. Fishing
ground, UPSA car park)
Non-Rivalriness Impure public good: Pure public goods:
Club goods (eg. street lights, police,
Concert party, music defence, free
concert etc) community radio
service, etc

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 Market failure and Public goods
• The two characteristics (non-rivalriness and non-excludability) make it difficult for the competitive
market mechanism to produce optimal levels of such goods. How & Why?
• Excludability in a private goods: By excluding those individuals who are not willing to pay the going
price from the consumption of a good, the existing quantity can be rationed to those who value it
most (or want to pay) so that (Pareto) efficiency in consumption can be achieved.
• Non-excludability in public goods: With non-exclusion, sellers cannot exact a price from users since
users can consume it free of charge in any case. Voluntary pricing system cannot also be enforced
on rational consumers unless it is coercive (as with taxes). The failure of voluntary pricing system to
be enforced due to non-excludability is known as the Free-rider problem. The reluctance of
individuals to contribute voluntarily to provision of public goods.
• Again, although all individuals consume the same quantity of a public good, they derive different
MB implying different price will have to be exacted from each individual, and market efficiency
requires one P=MC=MR, therefore the market will be inefficient.

• Rivalry in a private good: With private good, because it is rivalry, the MC of allowing one more
individual to consume the same good is at least non-zero so consumers will enforce it. Thus, any
additional consumption of a private good by one more person comes entirely at the expense of a
forgone consumption by someone else.
• Non-rivalry in public goods: Because such goods can be jointly consumed, the MC of allowing one
extra individual to consume is zero. The MC of supplying to an additional user is zero. This means
zero price should be charged for additional consumption hence it will be inefficient to exclude
individuals. P=MC=0, will a private individual produce that?
• We will have a numerical example to demonstrate how these matter for public policy.
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 Market failure and Public goods
• A public good is therefore a commodity or service that exhibits the
characteristics of non-excludability and non-rivalry in consumption.
A pure public good exhibits both xtics (eg clean air, etc) and an impure
public good exhibits one of the xtics with varying degrees of the other
xtic.
• In the case of non-rival goods, exclusion is undesirable because it
results in under-consumption (an inefficiency) but including more
people will also cause under-supply.
• Will govt intervention resolve the public good situation? Yes, to some
extent because once voluntary pricing is impossible and individuals’
awareness of the fact that the govt can coerce them to pay through
taxation, they will not reveal their true preference or potential benefit
for such goods and the govt might fail to achieve efficiency, but equity
might be served.
• Public goods can also be classified according to geographical reach:
Local public goods, regional public goods, and national public goods.
• Do you consider an expressway or motorway as a public good? Why?
What kind? Will private individuals provide a motorway? Under what
circumstances will they provide it? Will public-private partnerships
enhance efficiency in the provision of public goods? How? Provoke
your thought! 18
 Market Efficiency and Public goods
• Efficiency in the provision of a public good requires that
• MRSAG,X + MRSBG,X + … + MRSZG,X = MRTG,X=MCG (This was formulated by Paul Samuelson) whereas
• Consumption Efficiency in the provision of a private good requires that MRSAX,Y = MRSBX,Y = … =P= MRTX,Y.
• Simply put, the efficiency in the provision of a public good requires that the summation of marginal
benefits (valuations) or payments equal the MC. The summation represents the total amount that all
individuals together are willing to pay for an extra unit of public good. This represents the collective
demand curve. The price represents how much of the other goods have to be forgone to produce one
more unit of public goods ( this is the MC or the Marginal Rate of Transformation (MRT). When DD=SS,
then the ∑P=∑MRS=MRT=MC produces Pareto efficient output of a public good (Samuelsonian
condition).
• Deduction: If people have not revealed their true valuations/ benefits from using a public good, there
would be problems in ensuring efficiency in provision.
• NB: Provision here denote the choice and payment process rather than products or service being
produced by the govt (eg public corporation or civil servants) or private firms. Thus, a public good can be
provided by govt but produced by a private firm, Eg. a bridge.
• What then determines whether a private firm or a public corporation should produce a public good for
govt: Relative wage and material cost, administrative cost, diversity of taste, distributional issues, etc.
• Check diagrams and illustration on private good vs public good. Check the calculations.

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Private good and demand

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Public goods and market demand

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 Solutions to Public goods Market Failure
• Summary of public good problem:
• Market failure as regards public goods is mainly due to free rider problem (Not paying for
the good but enjoying it or reluctance to voluntarily pay for the good). Free ridership
because of non-excludability.
• Free riding implies that people are not ready to reveal their true preference/valuation
for a public good otherwise they will be asked to pay amounts commensurate to it.
• Free ridership results from the non-rivalriness xtic which leads to MC=0=Price. So no
private production, hence govt intervention.
• Existence of free ridership in public goods will make market fail: unable to provide them
or unable to provide efficient levels if some willingness to pay is exacted.
• Govt intervention by providing necessary for as a solution. Why? Compulsion to pay
indirectly.
• Can perfect price discrimination (PPD) solve free rider problem? Possible market solution!
• NB: PPD is charging the highest amount of money the consumer who is prepared to pay.
• No. True revelation of preference difficult.
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 Solutions to Public goods Market Failure
• Non-excludability and non-rivalry property would lead to no price exacted from users
causing free rider problem and the solution to free rider problem involves:
• Government action (compulsion eg. taxes):
• Transform the public good into private good through metering, road tolls, etc.
• Government provision of public goods for equity reasons eg. to bridge the gap
between the rich and the poor.
• Government action is justified because government can compel indirect payment
through taxation, user charges, etc. Private market cannot compel!
• Private solution: Private markets can use technology (e.g. DSTV) and bundling of
public goods with others (e.g. public seats at super malls).
• Some review questions:
1. Can clean beaches, education, good roads, income distribution, information, GBC
Broadcast be considered as public goods?
2. To what extent has technological advances reduced the problem of non-excludability
for the market, eg DSTV, etc?.
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3. Under what circumstances will private firms provide an efficient level of a public
 Public goods conundrum insights
• Read this interview (Q & A) with a hypothetical private market on public good conundrum:
• Q: If you are a private entrepreneur, what will make you produce or provide public goods?
• A: When people are will to pay for it or government is willing to pay for it on behalf of the people.
• Q: How many units of a public goods will you provide if possible?
• A: The number of units that people’s total payments can cover (I will sum what they are willing to pay and equate that to MC).
• Q: Are you aware people can free ride the number of unit produced above?
• A: Yes, but once I have recovered my cost through such payments, I don’t care.
• Q: Can government adopt your strategy (“Samuelsonian condition”) to provide the public goods?
• A: No, because the government can compel people to indirectly pay for the public goods through taxes, user charges, or bundling
such payments with payment for other vital services like utilities. So government should provide the socially optimum for equity
reasons.
• Q: Will government always succeed in doing the above?
• A: No, because people might not reveal that they need the public good if they know government will indirectly compel them to
pay for it (problem of benefit revelation or revelation of willingness to pay). What makes the market fail can also make
government fail!.
• Q: Can the government always provide public goods because you the private entrepreneur has failed?
• A: No, because of government failure reasons such as rent-seeking, agency problems, bureaucracies, corruption, etc.
• Q: How can we then avoid the above government failure situations to address the market failures?
• A: Mechanisms should be put in place to ensure accountability and value for money in government expenditures targeted24at
resolving market failures due to public goods.
 Analytical numerical practice question
1. The residents of Pink-Sheet Community need 80 units of LED streetlights to enhance the general security of the
town. The marginal cost of producing the streetlights is $1700.
(a) Explain why a private entrepreneur will be unable to provide the 80 streetlights for the community.
(b) If three security-loving individuals and two couples are willing to pay some amounts for the provision of the
streetlights as P1=500-Q, P2=400-Q and P3=250-Q, and the couples P4=600-2Q and P5=300-2Q respectively,
where P is the amount, they are willing to pay, and Q is number of streetlights.
(i) If a private entrepreneur wants to provide the streetlights now, how many will be provided?
(ii) Why would the private entrepreneur be able to provide only the number in (i) above.
(iii)Briefly explain two limitations to provision of the number of streetlights in (i) by the private entrepreneur.
(iv)Why would it be inefficient to exclude those who did not pay from consuming the number of streetlights provided
in (i) above?
(a) Explain why the people of this community would be justified if they petition the government to provide the 80
streetlights.
(b) Discuss one problem the government could face if it wants to efficiently provide the 80 streetlights.
(c) State any three government failure issues that could affect the provision of the 80 streetlights.
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 Analytical numerical past question: Public Goods
For the general security, a community requires 300 LED streetlights, and this could be provided at a total
cost of 675Q, where Q is the number of streetlights.

(a) State one reason why the market mechanism cannot provide the 300 streetlights for this community.
[2 Marks]

(b) If four security-loving households reveal their preference for the streetlights as Q=500-P1, Q=200-P2,
Q=300-P3 and Q=150-0.5P4, where Pi with i = 1, 2, 3, 4 are prices respectively, find how many units of
the streetlight a private entrepreneur will provide using the Samuelsonian condition of efficient provision
of a public good. [10 Marks]

(c) Briefly explain why it will be inefficient to prevent other households from using the streetlights once
it is provided. [2 Marks]

(d) Briefly explain why free ridership cannot be avoided by the private entrepreneur. [2 Marks]

(e) Briefly explain why the people of this community will be justified if they petition the government to
provide the 300 LED streetlights. [2 Marks]

(f) Briefly explain two government failure problems that could affect the efficient provision of the 300
LED streetlights by the government. [2 Marks] 26
 Public goods modelling question
Afia and Kojo’s preference for a public good (Q) is given as
Q=500-P1 and Q=200-P2 , respectively, and suppose the
total cost of the public good is 500Q dollars.
(a)What is the total revenue (amount) of producing this
public good?
(b)How much (amount) is Kojo and Afia willing to pay
respectively?
(c)Why will it be inefficient to prevent other people from
consuming this public good with Afia and Kojo?
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 Practice questions
1. Briefly explain three roles of government even if the market is efficient.
2. How is market failure similar to market efficiency or otherwise?
3. Why does the market fail when there is imperfect competition?
4. Why does the market fail when there are externalities?
5. Why does the market fail when public goods are needed?
6. Why does the market fail in incomplete markets?
7. Why does the market fail when there is information asymmetry?
8. Why are externalities a source of market failure? Is there any remedial action by the
government? Illustrate with relevant diagrams.
9. Define the term “Market failure” and explain six conditions that bring about market
failure.
10.Explain five factors that warrant intervention in the economy by the government
with examples from Ghana. 28
 Practice questions
11. Briefly explain how excludability makes the market efficient.
12. Briefly explain the efficiency implication of goods non-rivaled in consumption.
13. Differentiate between a pure public good and an impure public good.
14. What is “free rider problem”? How does it relate to the provision of public goods?
15. Briefly explain how non-excludability leads to free ridership of a pure public good.
16. Briefly explain how non-rivalriness in consumption leads to free ridership of a pure public good.
17. Briefly explain the Samuelsonian condition for efficient provision of a public good.
18. Define “Public good” and explain how the efficient output of a public good is determined with
the help of a diagram.
19. Briefly explain how technological advances can change a pure public good into an impure public
good and give one example.
20. Briefly explain why private entrepreneurs are able to provide some public goods like radio
broadcast.
21. Briefly explain two ways by which private market induces payment for public goods.
(Technology (DSTV); bundling with other goods e.g. public seats at malls) 29