Market Failure

• It is a situation where the market fails to

allocate resources efficiently.
Examples of market failure

Speculation
Asymmetric
and market Moral hazard
information
bubbles

Under-
provision of Externalities
public goods
Externalities
Unit 15
 A type of market failure

Cost or benefit that is spillover to 3rd party

Externalities not reflected in the market price

The decision (allocation of resources) does

not take into account the full social cost and
benefits of production and consumption
 Externalities

In this topic, we will mainly focus on:

NEGATIVE EXTERNALITIES POSITIVE EXTERNALITIES

OF PRODUCTION OF CONSUMPTION
Negative externalities of production
Social
Cost
> Private
Cost
Positive externalities of consumption
Social
Benefits
> Private
Benefits
Marginal Costs and Benefits
Marginal Cost (MC, MPC, MSC)
• The extra cost of producing an additional unit of output

Marginal Benefit (MB, MPB, MSB)

• The extra benefit of consuming an additional unit of output

Welfare loss
• Situations where marginal social benefit is not equal to marginal
social cost and society does not achieve maximum utility
 Demand / MPB

Benefits • The more consumption of hamburgers, the less value obtained

• Therefore, the price you willing to pay for the hamburger decrease
as you consume more of them

D = MPB (marginal private benefit)

Unit of hamburger
0
 Supply / MPC

Costs S = MPC (marginal private cost)

• As businesses produce more hamburgers,

the cost of production increases
• Why?
• Businesses start to pay more factor resources
• Charging higher prices are necessary to cope with
higher costs

Unit of hamburger
0
Market equilibrium
Costs/Benefits
S = MPC Identify:
Market equilibrium

D = MPB

Output
0 Q1 Q2 Q3
Negative Externality in Production
Costs/Benefits
MSC

MPC = S

Why would the MSC position

above the MPC?

Output
0
Negative Externality in Production
Costs/Benefits
MSC
Identify:
Market equilibrium
MPC = S Optimal level of output
B
P2
P1 A

D = MPB = MSB (assume no external benefit)

Output
0 Q2 Q1
 Negative Externality in Production

Costs/Benefits Welfare loss

MSC

Over-production of Q1-Q2
MPC = S
B
P2
P1 A

D = MPB = MSB (assume no external benefit)

Output
0 Q2 Q1
The diagram shows the market for the production
of chemicals. Which one of the following can be
deduced from the diagram?
• A The social optimum quantity is Q1 and price is P1
• B The market equilibrium quantity is Q2 and price is P2
• C The welfare loss area is RTU
• D The welfare loss area is RST
Positive Externality in Consumption
Costs/Benefits

Why would the MSB position

above the MPB?

MSB

MPB
Output
0
Positive Externality in Consumption
Costs/Benefits

MPC =MSC (assume no external cost)

Identify:
Market equilibrium
P2 Optimal level of output
P1
MSB

MPB
Output
0 Q1 Q2
 Positive Externality in Consumption

Costs/Benefits

MPC =MSC (assume no external cost)

Welfare loss
P2
P1
MSB
Under-consumption of Q2-Q1

MPB
0 Q1 Q2 Output
The diagram shows the market for vaccinations
against measles. Which one of the following can
be deduced from the diagram?
• A The social optimum output is Q1
• B The market equilibrium output is Q2
• C Welfare gain is shown by the area BCE
• D Welfare gain is shown by the area ABC