BACC 131

MODULE 5
PROBLEMS AND ISSUES OF GOVERNANCE,
MARKET FAILURES AND GOVERNMENT FAILURES:
ECONOMIC ANALYSIS OF GOVERNANCE
BY
LORENCE M. RESURRECCION
Market Failures
When good governance is not practiced by the private sector and the
public sector separately or collectively, there are economic problems
that created which are generally known as Market Failures.
Market Failures is the economic situation defined by an inefficient
distribution of goods and services in the free market. Furthermore, the
individual incentives for rational behavior do not lead to rational
outcomes for the group. Put another way, each individual makes the
correct decision for him/herself, but those prove to be the wrong
decisions for the group. In traditional microeconomics, this is shown as
a steady state disequilibrium in which the quantity supplied does not
equal the quantity demanded.
Market Failures
Market fails to produce the right
amount of the product
Resources may be
• Over-allocated
• Under-allocated
Types of Market Failure
Imperfect competition - when prices of goods are not based on demand and supply or
that markets are not purely competitive thus there are certain market players that
control the market
Imperfect information- when some market players have more knowledge about the
market, prices and costs than others
Resource immobilities - when resources are not sold and bought based on demand
and supply or when some market players have control over resources, hence affecting
the resource distribution, prices and use are controlled by some market players.
Externalities - the positive and negative effects of production and consumption of
goods and services are transferred to third parties ( not the producer or the consumer.
Externalities occur when one person’s actions affect another person’s well-being and
the relevant costs and benefits are not reflected in market prices. 
Government failures – when government interventions to solve market failures lead to
more economic issues or problems or new market failures.
Imperfect Competition: Supply –side
failures and Demand-side failures
Supply-side failures
• External costs of producing the good are not
reflected in the supply
• Occurs when a firm does not pay the full cost of
producing its output
Demand-side failures
• Impossible to charge consumers what they are
willing to pay for the product
• Some can enjoy benefits without paying
Efficient Market
Demand curve must reflect the consumers full willingness to pay
Supply curve must reflect all the costs of production
Competition among firms to produce the private goods that consumers
demand forces them to use the best technology and the right
combination of productive resources.
This results in productive efficiency: the production of a good in the
least cost way.
◦ Firms that are not productively efficient face competition from lower cost
firms.
Efficient Market
Competitive markets also produce allocative efficiency: the production
of the “right” mix of products (minimum-cost production assumed).
◦ Firms will produce goods and services that are highly valued by society
ensuring that resources are allocate efficiently, where consumer surplus and
producer surplus are maximized.
When market is imperfect, it takes the form of monopoly, oligopoly,
monopolistic competition, monopsony or oligopsony or any other form that
does not allow the presence of a free market where no producer nor
consumer is in control of the market.
Consumer Surplus
Difference between what a consumer is
willing to pay for a good and what the
consumer actually pays
Extra benefit from paying less than the
maximum price

LO2 5-8
Consumer Surplus
Difference between what a consumer is
willing to pay for a good and what the
consumer actually pays such that after
purchasing the good, he is able to bring
home money unspent ( cash on the table)
Extra benefit from paying less than the
maximum price

LO2 5-9
Consumer Surplus

Consumer
Surplus
Equilibrium
Price (per bag)

Price
P1

Q1
Quantity (bags)

LO2 5-
Producer Surplus

Difference between the actual price a

producer receives and the minimum price
they would accept which means that he is
able to have revenue that is more than
what he expected.
Extra benefit from receiving a higher price

LO2 5-
Producer Surplus

Producer S
surplus
Price (per bag)

P1
Equilibrium
price

Q1
Quantity (bags)

LO2 5-
Efficiency Revisited

Consumer
surplus
S
Price (per bag)

P1

Producer D
surplus

Q1
Quantity (bags)

LO2 5-
Efficiency Losses

a Efficiency loss S
from underproduction

d
Price (per bag)

D
c
Q2 Q1
Quantity (bags)

LO2 5-
Efficiency Losses

a S
Efficiency loss
from overproduction

f
Price (per bag)

b
g

D
c
Q1 Q3
Quantity (bags)

LO2 5-
Efficiency Losses
When there is underproduction, the producers produce less than what
is demanded at the market price thus the consumer pays at a higher
price. Both loss a part of their surplus.
When there is overproduction, the producers produce more than what
is demanded thus the price which the consumers pay will be lower than
the price that producers are willing to accept.
 Imperfect Information
Consumers and producers engage in the buying and selling of merit and de-
merit goods.
Merit good is a good that has positive externality
De-merit good is a good that has negative externality

In terms of imperfect information:

Merit good – a good that is better for a person than the person who may
consume the good realizes
De-merit good – a good that is bad for the individual consumer than he
realizes
Imperfect information
Asymmetric information – one party to a contract has different
information than the other party. Two parties (the consumers and the
producers) do not have the same information. It is possible that some
consumers know more than other consumers and that some producers
know more than other producers. It has two types:
◦ Adverse selection
◦ Moral hazard
Adverse selection
Occurs when the parties who are willing to accept a contract are of
“lower quality” (from the perspective of the other party) than a random
member of the population
“Lemon’s problem”
Examples: used cars, insurance issues, financial markets
Moral hazard
Occurs when one party to a contract has an incentive to alter his or her
behavior to the detriment of the other party once a contract exists
This can be seen among insurance agents who promise to service an
insured person all throughout the life of the insurance, but later on, the
agent upon receipt of his cut from the insurance sold transfers to
another insurance company.
Solutions to asymmetric
information problems
Mandated information requirements
Mandated warranties
Copayments and deductibles
Incentive-compatible contracts designed to reduce the moral hazard
problem
Resource Immobilities
When some firms are better than others, profit more than others, they
have the advantage of access and ability to purchase more resources
than others, better resources than others.
Owners of resources in the form of capital, land, labor and
entrepreneurial ability want to sell their resources to the highest bidder
leaving small companies with less quantity and quality of resources.
Resource immobilility due to
licensing policy
An optimal policy is one in which the marginal cost of undertaking the
policy equals the marginal benefit of that policy.
Some economists argue that licensing is as much a problem of
restricting supply as it is to help the consumer.
Whom do these restrictions benefit: the general public or the doctors
who practice mainstream medicine or the nurse or the lawyer or the
engineer or the architect or the accountant or any professional who is
only allowed to practice profession when he/she passes the board or
the bar?
What have the long-term effects of licensure been?
Resource immobilility due to
licensing policy
Some economist say that this policy by states or by governments
reduces the supply of human resource in these professions, making the
low supply of professionals charge higher fees or compensated much
higher than necessary leaving the customer/consumer of their service
pay high prices more than what is charged in a free market.
An Informational Alternative
to Licensure
For the medical professions, as an alternative, the government could
provide the public with information about which treatments work and
which do not.
◦ This would give rise to consumer sovereignty – the right of the individual to
make choices about what is consumed and produced.
An Informational Alternative
to Licensure
In such scenario, the government would provide such information as:

– Grades in college.
– Grades in medical school.
– Success rate for various procedures.
– References.
– Medical philosophy.
– Charges and fees.
An Informational Alternative
to Licensure
Here are some words of caution about the informational alternative.

– To get a true picture of whether the present

system is best would require experts on real-
life practices and institutions.
– The problem is that the experts may have a
vested interest in keeping things just the way
they are.
 Externalities
An externality occurs when some of the costs or the benefits of a good are passed
on to or “spill over to” someone other than the immediate buyer or seller.
Externalities can be positive or negative and can affect production or consumption.
Externalities
• A cost or benefit accruing to a third party
external to the transaction
• Positive externalities
• Too little is produced
• Demand-side market failures
• Negative externalities
• Too much is produced
• Supply side market failures
 Negative Externalities
Negative externalities, or spillover costs, are production or consumption costs that
affect a third party without compensation.
When negative externalities occur, the producers’ supply curve lies to the right of
the full-cost supply curve.
◦ The equilibrium output is greater than the optimal output; resources are overallocated to
the production of this commodity.
 Positive Externalities
Positive externalities are spillover production or consumption benefits conferred on
third parties without compensation from them.
When positive externalities occur, the market demand curve lies to the left of the
full-benefits demand curve.
◦ The equilibrium output is less than the optimal output; the market fails to produce
enough of the good.
Externalities
Externalities
From graph A, if negative externalities are accounted for St will be the
supply curve, which entail lower output at higher price but externalities
like pollution are prevented which is in itself discounting the future in
order to attain environmental sustainability as in the case of hotels that
provide their own sewage and sewerage system, drainage system or
waste disposal system.
Cost –benefit analysis
Identify all relevant costs and benefits arising out an economic activity
(private and external)
Putting a monetary value on the various costs and benefits
Forecasting future costs and benefits
Decision-making –interpretation of the CBA

-considering financial and economic analysis-market prices and

shadow prices
The Effect of a Negative
Externality
Cost Marginal social cost
Marginal private cost
Marginal cost from
P1 externality
P0
Marginal social
benefit
0 Q1 Q0 Quantity
The effect of a Positive
Externality
S = Marginal private and social cost
Cost
P1
D1 = Marginal social benefit
Marginal benefit of an externality
P0

D0 = Marginal private benefit

0 Q0 Q1 Quantity
Government intervention : Public
goods
In an economy there are private and public goods.
Private goods are those that people individually buy and consume and
that private firms can profitably provide because they keep people who
do not pay from receiving the benefits.
Two characteristics of private goods are:
◦ Rivalry (in consumption)
◦ Excludability
Government intervention : Public
goods
Public goods are those that everyone can simultaneously consume and
from which no one can be excluded, even if they do not pay.
Two characteristics of public goods are:
◦ Nonrivalry (in consumption) the characteristic of indivisible benefits of
consumption such that one person’s consumption does not preclude that of
another
◦ Nonexcludability – the characteristic that makes it impossible to prevent
others from sharing in the benefits of consumption
Government intervention : Public
goods
Nonrivalry and nonexcludability create a free-rider problem; once a
producer has provided a public good, everyone including nonpayers can
obtain the benefit. There is no sense of stewardship for the users.
◦ This makes it impossible for firms to gather resources and profitably provide
the good.
◦ In order to have the good, society must direct the government to provide it.
Surveys and public votes may be used to determine the demand for a public
good.
Government Failures and
Market Failures
Government failure occurs when the government intervention in the
market to improve the market failure actually makes the situation
worse.
Sometimes, it can happen that government engages the private sector
to provide the public good - privately provided public good or the
government itself provides a private good – publicly provided public
good. Either way, there is a government failure as there can be
overpricing in the first while there can be dependence and slow growth
of private sector in the second ( infantile or senile argument).
Government failure
Types of government failures:
Public choice theory- explains how public decisions are made. It involves the
interaction of the voting public, the politicians, the bureaucracy and political
action committees. Sometimes, economic decisions are politicized.

Logrolling -the practice of exchanging favors, especially in politics by reciprocal

voting for each other's proposed legislation.

Rent seeking-a concept in economics that states that an individual or an entity

seeks to increase their own wealth without creating any benefits or wealth to the
society. Rent-seeking activities aim to obtain financial gains and benefits through
the manipulation of the distribution of economic resources at the expense of the
society or the state.
Reasons for Government
Failures
Governments do not have an incentive to correct the problem.
Governments do not have the information to deal with the problem.
Intervention in the markets is almost always more complicated than it
initially looks.
Government intervention does not allow fine-tuning, and so, when the
problems change, the government solution often responds far more
slowly.
Government intervention leads to more government intervention.
 Analyzing Environmental Quality
A Public Good or A Negative Externality

A public good is a commodity that is nonrival in consumption and yields

nonexcludable benefits. The relevant market definition is the
public good – environmental quality, which possesses
these characteristics. Example of which is the air we
breathe or the public lands and national parks.

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 Environmental Quality as a Public
Good
Public goods generate a market failure because the nonrivalness and
nonexcludability characteristics prevent market incentives from achieving
allocative efficiency.

Consumers are unwilling to reveal their Willingness –to- Pay

(WTP) because they can share in consuming the public good
even when purchased by someone else. This problem is called
nonrevelation of preferences, which arises due to free-ridership.

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 Environmental Quality as a Public
Good
In addition, lack of awareness of environmental problems
(i.e., imperfect information) exacerbates the problem
Consequently, allocative efficiency cannot be achieved
without third-party intervention.

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 Solution to Public Goods Dilemma
Government Intervention
Government might respond through direct provision of
public goods
Government might use political procedures and voting
rules to identifying society’s preferences about public
goods.
What if the government intervention does not work? Like
government beautifies and cleans the parks and people
vandalize them? What if environmental quality
monitoring equipment are destroyed by the public?

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 Environmental Problems as a Negative
Externality

If the environment is overused, abused and misused, which

are caused by human economic activity, then the
environment creates negative externality.
The effects of climate change, the pollution of air, water
and land, the denudation of forests, the low supply of
water, decrease in the fertility of soil ,extinction of flora,
fauna and wildlife, among others are the negative
externalities experienced by humanity?
What are the government initiatives to mitigate the said
externalities?

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 Environmental Problems as a Negative
Externality
Environmental economists are interested in externalities
that damage the atmosphere, water supply, natural
resources, and overall quality of life
To model these environmental externalities, the relevant
market must be defined as the good whose production or
consumption generates environmental damage outside the
market transaction.

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 Relationship Between Public Goods
and Externalities
Although public goods and externalities are not the same
concept, they are closely related
◦ If the externality affects a broad segment of society and if its
effects are nonrival and nonexcludable, the externality is itself
a public good
◦ If the externality affects a narrower group of individuals or
firms, those effects are more properly modeled as an
externality

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Solution to Externalities
Government Intervention
Internalize externality by:
◦ Assigning property rights, OR
◦ Set policy prescription, such as:
◦ Set standards on pollution allowed
◦ Tax polluter equal to MEC at QE
◦ Establish a market and price for pollution

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