Market Failure

Definition of Market Failure

 Failure to achieve allocative efficiency

 Too many/few goods & services are produced and
consumed from the POV of what is socially most
desirable.
 Marginal Benefit (MB) ≠ Marginal Cost (MC)
Externalities

 Externalities occur when actions of producers or

consumers give rise to negative/positive side effects on
3rd parties, whose interests are not considered.
 If side effects are beneficial for the 3rd parties, it is
called positive externality (spill-over benefit.)
 If side effects are harmful or detrimental then it is
called negative externality (spill-over cost.)
Marginal Private & Social Costs &
Benefits
 Private costs & benefits are the costs & benefits to
producers & consumers that produce & consume the
goods & services.
 Social costs & benefits are the costs & benefits to all of
society (non-producers/consumers) from the
consumption/production of goods & services.
 Social costs & benefits = Private costs & benefits +
externalities
Graphs

 Demand curve is marginal private

benefit (MPB) curve.
 Supply curve is marginal private
cost (MPC) curve.
 When there are no externalities:
> D = MPB = MSB
> S = MPC = MSC
Negative Production Externalities

 MSC is higher than MPC because there

are some negative externalities
associated with the production of the
good/service.
 Vertical difference between MSC &
MPC is the social cost.
 Demerit goods have negative
externalities.
 Correcting:
- Government regulations
- Market based policies (indirect taxes
& trade/cap schemes)
Correcting Negative Production
Externalities
Negative Consumption Externalities

 MSB is lower than MPB because there are

some negative externalities associated
with the consumption of the
good/service.
 Vertical difference between MSB & MPB is
the social cost.
 Demerit goods have negative
externalities.
 Correcting:
- Government regulations
- Advertising (awareness)
- Market based policies (indirect taxes)
Correcting Negative Consumption
Externalities
Positive Production Externalities

 MSC is lower than MPC because there

are some positive externalities
associated with the production of the
good/service.
 Vertical difference between MSC &
MPC is the social benefit.
 Correcting:
- Direct government provision
- Market based policies (subsidies)
Correcting Positive Production
Externalities
Positive Consumption Externalities

 MSB is higher than MPB because there

are some positive externalities
associated with the consumption of the
good/service.
 Vertical difference between MSB & MPB
is the social benefit.
 Merit goods have negative
externalities.
 Correcting:
- Legislation/advertising (awareness)
- Direct government provision
- Market based policies (subsidies)
Correcting Positive Consumption
Externalities
Lack of Public Goods

 Private goods are rivalrous & excludable:

- Rivalrous is when consumption by someone reduces
availability for others
- Excludable means it is possible to exclude some people
from consuming a good. Usually achieved through charging a
price for it.
 Public goods are non-rivalrous & non-excludable.
 Free rider problem.
 Correcting failure to provide public goods:
- Direct government provision
Common Access Resources & threats to
Sustainability
 Common Access Resources are resources that are not
owned by anyone and can be used by all for free.
Examples are clean air & forests.
 Failure occurs in that use by one leaves less for others.
 They are rivalrous & non-excludable.
 Sustainability refers to the ability to be maintained &
preserved over time.
Maximum Sustainable Yield of Common
Access Resources
Government Responses to threats to
Sustainability
 Legislation:
- licenses
- quotas
- permits
- restrictions
 Carbon taxes vs Cap & trade schemes
- Carbon taxes are methods to reduce emissions
- Cap & trade schemes are tradeable permits
 Funding clean technologies
 Eliminating environmentally harmful subsidies
Asymmetric information

 Refers to situation where buyers & sellers do not have equal

access to information.
 Seller knows of a defect in a product but doesn’t inform
customers.
 Buyer knows about sickness but doesn’t tell insurance
provider.
 Government responses:
- Regulation
- Provision of information
- Licensure
Abuse of monopoly power

 Monopoly power is the market structure where 1 firm

dominates the market for a product/service & is able to
control prices.
 It is a failure because:
- welfare loss
- allocative inefficiency
- productive inefficiency
 Government responses:
- Legislation
- Regulation
- Nationalisation
- Trade liberalisation