Market Failure

Learning Outcomes

At the end of this chapter, you will be able to

 describe the conditions of market efficiency.

 explain the causes of market failure.
 discuss the remedies for market failure.
 define externality and distinguish between a positive and a negative externality.
 distinguish between private cost, external cost, and social cost.
 distinguish between private benefit, external benefit, and social benefit.
 analyze the impact of externality on the market outcomes.
 discuss the private solutions to address externality and their limitations.
 discuss public policy towards externality.

Introduction

The market is usually the best way to organize the economic activity. The word usually simply
means that the market failure can occur. We shall first examine the conditions for the market
efficiency before exploring the reasons for market failure.

The Conditions for Market Efficiency

 The market has to be a competitive market. A competitive market consists of many buyers
and sellers. Individual market participants cannot influence the price of the good. The price
of the good is set by the market demand and supply.
 Perfect knowledge. All market participants have perfect knowledge of the market.
 No externality. Externality represents a spillover effect of a person’s activity on a bystander
who is not involved in the activity. It creates external cost and external benefits.
 No distorting taxes. Taxes distort in two ways: price no longer equals marginal cost and, if
different consumers face different taxes, the prices will not be the same among consumers.
 No price control (price ceiling and price floor).

1
Market Failure

Market failure occurs when resources are not allocated efficiently. This happens as the price
mechanism fails to account for all of the costs and benefits involved when providing or
consuming a specific good. The market output will either less than or more than the socially
optimal output, causing overproduction or consumption and under production or under
consumption.

In order to fully understand market failure, it is important to understand the reasons for market
failure. The imperfection of the market causes market failure causing market inefficiency and
government intervention is needed to rectify the problem.

The reasons for market failure

 Positive and negative externalities: An externality is an impact of one person activity on a

third party or bystanders. The activity may be from consumption or production of a good or
service. A positive externality is a positive spillover effect (benefits) that results from the
consumption or production of a good or service. For example, although public education
may only directly affect students and schools, an educated population may provide positive
effects on society as a whole. A negative externality is a negative spillover effect (adverse
impact) on the third parties. For example, a second-hand smoker is adversely affected even
though they are not directly engaging in smoking.

 Environmental concerns: Effects on the environment as an important consideration as well

as sustainable development.

 Lack of public goods: Public goods are goods where the total cost of production does not
increase with the number of consumers. As an example of a public good, a lighthouse has a
fixed cost of production that is the same, whether one ship or one hundred ships use its light.
Public goods can be underproduced; there is little incentive, from a private standpoint, to
provide a lighthouse because one can wait for someone else to provide it, and then use its
light without incurring a cost. This problem - someone benefiting from resources or goods
and services without paying for the cost of the benefit - is known as the free rider problem.

2
 Underproduction of merit goods: A merit good is a private good that society believes is
under-consumed, often with positive externalities. For example, education, healthcare, and
sports centers are considered merit goods.

 Over provision of demerit goods: A demerit good is a private good that society believes is
over consumed, often with negative externalities. For example, cigarettes, alcohol, and
prostitution are considered demerit goods.

 Abuse of monopoly power: Imperfect markets restrict the output in an attempt to maximize
profit causing a loss in the economic welfare.

 Asymmetric information: Information failure is another, aspect of market failure and can
occur in two basic situations. Firstly, information failure exists when some, or all, of the
participants in an economic exchange, do not have perfect knowledge. Secondly,
information failure exists when one participant in an economic exchange knows more than
the other, a situation referred to as the problem of asymmetric, or unbalanced, information.

In both cases, there is likely to be a misallocation of scarce resources, with consumers

paying too much or too little, and firms producing too much or too little. Information failure
is common and appears to exist in numerous market exchanges.

It can be argued that markets work best, that is, they are at their most efficient when
knowledge is perfect and is equally shared by all the parties in a transaction. Hence,
asymmetric knowledge is an economic problem because one party can exploit their greater
knowledge.

There are many examples of an information failure associated with economic transactions,
including the following cases:

 In the employment market, the job applicants do not reveal their skill deficiency in a
job interview.
 The estate agent, who exploits the fact that a potential buyer of a property has very
little knowledge about the property, and any possible problems.

3
  The cigarette manufacturers do not reveal to the smokers of the true health risk of
smoking.
 The buyer of a financial product unaware of the true level of risk, as in the case of
derivative products.
 In a second-hand car market, the seller knows the condition of the car, but not the
buyer. The buyer may pay a high price for a low quality and poorly maintained car.

Remedies
The government can intervene in markets in at least three ways: (1) by directly providing goods
and services, (2) by creating incentives to alter economic decisions through the use of taxes and
subsidies, and (3) by using the command and control policy to influence the market activity
through the introduction of legislation and standards.

The government can use two basic strategies to address the market failures.

The price mechanism

The first strategy is to implement policies that change the behavior of consumers and producers
by using the price mechanism. For example, this is done by increasing the price of ‘harmful’
products (demerit goods), through taxation, and providing subsidies for the ‘beneficial’ products
(merit goods). In this way, the behavior is changed through financial incentives, much the same
way that markets work to allocate resources.

The legislation and force

The second strategy is to use the force of the law to change behavior. For example, by banning
cars from entering city centers, or having a licensing system for the sale of alcohol, or by
penalizing polluters, the unwanted behavior may be controlled.
In the majority of cases of market failure, a combination of remedies is most likely to succeed.

4
Market Failure – In the Case of Externality

In the previous chapter, we have looked at the conditions for a market to be efficient. The market
is usually good at organizing the economic activity, but there are times when the market fails to
do so. An externality is an unintended consequence of an economic activity. It is one form of
market failure. It arises when a person engages in an activity may indirectly affect the well-being
of a bystander and yet neither pays nor receives any compensation for that effect. Therefore, an
externality is a spillover effect of the market activities. Market activities will have a direct impact
on the market participants who are directly involved in the activity, but it has an indirect effect
on the bystanders who are not engaged in the activity. For example, pollution emitted by a
factory that pollutes the environment adversely affects the health of the residents. When you
consume education you get a private benefit. But there are also benefits to the rest of society.
Example, you are able to educate other people and therefore they benefit as a result of your
education (positive consumption externality).

Social Cost vs. Private Cost

Private cost is the cost borne by an individual or firm directly involved in a transaction. For
example, a firm needs to purchase raw materials, employ workers and use machines for its
production activity. The payments to the suppliers of the raw materials, workers’ wages, and the
payment for the purchase of the machines and the maintenance payments are the private cost of
the firm. The marginal private cost (MPC) is the additional private cost to produce an additional
unit. It is the cost of an economic activity directly borne by the producer or consumer. Suppose
the cost of production of a firm to produce 100 units was $1,000, and to produce an additional
unit its cost increases to $ 1,050. Therefore, the MPC is $50.

An external cost (EC) or negative externality is a cost that a transaction or activity imposes on a
party (households or firms) that is not part of the transaction or activity. Marginal external cost
(MEC) is the change in the cost to parties other than the producer or buyer of a good or service
due to the production of an additional unit of the good or service. For example, suppose it costs
the producer $50 to produce another unit of a good. Suppose this production result in pollution,
which causes an additional $60 worth of damage to another company's plant. The marginal
external cost is $60.

5
The social cost is the true cost to the society, which includes the PC and the EC. Marginal social
cost (MSC) is the full resource costs of an additional unit of an economic activity including the
cost of externalities. For example, suppose it costs a producer $50 to produce an additional unit
of a good. Suppose that when the additional unit is produced pollution is emitted which causes
$25 worth of damage to the paint on your car. The marginal social cost of production is the
producer's cost plus the external cost, or $75.

The formula for Marginal Social Cost is:

MSC = MPC + MEC

The difference between the social cost and private cost is known as the external cost.

Using the previous definitions, we can rearrange the formula to determine what private cost is in
the context of society and externality.

MPC = MSC – MEC

or

MEC = MSC – MPC

Private Benefits (PB) and Social Benefits (SB)

Private benefit is the benefit derived by an individual or firm directly involved in a transaction as
either buyer or seller. For example, if we cycle to work, the private benefits include lower cost of
cycling rather than driving, health benefits of cycling, and ability to avoid congestion, and
quicker journey to workers

Marginal private benefit (MPB = D) – It’s the benefit from an additional unit of a good and
service that the consumer of that good and service receives.

6
External benefit (EB) is the benefit receives by a bystander who is not involved in the activity.
Marginal external benefit (MEB) is the benefit of producing or consuming an additional unit of a
good or service that falls on people other than the producer or consumer. For example, the
external benefit of cyclings, such as lower congestion for other road users, lower pollution levels
from a decision to cycle rather than drive, and better health may lead to lower health care costs.

Marginal external benefit (MEB) – It’s the benefit from an additional unit of a good and service
that people other than the consumer of a good and service enjoy.

Social benefit (SB) is the actual benefit to the society, which includes the PB and the EB.
Marginal social benefit (MSB) is the full resource benefit of an additional unit of an economic
activity including the benefits of externalities.

Marginal social benefit (MSB) – It’s the marginal benefit enjoyed by society – by the consumers
of a good and service and by everyone else who benefits from it. It’s the sum of marginal private
benefit and marginal external benefit.

The formula for Marginal Social Benefit is:

MSB = MPB + MEB

Suppose the social benefits differ from the private benefits, therefore the external benefit is equal
to the difference between the social benefit and the private benefit.

Using the previous definitions, we can rearrange the formula to determine what private benefit is
in the context of society and externality.

MPB = MSB – MEB

or

MPB = MSB – MEB

7
The Negative Spillover Effect

The spillover effect of an activity could be beneficial to a bystander (positive externality) or

adversarial to the bystanders or negative effect (negative externality). The existence of negative
externality makes the true cost to the society (Social Cost = SC) greater than the private cost
(PC). The difference between the SC and PC is the external cost (EC).

SC = PC + EC

EC = SC – PC > 0 (Negative externality- Production activity)

A negative externality can also occur when there is over-consumption of goods. In this case, The
Social Benefits (SB) is less than the Private Benefits (PB).

SB = PB + EB

EB = SB – PB < 0 (Negative externality – Consumption activity)

The Positive Spillover Effect

A positive externality exists when an individual or firm making a decision does not receive the
full benefit of the decision. The benefit to the individual or firm is less than the benefit to society.
Thus, when a positive externality exists in an unregulated market, the marginal benefit curve (the
demand curve) of the individual making the decision is less than the marginal benefit curve to
society. The market quantity is less than the socially optimal quantity, resulting in under
consumption or underproduction. There are many common examples of a positive externality.

SB = PB + EB

EB = SB – PB > 0 (Positive externality – Consumption activity)

A positive externality occurs when the market quantity is less than the socially optimal quantity
(under production). In this case, the SC will be less than the PC.

8
 SC = PC + EC

EC = SC – PC < 0 (Positive externality- Production activity)

Examples of Production and Consumption Externality

Negative Externalities (Production)

Airplane noise, pollution from factories, and logging are examples all negative production
externality.

Positive Production Externalities

Honey and orange producers have a positive externality from bees. The oranges get pollinated,
while the honey producers obtain the nectar of flowers to produce honey.

Negative Consumption Externalities

Smoking activity for those of us that do not smoke, and noisy neighbor affecting your sleep is a
negative consumption externality.

Positive Consumption Externalities

Flu and infant vaccinations for those how do not take them, restoration of historical buildings,
and educated labor force is a positive externality

Market Decision

The market makes decisions by comparing the marginal private cost and the marginal private
benefit. The market quantity is determined at the point where MPC = MPB.

Efficiency Decision

The socially efficient quantity decision is based on social cost and social benefit. The socially
desirable or efficient quantity is obtained at MSC = MSB.

9
The Consequences of Externality

 In a situation where a market activity has resulted in the creation of externality, the market
quantity and socially efficient quantity vary, causing the market to over or under produce or
consume.
 The market price and the efficient price will also differ.
 In both cases, the market activity causes a loss of economic welfare or deadweight loss.

The following equations are used to examine the consequences of externality.

MPB = 100 – Q (Market Demand)

MPC = 3Q (Market Supply)

MSC = 4Q

Assumption: There is no externally from the consumption activity, therefore MPB = MSB.

Market Decisions

MPB =MPC

100 – Q = 3Q

4Q = 100

Qmarket = 25 units

Pmarket = 100 - 25 = $75 per unit

Efficiency Decisions

MSB = MSC

100 – Q = 4Q

10
5Q = 100

Qefficiency = 20 units

Pefficiency =100 - 20 = $80 per unit

Analysis:

1) Qmarket = 25 units > Qefficiency= 20 units = The market overproduced 5 units causing a
negative externality from a production activity.
2) Pmarket < Pefficiency
3) Loss of economic welfare = Deadweight loss(DWL) = ½ x ( Qmarket – Qefficiency) x ( MEC at
Qmarket)

MEC = MSC – MPC = 4 (25) – 3 (25) = $25

DWL = ½ x (25 – 20) x $25 = $62.50

Graphical Illustration: Negative externality (Production activity)

MPB = 100 – Q (Market Demand)

MPC = 3Q (Market Supply )
MSC = 4Q
Q MPB=MSB MPC MSC
0 100 0 0
20 80 60 80
25 75 75 100
40 60 120 160
60 40 180 240
80 20 240 320
100 0 300 400

11
 450

400
MSC
350

300 MPC

250

200
DWL
150

100
80 50
75 MPB = MSB
0
0 20 25 40 60 80 100 120

Graphical Illustration: Positive externality (Production activity)

$
MPC

MSC

Pmarket f

Pefficient
e
MSC
g
MPB=MSB
Q
Qmarket Qefficient

12
Analysis:

1) Qmarket< Qefficient= Underproduction causing positive production externality.

2) Pmarket > Pefficient
3) MEC = MSC – MPC = -fg
4) Loss of economic welfare = Deadweight loss(DWL) = efg

Graphical Illustration: Positive externality (Consumption activity)

MPC = MSC
MSB g

f
Pmarket e
Pefficient MSB

MPB
Q
Qmarket Qefficient

Analysis:

1) Qmarket< Qefficient= Underconsumption causing positive consumption externality.

2) Pmarket < Pefficient
3) MEB = MSB – MPB = ge
4) Loss of economic welfare = Deadweight loss(DWL) = efg

13
Graphical Illustration: Negative externality (Consumption activity)

MPC = MSC
Pefficiency
Pmarket f
e

MSB MPB
g
MSB
Q

Qefficient Qmarket
Analysis:

1) Qmarket> Qefficient= Overconsumption causing negative consumption externality.

2) Pmarket <Pefficient
3) MEB = MSB – MPB = - fg
4) Loss of economic welfare = Deadweight loss(DWL) = efg

Externality- Remedies

Externalities are one of the causes of market failure resulting in a misallocation of resources.
There are various ways the individuals and policymakers can respond to the externalities. The
remedial action is to achieve an optimal outcome.

14
Public Policies towards Externality

Negative Externality

The government uses the command and control policies and market-based policies to deal with
the issue of a negative externality. The following are some of the policies used by governments
to curb negative externality:

a. Imposing emission Charges

b. Issuing marketable Permits
c. Legislations and Regulations
d. Imposing taxes

Emission charge

A fee imposed on polluters, based on the quantity of pollution. An emission charge increases
marginal private cost and thus reducing the market’s output. An example of emission tax is the
carbon tax. It is a tax levied on the carbon content of fuels.

Marketable Pollution Permits

Pollution Permits involve giving firms a legal right to pollute a certain amount e.g. 100 units of
Carbon Dioxide per year. If the firm produces less pollution, it can sell its pollution permits to
other firms. However, if it produces more pollution, it has to buy permits from other firms.
Therefore, there will be a market for pollution permits. If firms pollute a lot there will be low
supply and high demand for the permit, therefore, the price will be high for permits. Therefore,
there is an incentive for firms to cut pollution

Legislations and Regulations

The government can influence the market activities by using the command and control approach,
such as legislation, regulations, and setting of standards. Example, the Environmental Quality
Act 1974 in Malaysia is an Act relating to the prevention, abatement, control of pollution and
enhancement of the environment, and for purposes connected therewith

15
(http://www.agc.gov.my/Akta). The Malaysian government has also established the Department of
Standards as the national standards and accreditation body of Malaysia. The main function of
Standards Malaysia is to foster and promote standards, standardization and accreditation as a
means of advancing the national economy, promoting industrial efficiency and development,
benefiting the health and safety of the public, protecting the consumers, facilitating domestic and
international trade and furthering international cooperation in relation to standards and
standardization. Malaysian Standard is governed by the Standards of Malaysia Act 1996
(Department of Standards Malaysia, 2011).

Pollution Tax

Suppose the government has assessed the marginal external cost accurately and imposes a tax (T)
on the producer which is equal to the MEC. If it is a negative consumption externality then the
tax is imposed on consumers to discourage the consumption of the goods or services. Tax is used
to internalize the external cost.

Taxproducer = MSC – MPC = MEC . The MEC is calculated at the socially efficient output.

Tax consumer = MSB – MPB = -MEB. The MEB is calculated at the socially efficient output.

To find the MSC we do the following:

MPC1=MPC + Taxproducer = MSC

Taxproducer = MSC – MPC = MEC

MPC1 is the new market supply curve. The MPC curve will shift to the left to MPC1 and it will
be equal the MSC at the socially efficient quantity. The MPB curve will shift to the left if the
government imposes a tax on the consumer and it will be equal to MSB at the socially efficient
quantity.

16
Positive Externality

In the presence of external benefits , the government will intervene in order to get the market to
produce at the socially efficient quantity. The following are the government policy towards a
positive externality.

Public provision

The government will provide the good or service using the tax revenue.

Subsidy

It’s a payment that the government makes to private producers which depends on the level of
output. Suppose the government managed to assess the marginal external benefit accurately. It
will then provide a subsidy (S) to the producer or consumer which is equal to the marginal
external benefit. The subsidy is given to the producer in the case of a positive production
externality. This will reduce the cost of production, and hence increase the supply. The MPC
curve will shift to the right by the amount of the subsidy, and it will be equal to the MSC at the
socially efficient quantity. The government will give subsidies to the consumers in the case of
positive consumption externality. This will increase the demand and it will shift the MPB curve
to the right. The MPB will be equal to the MSB at the socially efficient quantity.

Subsidesconsumer = MSB – MPB = MEB (the MEB is calculated at the socially efficient quantity)

Subsidiesproducer = MSC –MPC = - MEC (the MEC is calculated at the socially efficient quantity)

MPB1 =MPB + S = MSB

Subsidyconsumer = MSB– MPB = MEB

The subsidy given to consumers will shift the MPB curve to the right and it will be equal to MSB
at the socially efficient quantity. The MPC schedule will shift to the right and it will be equal to
MSC if subsidies are given to producers.

17
Voucher

It’s a token that the government provides to households that can be used to buy specified goods
or services. For example, the Malaysian government has introduced BB1M since 2012 to ease
the burden of buying academic books and to inculcate the reading habit among the people.
Currently, the BB1M scheme is benefiting more than 3.9 million Malaysian pre-university and
institutions of higher learning students with an allocation of RM890 million.
(http://www.nst.com.my/)

Patents and Copyrights

 Intellectual property rights – It’s the property rights of the creators of knowledge and
other discoveries.

 Patent or copyrights – It’s a government-sanctioned exclusive right granted to the

inventor of goods, services, or production process to produce, use, and sell the invention
for a given number of years.

Private Solutions

The private solution can also be used to address externalities in order to achieve an optimal
solution. The private solutions towards externality will include moral codes, charities, bargaining
and business mergers or contracts. In practice, private parties often fail to resolve the problem of
externalities on their own.

Moral codes

Moral codes guide individuals' behavior. Individuals know that certain actions are simply not
"the right thing to do" or disapprove by others. For example, in the case of littering, moral codes
provide an incentive to refrain from littering.

18
Charities

Charities channel donations from private individuals towards fighting to limit behaviors that
result in negative externalities or promoting behaviors that generate positive externalities. The
former can be seen in the case of organizations that protect the environment, while the latter is
exemplified through organizations that raise money for education.

Business mergers or contracts

Two businesses that offer positive externalities to each other can merge or enter into a contract
that makes both parties better off. This will internalize the externalities by combining the parties
involved.

For example, if steel firm and fishery is under one firm and steel firm took into account the
damages imposed on the fishery, then a net gain would be possible. The steel manufacturer will
willingly produce less steel and by doing so it will increase the profits of its fisheries subsidiary
–will not lead to inefficiency. The merger may also encourage R&D which will create positive
externalities because research done by one firm could be utilized by another firm.

Bargaining and Negotiation

The Coase theorem states that in the presence of an externality, the affected parties will be able
to bargain and reach an efficient outcome. Bargaining and negotiation are possible only when the
transaction costs are low and with a well-defined property rights. If the conditions are met, the
bargaining parties are expected to reach an agreement where everyone is better off. For example,
your neighbor dog has affected your sleep. Suppose the owner of the dog has the rights to keep
the dog. An efficiency outcome can be achieved by examining the benefits of the dog to the
owner and the cost due to the interrupted sleep of the neighbor. Let assume that, the maximum
benefit to the owner of the dog is $1000 and the neighbor suffering is equivalent to $2000. It is
obvious here that the transaction cost is low and the neighbor will be prepared to pay the dog
owner $1000 to get to get rid of the dog. The efficient outcome is bye, bye the dog, there is no
more dog and the neighbor will now have a good night’s sleep.

19
The Effectiveness of the Remedies for Externality

 The assignment problem: In cases where externalities affect many agents (e.g. global
warming), assigning property rights are difficult). The Coasian solutions are likely to be
more effective for small, localized externalities than for larger, more global externalities
involving a large number of people and firms.
 The Free Rider Problem: When an investment has a personal cost, but a common benefit,
individuals will under-invest (example: a single country is better off walking out of the
Kyoto protocol for carbon emission controls).
 Transaction Costs and Negotiating Problems: The Coasian approach ignores the
fundamental problem that it is hard to negotiate when there are large numbers of individuals
on one or both sides of the negotiation. This problem is amplified for an externality such as
global warming, where the potentially divergent interests of billions of parties on one side
must be somehow aggregated for a negotiation.
 Difficulty in estimating the external cost. (What is the external cost of water pollution?)
 Difficulty in determining who is responsible for the cost. (Who is responsible for air
pollution?)

20