CHAPTER 8

Market Failure

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 Chapter Goals
• Explain what an externality is and show how it affects
the market outcome.
• Describe three methods of dealing with externalities.
• Define public good and explain the problem with
determining the value of a public good to society.
• Define common resources and the tragedy of
commons
• Explain how informational and moral hazard
problems can lead to market failure.
• Explain why market failure is not necessarily a reason
for government intervention.
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 Market Failures
A market failure is a situation in which the invisible hand pushes
in such a way that individual decisions do not lead to socially
desirable outcomes.
They can be caused by:
• Externalities
• Public goods / Common Resources
• Imperfect information

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 Externalities
Externalities are the effects of a decision on a third
party that are not taken into account by the decision-
maker.
Negative externalities occur when the effects are
detrimental to others. Example: Second-hand smoke
and carbon monoxide emissions
Positive externalities occur when the effects are
beneficial to others. Example: Education

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 No Externality Example
When there are no externalities, the supply curve S
represents the marginal private cost to society and the
demand curve D represents the marginal private
benefit to society.
At equilibrium, the private and social benefits are equal
and society is as well off as possible.

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 No Externality Example
Because there are no
externalities, the supply
P curve and demand curve
represent the marginal
social cost and benefits
S0 = Marginal of producing and
Private Cost
consuming steel.

P0 If there are no
externalities, P0Q0 is the
D = Marginal
Social Benefit equilibrium.

Q0 Q

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 A Negative Externality Example
When there are negative externalities, the marginal
social cost differs from the marginal private cost.
The marginal social cost includes the marginal private
costs of production plus the cost of negative
externalities associated with that production.
It includes all the marginal costs that society bears.

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 A Negative Externality Example
If there are no
externalities, P0Q0 is the
P equilibrium.
S1 = Marginal
When there is a negative
Social Cost
externality, the marginal
S0 = Marginal
Private Cost
private cost will be below
P1 the marginal social cost
Cost of externality and the competitive price
P0 will be too low to
maximize social welfare.
D = Marginal Government intervention
Social Benefit
Q
may be necessary to
Q1 Q0 reduce production.
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 A Negative Externality Example
When there are negative externalities, the marginal
social cost differs from the marginal private cost.
The marginal social cost includes the marginal private
costs of production plus the cost of negative
externalities associated with that production.
• It includes all the marginal costs that society
bears.

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 A Positive Externality Example
When there are positive externalities, the marginal
social benefit differs from the marginal private benefit.
The marginal social benefit includes the marginal
private benefit of consumption plus the benefits of
positive externalities resulting from consuming that
good.
• It includes all the marginal benefits that society
receives.

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 A Positive Externality Example
If there are no
externalities, P0Q0 is the
P equilibrium.
When there is a positive
externality, the marginal
S = Marginal social benefit will be
Private Cost
Benefit of
above the marginal
P1 externality private benefit and the
market price will be too
P0 D1 = Marginal low to maximize social
Social Benefit
welfare.
D0 = Marginal Government
Private Benefit
intervention may be
Q0 Q1 Q
necessary to increase
consumption.
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 Alternative Methods of
Dealing with Externalities

Direct regulation is when the government directly limits the

amount of a good people are allowed to use.
Incentive policies:
• Tax incentives are programs using a tax to create
incentives for individuals to structure their activities in
a way that is consistent with the desired ends
• Market incentives are plans requiring market
participants to certify that they have reduced total
consumption by a certain amount
Voluntary reductions.

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 Tax Incentive Policies
A tax on pollution that
equals the social cost of
Cost the negative externality
S1 = Marginal will cause individuals to
Social Cost reduce the quantity of
the pollution causing
S0 = Marginal activity to the socially
Private Cost
P1 optimal level Q1.
P0 Efficient tax Such taxes are often
called are called effluent
D = Marginal fees, charges imposed by
Social Benefit government on the level
Q1 Q0 Q of pollution created.

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 Market Incentive Policies
A market incentive plan is similar to direct regulation in
that the amount of the good consumed is reduced.
A market incentive plan differs from direct regulation
because individuals who reduce consumption by more
than the required amount receive marketable
certificates that can be sold to others.
Incentive policies are more efficient than direct
regulatory policies

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 Voluntary Reductions
Voluntary reductions allow individuals to choose
whether to follow what is socially optimal or what is
privately optimal.
The socially conscious will often become discouraged
and quit contributing when they believe a large number
of people are free riding.
Free rider problem is individuals’ unwillingness to share
the cost of a public good.

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 The Optimal Policy
An optimal policy is one in which the marginal cost of
undertaking the policy equals the marginal benefit of
that policy.

Resources are being wasted if a policy isn’t optimal.

For example, the optimal level of pollution is not zero

pollution, but the amount where the marginal benefit
of reducing pollution equals the marginal cost.

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 Public Goods
A public good is nonexclusive and nonrival
• Nonexclusive: No one can be excluded from its
benefits.
• Nonrival: Consumption by one does not
preclude consumption by others.
Many goods provided by the government have public-
good aspects to them.

There are no pure public goods; national defense is the

closest example.
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 Public Goods
A private good is only supplied to the individual who
bought it.
Once a pure public good is supplied to one individual, it
is simultaneously supplied to all.
In the case of a public good, the social benefit of a
public good (its demand curve) is the sum of the
individual benefits (value on the vertical axis).
To create market demand:
• Private goods: sum demand curves horizontally
• Public goods: sum demand curves vertically
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 The Market Value of a Public Good

Price
A public good is enjoyed
$1.20
$1.10 by many people without
$1.00 diminishing in value.

Individual A’s demand is

$0.80
vertically summed with…
$0.60
Individual B’s demand to
Market Demand
equal…
$0.40 Demand B
$.60
$.50
market demand for a
$0.20 public good.
Demand A
Quantity
1 2 3
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 Excludability and the Costs of Pricing
The public-/private-good differentiation is seldom clear-cut.
Some economists prefer to classify goods according to their
degree of rivalry and excludability.

Degree of Rivalry in Consumption

Rival NonRival
100% Apple Encoded radio
broadcast

Degree of
Excludability

0% Fish in ocean General R&D

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 Common Resources
A common resource is nonexclusive and rival.
This means that anyone has access to the good, but that the
use of the good by one person reduces the ability of someone
else to use it. (A classic example of a common good are fish
stocks in international waters; no one is excluded from fishing,
but as people withdraw fish without limits being imposed, the
stocks for later fishermen are potentially depleted.)

With common resources, when individuals act independently

and rationally, they may collectively trade long-term benefit
for short-term gain. The tragedy of the commons refers to the
overexploitation of a common good by individual, rational
actors.
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Informational and Moral Hazard Problems
Perfectly competitive markets assume perfect information.
In the real world, buyers and sellers do not usually have
equal information, and imperfect information can be a
cause of a market failure
An adverse selection problem is a problem that occurs
when buyers and sellers have different amounts of
information about the good for sale
A moral hazard problem is a problem that arises when
people don’t have to bear the negative consequences of
their actions

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Policies to Deal with Informational Problems
Regulate the market and see that individuals provide
the correct information.
License individuals in the market and require them to
provide full information about the good being sold.
Allow markets to develop to provide information that
people need and will buy.

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Government Failures and Market Failures
The three types of market failure covered (externalities,
public goods, and informational problems) show that all
real-world markets in some way fail.
Market failures should not automatically call for
government intervention because governments fail,
too.
Government failure occurs when the government
intervention in the market to improve the market
failure actually makes the situation worse.

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 Reasons for Government Failures
1. Government doesn’t have an incentive to correct
the problem.
2. Government doesn’t have enough information to
deal with the problem.
3. Intervention in markets is almost always more
complicated than it initially seems.
4. The bureaucratic nature of government intervention
does not allow fine-tuning.
5. Government intervention leads to more government
intervention.
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