Market Failure: Causes and
Remedies
Messere – IB Economics (CIA 4U7)
Outline
I. Market Failure
A. Definition
B. Causes
II. Market Power
III. Externalities
A. Negative
B. Positive
C. Calculating the Cost
D. Allocative Efficiency
E. Correcting Externalities
IV. Public Goods
A. Non-rivalry and Non-excludability
B. Free Riding
V. Merit and Demerit Goods
Market Failure
• Market failure occurs when the competitive
outcome of free markets is not efficient from the
viewpoint of the economy as a whole
– This is because the benefits that the market provides
individuals or firms carrying out certain action diverge
from the benefits to a society as a whole
– Results in a sub-optimal amount of good/service being
provided
• Markets can also fail when firm/individual has
insufficient information to recognize returns from
undertaking an action
Causes of Market Failure
• Market dominance and abuse of monopoly power
• Imperfect information
• Externalities causing private and social costs
and/or benefits to diverge
• Pure public goods / Merit goods
• Factor immobility
• Equity (fairness) issues. Market can generate an
unacceptable distribution of income and social
exclusion
Market Power
• Imperfect information can lead to resource
misallocation eg. firm does not accurately gauge
price of key input (oil)
• Monopoly prices above those in competitive
markets
– Loss of consumer surplus
– Output below competitive equilibrium level
– Loss of allocative & productive efficiency
Monopoly Power: Good or Bad?
• Monopolists may waste scarce resources
– High levels of advertising and marketing to increase
brand loyalty and build entry barriers
• Monopoly power can bring economic benefits:
– Exploitation of economies of scale
– Higher profits used to fund research & development,
leading to faster pace of innovation & gains in dynamic
efficiency
– Greater ability to compete internationally as many
domestic markets have become more contestable
Externalities
• Imagine you are in your dorm studying and
suddenly a loud explosion is heard shaking
the walls of your room as other students
next door play Quake 3 on-line.
• You complain to your neighbor that “you
have an economics exam tomorrow” and
they tell you “But I don’t have one
tomorrow, so what do I care?”
Externalities
• You have just had first hand experience with
an externality.
• When we talk about how in individual
maximizes utility or a firm maximizes
profit, we are implicitly assuming that these
decisions do not affect other firms’ profits
or other people’s utility.
Externalities
• Externalities are the incidental costs
(negative externalities) or benefits (positive
externalities) that accompany economic
activities
– Externalities have their effects upon persons
whom the market neither compensates for costs
or charges for benefits
Why Do We Care?
• Externalities arise because transactions that occur in the free market
don’t always yield socially optimal (or allocatively efficient) outcome
– People involved in transaction put their needs first even if they clash with
those of society as a whole
• When a firm or individual makes a decision without taking into
consideration how that action affects others, then that decision
(though optimal for that individual & productively efficient for that
firm) may not be optimal for the whole of society
(Sorry kids – no Simpsons clip on Internet version)
Social Cost
• Finding the cost of an externality requires us to
compare the total social cost with social benefit.
• The total social cost is the MC of the first unit +
MC of the second unit +…
• Marginal social cost (MSC) equals the marginal
private cost + the marginal external cost
Social Benefit
• We can measure social benefit by looking at
the demand curve.
• The demand curve represents what people
are willing to pay (hence the dollar value of
the benefit).
• Thus, we can also think of the demand
curve as the Marginal Benefit curve (MB).
Social Benefit
• To find the total benefit to society of
consuming multiple units of a good, we can
add up the marginal benefit of each unit
consumed.
Allocative Efficiency
• Allocative efficiency occurs when firms produce
those goods and services most valued by society
– This means scarce resources are allocated to the
production of the goods and services so that consumer
wants and needs are met in the best way possible
• Allocative efficiency in a given market involves
comparing the cost of producing an extra unit marginal cost (supply curve) - with the benefit
gained from its consumption (demand curve) marginal benefit.
Allocative Efficiency con’t
• If marginal cost of an extra unit is
less than the marginal benefit
derived from its consumption
(10th unit), then it makes sense to
increase production.
• If marginal cost is more than the
marginal satisfaction gained from
consumption (30th unit), then it
makes sense to reduce production
and release resources for
alternative, 'better' uses.
Allocative
efficiency
occurs at
20th unit of
output
Pollution Example
• Let’s say that my peanut butter & jam plant is
releasing a toxic peanut butter by-product into the
groundwater and is making people very ill.
• The cost to society AS A WHOLE can be
represented as my costs of production (since I am
part of society) plus the costs I am making others
bear.
• We can represent this graphically as...
Pollution Example
MSC (Marginal Social Cost)
$
MPC (Marginal Private Cost)
External
Cost
QSocial QPrivate
Q
Pollution Example
• So, if I only consider my private costs
(Peanut Butter, Jelly, Labor, etc), I will
produce at QPrivate.
• But accounting for the costs to the whole of
society, I ought to produce at QSocial.
• Notice that the private outcome is higher
than the social outcome.
– That is, firms create more pollution than is
socially optimal.
Negative Externalities in Production
(MSC > MPC)
Price
Optimal equilibrium for
society is where MSC =
MSB at Qopt
Free market produces at
Qprv where MPC =
MPB & overproduces
good
Welfare loss (= burden)
of producing Qopt - Qprv
units
MSC
MPC
Popt
Pprv
eg. Firm producing
petrochemicals dumps
effluent in a river
MSB(=MPB + zero external benefits)
MPB
Qopt
Qprv
Quantity/time
Negative Externalities in Consumption
(MPB > MSB)
Price
Optimal equilibrium for
society is where MSC =
MSB at Qopt
Free market produces at
Qprv where MPC = MPB
& over-provides good
eg. Private car use causes
other people to suffer
from exhaust fumes,
traffic congestion & noise
Welfare loss of consuming
beyond socially optimum level
of Qopt units
MSC(=MPC + zero external costs)
Pprv
Popt
MPB
MSB
Qopt
Qprv
Quantity/time
Positive Externalities
• Externalities do not always have to be a social
cost.
• Sometimes an individual’s behavior affects a third
party in a positive way
• For instance, if that same dorm pal who was
loudly playing Quake 3 bakes bread every
morning and the smell of the bread makes you
happy - there is a positive externality
Positive Externalities
• With a positive externality, the social
benefit is higher than the private benefit.
• Thus, the privately optimal amount to
produce is less than the socially optimal
amount to produce.
• There is a loss in net benefit from this
underproduction.
Positive Externalities in Production
(MSC < MPC)
Optimal equilibrium for
society is where MSC =
MSB at Qopt
Free market produces at
Qprv where MPC = MPB &
under-produces good
eg. Production of solar panels
will benefit society via reduced
CO2 emissions / private firms
training workers who can then
transfer those skills over to rest
of society with society
benefiting from skilled workers
Price
Welfare gain not producing
to socially optimal output level
(Qopt units)
MPC
MSC
Pprv
Popt
MSB(=MPB + zero external benefits)
Qprv
Qopt
Quantity/time
Positive Externalities in
Consumption (MSB>MPB)
Price
Optimal equilibrium for
society is where MSC =
MSB at Qopt
Free market produces at
Qprv where MPC = MPB
& under-consumes good
Welfare gains of producing
Qprv - Qopt more units
MSC(=MPC + zero external costs)
Popt
Pprv
eg. MSB of immunization shots
(school age) exceeds private
benefits through reduced
transmission of diseases and lost
work time from illness
MSB
MPB
Qprv
Qopt
Quantity/time
What Can Society Do To Correct
for an Externality?
• The solution for economists is to internalize
the externality - to make the private cost (or
benefit) equal to the social cost (or benefit).
• But how to do this is a more difficult problem
since it is difficult to calculate & prioritize
costs and benefits of activity
– How do you assess a firm’s costs of polluting a river?
• Must weigh job security (costs) vs. ability to swim in
river (benefits)
What Can Society Do To Correct
for an Externality?
What Can Society Do To Correct
for an Externality?
Property Rights
• One way to correct for an externality is to assign
property rights
– Example: You are assigned the right to peace
and quiet. If someone wants to play loud music,
they have to compensate you to give up that
right. This makes your cost part of their cost.
– This works the other way as well, though. They
could have the right to play music and you have
to compensate them not to play. You pay them
what it costs you.
Property Rights
• Either way, the socially optimal quantity is
produced
• NOTE: It is important to note that the
socially optimal amount of pollution is NOT
zero. Think about why that is...
Other Solutions
• Persuasion
• Voluntary Agreements (eg. Kyoto protocol)
• Subsidies
– Government might subsidize all or part of firm’s costs
of implementing pollution control technology
– A subsidy will shift the MPC curve to the right towards
the MSC curve
• Taxes
– If the government knows exactly how much to shift the
curve to correct for the externality, they simply tax or
subsidize the production.
– A tax will shift the MPC curve to the left
Internalizing Externality: Taxation
• Polluting firm can be made to internalize externality by
producing at socially optimal output (MSB=MSC)
• To correct market failure government would have to apply
tax equivalent to external costs
Public Goods
• Public Goods are goods that are available for all to
consume, regardless of who pays and who does
not.
• Example: National Defence (pure public good)
• All public goods must exhibit two characteristics:
– Non-rivalry
– Non-excludability
Non-rivalry and Non-excludability
• Non-rivalry means that one person’s
consumption of the good does not limit the
ability of someone else to consume the
good.
– Example: A TV Show
• Non-excludability means that you can’t
keep anyone from consuming the good.
– Example: Police Protection
What is Special about Public
Goods?
• The problem with public goods is getting
people to fund them.
• Imagine if we expected everyone who
wanted national defence to pay for it. You
might be tempted to let other people chip in
for it and you get the benefit.
• This behavior is called “free riding” and is
endemic to the provision of a Public Good
Free Rider Solutions
• Often we let the government provide public
goods because they can force people to pay
for it via taxes
• Find ways to exclude people (scramble TV
signals, private police, etc.)
Merit Goods
• Merit Goods are goods that the government
deems necessary for society because the social
benefits exceed the private benefits
– Example: health care, education, roads
• Merit goods can be provided by the private &/or
public sector
• To encourage increased consumption of merit
goods, governments will subsidize consumption
(and cause an expansion of demand) in order to
reduce the private marginal costs of consumption
Demerit Goods
• De-merit goods are those goods or services
that create negative externalities when the
product is consumed
– This reduces the social benefit of consumption
and also leads to potential market failure
through over-consumption.
• eg. cigarettes, alcohol
• Governments may choose to tax or regulate
the consumption of these goods
Public, Merit & Private Goods
Environment or Profit …..?
Environment or Profit ….. ?