Institute of Economic Theories - University of Miskolc
Microeconomics
MARKET FAILURES
Mónika Kis-Orloczki
Assistant lecturer
1
Market failure
The ‘invisible hand’ of the marketplace and
competition lead profit-seeking producers to offer
consumers an efficient variety of goods and services,
which are produced at least cost, and in efficient
quantities. Efficiency is the market’s great success,
and is the reason market economies have been able
to improve living standards over time. However, there
are also instances of market failure, in which markets
do not bring about economic efficiency.
market failure
Occurs when resources are
misallocated or allocated inefficiently.
Examples:
– Monopoly
– Externalities,
– Public goods
2
Externality
• externality arise when the production or
consumption of private goods leads to cost or
benefits to third parties, meaning people or
businesses who are not party to the transaction.
– negative externality - an externality that harms
someone.
– positive externality – an externality that benefits
other.
3
Cost
marginal social cost (MSC) The total cost to society
of producing an additional unit of a good or service.
MSC is equal to the sum of the marginal costs of
producing the product and the correctly measured
damage costs involved in the process of production
(marginal social cost = marginal private cost +
marginal external cost).
Sample activities with external costs:
– Allowing your cell phone to ring in class
– Driving a vehicle that emits exhaust gas
– Using river water to remove industrial waste
– Burning coal to generate electricity
4
Benefit
Marginal social benefit is equal to the private
marginal benefit a good provides plus any external
benefits it creates. In other words, MSB gives the total
marginal benefit of the good to society as a whole.
(Marginal social benefit = Marginal private benefit +
Marginal external benefit)
Sample activities with external benefits
– Looking your best
– Getting immunized against disease
5
MSC
P
S=MC
lB
P*
Pmkt
lC
lA
D=MU
Qefficient Qmarket
Q
A=Free Market Equilibrium
C=Efficient equilibrium which
occurs when all costs of
production are included.
• Without intervention, the free
market will produce too
much at too low a price (the
market does not allocate
resources efficiently)
• To correct this, the
government must tax the
good, and use the money to
correct the problem or pay
those hurt by the negative
externality
6
A = free market
equilibrium;
free maket. produces
less than the efficient
equilibrium.
If all benefits are added
in, should be at C
(efficient equilibrium).
Need a subsidy to
correct (internalize) the
externality.
P
S=MC
lB
lC
P*
Pmkt
lA
MSB
D=MU
Qmarket Qefficient
Q
7
Internalizing externalities
Policies to control pollution or preserve common
property resources require a government. Five
approaches have been taken to solving the problem
of externalities:
1.
2.
3.
4.
government-imposed taxes and subsidies,
private bargaining and negotiation,
legal rules and procedures,
sale or auctioning of rights to impose externalities,
and
5. direct government regulation.
Taxes, subsidies, legal rules, and public auction are
all methods of indirect regulation designed to
induce firms and households to weigh the social costs
8
of their actions against their benefits.
Industrial CO2 Emissions, 2004
9
The government
• might control pollution directly by restricting the
amount of pollution that firms may produce
• emissions standard
• by taxing them for pollution they create. A
governmental limit on the amount of air or water
pollution
• emissions fee – tax on air pollution
• effluent charge - tax on discharges into the air
• internalize the externality - to bear the cost of
the harm that one inflicts on others (or to
capture the benefit that one provides to others)
10
Reducing Externalities - Kyoto
protocol
Oftentimes market failures go beyond the confines of any single
country. In these situations, the best solutions often involve
international cooperation. It is important to recognize that many
countries’ governments have been responsible for the world’s
pollution.
Kyoto protocol Reached in Kyoto, Japan, in 1997
– required most industrialized nations to reduce CO2emissions by
an average of 5.2% below 1990 levels by 2008–2012. To achieve
this goal, the United States, Europe, and Japan need to curb their
CO2 emissions by 31%, 22%, and 35%, respectively, from the
levels that would have been attained in the absence of a reduction
policy.
– The Bush administration rejected this agreement.
– The EU and its Member States ratified the Protocol in May 2002.
Of the two conditions, the "55 parties" clause was reached on 23
May 2002 when Iceland ratified the Protocol. The ratification by
Russia on 18 November 2004 satisfied the "55%" clause and
11
brought the treaty into force 16 February 2005.
Public (social) goods
• A private good is a good or service that can be
consumed by only one person at a time and only by
those people who have bought it or own it. A private
good is both rival and excludable.
• A public good is a good or service that can be
consumed simultaneously by everyone and no one
can be excluded from enjoying its benefits. It is both
nonrival and nonexcludable.
In an unregulated market economy with no
government, public goods would at best be produced
in insufficient quantity and at worst not produced at all.
12
The characteristics of public
goods
• nonrival in consumption A characteristic of
public goods: One person’s enjoyment of the
benefits of a public good does not interfere with
another’s consumption of it.
• nonexcludable A characteristic of most public
goods: Once a good is produced, no one can
be excluded from enjoying its benefits.
13
The characteristics of public goods
Excludable
Non-excludable
Rival
Private good (pencil, coke)
Merit goods
Common property (fish in the sea,
space on a public beach)
Nonrival
Club goods (concert, tennis
club, cable television)
Pure public goods (national defence,
clean air
mixed goods Goods that have characteristics that are part public
and part private.
–Common property
–Club goods
merit goods are those goods and services that the government
feels that people left to themselves will under-consume and
which therefore ought to be subsidised or provided free at the
point of use. Consumption of merit goods is thought to generate
positive externality effects where the social benefit from
consumption exceeds the private benefit. (health services 14
vaccination, education)
Common property resources are nonexcludable, so consumers cannot prevented
from using them and are rival, so one person’s
use reduces another person’s ability to benefit
from the good.
These two characteristics lead to an important
economic implication: Consumers will have an
incentive to overuse the good. Because it’s
rival, if a consumer doesn’t use the good, they
will lose the opportunity to use it.
Club goods a subtype of public goods that are
excludable but non-rival, at least until reaching
a point where congestion occurs.
15
• free-rider problem Because people can enjoy the
benefits of public goods whether they pay for them or
not, they are usually unwilling to pay for them. A free
rider is a person who enjoys the benefits of a good or
service without paying for it. Because of the free-rider
problem, the market would provide too small quantity
of a public good. To produce the efficient quantity,
government action is required.
Methods reducing free riding:
–
–
–
–
social pressure,
mergers,
compulsion,
privatization.
• drop-in-the-bucket problem The good or service is
usually so costly that its provision generally does not
depend on whether or not any single person pays. 16
Optimal level of provision for
public goods
Government has no choice but to produce pure public
goods itself. For impure public goods, it is possible for
government to use regulation, or price incentives to
guide the marketplace towards efficiency. Government
policy alternatives are of three general sorts:
– Government can price the good.
– Government can produce the good.
– Government can regulate the good.
Governments can impose taxes and licensing fees to
require those who benefit from public goods to pay for
them.
17
Optimal provision of public
goods
• The price mechanism forces people to reveal what
they want, and it forces firms to produce only what
people are willing to pay for, but it works this way only
because exclusion is possible.
• For private goods, market demand is the horizontal
sum of individual demand curves—we add the
different quantities that households consume (as
measured on the horizontal axis).
• For public goods, market demand is the vertical sum
of individual demand curves—we add the different
amounts that households are willing to pay to obtain
each level of output (as measured on the vertical
18
axis).
At the optimal level,
society’s total
willingness to pay per
unit is equal to the
marginal cost of
producing the good.
19