UNIT 6:
MARKET FAILURE
What happens when the market falls
apart and needs correction?
In this section we will examine:
1. Define types of market failures
2. Marginal Social Benefit vs Marginal Social Cost
3. Marginal Private Benefit vs Marginal Private
Cost
4. Define & graph externalities from market
activities and resulting government corrections
5. Define socially optimum vs. private-market
equilibrium
6. Income Equality:
 Measuring income distribution
Types of Market Failure
Types of Market Failure:
There are plenty of reasons why the normal operation of market forces may not
lead to economic efficiency.
1. Externalities: are untended consequences of the free market
(could be positive – spill over benefits or negative – spill over costs)
Examples: Social costs for producing cigarettes, social benefits
of providing a flu shot, social cost of producing cars,
social benefit of the outcome on society when offering
nationalize healthcare.
Types of Market Failure
Types of Market Failure:
There are plenty of reasons why the normal operation of market forces may not
lead to economic efficiency.
2. Public Goods: are not provided by the free market because of their two main
characteristics:
1. Non-excludability: where it is not possible to provide a good or service to one
person without it thereby being available for others to enjoy
2. Non-rivalry: where the consumption of a good or service by one person will not
prevent others from enjoying it
Examples: Street lighting / lighthouse, fireworks, police
services, air defense systems, roads, etc.
Free-rider Problem: everyone waits until
someone pays for the good, then they can use it
freely. Consequently, the good is never made.
Types of Market Failure
Types of Market Failure:
There are plenty of reasons why the normal operation of market forces may not
lead to economic efficiency.
2. Asymetric Information: there is an imbalance of information between buyer and
seller.
Example: dentist sells extra services that are not really needed by
the buyer, however the buyer gives in to seller’s superior
knowledge
Example: expert antique dealer enters into an antique shop and
negotiates a low price for a very valuable antique due to
the fact of his superior knowledge of the product
compared to that of the seller.
Solution: government will enforce symmetric
information between buyer and seller.
Types of Market Failure
Types of Market Failure:
There are plenty of reasons why the normal operation of market forces may not
lead to economic efficiency.
3. Monopolies: government intervention to correct monopoly/oligopoly behavior
(enforcing social optimal or fair-return pricing)
Examples:
 Control of TVA,
 Windfall Tax (charged to certain
industries when economic conditions
allow those industries to experience
above-average profits)
 Price Ceilings in apartment
rental market
Types of Market Failure
Types of Market Failure:
There are plenty of reasons why the normal operation of market forces may not
lead to economic efficiency.
4. Unstable Prices: government intervention to correct varying price (usually in
commodity markets.
Examples:
 Gas prices in 1970s,
 Rent Controls in New York
Types of Market Failure
Types of Market Failure:
5.
There are plenty of reasons why the normal operation of market forces may not
lead to economic efficiency.
Income Inequality: government intervention to lessen the gap between income groups
Lorenz Curve shows the income
distribution of a county
Example: Progressive Taxation,
minimum wage, welfare
The Lorenz curve can be used to show what
percentage of a nation's residents possess what
percentage of that nation's income.
For example, it might show that the country's
poorest 10% possess only 2% of the country's
wealth.
Market Failure: Vocabulary
Marginal private benefit (MPB) is the extra benefit to a firm from
producing an extra unit of its product. This is the price the firm
receives from selling the extra unit.
Marginal private cost (MPC) is the extra cost to the firm of
producing an extra unit of output.
Marginal social benefit (MSB) is the extra benefit to society from the firm
making an extra unit of output. MSB shows the highest price consumers
are willing to pay for a unit of the good.
MSC includes the firm’s marginal private benefits plus any other
spill over benefits (positive externalities) to other members of society.
Marginal social cost (MSC) is the true cost to society of a firm making
an extra unit of output.
MSC includes the firm’s marginal private costs plus any
other spill over costs (negative externalities) to other
members of society.
GRAPHING
EXTERNALITITES
Negative Externality: Detailed Example
Negative Externalities (spill over costs: untended (-) outcomes)
The Putrid Paper Company is located on the
Cherokee River above the Clean Chemical
Company.
Neither firm pollutes the river at the moment:
each firm takes in clean water from the Cherokee,
creates dirty waste water as it makes its product,
but then at its own expense cleans that dirty water
before returning clean water to the river.
Negative Externality: Detailed Example
Negative Externalities (untended (-) outcomes)
The Putrid Paper Company is located on the
Cherokee River above the Clean Chemical
Company.
Neither firm pollutes the river at the moment:
each firm takes in clean water from the Cherokee,
creates dirty waste water as it makes its product,
but then at its own expense cleans that dirty water
before returning clean water to the river.
Negative Externality: Detailed Example
Supply curve S0 in each graph represents a firm’s supply
curve when there is no pollution.
Based on the demand for each product, the equilibrium
price and quantity (in the absence of pollution) are $8 and
700 units in the paper market and $19 and 280 units in the
chemical market.
Negative Externality: Detailed Example
Assume now that the Putrid Paper Company decides to stop
cleaning its waste water and dumps dirty water into the
Cherokee.
It does this to reduce its production costs and increase its
total profit. By reducing its costs, the firm’s supply curve shifts
to the right to S1. Its equilibrium price drops to $6 and its
equilibrium quantity increases to 800 units.
Negative Externality: Detailed Example
These changes look like good ones – consumers can buy paper at
a lower price so they buy more paper. To see the undesired effects of
the pollution we look downriver at its effect on the chemical market.
The pollution increases Clean Chemical’s cost of making its
product since it now must clean the river water before using it. This
increase in costs shifts its supply curve to the left to S1. The price of
chemicals rises to $22 and the number of units sold drops to 260.
Tax Correction for Negative Externality
Results from a tax levied to
correct a negative externality
Putrid Paper Company
Socially Optimal quantity
of pollution
This is the government’s
answer to pollution.
Amount of market
correction due to tax
MPrivateC
Area of correction needed.
Guess what this is?
DEAD WEIGHT LOSS
Pre-market-corrected quantity
of pollution
Positive Externality
Positive Externalities (spill over benefits: untended (+) outcomes)
FLU SHOTS
Cost /
Benefit to
Society
S = MSC
Problem
DWL
Too few shots offered by Free Market (FM)
AMC
Amount
of
subsidy
Solution
Provide incentive for societal
consumption (close the DWL and fill in
the Area of Market Correction AMC)
D = MSB
D = MPB
QFM
QSO
Amount of
under-allocation
Income Inequality: Lorenz & Gini
Income Inequality: government intervention to lessen the gap between income groups
Lorenz Curve shows the wealth
distribution of a county
The Gini Coefficient is a
measurement of the income
distribution of a country's
residents.
Income Inequality: Lorenz & Gini
The Gini Coefficient is the
ratio of the area between the
income distribution curve
(Lorenz) and the line of
equal distribution.
Gini ranges from 0 to 1, with
1 being the most unequal
distribution of wealth (one
person owns everything) and
0 being the most equal (each
person owns an equal share)
Comparing
this area
to…
…this
area.
Practice: Lorenz & Gini
Family Income Distribution: U.S. 1983
Income
Category
Share of Total
Income (%)
p = Cumulative Share
of Population (%)
L = Cumulative
Share of Income (%)
Top 20%
42.7
100
100.0
4th 20%
24.4
80
57.3
3rd 20%
17.1
60
32.9
2nd 20%
11.1
40
15.8
Lowest 20%
4.7
20
4.7
Total
100
Can One Measure Inequality? YES
Gini = Area A/(Area A + Area B)
Practice: Lorenz & Gini
Gini = Area A/(Area A + Area B)
Area A + Area B
100*100/2 =
Area 1
20*4.7/2 =
Area 2
20*(4.7+15.8)/2 =
Area 3
20*(15.8+32.9)/2 =
Area 4
20*(32.9+57.3)/2 =
Area 5
20*(57.3+100)/2 =
Total Area B
Area A
5000 - 3214 =
Gini Coefficient
1786/5000 =
Practice: Lorenz & Gini
Gini = 36% thus income
distribution is relatively equal
Area A + Area B
100*100/2 =
Area 1
20*4.7/2 =
47
Area 2
20*(4.7+15.8)/2 =
205
Area 3
20*(15.8+32.9)/2 =
487
Area 4
20*(32.9+57.3)/2 =
902
Area 5
20*(57.3+100)/2 =
1573
Total Area B
Area A
5000 - 3214 =
Gini Coefficient
1786/5000 =
5000
3214
1786
0.36 or 36%
FRQ Practice