1.4 Market failure
• 1.4a Positive externalities
• Free markets do not always work to encourage
efficient outcomes.
• Market failure refers to the situation where—
for whatever reason—production tends to a
level where marginal social cost does not
equal marginal social benefit.
A merit good is a good that provides
benefits to society beyond what is enjoyed
by the buyer. We call those benefits a
positive externality.
A good example is a flu shot. If you decide
to receive a flu shot, you are not only
helping yourself avoid illness, you are also
helping your friends and relatives avoid
catching the flu from you, and they get that
for free.
If people have to pay the market price for a
flu shot, many might decide the benefit is not
worth the cost, and flu shots would be less
than is best for the community as a whole.
As with all merit goods, flu shots would be
under-provided in a free market. Can you
think of any other merit goods?
In the diagram below, free market demand is
considered to be the marginal private benefit
that consumers gain from the good or service.
When the marginal private benefit is combined
with the external benefits, this is called marginal
social benefit.
The free market equilibrium is where
marginal private benefit = marginal private
cost is indicated by Pp and Qp.
If we presume that the supply curve
represents marginal private cost = marginal
social cost, then the relationship would be
MSB > MSC.
However, the area directly above the
private market equilibrium (indicated by the
arrow which points towards the MSB curve)
is the area of the positive externality and
the spillover benefits are reflected in the
marginal social benefit curve.
If we presume the marginal private cost to
be equal to the marginal social cost, then
the private market transaction would result
in MSB > MSC. This is a short hand way
of explaining a good or service with
positive externalities.
Government intervention can minimize the
under-provision of merit goods by
subsidizing production or consumption, or
by providing the good socially.
Merit goods v. public goods
Sometimes the government provides
goods that the market will not and these
are known as public goods. Public goods
are characterized by several factors:
Nonrivalry: This means that consumption
by one person does not reduce the amount
available to be consumed by another
person. My use of a road does not reduce
others ability to use the road.
Nonexcludability: This means that
nobody can be excluded from consuming
the good or service. Streetlights are a good
example.
Free – rider problem: The challenge for
public goods is that people who don’t pay
for them get a “free ride” by consuming the
good or service for which others pay. An
example might be a public park in a large
city that is paid for by the taxes of wealthy
income earners but used by less well off
residents who may not pay any taxes at all.
Lack of public goods can be considered to
be a form of market failure, as providers
cannot charge directly for their use and
consumers know that they cannot be
prevented from using the good even if they
don’t pay.
1.4b Negative Externalities
• Demerit goods are always overprovided in a
free market because negative externalities are
created, meaning that social costs are greater
than production costs.
Here we see that a free market will oversupply the good because external costs are
not considered. The market equilibrium is
where marginal private benefit = marginal
private cost is indicated by Pp and Qp.
However, the area directly above the private
market equilibrium (indicated by the arrow
which points towards the MSC curve) is the
area of the negative externality and the
spillover costs are reflected in the marginal
social cost curve.
If we presume the marginal private benefit to
be equal to the marginal social benefit, then
the private market transaction would result in
MSC > MSB. This is another way of
explaining a good or service with negative
externalities.
The most common examples of negative
externalities are air and water pollution, where
firms harm others by discarding their waste
without consequence.
Negative externalities harm others by creating
health problems or an unpleasant
environment.
Smaller examples include leaving trash in
the park, playing loud music that disturbs
you neighbors, or smoking in a restaurant
when others are trying to enjoy a good meal.
Governments try to minimize negative
externalities through legislation or tax, either
outlawing the production of certain
pollutants, or taxing production of goods that
create pollution, increasing costs and
decreasing production.
Another government response to pollution
problems is to create a market for pollution
permits. Because firms are free to buy and
sell their permission to pollute, the permits
are known as tradable permits.
Allowing companies to sell their permits
encourages new technologies for pollutionfree production and ensures that the permits
end-up in the hands of companies that need
them most.
Is there another way to mitigate these
externalities?
The Coase Theorem was developed to provide an
alternative to government remedies for negative
externalities. For this to work there are several
conditions that need to be in place:
- Property ownership must be easily defined so that
responsibility can be assigned.
- The number of parties involved needs to be small.
- Negotiating costs must be very small or negligible.
Under these conditions, the government’s role is to
encourage bargaining between the parties most
effected.
1.4c Asymmetric information (HL
only)
• Asymmetric information is a form of
information failure where unequal
knowledge is possessed by the parties to
a transaction.
• The most common area is which we see
this is in the area of medicine where
patients have limited medical knowledge
and the doctor possesses detailed medical
knowledge. A situation is created where
the producer is telling the consumer what
health services he or she should buy.
1.4c Asymmetric information (HL
only)
• Solutions for these situations usually
revolve around government regulations via
the legislative process. This means that
the government will increase access to
information.
- The government can require full disclosure
of certain information during the
negotiating process.
- Another solution is for the government to
directly provide information to the public.
1.4c Monopoly
• Monopoly markets can also lead to market
failure, especially when demand is inelastic.
Because of the higher revenues available at
higher prices, essential goods might be
underprovided in a free market.
Maximizing profit, a monopoly will
charge price P1, meaning that many
fewer goods will be sold than where
production is efficient, at Q2.
For a limited time, monopoly profits are
allowed under copyright and patent laws
as a way to encourage innovation and
invention.
In other cases, governments may encourage
production by subsidy or direct intervention,
buying the good at monopoly prices and
selling at a lower price. This sometimes
happens with pharmaceuticals that are
necessary for the prevention of disease.
1.4d Tragedy of the Commons
• Market failure can also occur when property
rights are not well established or property is
shared—in common—among many users.
• Tragedy of the Commons refers specifically to
an historical example.
Previous to industrialization, it was normal
for towns to have an open space available
for grazing animals or growing crops. This
space was called a commons and citizens
were free to use the space as they liked.
The tragedy occurs when someone realizes
that he can use the land for his own profit,
maybe grazing too many cows on the land,
generating profit for himself, but destroying
the land for other users.
Resources that are shared among many
users tend to be overused because the cost
of the lost resource is very small for the
individual, and any revenue generated is likely
to overwhelm the cost.
Contemporary examples include over-fishing
of the oceans, over-hunting of animals leading
to possible extinction, and the over-use of
clean air and water (pollution).