3.1. Problems of Market Failures
(1)
In reality, no market such a perfectly competitive
market. Market tends to be imperfect
Hence, Pareto Efficiency cannot be achieved if rely on
market mechanism in allocating resource in the
economy
3.1. Problems of Market Failures (2)
More over, efficiency in allocation of resources is
not the only concern of people.
People need some other than resource allocation
efficiency, such as more equal distribution of
income, good condition of environment,
elimination of unemployment and popverty
3.1. Problems of Market Failures (3)
 All these are beyond market
concern. Since, the market only
deals with efficiency
 Government intervention is
required to satisfy these other needs
of people
3.1. Problems of Market Failures
(4)
In short, if market fails to achieve pareto efficiency
and fail to deliver the other needs of people the
government has to substitute the role of market to
satisfy all these
 Market failures  government intervention to
improve welfare of the society
3.2. Sources of Market Failures
Public goods
Externalities
Natural monopoly
Imperfect information
Merit goods
 Income distribution/equality
Unemployment
Inflation
3.3. Public Goods (1)
 Three main characters:
Non-rivalry
Non-excludable
Non-congest
3.3. Public Goods (2)
 Three types public goods:
 Excludable, non-rival public good
impure public goods
 Non-excludable, rival public goods
 impure public goods
 Non-excludable, non-rival public good
 pure public goods
3.3. Public Goods with Excludable, Non-rival
Characters (1)
Example: Free way
Exclusion makes the service marketable
Price > 0 even though MC =0 provision by
private sector becomes feasible
 But, private provision will not be pareto
optimum.
Since, price will be determined not by
market mechanism (S and D)
 MC = P, MC = 0, hence P = 0
3.3. Public Goods with Excludable, Non-rival
Characters (2)
Price must be determined by mechanism other
than market mechanism, such as government
decision
Consequently, the determined price may be too
high or too low
 Provision will not be optimum
Though not achieve ‘Pareto Efficiency’, private
provision will result in social improvement
3.4. Public Goods with NonExcludable, Rival Public Characters
(1)
Common property resource
 Example, ocean fishing ground
If market mechanism over fishing
Tragedy of the Common
Individual rationality leads to collective
disaster
3.4. Public Goods with NonExcludable, Rival Public Characters
(2)
Resource depletion and dissipation of economic
rent
Economic rent  incentive for conservation
Pareto inefficiency
Government intervention is desirable to improve
the condition
3.5.Public Goods with Non-Excludable, NonRival Public Characters (1)
 Example, lighthouse
 Collective action to build
 Free rider as constraint for collective action to take
place
If free rider problem is not controlable lighthouse
will not be present
Hence, government intervention is desirable in
building the lighthouse
3.5.Public Goods with Non-Excludable,
Non-Rival Public Characters (2)
However, when ‘ a privilege group’ exists 
private provision of the lighthouse is feasible even
though free riders are at large
But, the private provision will not be pareto
efficiency  undersupply
Hence, government intervention is desirable to
improve the supply
3.6. Externalities (1)
Two types by characters :
 Negative  e.g. air pollution by manufactures
 Positive  e.g. fresh air produced by Bogor botanical
garden
 Two types by sources :
 Consumption  demand curve
 Production supply curve
 Government intervension is desirable
3.7. Positive Externalities:
Problem of Under Supply of Goods
Generating Positive Externalities
Price
Socially
Optimum
MSB
MPB
MPC
Ps
Pm
Qm
Qs
Note: Qm < Qs
3.8. Negative Externalities:
Problem of Over Production of Goods
Generating Negative Externalities
Price
Socially
Optimum
MSC
Ps
Supply Curve
MPC
Pm
MB
Qs
Qm
Note: Qm > Qs
Demand Curve
3.8. Natural Monopoly (1)
 Natural Monopoly?
 Cost production declines as scale
operation increase  economies of scale
Cause  large total fixed cost
Example,
Production electricity
 Airport service for airline landing and
take-off
3.8. Natural Monopoly(2)
 Large economies of scale
 production is best by a single big firm
 But, monopoly right is granted to a private firm, it
may not produce the required goods at the lowest
cost
Instead, it may produce at level that satisfy MR = MC
to earn extra profit
3.8. Natural Monopoly(3)
If produced at MR = MC  P > MC. Thus, social
loss will prevail
 Social loss  pareto inefficiency
 Government intervention is required to correct the
condition



Government own firms (e.g. PT PLN and PT Angkasa
Pura)
But, government own firms often create another kind of
inefficiency problem ?
3.9. Imperfect Information (1)
 Facts
 Information is imperfect
 Information is costly to acquire
 Direct consequence  Asymmetric information
between market actors
 E.g Buyer vs seller, employee vs employer
3.9. Imperfect Information (2)
 Consequences :
 Moral hazard problem
 Adverse selection problem
 Missing markets (e.g absence of crop insurance in
Indonesia )
 Government intervention is desirable to improve
the condition
3.10. Other Market Failures
 Market is not concern about all these:  Provision
of merit goods
 Controlling inflation
 Poverty alleviation
Controlling Unemployment
Income redistribution
Government intervention is desirable to address and
solve them
3.11. Government Failures
(2)
 Government intervention often fail to make
improvement. Instead, it makes even worsened
 Example, provision of electricity power by the
government controlled monopolizing firm is often
criticized of being inefficient
3.11. Government Failures
(2)
Why government failures occur?
Conflict of interest’
Political motives
Rent seeking activities
3.12. Readings
Stiglitz, Joseph E. 2000. “Economics of the Public
Sector”. New York: W.W. Norton and Company.
Chapters 4 and 5
 Weimer, David L. and Vining, Aidan R. 1992.
“Policy Analysis: Concepts and Practice”. New
Jersey: Prentice Hall. Chapters 3,4 and 5.