 In general, competition gives better results than a monopoly
 in terms of output, price & consumer surplus
 But in some cases competition does not give desirable results, and Government intervention becomes necessary.

 Produce the wrong amounts of goods or services due to externalities or
‘spillovers’
 Failure to allocate sufficient resources to the production of certain goods, called
‘ public’ or ‘social’ goods
 Information constraints
 Rent seeking & monopoly
 Non-market goals

 Definition : Costs or benefits associated with the production or consumption of a good (or service) that flow on to 3 rd parties outside the market transaction
Buyer Seller
3 rd Party
 External Costs
 e.g. pollution from cars, smoke from factories etc
 External Benefits
 e.g. development of new technology can also benefit the society as well as the firm concerned

Includes external costs
 External cost = bf
 Over allocation of resources



Q e equilibrium output
Q
0 socially optimal output
Society’s loss = cbf
Excludes external costs  Conclusion: When the supply curve fails to include external costs, the equilibrium price is artificially too low and the equilibrium quantity is artificially too high
(ie. there is an overallocation of resources )

 Policy implications: Try to internalise
(or capture) external costs
 Ban the products
 Impose additional duties and taxes
 Property rights (eg. in the case of environmental pollution)

Correcting for External Costs
P
Externa l costs
S t
S
TAX
0 Q
0
Q e
Over-allocation corrected
D
Q

Includes external benefits
Excludes external benefits
 External benefit = gk
 Under allocation of resources



Q e equilibrium output
Q
0 socially optimal output
Society’s loss = gkh
 Policy implications :
 Government produces the goods
 Subsidize producers or buyers
 Property rights (patents etc.)

P
S
Subsidy to consumer
0
Under-allocation corrected
D
Q
D t

P
S t
Subsidy to producers increases supply
S ′ t
0 Q e
Q
0
Under-allocation corrected
D
Q

 Goods that are produced through the market system.
 Divisible : goods comes in units small enough to be bought by individual buyers.
 Excludable : people who are willing and able to pay the equilibrium price will consume the product, but the people who are unable or unwilling to pay are
excluded from the benefits provided by that particular product.

 Goods would not be produced at all by the market system.
 Indivisible : goods that cannot be divided into
“units” so that they can be sold to individual buyers.
 Non- Excludable : there is no effective way of
excluding individuals from the benefit available from the consumption of public goods once these goods have been produced.
 Goods that have both characteristics are referred to as pure public goods.

Private goods
Produced through the market system
 Divisible
 Excludable
( ie. subject to the exclusion principle )
 Examples ?
Public goods
Not provided by the market system
 Indivisible/joint consumption possible
 Non-excludable
( ie. not subject to the exclusion principle)
– free rider problem
 Examples ?

 Free-Rider Problem: when people can receive benefits from the consumption of goods and services without contributing directly to its costs.
 Given the inapplicability of the exclusion principle (free-rider problem), there is no economic incentive for private firms to supply public goods.
 As a result, government has to step in to provide the good (or service) because of its substantial social benefits

 Joint consumption is possible up to a certain capacity
 Exclusion is possible
 Eg. public transport (bus, train travel), museums, libraries, a football match, etc
 NOTE: In some cases Public / Quasi public goods can be privately produced. In this case “public” does not mean “Government owned or made”.

 Consumers may not have complete information
(or understanding) about some products
 e.g. medicines, houses, cars, TV sets etc
 If the consequences of having incomplete or wrong information are severe, the Government may intervene
 Interventions could be in the form of warranties, production standards, product liability etc .

 Rent seeking involves any unproductive activity undertaken to earn supernormal profits e.g. lobbying for quotas, market protection from imports, changes in tax/duties, monopoly rights etc.
 There is a double loss: (a) resources wasted on rent seeking (b) loss because of misallocation of resources (due to the quota, tariff etc)
 The Government needs to handle such situations using specific policies

 We have always considered profit
maximisation to be the ultimate economic goal for a firm
 Some activities are not driven by profit (or may not even generate any revenue)
 socially desirable
 e.g. orphanages, animal shelters, free primary education etc.
 Left to itself, the market will not produce such goods. Thus Government intervention is required .

 When the market fails to operate efficiently, the government may be required to intervene. Outline the type of measures the government would be expected to take when the market failure was due to:
 (i) an external cost (or external diseconomy)
 (ii) the commodity involved being a public good.