MARKET FAILURES
AND GOVERNMENT
INTERVENTION
Inna Ushcatz and Ieta Shams
Market Failure


The difference between a socially optimum
level of production and the market level
production is a market failure.
In a free market economy it is sometimes
possible for individual parties to work out a
solution, but government intervention is
needed when:
 Property rights are unclear
 The number of people concerned is large
 Bargaining costs are high

Market fails because it does not allocate
resources efficiently.
Types of Inefficiency

The resulting inefficiency of market
failures:
 Productive inefficiency: businesses are not
maximizing their outputs. More output, could have
satisfied more wants and needs. Costs are higher;
productivity is lower than could have been.
 Allocative inefficiency: businesses misallocate
resources and produce goods and services that are
not wanted by the consumers. Resources could
have been used more efficiently.
Government Intervention
 In
a market failure the unrestrained
market creates more harm than
good.
 In a market failure the government
has a role to play in correcting or
internalizing the market failure.
 Government intervention aims to
achieve economic efficiency.
Roots Causes of Market
Failures

Externalities in production and
consumption

Public Goods (missing market)

Lack of Competition (Monopoly)

Poverty and Inequality in an
Economy
Externalities
-Marginal BenefitMarginal analysis is
used to study
Price
externalities.
 Marginal Private Benefit
(MPB): belongs to the
producer or consumer
of the good.
 Marginal External
Benefit (MEB): the
spillover.
MPB + MEB = Marginal
Social Benefit (MSB)

Supply
(private cost)
Social
value
Demand
(private value)
QMARKET QOPTIMUM
Quantity
Externalities
-Marginal CostMarginal Private Cost
(MPC): the cost incurred
by the producer or
Price
consumer.
 Marginal External Cost
(MEC): is the spillover or
the externality.
MPC + MEC = Marginal
Social Cost (MSC)
 Market prices generally
reflect only private costs 0
and benefits.

Social
cost
Cost of
pollution
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
QOPTIMUM QMARKET
Quantity
Externalities
-Common Government ApproachesProblem
Resource Allocation
of Outcome
Ways to Correct
Spillover costs
(negative
externalities)
Over allocation of
resources
1. Individual
bargaining
2. Liability rules and
lawsuits
3. Tax on producers
4. Quantity controls
5. Market for
externality rights
Spillover Benefits
(positive externalities)
Under allocation of
resources
1. Individual
bargaining
2. Subsidy to
consumers
3. Subsidy to
producers
4. Government
provision
Externalities
-Quantity Control



The most common form of government regulation
is setting a quantity control on the production of a
good or service.
A direct control sets absolute levels.
The total amount of the good which can be
produced under the quantity control is called the
quota limit. The government limits quantity in a
market by issuing licenses for production.
Quantity controls typically create undesirable
side-effects:
Inefficiencies, or missed opportunities, in the form of
mutually beneficial transactions that don’t occur.
 Incentives for illegal activities

Externalities
-Subsidies-
•Where there are spillover benefits, government often uses subsidies to correct
the under allocation that the free market would produce.
•Subsidies can be paid either to the buyers or the sellers.
Subsidy to the Buyer

Shift of the demand curve to the
right, raising the output level
closer to the socially optimum
level.
Subsidy to the Seller

Shift of the supply curve to the
right, again correcting the under
allocation.
•Subsidies create undesirable side-effects:
Inefficient producers remain in business
Serves as a burden for the taxpayers
Externalities
-Tax on Producers


A way to solve negative externalities is through
issuing excise taxes. Excise taxes on producers
will raise the marginal cost, and decrease supply.
Sellers pass as much of the added cost on to
buyers as possible, by increasing selling price.
This will maintain the same profit margin, and
allow the consumer to cover the producers
purchase costs.
Taxes on producers create the following
undesirable side-effects:
 inefficiency as a result of the excess burden or
deadweight loss caused by the tax.
 They also encourage illegal activity in attempts to avoid
the tax.
Externalities
-Effects of a TaxA tax places a wedge between the price
buyers pay and the price sellers receive.
 Because of this tax wedge, the quantity
sold falls below the level that would be
sold without a tax.
 The size of the market for that good
shrinks.


A deadweight loss is the fall in total surplus that
results from a market distortion, such as a tax.
Externalities
-The Effects of a TaxPrice
Supply
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
Demand
Quantity
with tax
Quantity
without tax
Quantity
Externalities
-Public Provision of Goods and
Services-



Government provides previously decided
upon public goods with tax money
collected from all citizens.
Government cannot use price as a signal
of value in the way that a market would,
because price does not fully reflect the
value of most public goods.
Government must use other methods,
such as:
 Public surveys
 Market research
 Voting for certain political candidates
Monopolies
-Market FailuresIncreased competition in a market means
that a market is more likely to provide
allocative efficiency by providing the
socially optimum amount of a good.
 Some markets will organize themselves to
hinder competition, essentially creating a
monopoly.
 The government aims to make industry
more competitive.

Monopolies
-Government Responses
Antitrust Policies: Laws that aim to curb
monopoly power.
 Antitrust laws make the following practices
illegal:





Collusive price fixing
Separation of markets
Tying contracts
Interlocking directorates
Price discrimination when it reduces
competition
 Antitrust laws strengthen government
powers to promote competition.
Inequality
-Disparities in the Distribution of Economic
Resources
Questions to ask when measuring inequality:
– How much people are in our society?
– How many people live in poverty?
– How often do people move amongst income classes?



Failure to properly distribute income leads to a
inequality (a form of market failure)
Change in technology and outsourcing, has
decreased demand for unskilled labour and made
their incomes extremely low.
It is believed that everyone has an equal
opportunity to succeed, but the misallocation of
resources proves this wrong.
Inequality
-Solutions-

Policies that are imposed in order to decrease
Inequality:
– Minimum wages: If labour is inelastic, this policy is
effective at reducing inequality. If labour is elastic, not so
much.
– Welfare: government programs that supplement the
income of the needy
– Negative Income Tax: High income families pay tax, low
income families receive the “negative tax”
– In-kind Transfers: Things given to the poor in the form of
goods and services
Distribution of Income US 2007
Lorenz Curve



The Lorenz Curve: A curve
that shows the degree of
inequality. Illustrates how
income is distributed
unequally in a society.
The pink shaded area
labelled A represents
inequality present in a
society.
The Gini Coefficient finds the
area of inequality, divides it
by the total area to find the
percentage of inequality.
Factor Distribution & the Gini
Coefficient




Gini coefficient: An number between zero and one
that is used to measure inequality as it relates one
variable to another. For perfect equality the Gini
coefficient is 0. However, absolute inequality yields
a coefficient of 1.
The Gini Coefficient can be found from the Lorenz
Curve by dividing area A by the combination of area
A and B
Thus, A/(A+B)
Factor Distribution of Income: is the division of total
income among labor, land and capital.
Video
 http://www.youtube.com/watch?v=8
DuWQVDi9bQ&list=PL71234D006E68
2C13&index=1&feature=plpp_video
Practice Multiple Choice
Question
1.
In the case of a market in which a negative
externality is produced, which of the following
is true of marginal social cost?
a)
b)
c)
d)
MSC=MPC
MSC=MPB
Government can intervene to cause MSC=MEC
Marginal social cost is not reflected in the
supply curve
e) Bystanders are bearing the marginal social cost
Practice Multiple Choice
Question
1.
At the socially efficient output and price
for a good whose production causes
pollution, we can expect that
a) The offending pollution will be eliminated
b) The marginal social cost of production will exceed
the marginal social benefit of production
c) The private cost of production will equal the private
benefit of production
d) The marginal social benefit of production will equal
the marginal social cost of production
e) Too little of the good will be produced
Practice Free- Response
1.
Assume that product X is produced in a
perfectly competitive market and yields costs
that are borne by third party individuals.
Using a correctly labeled graph, show the
market output and price if the market ignores
the externality.
a) Identify the problem in this market.
b) Identify and explain a remedy to the problem of
misallocation of resources.
c) Amend the graph to show how your remedy has
changed the output to the socially optimum amount.
To be Marked Free Response
 Question
to be marked:
– http://www.diigo.com/bookmark/http%3A%
2F%2Ftw.neisd.net%2Fwebpages%2Fdmaye
r%2Ffiles%2Fap_micro_frq.htm?tab=people
&uname=mscuttle