MARKET FAILURE

In this chapter we will see why the market economy fails to achieve many
of its promises
how government intervention can help markets overcome their failures.
The meaning of market failure: allocative
inefficiency
• Market failure refers to the failure of the market to allocate resources efficiently.
• Market failure results in allocative inefficiency, where too much or too little of
goods or services are produced and consumed from the point of view of what is
socially most desirable.
• Overprovision of a good means too many resources are allocated to its production
(overallocation);
• underprovision means that too few resources are allocated to its production
(underallocation).
Definitions
• Externality : An externality occurs when the actions of consumers or producers
give rise to negative or positive side-effects on other people who are not part of
these actions, and whose interests are not taken into consideration.
• positive externality: If the side effects on third parties involve benefi ts, there
arises a positive externality, also known as external (or spillover) benefi t
• Negative externality: if they involve costs, in the form of negative side-effects,
there arises a negative externality, also known as external (or spillover) costs.
• Externalities can result either from consumption activities (consumption
externalities)
• production activities (production externalities).
Marginal private benefits and costs,
• Marginal benefit: marginal benefit is the benefit received by consumers for
consuming one more unit of the good.

• Benefits derived from consuming the good go to private individuals, who are the
consumers buying the good, the demand curve represents marginal private benefits.

• Marginal cost : Marginal cost is the cost to producers of producing one more unit of the
good.

• standard supply curve reflects fi rms’ costs of production, specifically marginal costs
• PRIVATE VS. SOCIAL COSTS
• A private cost is a cost that firms incur in producing goods and services to
supply the market, such as wages and rent (i.e., costs of production).
• A marginal private cost is the change in total cost that comes from a firm
making or producing one additional item.
• When a good is produced it may have a spillover effect on other people in
society (third parties). These spillover effects are termed externalities,
because they affect people outside of (or external to) the market. These
spillover effects affecting third-parties can be good (positive) or bad
(negative).
• Additional costs may be imposed on third parties may be created by firms in
the production process. For example, air pollution from a factory
adversely impacts the quality of life for others in society whom have to
breath in unpleasant and toxic pollutants. This is a negative externality
• At the other end, benefits may be gained by third parties as a result of the
production process. For example, a forestry company that has planted trees
and opened roads and trails has provided recreational opportunities for dog
walkers, runners and mountain bikers. This is a positive externality.
Another great example is the production of honey production and the plant
pollination that occurs as bees forage for pollen to make their honey.
• Marginal social costs are the costs to society from the production of one
more unit of a good or service.
• A marginal social cost will be lower than marginal private costs
when positive externalities are created when the good or service is
produced. Conversely, the marginal social cost will be higher than the
marginal private cost when negative externalities are created when the
good or service is produced.
• EXTERNALITIES & MARKET FAILURE
• Externalities result in market failure. Externalities cause the market to fail
to achieve a social optimum where MSB = MSC, and this will occur for two
reasons:
• Firstly, consumers may not consider the external costs or benefits
associated with their consumption of a good or service. A smoker may be
unconcerned that the consumption of cigarettes increases the costs of
healthcare for all in society (negative externality). And, an individual
consuming a vaccination may not be thinking that it is benefiting society by
ensuring that he/she is immune to a disease, he/she just wants to avoid a
nasty illness (positive externality).
• Secondly, producers may not consider the external costs or benefits
associated with their production of a good or service. A producer pursuing
the objective of profit maximisation may be unconcerned that their factory is
polluting the air and adversely affecting others (negative externality). And,
a forestry producer does not factor in all of the recreational benefits their
forest plantations provide society (positive externality).
NEGATIVE EXTERNALITIES OF PRODUCTION AND
WELFARE LOSS
Steel manufacturing is often very polluting as the lowest cost
method of production is to burn lots of coal to provide the
energy needed in the steel manufacturing process.

In Figure 5 above, it is assumed that there are only external

costs associated with producing steel, and no external
benefits. Each tonne of steel produced adds to the
surrounding air pollution. Thus, MSB = MPB. The firm
producing the good aims to maximize profits and as such does
not take into account any external costs associated with
producing the next unit of output. The profit maximizing firm
sets quantity to Qe where the MSB = MPC. This is not the
socially optimum level of output because this is where MSB =
MSC, and factors of production are being misallocated (e.g.,
more labour and capital are being used to produce steel, and
less labour and capital is being used to produce, say,
education and health services).
Figure 5 illustrates this. In the free market the price of steel is too low – Pe instead of P* – and the output of steel is
too high – Qe instead of Q*. Thus, between Q* and Qe, MSC > MSB. The value of the resources used to make
additional tonnes of steel (MSC) is greater than the satisfaction gained from society buying and consuming
another tonne of steel (MSB). Thus, MSC > MSB in regards to steel production and consumption. On and every
unit of output (tonnes of steel produced) between Q* and Qe, a loss of social welfare occurs. The MSC is less than
private benefit of steel consumption because of the negative externalities associated with the production of that
good. The yellow triangle shows the total welfare loss.
Externalities: diverging private and social
benefits and costs
In a diagram, social benefits appear as a marginal social benefit curve.
MSB, representing the full benefits to society from the consumption of a
good, and social costs as a marginal social cost curve
MSC, representing the full costs to society of producing the good.

When MSB and MSC are equal to each other, there is a social optimum in
which allocative efficiency is realised.

Figure 5.1 shows the case where there are no external benefits or external
costs (no externalities). Therefore D = MPB = MSB, and S = MPC = MSC.
Allocative Efficiency
• Maximisation of Society Surplus ( Sum of CS and PS)
D=S
Maximisation of net Social benefit
MSB = MSC
Where resources perfectly follow consumer demand.
No shortage no surplus.
MPC = MPB = Private optimum
MSC= MSB = Social Optimum Allocative efficiency.
Assumptions
• (i). Many buyers and sellers
• (ii). Perfect information
• (iii). No barriers to entry
• (iv). Firms profit maximum
• (v). Maximum consumer utility
Types of externalities
• There are four types of externalities:
• 1. negative production externalities
• 2. negative consumption externalities
• 3. positive production externalities
• 4. positive consumption externalities
• Negative externalities= external cost and MSC>MSB
• Positive externalities = external benefits and MSB>MSC
Negative production externalities (external or spillover costs)
Externality diagrams: points to note

Qm and Pm show the market outcome, found by the

intersection of MPC with MPB

Qopt and Popt shows the socially optimum (or “best

Outcome”, found by the intersection of MSC with MSB.

Negative Externalities : the market always overallocates

resources : too much is produced relative to the social
optimum, Qm > Qopt.

Positive Externalities: the market always underallocates

resources too little is produced relative to the social
optimum, Qm < Qopt

Resource misallocation (overallocation or underallocation)

leads to welfare loss deadweight loss for society = brown
shaded triangle.
 Negative production externalities (external or spillover costs)
in Figure 5.2, where the supply curve, S = MPC, reflects the fi
rm’s private costs of production

the marginal social cost curve given by MSC represents the full
cost to society of producing cement.

For each level of output, Q , social costs of producing cement

given by MSC are greater than the firm’s private costs

The vertical difference between MSC and MPC represents the

external costs

Since the externality involves only production (the supply

Negative externalities of production curve), the demand curve represents both marginal private
refer to external costs created by benefi ts and marginal social benefi ts.
producers example environmental
pollution. Pg. 103 example
Negative externalities: imposition of
external costs on society
• When there is a negative production externality, the free market overallocates
resources to the production of the good and too much of it is produced relative to
the social optimum. This is shown by Qm > Qopt and MSC > MSB at the point of
production, Qm, in Figure 5.2.
The welfare loss of negative production externalities

• Whenever there is an externality, there is a welfare (deadweight) loss, involving a

reduction in social benefi ts, due to the misallocation of resources.
the shaded area represents the welfare loss arising from the negative
production externality.

For all units of output greater than Q opt, MSC > MSB, meaning that
society would be better off if less were produced

The welfare loss is equal to the difference between MSC and MSB for the
amount of output that is overproduced (Q m – Q opt).

It is a loss of social benefits due to overproduction of the good caused by

the externality.
If the externality were corrected, so that the economy reaches the social
optimum, the loss of benefits would disappear
Welfare loss in relation to consumer and
producer surplus
In market equilibrium, consumer surplus is equal to areas a + b + c + d,
producer surplus is equal to areas f + g + h

external cost = MSC - MPC curves up to Q m (the quantity produced by

the market)
which is c + d + e + g + h.

Social benefit in market equilibrium = consumer surplus((a + b + c + d)

plus producer surplus (f + g + h) minus the external cost (c + d + e + g +
h) = a + b + f – e

At the social optimum, or at Q opt and P opt, consumer surplus is equal

to area a, and producer surplus is equal to area b + f. The external cost is
now equal to zero.
Therefore, the total social benefits are equal to consumer surplus plus
producer surplus:
a+b+f
• Comparing total social benefits at the market equilibrium and at the social
optimum, we find that they are smaller at the market equilibrium by the area ‘e’.
This is the welfare loss.
Correcting negative production
externalities
• Government regulations Pg. 105
• limit the emission of pollutants by setting a • maximum level of pollutants
permitted
• limit the quantity of output produced by the • polluting firm
• require polluting firms to install technologies • reducing the emissions.
Market-based policies
• Imposing a tax to correct the negative production externality :
• tax on the firm per unit of output produced and tax per unit of pollutants emitted –
Carbon tax(which is a tax per unit of carbon emissions of fossil fuels)

•
• tax per unit of output produced and a tax per unit of pollutants emitted appear to
have the same result same diagram, actually they work quite differently
• A tax per unit of output is intended to work by directly correcting the
overallocation of resources to the good, resulting in quantity Q opt
• A tax per unit of pollutants is intended to work by creating incentives for the firm
to buy fewer polluting resources (such as fossil fuels), and to switch to less
polluting technologies (alternative energy sources).
Page 106.
• A tax on carbon (or on emissions generally) has the effect of creating
incentives for producers to reduce the amount of pollution they create by
purchasing less polluting resources.

• This reduces the size of the negative externality and increases the optimum
quantity of output

• A tax on the output of the polluter does not have this effect; it only reduces the
amount of output produced
• Tradable permits, also known as cap and trade schemes, involve giving firms a
legal right to pollute a certain amount e.g. 100 units of Carbon Dioxide per year.
• These permits to pollute can be traded (bought and sold) in a market.
• The permits to pollute can be bought and sold among interested firms, with the
price of permits being determined by supply and demand
• If a fi rm can produce its product by emitting a lower level of pollutants than the
level set by its permits, it can sell its extra permits in the market
• If a fi rm needs to emit more pollutants than the level set by its permits, it can buy
more permits in the market
• The aim of pollution permits is to provide market incentives for firms to reduce
pollution and reduce the external costs associated with it. For example, it is
argued carbon dioxide emissions contribute towards global warming
• Pollution permits can also be a way for the government to raise revenue, by selling
firms these permits to allow pollution
Kyoto protocol-This type of solution was agreed upon in The Kyoto Protocol, made
under the United Nations Framework Convention on Climate Change, which came
into force in February 2005
• Objective: reduce the global emission of greenhouse gases
• In this particular example, the agreement was between countries, but a similar
procedure could be applied to individual market cases.
Evaluating government regulations and market-based policies
The supply of permits is perfectly inelastic (i.e. the supply curve is vertical), as it is
fixed at a particular level by the government (or an international authority if several
countries are participating).

This fi xed supply of permits is distributed to fi rms

The position of the demand-for-permits curve determines the equilibrium price.

As an economy grows and the fi rms increase their output levels, the demand for
permits is likely to increase, as shown by the rightward shift of the demand curve from
D1 to D2

With supply fi xed, the price of permits increases from P1 to P2.

• Tradable permits are like taxes on emissions in that they provide incentives to
producers to switch to less polluting resources for which it is not necessary to
buy permits.
• If a firm finds a way to reduce its emissions, it can sell its permits thus adding to
profits.
• Permits therefore are intended to reduce the quantity of pollutants emitted,
thus reducing the size of the negative externality, and increasing the optimum
quantity of output produced, by shifting the MSC curve downward toward
MPC
Evaluating government regulations and market-based policies

• Advantages of market-based policies :

• Economists usually prefer market-based solutions to government regulations to
deal with negative production externalities
• internalising the externality: costs that were previously external are made internal,
because they are now paid for by producers and consumers who are parties to the
transaction
• Taxes on emissions are superior to taxes on output: Taxes on output gives
incentives to reduce the quantity of output produced, with a given technology.
• Taxes on pollutants emitted provide incentives to fi rms to economise on the use of
polluting resources (such as fossil fuels) and use production methods that pollute
less.
• tradable permits, the system creates incentives for firms to cut back on their
pollution if they can do so at relatively low cost
• If it is a relatively low cost procedure for a firm to reduce its pollutant emissions,
• it will be in its interests to do so and sell excess permits
• Both taxes and tradable permits are methods to reduce pollution more effi
ciently (at a lower cost).
Disadvantages of market-based policies
• Whereas taxes and tradable permits as methods to negative externalities are simple in
theory, in practice they are faced with numerous technical difficulties
• Taxes: Taxes face serious practical difficulties that involve designing a tax equal in value to
the amount of the pollution.
• An effective tax policy requires answers to the following questions:
• What production methods produce pollutants?
• Which pollutants are harmful ?
• What is the value of the harm?
• Aside from the technical difficulties, there is also a risk that even if taxes are imposed some
polluting firms may not lower their pollution levels, continuing to pollute even though they
pay a tax.
• Tradable permits : tradable permits require the government (or international body)
to set a maximum acceptable level for each type of pollutant, called a ‘cap’.
• This task demands having technical information on quantities of each pollutant that
are acceptable from an environmental point of view, which is often not available
• It can be difficult to measure pollution levels. There is potential for hiding pollution
levels or shifting production to other countries, with looser environmental
standards. In a globalized world, multinationals increasingly shift production around.
• There are administration costs of implementing the scheme and measuring
pollution levels
• For global pollution permits, countries who pollute more than their quotas can
simply buy permits from other countries.
• Therefore rich developed countries can simply buy permits from less developed
countries.
• This does not significantly reduce pollution but shifts it from the richer countries
to poorer countries.
• The biggest carbon trading scheme is the EU Emissions Trading Scheme (ETS),
however political interference has created a glut of permits and it has done little to
reduce carbon dioxide and reverse global warming.
• Some carbon trading schemes have a component called ‘carbon offsetting.
• This means if pay to plant trees, this can count against carbon emissions.
• critics argue carbon offsetting effectively enables firms to keep polluting with no
guarantee planting trees will on their own solve the pollution problem.

• To date, tradable permits have been developed for just a few pollutants (CO2,
SO2).
Solutions
• Examples – Sulphur Trading scheme
• In 1990, the US pursued a form of sulphur trading scheme which gradually reduced
the number of permits to pollute sulphur. (a cause of acid rain).
• It was relatively straight-forward as sulphur emissions came predominantly from
coal-burning power stations. This made it easy to monitor
• There was no scope for ‘sulphur offsetting’
• The scheme was successful in reducing sulphur dioxide by 40%.
• Though critics note sulphur dioxide also fell in other countries who pursued more
standard regulatory legislation to limit the amount of pollution – rather than
carbon trading.
• China’s national cap-and-trade program
• The biggest carbon trading scheme will be in China, who have sought to learn
from the EU’s experience with ERS
• The scheme will give a cap to polluters – this is the amount of pollution that can be
created without cost. If polluters go above this ‘free’ cap, they have to buy
allowances on the market for permits.
• The scheme set the initial carbon allowances to 3 -5 billion tones per year
Advantages of government regulations
• They are simple compared to market-based solutions, and can be implemented
more easily.
Overcome problem of technical difficulties in case of market based policies
regulations force polluting firms to comply and reduce pollution levels (which taxes
may not always do)
For these reasons, regulations are far more commonly used as a method to limit
negative externalities of pollution in countries around the world.
Disadvantage of Government Regulation
• Pg, 108