Market Failures Versus

Government Failures

Lecture Series on Basic Microeconomics

Prepared by Elizabeth R. Bajit, Ph.D.
CBAA, CLSU
At the end of this lecture, you should be able
to:
 differentiate private cost and private gain from public cost and public
gain
 define what is market failure and identify the factors that cause
market failures
 define what is externality, differentiate negative from positive
externality, and provide examples of both
 discuss how externality causes market inefficiency
 discuss why the lack of competition reduces the welfare of the
society
 define asymmetry of information and explain why this produces non-
optimal market outcome
 define what is inalienable rights and discuss why the violations of
these rights results to non-optimal market outcome
 discuss why the government intervention can sometimes solves
market inefficiency or improve market outcomes but may also make
 Market Failures
 In real life, the market is not always efficient. This is because private decisions
do not factor in the social benefits and social costs. We will then discuss the
externalities in production and consumption which caused non-optimal
decisions and non-optimal outcomes.
 Consumers benefit from more competition in the market, but companies may find it
beneficial to reduce or eliminate competition in order to maximize their profits.
Here we will discuss the impact of monopoly power on the society.
 When there is complete information, the decision makers are aware of the options,
thus, decisions are optimal. However, when decisions are made with incomplete
information, the decisions may be suboptimal. We will discuss why the asymmetry
of information leads to suboptimal outcomes.
 The market may be efficient, where it allocates the resources to where they are
valued the most. However, it does not address equity issue. We will discuss how
the government intervention address this distribution issue and reduces
the inequality brought about by the market.
 There is suboptimal outcome when some markets are missing. We will discuss why
some goods cannot be bought and sold.
 We will also discuss why the government intervention may worsen rather than
solve the market failures
Market Efficiency is Maximizing the Total
Surplus
The market is efficient when it
allocates the resources such that the
output desired by the consumers is
produced (P = MC) and it is produced
with the least cost of production.

The market is efficient when it

allocates the resources to the goods
most valued by the consumers and it
maximizes the consumer surplus

The market is efficient when the

resources used also maximized the
producer surplus
 Market Failure and Externality
 We define market failure are situations where the market does not lead to a
desired result. It results to loss in market efficiency. Price no longer serves as a
mechanism for efficient allocation of resources.
 There is market failure when consumers derive lower satisfaction because they pay
prices higher than what they are supposed to pay. This happens when there is less
competition, producers (monopoly, monopolistic competition and oligopoly) reduce
the quantity produced so they can charge a higher price (under pure competition,
MR = MC, profit is maximized. Since P = MR, then P = MC, resources are
optimally allocated and welfare is maximized). When there is imperfect
competition, MR = MC, profit is maximized. However, P > MR, therefore P >
MC, resources are not optimally allocated)
 Although the level of output is consistent with the profit maximization criterion
(Private Marginal Benefit = Private Marginal Cost), if there is negative
externality, the Public Marginal Cost is not considered in making the decision.
Logging provides private benefits to those earning from this economic activity. The
owners ignore the social cost it brings in terms of flash floods which adversely
affect communities in the area. When there is negative externality, the output is
overproduced relative to the optimal output.
 Market Failure and Externality
On the other hand, there are economic activities which provide
positive externalities. For example, education does not only provide
financial rewards to the family which improves their standard of
living, it also reduces unemployment and crime rates. Thus,
education provides benefits to the society.

However, individuals or families will make decisions whether to

provide primary education only, secondary education only, or
tertiary education on the basis of the Private Marginal Benefit =
Private Marginal Cost. The families do not care about the
potential social benefit of education in making decisions about
undertaking education for the children. When there is positive
externality, the output is underproduced relative to the
optimal output.
 Market Failures and Failure of Market
Outcomes
1. Existence of externalities
There are two types of externalities: positive and negative.
Positive externality occurs when the beneficial effects of a decision or activity
benefits others other than those make the decisions or those who undertake the
activity.
Negative externality occurs when the cost of a decision affects others other than
the person who makes the decision or those who undertake the activity (see
examples in the succeeding slides).
2. Presence of monopoly power
Monopoly, monopolistic competition and oligopoly deviate from the efficiency
standard. We know that there is efficient allocation of resources when there is
competition because output is produced where P = MC. If there is imperfect
competition, output is produced where P > MC.
Market Failures and Failure of Market Outcomes
3. Absence of perfect information
the markets do not achieve market efficiency when there is
imperfect information. An example is information asymmetry
and the market for lemons
4. The market addresses efficiency issues but ignores
distribution issues. Output is produced at the least cost, but who
get those output?
5. Sometime the individuals do not know what is best for
themselves? Do people who can buy liquor or cigarettes at a
lower cost get higher benefits? The market price may be the result
of the total market demand and supply but the outcome may be a
failure.
6. Another cause of the failure of market outcome is the violation of
inalienable rights. Inalienable rights refer to the rights of a
person which are given to a person at birth, and this cannot be
 Positive Versus Negative
Externality
1. Existence of externalities
There are two types of externalities: positive and negative.
Positive externality occurs when the beneficial effects of a decision or activity
benefits others other than those make the decisions or those who undertake the
activity.
Negative externality occurs when the cost of a decision affects others other than
the person who makes the decision or those who undertake the activity (see
examples in the succeeding slides).

The Positive Externality can be in the form of positive production

externality or positive consumption externality

The Negative Externality can be in the form of negative

production externality or negative consumption externality
 Examples of Positive Externalities
1. Bee farm with flower farm2. Beautiful hanging 3. Free Seminars on
plants within your 4. Use of bicycles
Cardiopulmonary as transportation
neighborhood Resuscitation (CPR)
 Examples of Positive Externalities
6. Creation of Worldwide web Government Research
5. Vaccinations that the individuals can access and Medical Center

This Photo by Unknown Author is licensed under

CC BY-NC

This Photo by Unknown Author is https://betanews.com/2013/04/30/the-way-we-were

licensed under CC BY -cern-recreates-the-first-web
 Examples of Negative
Externalities
2.Water
4. Traffic congestion

Pollution

1. Air pollution 3. Illegal logging

This Photo by Unknown Author is
licensed under CC BY-SA

This Photo by Unknown Author is licensed

This Photo by Unknown Author is licensed under
under CC BY-NC-ND
CC BY
 Examples of Negative
Externalities
Noisy neighbors singing with
loud microphone
Construction of buildings
in your neighborhood or
Piggery in a residential area
/lack of zoning policy
road on your way to
work

This Photo by Unknown Author is licensed under CC BY-NC This Photo by Unknown Author is licensed
This Photo by Unknown Author is licensed under CC BY
under CC BY-SA
 Government Solutions to Market
Inefficiency Caused by Externality

Goods which create Goods which create

negative externality positive externality
are overproduced are underproduced

Solution: Provide subsidies, for

Solution: Implement policies example, scholarships to
to prevent improper disposal students particularly to the poor
of waste, or prevent families so they can get a good
discharging toxic waste on education. Offer free trainings to
our waterways. Impose make the poor productive.
penalties to violators.
 How to Reduce Monopoly Power?
Republic Act 10667 is known as the Philippine Competition Act . It is
an act providing for a national competition policy prohibiting anti-
competitive agreements, abuse of dominant position, and anti-competitive
mergers and acquisitions, establishing Philippine Competition Commission
and appropriating funds therefor.
1) The State shall enhance the economic efficiency and promote free
and fair competition in trade, industry and all commercial activities ,
as well as establish the National Competition Policy
2) The State shall prevent economic concentration which will control
the production, distribution, trade or industry that will stifle competition,
lessen, manipulate or constrict the discipline of the markets.
3) The State shall penalize all forms of anti-competitive agreements,
abuse of dominant position and anti-competitive mergers and
acquisitions, with the objective of protecting the consumer welfare and
advancing domestic and international trade and economic development.
Source: https://www.officialgazette.gov.ph/2015/07/21/republic-act-no-10667/
 References
1. Colander, D. C. (2020). Microeconomics (11th
Edition). New York, N. Y.: McGraw Hill
Education

2. Mankiw, N. G. (2018). Principles of

Economics (8th Edition). Boston MA, USA:
Cengage Learning
 This ends part 1 of the lecture on
market failures versus government failures

See you again in part 2 🍕🥤