AF1605

Introduction to Economics

Topic 6 Market Failure

 Sources of Market Failure

 A perfectly competitive market is able to maximize social surplus and

achieve allocative efficiency.

 Market failure is a situation in which the market is inefficient (cannot

achieve allocative efficiency).

 Inefficiency can occur because:

 Too little is produced – underproduction.
 Too much is produced – overproduction.

 Sources of market failure:

 Monopoly power (discussed in Topic 5).
 Externalities.
 Public good.

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 Externalities

 Private benefit: The benefit enjoyed by an individual who takes the action.
 Private cost: The cost incurred by an individual who takes the action.

 Social benefit: The benefit enjoyed by the whole society.

 Social cost: The cost incurred by the whole society.

 Social benefit = Private benefit + External benefit

 Social cost = Private cost + External cost

 Externalities occur when there is a divergence (a) between private benefit

and social benefit, and/or (b) between private cost and social cost .

 Allocative efficiency occurs when marginal social benefit (MSB) equals

marginal social cost (MSC).

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 Externalities

 Negative externalities
 A production or consumption activity that creates an external cost.

 Positive externalities
 A production or consumption activity that creates an external
benefit.

 Types of externalities:
 Negative production externalities: e.g., factories generate pollution
during the production process.
 Positive production externalities: e.g., academic research.
 Negative consumption externalities: e.g., smoking.
 Positive consumption externalities: e.g., education.

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 How to Solve Externalities

 Coase Theorem
 The proposition that if property rights exist, only a small number of
parties are involved, and transaction costs are low, then private
transactions are efficient and the outcome is not affected by who is
assigned the property right.
 It is not easy to meet the above conditions.

 Remedies by government to solve externalities

 When there are negative externalities: Taxation by government.
 When there are positive externalities: Subsidy by government.

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 Negative Externalities: Pollution

 During the production of

chemicals, the factories also
generate pollutants and the
amount of pollutants is
increasing with the output level
of the factories.

 When output is 4,000 tons of

chemicals per month:
 Marginal private cost is $100 a
ton.
 Marginal external cost is $125 a
ton.
 Marginal social cost is $225 a
ton.

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 Negative Externalities: Pollution

 Without regulation, the

market is in equilibrium (S=D)
at a price of $100 a ton and
4,000 tons of chemicals a
month.

 The efficient quantity is 2,000

tons of chemicals, where
marginal social cost (MSC)
equals marginal benefit.

 The gray triangle shows the

deadweight loss created by
overproduction.

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 Correction by Pollution Charges or Taxes
 A pollution charge or tax
is imposed by the
government that is equal
to the marginal external
cost of pollution.

 The supply curve

becomes the marginal
private cost (MC) curve
plus the tax.

 Because the charge or tax

equals the marginal
external cost, the MSC
curve becomes the supply
curve.

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 Correction by Pollution Charges or Taxes

 After the imposition

of pollution tax, the
market can produce
at the efficient
quantity (S = MSC =
D = MB).

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 Positive Externalities: Education

 When 15 million students

attend university:
 Marginal private benefit
is $10,000 per student.
 Marginal external benefit
is $15,000 per student.
 Marginal social benefit is
$25,000 per student.

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 Positive Externalities: Education

 Without regulation, the

market is in equilibrium at a
quantity of 7.5 million
students per year.

 The efficient number of

students is 15 million, where
marginal social benefit
(MSB) equals marginal cost.

 The gray triangle shows the

deadweight loss created by
underproduction.

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 Government Subsidizes Education

 Government gives the

university a $15,000
subsidy per student.

 The subsidy shifts the

supply curve to S = MC –
subsidy.

 Student pays $10,000 for

tuition fee.

 The market equilibrium is

efficient with 15 million
students enrolled in
university.

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 Classifying Goods and Services

 All goods and services can be classified according to whether they are (a)
excludable or nonexcludable, and (b) rival or nonrival.

 Excludable vs Nonexcludable
 A good, service, or resource is excludable if it is possible to prevent
someone from enjoying its benefits.
 A good, service, or resource is nonexcludable if it is impossible to
prevent someone from enjoying its benefits.

 Rival vs Nonrival
 A good, service, or resource is rival if its use by one person decreases
the quantity available for someone else.
 A good, service, or resource is nonrival if its use by one person does
not decrease the quantity available for someone else.

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 Fourfold Classification of Goods and Services

Rival Nonrival

Private Goods Natural Monopoly Goods

Excludable Example: Food and drinks, Example: Cable TV
Houses
Common Resources Public Goods
Nonexcludable Example: Fishes in ocean Example: National defense,
Street lights

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 Public Good

 Public goods create a free-rider problem.

 A free rider is a person who enjoys the benefits of a good or service

without paying for it.

 Because of the free-rider problem, the provider of a public good is

difficult to collect the revenue.

 The quantity of public good provided by the private market will be

insufficient.

 To produce the efficient quantity, government action is required.

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Marginal Benefit of Public Good

 To find the economy-wide

value of the public good, we
add together the marginal
benefits of everyone who
enjoys the benefits.

 Lisa’s marginal benefit curve is

MBL.

 Maxs marginal benefit curve is

MBM.

 The MSB curve for the

economy is the vertical sum of
the marginal benefit curves of
everyone in the economy –
Lisa and Max.

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 Efficient Quantity of Public Good

 The marginal cost curve of

public good is upward sloping.

 The efficient quantity of the

public good occurs at the level
where MSB equals MSC.

 Because of the free-rider

problem, private provision leads
to underproduction – in the
extreme case, to zero
production.

 Very often public provision of

public good is required.

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