MARKET FAILURE

Introduction
and
reasons for market failure

1
 Market failure: Introduction
• 1. Under certain conditions, the competitive market results in a Pareto efficient resource allocation.
When the conditions required for this are not satisfied, a rationale for government intervention in the
market is provided. In certain respects, markets overproduce, underproduce or lead to people having
little income to live on.
• 2. Government is required to establish/define and enforce property rights and enforce contracts.
Without this, markets by themselves cannot function. E.g. over-grazing of land bc no one has
property rights (PRs) over it; PRs not well defined in common housing so price not
accurate/reflective. Loan default contracts, incentive to run away with others’ investment, etc.
• 3. There are six reasons why the market mechanism may not result in a Pareto efficient resource
allocation (Pareto inefficient): failure of competition, public goods, externalities, incomplete
markets, information failures, and unemployment. These are known as market failures.
• 4. Even if the market is Pareto efficient, there may be two further grounds for government action.
• First, the competitive market may give rise to a socially undesirable distribution of income.
• Second, some believe that individuals, even when well informed, do not make good judgments
concerning the goods they consume, thus providing a rationale for regulations restricting the
consumption of some goods, and for the public provision of other goods.
• 5. Though the presence of market failures implies that there may be scope for government activity, it
does not imply that a particular government program aimed at correcting the market failure is
necessarily desirable. To evaluate government programs, one must consider not only their objectives
but also how they are implemented.
• 6 The normative approach to the role of government asks, how can government address market
failures and other perceived inadequacies in the market’s resource allocation? The positive approach
asks, what is it that the government does, what are its effects, and how does the nature of the
political process (including the incentives it provides bureaucrats and politicians) help explain what
the government does and how it does it? 2
 Market failure
• Introduction:
• Adam Smith posits that in competitive markets, an individual
pursuing private gains would promote the common (public)
good. This is the root of market efficiency.
• We have so far studied the circumstances under which
competitive price/market mechanism would lead to an efficient
or Pareto optimal allocation of resources.
• The conditions require (including the specification of technology
and/or revelation of preferences, perfect competitive market
assumptions) are more stringent than those likely to exist in the
real world.
• We’re going to demonstrate even in a single market, there are
circumstances under which the market would produce nothing
(e.g. in the case of public goods), produce inefficient results
(under-produce or over-produce what is socially optimal as in
the case of externalities).
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 Market failure
• In circumstances when the market is unable to produce efficient
results, it is termed market failure. Market failure is most likely
to be associated with resources which have non-existent
markets (eg. public goods) or inefficient/incomplete markets
(eg. externalities). You should be able to distinguish non-existent
markets from incomplete markets! and how market failure
unfolds in them.
• Market failure is the inability of the competitive market
mechanism to efficiently produce socially optimal quantities of
goods and services or efficiently allocate resources.
• Put differently, Market failure is the inability of the competitive
market mechanism to efficiently allocate resources. Efficient
allocation of resources implies that goods and services are
produced at socially optimal levels.
• In principle, whenever markets fail government intervention can
enhance welfare depending on some SWF.
• Market failure issues are of prime interest for two reasons: The
market prices do not necessarily reflect social marginal benefits
(sMB) or costs (sMC); and market profitability does not
necessarily reflect net social benefits.
4
 Rationale for Market failure
• Broadly, Market failure occurs because:
➢Competition is imperfect (Imperfect Competition). For
example, someone may have monopoly power, oligopolistic
cartels, etc.
➢Producers or consumers may impose a cost on or confer a
benefit to other producers or consumers without paying for
the cost or charging for the benefit, that is, there are
production or consumption externalities.
➢The process produces a public good for which it is
impossible or undesirable to levy a charge.
➢Markets are incomplete (Incomplete markets). They do not
extend infinitely far into the future, and they do not cover
all risks.
➢Information is incomplete and imperfect (Information
asymmetry).
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 Explanation of Market failure Situations
• Failure of competition (Imperfect Competition)
• For markets to result in Pareto efficiency, there must be perfect
competition; perfect competition conditions must also work
absolutely. But in reality, there abound monopolies (1 firm + several
buyers), oligopoly (few firms +several buyers), monopolistic
competition (several firms producing slightly differentiated product
and different prices), natural monopoly (where it cheaper for a single
firm to produce entire output instead of several smaller firms
producing part of it, imperfect information (where a firm raises prices
but does not lose all of its customers, firms in strategic
behaviour/cartels with threats to cut down prices to discourage entry
(e.g. OPEC), Govt patents to firms to innovate, etc. These are
imperfect competition and firms have influence on prices.
• First-best requires perfect competition (no influence on prices but
only the market) to produce Pareto efficiency. Not some competition.
• Therefore, market may fail under such circumstance because for a
competitive market MR=MC=P but in a monopoly or imperfect
competition for instance, MR=MC<P or P>MC=MR.
• This makes competition imperfect, and the market will fail. 6
 Explanation of Market failure Situations
• Incomplete markets
• Whenever private market fails to provide a good or service even
though the cost of providing is less than what individuals are willing to
pay, this is referred to as incomplete market (because complete
market would provide all goods and services for which the cost of
provision (e.g. GHS40) is less than what individuals are willing to pay
(e.g. GHS 50)). Why this phenomenon?
• Because the market believes that there are certain risks which have
been hidden or under-estimated but will pop up in the future which
will cause them to make losses in the long run. Hence though the cost
is lower today than what those individuals are paying, in future, the
costs will be higher than what they pay today to cover that future
costs.
• Examples are loan provision (under-estimated risk of default by loan
applicants) and health insurance (under-estimated risk of high illness
or over-consumption of health care far and above the amount paid).
• So health insurance is often provided by govts or if markets, then at a
very high premium.
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 Market failure
• Information asymmetry
• When markets are generally incomplete, they are also likely to be associated
with information asymmetry- (a situation whereby there is imperfect
information i.e. information available to one set of market participants is not
the same as information available to the other set of market players).
• This gives rise to moral hazard and adverse selection problems which
increase risks in the market.
• Moral hazard is a situation when information about actions is hidden from
one party to a transaction and only becomes apparent after a deal or
agreement. Health insurance, used car sale, loan contracts, etc.
• Adverse selection occurs when knowledge about the characteristics is
hidden to from one party to a transaction and therefore makes the market
tilts towards high-risk clients rather low risk. The two problems generally
leads to misallocation of resources in the market.
• Example: high illness parties can buy low illness insurance and consume
more than what they paid as premium.
• Info asymmetry can lead to market failure in insurance policy. E.g.:
• Provider contemplating charging high premium to a firm, the firm will not
insure; charging lower premium means firm will buy but the policy provider
will lose; and this dilemma make market fail.
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 Market failure
• Increasing returns to scale, risk and uncertainty
• There are markets that require huge capital outlay to start and
thereby enjoy significant increasing returns to scale which have
the tendency to push small firms out of entering or producing in
such markets due to risk, uncertainty and the long time it takes
to break-even.
• Meanwhile market efficiency implicitly requires that firms’
technologies should exhibit constant or decreasing returns to
scale.
• A market with increasing returns to scale will have large firms
producing at a lower cost hence charge a lower price which
might not resonate with small firms’ production cost structures.
• The market may end up being a monopoly. Eg: Airlines, railways,
and utilities generally.
• Govt intervention to break the monopoly or to make such govt
production with social welfare in mind.
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 Government intervention in Pareto efficient economy
• Even if the economy is Pareto efficient, two further arguments
for govt intervention:
• 1. Income distribution: Efficient market makes allocations based
on factor endowments and this brings a lot of income inequality
issues. Utilitarian SWF! Govt intervention to redistribute in what
is fair and line with development goals. Taxes and subsidies to
achieve this.
• 2. Individuals may not act in their own best interests. Even fully
informed consumers may make bad decisions (bounded
rationality too). E.g. Smoking even though bad; use of seat belts;
• Government intervention: compel individuals to consume merit
goods like seat belts, basic educ. Goods that the govt compels
individuals to consume are merit goods.
• View that govt should intervene because it knows what is in the
best interest of individuals is paternalism.
• View that government should not interfere in the choices of
individuals is libertarianism. 10
 Market Failure

•PUBLIC GOODS

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 Public Goods Xtics
Public goods:
• Goods that will either not be supplied by the market or supplied in insufficient quantity. Eg.:
• All goods provided by the private sector or the private market share one important feature:
the provider of the good can charge those who wish to consume it thru exclusion and make a
profit in the process. Not every good shares these xtics however.
• A broad category of goods exists (public goods) for which charging is impossible or
undesirable. The private sector usually shies away from producing public goods. If it does
produce them, it produces too little of them based on only payment.
• Some goods exhibit a property that they simultaneously provide benefits to more than one
individual at the same time (they are jointly consumed eg. defense, law enforcement, radio
and television, street lights, flood control, clean air). Once they can be jointly consumed, they
are said to be non-rivalry in consumption. Thus, one individual’s consumption of the good
does not reduce the benefits simultaneously accruing to other individuals. Thus, the MC for
an additional individual enjoying the good is zero. It cost nothing for extra consumers
• It doesn’t make economic sense for exclusion, if the good is non-rivaled because MC of added
consumer is zero. Hence, charging for non-rival goods is inefficient since P=MC=0.
• Besides, the use of public goods may be non-excludable. Thus, it may be difficult, impossible
or at least very costly to exclude particular individuals from the consumption or use of the
existing output of a public good.
• If a particular good has both xtics, it is referred to as a pure public good and if only one xtic is
present is referred to as impure public goods (eg commons and club goods are impure public
goods). Impure public goods can have congestion (partial rivalry) and for that matter the
opportunity cost of allowing more use of the public good, or the reduction in the benefits to
those already consuming it is called a congestion cost.

12
Private vs. Public Goods Matrix
Exclusion Non-Excludability
Rivalriness Private goods: Impure public good:
(E.g.: cars, etc) Commons (eg. Fishing
ground, UPSA car park)
Non-Rivalriness Impure public good: Pure public goods:
Club goods (eg. street lights, police,
Concert party, music defence, free
concert etc) community radio
service, etc

13
 Market failure and Public goods
• The two characteristics (non-rivalriness and non-excludability) make it difficult for the
competitive market mechanism to produce optimal levels of such goods. How & Why?

• Excludability in a private goods: By excluding those individuals who are not willing to pay the
going price from the consumption of a good, the existing quantity can be rationed to those
who value it most (or want to pay) so that (Pareto) efficiency in consumption can be achieved.
• Non-excludability in public goods: With non-exclusion, sellers cannot exact a price from users
since users can consume it free of charge in any case. Voluntary pricing system cannot also be
enforced on rational consumers unless it is coercive (as with taxes). The failure of voluntary
pricing system to be enforced due to non-excludability is known as the Free-rider problem.
The relunctance of individuals to contribute voluntarily to provision of public goods.
• Again, although all individuals consume the same quantity of a public good, they derive
different MB implying different price will have to be exacted from each individual, and market
efficiency requires one P=MC=MR, therefore the market will be inefficient.

• Rivalry in a private good: With private good, because it is rivalry, the MC of allowing one
more individual to consume the same good is at least non-zero so consumers will enforce it.
Thus, any additional consumption of a private good by one more person comes entirely at the
expense of a forgone consumption by someone else.
• Non-rivalry in public goods: Because such goods can be jointly consumed, the MC of allowing
one extra individual to consume is zero. The MC of supplying to an additional user is zero. This
means zero price should be charged for additional consumption hence it will be inefficient to
exclude individuals. P=MC=0, will a private individual produce that?
• We will have a numerical example to demonstrate how these matter for public policy.

14
 Market failure and Public goods
• A public good is therefore a commodity or service that exhibits the
characteristics of non-excludability and non-rivalry in consumption.
A pure public good exhibits both xtics (eg clean air, etc) and an impure
public good exhibits one of the xtics with varying degrees of the other
xtic.
• In the case of non-rival goods, exclusion is undesirable because it
results in under-consumption (an inefficiency) but including more
people will also cause under-supply.
• Will govt intervention resolve the public good situation? Yes, to some
extent because once voluntary pricing is impossible and individuals’
awareness of the fact that the govt can coerce them to pay through
taxation, they will not reveal their true preference or potential benefit
for such goods and the govt might fail to achieve efficiency, but equity
might be served.
• Public goods can also be classified according to geographical reach:
Local public goods, regional public goods, and national public goods.
• Do you consider an expressway or motorway as a public good? Why?
What kind? Will private individuals provide a motorway? Under what
circumstances will they provide it? Will public-private partnerships
enhance efficiency in the provision of public goods? How? Provoke
your thought! 15
 Market Efficiency and Public goods
• Efficiency in the provision of a public good requires that MRSAG,X + MRSBG,X + … + MRSZG,X
= MRTG,X=MCG whereas efficiency in the provision of a private good requires that MRSAX,Y
= MRSBX,Y = … =P= MRTX,Y.
• Simply put, the efficiency in the provision of a public good requires that the summation
of marginal benefits (valuations) equal the MC. The summation represents the total
amount that all individuals together are willing to pay for an extra unit of public good.
This represents the collective demand curve. The price represents how much of the
other goods have to be forgone to produce one more unit of public goods ( this is the MC
or the Marginal Rate of Transformation (MRT). When DD=SS, then the ∑MRS=MRT=MC
produces Pareto efficient output of a public good.
• Deduction: If people have not revealed their true valuations/ benefits from using a public
good, there would be problems in ensuring efficiency in provision.
• NB: Provision here denote the choice and payment process rather than products or
service being produced by the govt (eg public corporation or civil servants) or private
firms. Thus, a public good can be provided by govt but produced by a private firm, Eg. a
bridge.
• What then determines whether a private firm or a public corporation should produce a
public good for govt: Relative wage and material cost, administrative cost, diversity of
taste, distributional issues, etc.
• Check diagrams and illustration on private good vs public good. Check the calculations.
16
Private good and demand

17
Public goods and market demand

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 Solutions to Public goods Market Failure
• Market failure as regards public goods is mainly due to free rider problem
(Not paying for the good but enjoying it or reluctance to voluntarily pay
for the good).
• Free riding implies that people are not ready to reveal their true
preference/valuation for a public good otherwise they will be asked to
pay amounts commensurate to it.
• Free ridership results from the non-rivalriness xtic which leads to
MC=0=Price. So no private production, hence govt intervention.
• Existence of free ridership in public goods will make market fail: unable
to provide efficient levels.
• Govt intervention necessary for as a solution.
• Can perfect price discrimination solve free rider problem?
• NB: PPD is charging the highest amount of money the consumer who is
prepared to pay.
• No. True revelation of preference difficult.
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 Solutions to Public goods Market Failure
• Non-excludability and non-rivalry property would lead to no price
exacted from users causing free rider problem and the solution to free
rider problem involves:
• Government action (compulsion eg. taxes).
• Transform the public good into private good through metering, road tolls,
etc.
• Government provision of public goods for equity reasons eg. to bridge
the gap between the rich and the poor.
• Review questions for mental gymnastics:
1. Can clean beaches, education, good roads, income distribution,
information, GBC Broadcast be considered as public goods?
2. To what extent has technological advances reduced the problem of non-
excludability?.
3. Under what circumstances will private firms provide an efficient level of
a public good?
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 Analytical numerical practice question
1. The residents of Pink-Sheet Community need 80 units of LED streetlights to enhance the general
security of the town. The marginal cost of producing the streetlights is $1700.
(a) Explain why a private entrepreneur will be unable to provide the 80 streetlights for the community.
(b) If three security-loving individuals and two couples are willing to pay some amounts for the
provision of the streetlights as P1=500-Q, P2=400-Q and P3=250-Q, and the couples P4=600-2Q
and P5=300-2Q respectively, where P is the amount, they are willing to pay, and Q is number of
streetlights.
(i) If a private entrepreneur wants to provide the streetlights now, how many will be provided?
(ii) Why would the private entrepreneur be able to provide only the number in (i) above.
(iii)Briefly explain two limitations to provision of the number of streetlights in (i) by the private
entrepreneur.
(iv) Why would it be inefficient to exclude those who did not pay from consuming the number of
streetlights provided in (i) above?
(a) Explain why the people of this community would be justified if they petition the government to
provide the 80 streetlights.
(b) Discuss one problem the government could face if it wants to efficiently provide the 80 streetlights.
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(c) State any three government failure issues that could affect the provision of the 80 streetlights.
 Market Failure

•EXTERNALITIES

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 Market Failure and Externalities
• An externality refers to the uncompensated impact of one person’s
actions on the well-being of a bystander or a third party.
• An externality arises...
. . . when a person engages in an activity that influences the well-
being of a bystander and yet neither pays nor receives any
compensation for that effect.
• When the impact on the bystander is adverse, the externality is called
a negative externality. E.g. Automobile exhaust, cigarette smoking,
barking dogs, loud music, etc.
• When the impact on the bystander is beneficial, the externality is
called a positive externality. E.g. Immunizations, New technologies,
honesty, etc.
• Negative externalities lead markets to produce a larger quantity than
is socially desirable.
• Positive externalities lead markets to produce a larger quantity than is
socially desirable.
23
 Market Failure and Externalities
• Externalities involves the creation of a service or disservice in the
process of production or consumption of goods or services, which is
extended to unintended group of consumers or producers.
• In other words, it describes a situation when a good or service is produced or
consumed, not paid for but being consumed /utilized, or is paid for but not
being consumed /utilized.
• Obviously, there are externalities in consumption and production.
• If one individual’s consumption increases the utility/satisfaction of another
individual or one firm’s production increases the production possibilities of
another firm, it is termed as positive externalities or external economies. Eg
honesty, information flow, knowledge discovery, com. disease prevention.
• If one individual’s consumption reduces the utility/satisfaction of another
individual or one firm’s production reduces the production possibilities of
another firm, it is termed as negative externalities or external diseconomies
eg: noise, pollution.
• Generally, an action by one agent which affects directly the well-being or
production possibilities of other agents but chosen without regard to those
consequences is known as externality. 24
Types of Externalities
• Positive externalities: E.g. Invention, Innovation, education,
• Negative externalities. E.g. smoke, bad odour, pollutants, garbage,
polluted water in galamsey.

• Consumer to consumer externalities

• Producer to producer externalities
• Producer to consumer externalities

• Variations
• Consumer to consumer positive externalities
• Consumer to consumer negative externalities

• Producer to producer positive externalities

• Producer to producer negative externalities

• Producer to consumer negative externalities

• Producer to consumer positive externalities 25
 Market Failure and Externalities
• Externalities also do have non-excludability & non-rivalriness
xtics, and they are unpriced hence the tendency to free ride
them or suffer unduly for them.
• Market conditions make an individual or firm choose that level of
activity at which the private MB from the activity just equal
private MC of undertaking it, thus ignoring the MBs jointly
accruing to other parties (positive externalities).
• pMB<sMB or pMC>sMC:
• This lead to market failure. In this instance, the private
individual undertaking the activity will under-produce such
goods (or will produce sub-optimal levels) because other parties
will enjoy without paying for it. Check diagram!
•

26
 Positive Externalities (Education) and the Social Optimum

Price of
Education
Supply
(private cost)

P* External
subsidy benefits
P

Demand
(private value)

0 QMARKET QOPTIMUM Quantity of

Education
Positive Externalities
• The intersection of the supply curve and the social-value
curve determines the optimal output level.
• The optimal output level is more than the equilibrium quantity.
• The market produces a smaller quantity than is socially
desirable.
• The social value of the good exceeds the private value of the
good.
• Internalizing Externalities: Subsidies
• Used as the primary method for attempting to internalize
positive externalities.
• Industrial Policy
• Government intervention in the economy that aims to promote
technology-enhancing industries
• Patent laws are a form of technology policy that give the individual (or
firm) with patent protection a property right over its invention.
• The patent is then said to internalize the externality.
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 Market Failure and Externalities
• Again, activities of an individual or a firm may damage or
produce dis-benefits to other parties without having to consider
the opportunity of cost of inflicting the damage (negative
externalities). In this case, only private MB from the activity is
equated to the private MC neglecting the cost imposed on
others.
• pMB>sMB or pMC<sMC
• Market failure resulting in the misallocation of resources again
pops up. Here, there will be over-production because the party
undertaking the activity incurs an extra costs borne by others.
Check the diagram!
• Externalities bring a discrepancy between private cost and social
cost or private benefit and social benefit with its respective
associated over-production and under-production. Check
diagram!
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 Negative Externalities (Pollution) and the Social Optimum

Price of
Aluminum
Cost of
pollution
Supply
(private cost)

Optimum
P*
tax
P Equilibrium

Demand
(private value)

0 QOPTIMUM QMARKET Quantity of

Aluminum
Negative Externalities
• The intersection of the demand curve and the social-
cost curve determines the optimal output level.
• The socially optimal output level is less than the market
equilibrium quantity.
• Internalizing an externality involves altering incentives
so that people take account of the external effects of
their actions.
• Achieving the Socially Optimal Output
• The government can internalize an externality by
imposing a tax on the producer to reduce the
equilibrium quantity to the socially desirable quantity.

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Private solutions to externalities
• Government action is not always needed to solve the problem of
externalities.
• Private solutions:
• Moral codes and social sanctions
• Charitable organizations
• Contracting between parties: Mergers
• The Coase Theorem:
• The Coase Theorem is a proposition that if private parties can bargain,
without cost, over the allocation of resources, they can solve the
problem of externalities on their own.
• Transactions Costs
• Transaction costs are the costs that parties incur in the process of agreeing to
and following through on a bargain.
• Why private solutions do not always work?
• Sometimes the private solution approach fails because transaction
costs can be so high that private agreement is not possible.
• Government interventions or public policy solutions become crucial.
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 Public policy solutions to externalities
• When externalities are significant and private solutions are not
found, government may attempt to solve the problem through .
..
• command-and-control policies.
• market-based policies.
• Command-and-Control Policies
• Usually take the form of regulations:
• Forbid certain behaviors.
• Require certain behaviors.
• Examples:
• Requirements that all students be immunized.
• Quotas: Stipulations on pollution emission levels set by the Environmental
Protection Agency (EPA).
• Market-Based Policies
• Government uses taxes and subsidies to align private incentives with
social efficiency.
• Pigovian taxes are taxes enacted to correct the effects of a negative
externality.
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 Public policy solutions to externalities
• Examples of Regulation versus Pigovian Tax
• If the EPA decides it wants to reduce the amount of pollution coming
from a specific plant. The EPA could…
• tell the firm to reduce its pollution by a specific amount (i.e. regulation).
• levy a tax of a given amount for each unit of pollution the firm emits
(i.e. Pigovian tax).
• Market-Based Policies
• Tradable pollution permits allow the voluntary transfer of the
right to pollute from one firm to another.
• A market for these permits will eventually develop.
• A firm that can reduce pollution at a low cost may prefer to sell its
permit to a firm that can reduce pollution only at a high cost.
• E.g.: Korean donation of 500K clean cookstoves. It's not
actually a donation, because the Koreans are
generating carbon credits from the number of clean
cookstoves they give to Ghana.
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 Summary on Externalities
• When a transaction between a buyer and a seller directly affects a
third party, the effect is called an externality.
• Negative externalities cause the socially optimal quantity in a market
to be less than the equilibrium quantity.
• Positive externalities cause the socially optimal quantity in a market to
be greater than the equilibrium quantity.
• Those affected by externalities can sometimes solve the problem
privately.
• The Coase theorem states that if people can bargain without a cost,
then they can always reach an agreement in which resources are
allocated efficiently.
• When private parties cannot adequately deal with externalities, then
the government steps in.
• The government can either regulate behavior or internalize the
externality by using Pigovian taxes or by issuing pollution permits.
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 Solutions to Externalities Market Failure
1. Govt regulation by setting and enforcing quality standards and granting
of quotas of production. Eg: EPA in Ghana, GSA.
2. Govt intervention thru taxes (Pigouvian taxes) and subsidies. Tax the
producer of negative externalities to discourage their production and
subsidize the producer of positive externalities to encourage their
production).
3. Govt assigning, defining and enforcing property rights. (A property right
is a legal rule that describes what economic agents can do with an object
or idea).
4. Create a market for the externality if it has no existing market. Eg
creating institutions like EPA, GSA to operate the market.
5. Private arrangements through assignment of property rights and
compensation. Thus the “Coase Theorem” which explains that if a
bargaining cost is negligible, then bargaining can help internalize an
externality based on ownership of property rights. In this case, the one
who does not own the property rights compensates the one who owns
the property rights. 6. Mergers.
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 Analytical numerical practice question
1. In a competitive constant cost industry, the marginal cost is GHC50 and
the private demand function of individuals of a good whose production
generates external costs is P=250-4Q. If the marginal external cost (MEC)
function is: MEC=-120+4Q, find the following:
(i). Inefficient quantity (ii). Efficient quantity
(iii). Level of per unit tax needed to produce efficient quantity.
(iv). Marginal external cost before and after the tax and comment on your
results. (v) Provide a sketch of your work.
2. In a competitive constant cost industry, the marginal cost is GHC50 and
the private demand function of individuals of a product whose
consumption generates external benefits is P=250-4Q. If the marginal
external benefit (MEB) function is: MEB=220-4Q, find the following:
(i). Inefficient level of output. (ii). Efficient level of output
(iii). Level of govt subsidy needed for socially optimal output.
(iv). Marginal external benefit before and after the subsidy and comment
on your results. (v) Provide a sketch of your work.
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 Government Intervention
• In principle, there is a strong rationale for public sector
involvement whenever the market cannot or will not produce
the socially desirable quantity of a good or service.
• However, the selected intervention should most likely improve
welfare. Besides, to the extent possible, it must be shown that
society will be better-off as a result of government involvement,
that is, they must assess the costs and benefits of government
involvement and show that the benefits will outweigh the costs.
There is need for Cost-Benefit Analysis (CBA).
• The nature of involvement therefore merits a careful
consideration while reflecting on these questions vis-a-vie the
economic functions of the govt:
1. What market failure leads the private sector to produce none,
more or less than the socially optimal quantity of a good or
service?
2. What sort of government intervention is appropriate to ensure
that the optimal quantity is produced?
3. Is the recommended government intervention likely to have the
desired impact? 38
 Government Failure
• Government failure is the inability of government actions or
interventions to enhance the efficiency of the market. The inability of
the state to achieve a Pareto efficient outcome and to redistribute
income in a fair manner.
• The circumstances which make the market fail coupled with some
other peculiar xtics of the public sector can make governments also
fail in improving the efficiency of the market or in ensuring socially
optimal provision of goods and services.
• These include issues of revelation of marginal benefits,
incompleteness of markets and natural monopolies. These would
make government trade off some efficiency for equity.

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 Government failure reasons
• Other peculiar xtics include: Corruption, agency problems (reps and
democracy), Rent seeking activities and monopoly bureaucracy could
also make government fail to improve market outcomes.
• Agency problem conditionalities: if there is asymmetric information
between agent and principal; the goals of the agent and principal
differ; if costless observation of the activities of the agent is not
possible.
• Rent seeking: The idea that individuals will seek to influence public
policy so as to serve their own goals, self interests etc. Rent-seeking:
investing resources to gain special privileges and monopoly profits.
The diversion of government power from pursuing the general
welfare of society to promoting the special interests of some few
individuals at the expense of others. Rent seeking activities make
individuals gain transfer of wealth at the expense of others rather than
gain wealth through productive activity.
• Monopoly bureaucracies: When a bureaucracy is the sole supplier of a
service and can set the terms for its delivery. This confers significant
monopoly powers.
• Solutions: Privatization, agencies established to monitor other
government departments, re-election mechanisms, etc.
• Summary map of conceptual framework of analysis! 40