Micro Week 10

Market Failures
Reading: Varian Chapters 35, 37 and 38

Introduction

A market failure is a case where a market leads to an undesirable, or at

least inefficient, outcome. We will think of three distinct types of market
failure: externalities, public goods, and asymmetric information.

Externalities

An externality arises when one person or firm’s choices affect another

person or firm.

In the case of a consumption externality, one person’s consumption enters

into another’s preferences: for example, a non-smoker may be made worse
off by another person smoking (a negative consumption externality) or
someone may enjoy the view of their neighbour’s garden (a positive
consumption externality).

With a production externality, one firm’s production affects another firm’s

production: for example, a steel factory polluting a river adversely affects a
fishery (a negative production externality) or a beekeeper helps pollinate a
nearby orchard (a positive production externality).

We will look first at consumption externalities, then production externalities.

A consumption externality

Two housemates, A and B, have preferences over two things: money (which
allows them to buy consumption goods) and smoke. Money allows both to
consume more, so they prefer more money. A is a smoker, so gains utility
from smoke; B likes clean air, so loses utility from smoke.

We can show these consumers’ preferences in an Edgworth box, but with a

difference from the standard case. On the horizontal axis, money is divided
between the two consumers: moving from left to right means A receives more
money and B less. But on the vertical axis, we see the amount of smoke
consumed by both A and B increasing as we move upwards. A likes smoke,

1
so their utility increases in both money and smoke. B dislikes smoke, so
their utility is increasing in money and decreasing in smoke.

A's indifference curves are in green: moving up and right, A increases utility
through more money and more smoke. B’s indifference curves are purple:
moving down and left increases B’s utility through more money and less
smoke.

moneyB
B

smoke smoke
𝑢1𝐵

𝑢𝐵2
𝑢𝐵3

𝑢𝐴3

𝑢𝐴2

𝑢𝐴1
A
moneyA

We assume each person starts with half the total amount of money. This
forms part of their endowment, but we also need to consider the endowment
of smoke. We consider two cases: either B has a right to clean air
(endowment E), or A has a right to smoke as much as they want
(endowment E’).

2
 B
E’

smoke
smoke
𝑢1𝐵

X’
𝑢𝐴2

𝑢𝐵2
X

𝑢𝐴1

A
E
moneyA

If we start from E, we can find points that are on higher indifference curves
for both consumers: A will be willing to pay B for the right to smoke, and B
will be willing to give up clean air for enough money. If they trade to reach
point X, this is Pareto efficient: neither can move to a higher indifference
curve without the other moving to a lower indifference curve.

Similarly, if A has the right to smoke, we can find points where B would be
willing to pay A to smoke less. X’ is an example of a Pareto efficient point at
which B pays A for less smoke.

As long as property rights are defined – either A has the right to smoke, B
has the right to clean air, or perhaps some well-defined limit is set on how
much A can smoke for free – then trade between the two should result in a
Pareto efficient outcome.

This illustrates a version of the Coase Theorem: with well-defined property

rights, a market for the externality allows a Pareto efficient outcome to be
achieved.1

1
A stronger version of the Coase Theorem states that the Pareto efficient level of the externality is
independent of the initial property rights, as long as they are well defined. Varian illustrates this with
quasilinear preferences, but you do not need to know this.

3
Production externalities

A steel maker produces a quantity of steel s. The production process also

generates a quantity of pollution x that leaks into a river. A fishery produces
a quantity of fish f and is affected by the pollution released by the steel
producer.

The steel firm’s cost function is 𝑐𝑠 (𝑠, 𝑥), with costs decreasing in the amount
of pollution released: 𝜕𝑐𝑠 ⁄𝜕𝑥 ≤ 0. We can interpret this as saying that it is
costly for the firm to reduce the amount of pollution released into the river,
at least up to some level of pollution.

The fishery’s cost function is 𝑐𝑓 (𝑓, 𝑥) with costs increasing in the amount of
pollution released by the steel firm: 𝜕𝑐𝑓 ⁄𝜕𝑥 > 0. In other words, pollution
makes it more expensive to produce fish.

We assume both firms are price-takers, facing prices of ps and pf.

The steel firm, which can determine both the quantities of steel and
pollution it produces, has the following profit-maximisation problem:

max 𝜋𝑠 = 𝑝𝑠 𝑠 − 𝑐𝑠 (𝑠, 𝑥)
𝑠,𝑥

The fishery has no control over the level of pollution and has the following
profit-maximisation problem:

max 𝜋𝑓 = 𝑝𝑓 𝑓 − 𝑐𝑓 (𝑓, 𝑥)
𝑓

We find three first-order conditions, the first two for the steel producer and
the last for the fishery:
𝜕𝜋𝑠 𝜕𝑐𝑠
= 𝑝𝑠 − =0
𝜕𝑠 𝜕𝑠

𝜕𝜋𝑠 𝜕𝑐
= − 𝜕𝑥𝑠 = 0
𝜕𝑥

𝜕𝜋𝑓 𝜕𝑐𝑓
= 𝑝𝑓 − =0
𝜕𝑓 𝜕𝑓

Two of these conditions simply say the firms each produce where the
marginal cost of production equals the price of their product (both firms are
price-takers, so this is equal to their marginal revenue). The middle
condition says the steel producer should set the marginal cost of pollution
equal to zero – the firm doesn’t need to pay anything to pollute, so it has no
incentive to reduce pollution.

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There is a social cost of pollution – it increases the fishery’s production
costs – but this is not taken into account by the steel producer, hence there
is an externality.

Consider what would happen if instead of running two separate firms, the
steel producer and fishery merged into a single profit-maximising firm. The
merged firm would have the following profit-maximisation problem:

max 𝜋𝑚 = 𝑝𝑠 𝑠 + 𝑝𝑓 𝑓 − 𝑐𝑠 (𝑠, 𝑥) − 𝑐𝑓 (𝑓, 𝑥)

𝑠,𝑓,𝑥

Again we have three first-order conditions:

𝜕𝜋𝑠 𝜕𝑐𝑠
= 𝑝𝑠 − =0
𝜕𝑠 𝜕𝑠

𝜕𝜋𝑓 𝜕𝑐𝑓
= 𝑝𝑓 − =0
𝜕𝑓 𝜕𝑓

𝜕𝜋𝑠 𝜕𝑐 𝜕𝑐𝑓
= − 𝜕𝑥𝑠 − =0
𝜕𝑥 𝜕𝑥

Only the third condition has changed: this now says the firm should take
into account the effects of pollution on the costs not only of steel production,
but also of fishing.

Remembering that releasing pollution makes steel production cheaper but

adds to the cost of producing fish, we can compare the amounts of pollution
released in the two cases in the diagram below. We can think of –MCs as
representing the marginal cost of avoiding pollution for the steel factory.
When it operates as a separate firm, it will produce where the marginal cost
is zero, at xs. The merged firm will produce where the marginal cost of
avoiding pollution in steel production equals the marginal cost of that
pollution to the fishery, at xm.

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 cost

–MCs

MCf

xm xs
pollution

The Pareto efficient level of pollution is xm. For lower levels of pollution, the
cost of reducing pollution outweighs the cost imposed on the fishery; for
higher levels, the cost to the fishery of additional pollution outweighs the
cost of reducing it. Efficiency requires that the marginal cost of reducing
pollution for the steel firm equals the marginal external cost of pollution on
the fishery, and this is only achieved at xm.

Responses to a production externality

The analysis above shows one response to an externality: if the firms merge,
they will produce the Pareto efficient level of pollution. The merger is also in
the firms’ interests: the merged firm maximises the joint profit of the two
firms, so results in higher profit than the two firms would earn as separate
entities.

However, if the firms do not merge, how else could we achieve the Pareto
efficient outcome? Two possible ways are explained below.

Taxation

If we could directly tax the level of pollution at a rate t per unit, the steel
producer’s profit maximisation problem becomes:

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 max 𝜋𝑠 = 𝑝𝑠 𝑠 − 𝑐𝑠 (𝑠, 𝑥) − 𝑡𝑥
𝑠,𝑥

The fishery’s two first-order conditions are now:

𝜕𝜋𝑠 𝜕𝑐𝑠
= 𝑝𝑠 − =0
𝜕𝑠 𝜕𝑠

𝜕𝜋𝑠 𝜕𝑐
= − 𝜕𝑥𝑠 − 𝑡 = 0
𝜕𝑥

The second condition means the firm will respond to a tax by cutting its
pollution. If the tax is set equal to the marginal cost of pollution on the
𝜕𝑐𝑓
fishery , the Pareto efficient level of pollution will be reached.
𝜕𝑥

Defining property rights

As with the consumption externality, we could define property rights and

create a market for pollution. If the fishery was given the right to clean
water, the steel producer would be willing to pay to pollute; if the steel
producer was given the right to pollute, the fishery would be willing to pay
for cleaner water.

We can see this simply by treating pollution as something one firm pays the
other for. In the case where the fishery has a right to clean water, it can
charge the steel producer q per unit of pollution released. Profits for the two
firms are now:

𝜋𝑠 = 𝑝𝑠 𝑠 − 𝑞𝑥 − 𝑐𝑠 (𝑠, 𝑥)

𝜋𝑓 = 𝑝𝑓 𝑓 + 𝑞𝑥 − 𝑐𝑓 (𝑓, 𝑥)

Solving the profit maximisation problems will include conditions where

𝜕𝑐𝑠 𝜕𝑐𝑓
𝑞=− and 𝑞 =
𝜕𝑠 𝜕𝑥

So equating these means we would reach the Pareto efficient level of

pollution.

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Public Goods

Public goods have two main characteristics, they are non-rival and non-
excludable. This means that consumers consume them together (i.e. each
unit is simultaneously consumed by every consumer), and consumers
cannot be prevented from consuming a good, even if they do not pay. This
results in everyone consuming the same quantity of the good – if it is
provided by a government (e.g. streetlights or defence), the government
chooses that quantity. We will see that private consumption decisions may
not lead to optimal provision, but first we will consider how much of a public
good should be provided.

We start with an example. Two housemates are deciding whether to pay for
a television they will share. We denote each person’s initial wealth wi, their
contribution towards the television gi and their money spent on other
(private) consumption xi, for i = 1, 2. Their budget constraints are:

𝑥1 + 𝑔1 = 𝑤1 and 𝑥2 + 𝑔2 = 𝑤2

The cost of a television is c, so for the television to be bought we need2

𝑔1 + 𝑔2 ≥ 𝑐

Each housemate has a reservation price for the television – the maximum
amount they would be willing to contribute for the television to be bought.
These are given by r1 and r2. By definition of a reservation price, each
consumer is indifferent between spending their whole wealth on other
things, and spending their reservation price on the television and the rest of
their wealth on other consumption. Logically, this means that buying the
television would be a Pareto improvement as long as each housemate’s
payment for the good is below their reservation price. So the television
should be bought as long as

𝑟1 > 𝑔1 and 𝑟2 > 𝑔2

It follows that the television should be bought if 𝑟1 + 𝑟2 ≥ 𝑐, the sum of the

housemates’ reservation prices is greater than the cost of the television. Note
that this doesn’t imply a rule for how the cost should be divided, it simply
says the television should be bought if the sum of reservation prices (which
will depend, among other things, on each housemate’s initial wealth and
how much they enjoy watching television) is high enough.

This seems relatively straightforward for two people sharing a television, but
it suggests a far more complicated problem when a public good is shared by

2
We are assuming for now that only one model of television is available, which is either bought or not – i.e.
the housemates don’t decide whether to pay more for a bigger/better television. (But we will address that
choice later.)

8
more people. For example, street lighting should be supplied if the sum of
the reservation prices of all local residents exceeds the cost of providing the
lighting.

Free riding

Even with the simple example of the television, it doesn’t automatically

follow that the television will be provided if doing so would be a Pareto
improvement. Either housemate may hide their true reservation price, in the
hope that the other would pay all, or most, of the cost. This is an example of
free riding – relying on others to pay the cost of a public good. Again, this
problem will be magnified with more complicated public good provision
problems, shared by more consumers.3 So even when it is Pareto efficient for
the public good to be supplied, we cannot assume this outcome will be
reached.

Different levels of a public good

Now assume the housemates are not just deciding whether to buy a
television, but how much to spend on it – more money buys a better
television.

The cost of the television now depends on its quality G, so the cost function
is c(G). The housemates jointly face the constraint that the sum of the
amounts they spend on private consumption and the public good adds up to
the sum of their wealth:

𝑥1 + 𝑥2 + 𝑐(𝐺) = 𝑤1 + 𝑤2

To simplify our analysis, we will assume that each unit of the private
consumption good costs 1, so xi measures both expenditure on the private
good and quantity consumed. We also assume that we can measure
‘television quality’ and each unit of quality has a price of 1, so c(G) measures
both expenditure on the television and its quality (or more generally, it gives
both expenditure on, and quantity of, a public good).

It would be Pareto efficient for consumer 1 to maximise their utility given

consumer 2’s utility, with the additional constraint above. That means we
have the following problem:

3
Varian includes a free riding game example (p. 722), but it is slightly odd. If both players choose to buy, it
appears they both pay the full cost of the television rather than sharing the cost. Logically this implies (Buy,
Buy) leads to two televisions in the living room. If they shared the cost (paying 75 each) each would have a
payoff of 25 from (Buy, Buy). There would not be any pure strategy Nash equilibrium.

9
 max 𝑢1 (𝑥1 , 𝐺)
𝑥1 ,𝑥2 ,𝐺

s.t. 𝑢2 (𝑥2 , 𝐺) = 𝑢̅2

𝑥1 + 𝑥2 + 𝑐(𝐺) = 𝑤1 + 𝑤2

We set up a Lagrangian:

𝐿 = 𝑢1 (𝑥1 , 𝐺) − 𝜆[𝑢2 (𝑥2 , 𝐺) − 𝑢̅2 ] − 𝜇[𝑥1 + 𝑥2 + 𝑐(𝐺) − 𝑤1 − 𝑤2 ]

We get three first-order conditions:

𝜕𝐿 𝜕𝑢1 (𝑥1 ,𝐺)
= −𝜇 =0
𝜕𝑥1 𝜕𝑥1

𝜕𝐿 𝜕𝑢2 (𝑥2 ,𝐺)

= −𝜆 −𝜇 =0
𝜕𝑥2 𝜕𝑥2

𝜕𝐿 𝜕𝑢1 (𝑥1 ,𝐺) 𝜕𝑢2 (𝑥2 ,𝐺) 𝜕𝑐(𝐺)

𝜕𝐺
= 𝜕𝐺
−𝜆 𝜕𝐺
−𝜇 𝜕𝐺
=0

We divide the third equation by μ and rearrange to give:

1 𝜕𝑢1 (𝑥1 ,𝐺) 𝜆 𝜕𝑢2 (𝑥2 ,𝐺) 𝜕𝑐(𝐺)
−𝜇 =
𝜇 𝜕𝐺 𝜕𝐺 𝜕𝐺

Rearranging the first and second equations gives:

𝜕𝑢1 (𝑥1 ,𝐺) 𝜇 𝜕𝑢2 (𝑥2 ,𝐺)
𝜇= and =−
𝜕𝑥1 𝜆 𝜕𝑥2

Substituting these into the previous equation gives:

𝜕𝑢1 (𝑥1 ,𝐺)⁄𝜕𝐺 𝜕𝑢 (𝑥 ,𝐺)⁄𝜕𝐺 𝜕𝑐(𝐺)
+ 𝜕𝑢 2(𝑥 2,𝐺)⁄𝜕𝑥 =
𝜕𝑢1 (𝑥1 ,𝐺)⁄𝜕𝑥1 2 2 2 𝜕𝐺

The two terms on the left-hand side are the marginal rates of substitution
for consumers 1 and 2 between the public good and their private
consumption. So the condition says that the sum of MRS1 and MRS2 should
equal the marginal cost of providing an extra unit of the public good.

To understand why this condition must hold, we think what would happen
if it didn’t. MRS1 and MRS2 measure how much private consumption each
consumer would be willing to give up in exchange for one more unit of the
public good. If MRS1 + MRS2 > MC of the public good, this means we could
make both consumers better off if they each spent less on private
consumption and used the money to buy more of the public good. Similarly,
if MRS1 + MRS2 < MC, we could make both consumers better off if they each
spent more on private consumption and spent less on the public good.
Pareto efficiency is only achieved when MRS1 + MRS2 = MC, which means

10
the last unit the two consumers together spend on private consumption
gives the same utility as the last unit they spend on the public good.

Note that if both goods are private goods, the Pareto efficient allocation
would involve consumers separately equating MRS and MC, i.e. MRS1 = MC1
and MRS2 = MC2.

Free riding

We can illustrate the free riding problem by firstly thinking about what
would happen if two people decided in turn whether (and how much) to
provide the public good. Person 1 chooses quantity g1 based on their
preferences, then person 2 chooses whether to add to that quantity. We
don’t allow a consumer to take away from provision, so we constrain
contributions so g1 ≥ 0 and g2 ≥ 0.

In the diagram below, person 1 (on the left) has initial wealth w1 and
chooses how much to spend on private consumption x1 and how much on
public good provision g1. They maximise utility at a tangency between an
indifference curve and a budget constraint. When person 2 (on the right)
makes their choice, they treat g1 as part of their endowment, alongside their
wealth w2, and decide how much to spend on private consumption x2 and
how much to add to public good provision g2. Person 1’s provision of the
public good effectively shifts person 2’s budget constraint up by distance g1,
so only the thicker part of the budget constraint applies.

Depending on person 2’s preferences, they may have an indifference curve at

a tangency on this budget constraint, in which case they would add to
provision of the public good. But instead we may have the situation shown
in the diagram. Here the highest indifference curve 2 can reach is where
they simply accept the amount of the public good provided by 1, and spend
all their money on their own private consumption.

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 public public
good good

IC1
IC2

g1 = G G

w1 private
x1 w2 = x 2 private
good
good

While this example illustrates the incentive to free ride, the logic doesn’t
directly apply in most cases of public good provision: it is more likely that
consumers will be deciding simultaneously on how much of the public good
to provide and how much to spend on private consumption. They will then
make their decisions based on their expectations of what the other
consumer would do. We could treat this as a game, with each consumer
choosing their optimal gi given their expectation of how much the other
consumer would supply. But we get the same problem: consumers may rely
on each other to provide the public good, and therefore either supply
nothing or under-supply it themselves. As in the previous case we
considered, the problem is magnified when more consumers are involved,
and the public good will generally be under-supplied if left to private
(market-based) provision.

It may be possible to design a voting mechanism that ensures an efficient

level of provision of the public good, but particularly in cases where it is
consumed by a large number of people it is more often provided by
governments, funded through taxation.

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Asymmetric information

Our analysis of markets has usually assumed that buyers and sellers are
fully informed about what they are buying and selling. This means people
don’t make mistakes, and buy/sell something for more/less than their
valuation. It also usually means that any exchanges that benefit both buyer
and seller are made.

However, we can see how asymmetric information – where either buyers or

sellers are not fully informed about each other – creates problems for market
efficiency.

The Market for Lemons4

Consider a market in which a good is available at two quality levels: high

and low. Both buyers and sellers have different valuations of the good
depending on its quality.

For example, there is a market for used cars with the following
characteristics:

• Half the cars on sale are high quality, the other half are low quality.
• Every low-quality car is valued by its seller at £1000, and by any
buyer at £1200.
• Every high-quality car is valued by its seller at £2000, and by any
buyer at £2400.

If every buyer can be sure about the quality of every car, we effectively have
two markets: one for low-quality cars, which will exchange at prices in the
range £1000 – 1200; and one for high-quality cars, which will exchange for
prices in the range £2000 – 2400.

But what happens if buyers cannot observe the quality of any car before
they have bought it? We will assume they will be willing to pay their
expected valuation of a car, ½ 1200 + ½ 2400 = £1800.

But consider who would be willing to sell cars at this price – it is below the
valuation of high-quality sellers, so only low-quality cars would be sold. This
in turn means that buyers will know any cars for sale are of low quality.

The result is that there will only be a market for low-quality cars, selling
between £1000 and £1200. Even though there are buyers who value high-

4
We are not literally talking about buying and selling lemons – it is a term sometimes used for low-quality
products.

13
quality cars more than their sellers, so it would be a Pareto improvement for
these exchanges to happen, this market will not operate.

Quality choice

Now assume, rather than sellers who already have something of a given
quality to sell, producers choose a quality level for their product. Assume as
before that consumers cannot observe the quality of a product before they
buy it. Consumers are willing to pay reservation prices rH for a high-quality
product, or a lower rL for a low-quality product.

There is a large number of sellers, with proportion q selling the high-quality

product. Assume both high and low qualities have the same unit production
cost of c, with rL < c < rH. Will there be a market for this product?

We assume consumers are aware of the average quality of the product, and
buy if their expected valuation is at least as high as the price. Because of
the large number of sellers, price will be driven down to c. So the condition
for consumers to be willing to buy is:

𝑞𝑟𝐻 + (1 − 𝑞)𝑟𝐿 ≥ 𝑐

Rearranging, we can solve for q:

𝑞𝑟𝐻 − 𝑞𝑟𝐿 ≥ 𝑐 − 𝑟𝐿
𝑐−𝑟𝐿
𝑞≥𝑟
𝐻 −𝑟𝐿

Given our condition on the reservation prices and cost, this lies between 0
and 1: there must be a high enough share of high quality for consumers to
be willing to buy the good.

However, the case above raises the question of why producers would choose
to produce a low-quality product if the cost was the same as high quality.
The attraction to producers of producing low quality tends to be that it is
cheaper to produce. So what happens if production costs differ, with cL < cH?
We assume these are both between the high and low reservation price.

Consider the incentives facing an individual producer, facing a price of cH.

As one of a large number, their actions should not affect price. By switching
to low quality, they can earn a profit equal to cH – cL on each unit sold.
However, every producer will have the same incentive – so everyone would
produce low quality, and as rL < cL there will be no market for the product.

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We can consider one more case: suppose cL < rL < cH < rH. We are now in a
similar position to the ‘market for lemons’. Only low quality will be produced
and consumers will understand this, so there will be a market for low
quality, but not for high quality.

Adverse selection and moral hazard

We now turn to two issues that affect insurance markets (among others). To
help understand the concepts, consider the following questions:

• Would you be more likely to insure your bike if you lived in an area
where bike theft was common, or one where no bikes had been stolen?
• Would someone be more or less likely to be careful making sure their
bike was always locked if the bike was fully insured?

The answer to the first question illustrates adverse selection: people are
more likely to buy insurance if there is a higher probability they will need to
claim.

The answer to the second question illustrates moral hazard: the fact
someone is insured may change their behaviour, and increase the
probability they will need to claim.

In the first case, the decision on whether to buy insurance is based on the
existing level of risk, while in the second case the level of risk depends on
whether an individual has purchased insurance. But both create problems
for insurance markets if insurers cannot observe individuals’ behaviour.

Adverse selection

Consider a firm offering health insurance, in a country without free

healthcare. Every consumer can choose whether to buy insurance. The
insurer cannot observe the health status of any individual. We consider two
situations:

1. The insurer offers insurance at a price based on the average incidence of

health conditions across the population – they will at least break even if
their customers on average have the same rate of each condition as the
general population. However some people perceive their risk as low, and
choose not to buy insurance at the price it is offered. If these people are on
average healthier than the general population, those who buy insurance on
average are less healthy. The insurer will face higher costs than they can
pay based on the price they charge.

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2. The insurer offers insurance at a rate based on the incidence of health
conditions across the least healthy group in the population. Insurance is
now very expensive, but those people who correctly perceive themselves to
be at high risk will buy insurance. The insurer will at least break even, but
compared to case 1 the proportion of the population that is insured is much
lower.

Possible solutions to this problem include compulsory purchasing of health

insurance, pooled health insurance (for example for all employees of a
company) or state provision of healthcare.

Moral hazard

Now return to the case of bike insurance. Assume the insurer offers a full
insurance contract: if a bike is stolen, the insurer will fully pay for a
replacement. If we ignore the inconvenience of reporting the theft to the
police and the insurance company, the bike being stolen has no cost to the
owner. There is very little incentive to lock the bike.

In this case it is unlikely there will be a market for insurance: the price the
insurer would have to charge to cover the costs of all the bike replacements
would be so high that nobody would be willing to pay.

The usual solution to this problem is not to offer full insurance: the person
buying insurance usually has to pay some of the cost of replacing the bike.
However this is still a market failure. If the insurer could observe how well
everyone looks after their bike, then at least for careful bike-owners both the
insurer and the owner would prefer full insurance to be offered.

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