Chapter 6

Market failure
Outline
 Market failure
 Externalities
◦ Positive externalities
 Private and social benefits
◦ Negative externalities
 Private and social cost
 Market regulation, tax and subsidies
 Public goods and private goods
Market failure
 Inperfect world, market efficiency is
achieved if the quantity demand equal
to quantity supply or price of
demand equal to price of supply.

 However, the world is imperfect and

market fail to achieve efficiency.
Market failure
 Market failure
◦ Are imperfections in the exchange process between buyers and sellers
that prevent markets from efficiently allocating scare resources.

 Causes of market failure

◦ It means that the price in the market do not fully reflect the value of
production.
◦ Supply price and demand price are not equal.

 It comes in four varieties

◦ Externalities
◦ Public goods
◦ Market control
◦ Imperfect information
Externalities
 An externalities is the cost or benefit that affects
a party who did not choose to incur that cost or
benefit.

 Two types of externalities

◦ Positive externalities
◦ Negative externalities

 Here, every activity has benefits/costs that work on two

level:
◦ Private
 The total benefits/costs incurred by the individual producing or
consuming the product or service directly.
◦ External
 The total benefits/costs associated with any activity incurred by a
third party.
Positive externalities
 Is a benefit that is enjoyed by a third-party
as a result of an economic transaction/
activity.

 It leaves a positive effect on a third party,

 Example:
◦ When you consume education you get a private
benefit. But there are also benefits to the rest of
society. E.g you are able to educate other people and
therefore they benefit as a result of your education.
Positive externalities
 Social benefits
◦ Social benefit = Private benefit + External
benefit
◦ With positive externalities the benefits to
society is greater than your personal benefit.
◦ Therefore, with a positive externality, marginal
social benefits is greater than marginal private
benefits (MSB > MPB).
Positive externalities
P
SS =MPC=MSC

P2

P1

MSB

DD = MPB
0 Q1 Q2 Q
 In free market consumption will be at Q1 because demand = supply (private
benefit=private cost).
 However, this is socially inefficient because social benefit > private benefit.
Therefore there is under consumption of the positive externality.
 Social efficiency would occur at Q2 where social cost=social benefit.
 Example: In a free market without government intervention, there would be under-
consumption of education and public transport.
Implication: Positive externalities
 If goods or services have positive externalities,
then we will get market failure.

 This is because individuals fail to take into

account the benefit to other people.

 To achieve a more socially efficient outcome,

the government could try subsidies the good
with positive externalities.

 This will encourage consumers to consume

more good with positive externality.
Positive externalities
 Positive
externalities can come in
two form
◦ Positive production externalities
 Is the benefit gain by third parties/ bystander as
results of production
 Example: When government produce more
hospital/medical center.
◦ Positive consumption externalities
 Is the benefit gain by third parties/ bystander as
results of consumption
 Example: When consumer consume education.
Positive production externalities
 Since production involve cost, hence,
when producing goods with positive
production externalities, the cost in
social perspective is lower as
compare to private perspective
 Thus, MSC will be lower than MPC
 As result, market under produce
goods with positive production
externalities.
Positive production externalities
P
SS =MPC

MSC

P1

P2

DD = MPB = MSB
0 Q1 Qso Q
 In free market consumption will be at Q1 because demand = supply (private
benefit=private cost).
 However, this is socially inefficient because social cost < private cost. Therefore
there is under production of the positive externality.
 Social efficiency would occur at Qso where social cost=social benefit.
 Example: In a free market without government intervention, there would be under-
production of education and public transport.
Positive consumption externalities
 Since consumption involve benefit,
hence, when consuming goods with
positive consumption externalities, the
benefit in social perspective is higher as
compare to private perspective
 Thus, MSB will be higher than MPB
 As result, market under consuming
goods with positive consumption
externalities.
Positive consumption externalities
P
SS =MPC=MSC

P2

P1

MSB

DD = MPB
0 Q1 Qso Q
 In free market consumption will be at Q1 because demand = supply (private
benefit=private cost).
 However, this is socially inefficient because social benefit > private benefit.
Therefore there is under consumption of the positive externality.
 Social efficiency would occur at Qso where social cost=social benefit.
 Example: In a free market without government intervention, there would be under-
consumption of education and public transport.
Negative externalities
 Is a cost that is suffered by a third-party as
a result of an economic transaction/
activity.

 It leaves a negative effect on a third party,

 Example:
◦ When you drive a car, it creates air pollution and
contributes to congestion. These are both external
costs that imposed on other people who live in the
city.
Negative externalities
 Social cost
◦ Social cost = Private cost + External cost
◦ With negative externalities the cost to society
is greater than your private cost.
◦ Therefore, with a negative externality,
marginal social cost is greater than marginal
private cost (MSC > MPC).
Negative externalities
P MSC
SS =MPC

P2
P1

DD = MPB = MSB
0 Q2 Q1 Q
 In free market people ignore the external costs to others, output will be at Q1
because demand = supply.
 However, this is socially inefficient because social cost > social benefit. Therefore
there is over consumption of the negative externality.
 Social efficiency would occur at Q2 where social cost=social benefit.
 Example: In a free market without government intervention, there would be over-
consumption of car in the market.
Implication: Negative externalities
 If goods or services have negative externalities,
then we will get market failure.

 This is because individuals fail to take into

account the costs to other people.

 To achieve a more socially efficient outcome,

the government could try tax the good with
negative externalities.

 This means that consumers pay the full social

cost.
Negative externalities
 Negative externalities can come in
two form
◦ Negative production externalities
 Is the cost imposed to third parties/ bystander as
results of production
 Example: When LYNAS produce more rare-earth.
◦ Negative consumption externalities
 Is the cost imposed to third parties/ bystander as
results of consumption
 Example: When consumer consume cigaratee.
Negative production externalities
 Since production involve cost, hence,
when producing goods with negative
production externalities, the cost in
social perspective is higher as
compare to private perspective
 Thus, MSC will be higher than MPC
 As result, market over produce
goods with negative production
externalities.
Negative production externalities
P MSC
SS =MPC

P2
P1

DD = MPB = MSB
0 Qso Q1 Q
 In free market people ignore the external costs to others, output will be at Q1
because demand = supply.
 However, this is socially inefficient because social cost > social benefit. Therefore
there is over produce of the negative externality.
 Social efficiency would occur at Qso where social cost=social benefit.
 Example: In a free market without government intervention, there would be over-
production of car in the market.
Negative consumption externalities
 Since consumption involve benefit,
hence, when consuming goods with
negative consumption externalities, the
benefit in social perspective is lower as
compare to private perspective
 Thus, MSB will be lower than MPB
 As result, market over consuming goods
with negative consumption externalities.
Negative consumption externalities
P
SS =MPC=MSC

P1

P2

DD = MPB

MSB
0 Qso Q1 Q
 In free market consumption will be at Q1 because demand = supply (private
benefit=private cost).
 However, this is socially inefficient because social benefit < private benefit.
Therefore there is over consumption of the negative externality.
 Social efficiency would occur at Qso where social cost=social benefit.
 Example: In a free market without government intervention, there would be over-
consumption of cigaratee.
Externalities: The solution
 Several
option can be taken by
government to overcome the
problem of externalities.

 Three option:
◦ Law and regulation
◦ Tax
◦ Subsidy
Solution 1: Law and regulation
 To overcome market failure, the
government may place laws and
regulations which prohibit certain
behavior and actions.

 Example:
◦ Legal age for smoking.
◦ Prohibition on certain classes of drugs – cocaine,
heroin.
◦ Ban on drink driving above a certain limit.
◦ No drinking alcohol in certain city centers.
Solution 2: Tax
 Taxes on negative externalities are
intended to make
consumers/producers pay the full
social cost of the good.

 Thisreduces consumption and

creates a more socially efficient
outcome.
Tax on negative externalities
P MSC
SS =MPC

P2
P1

DD = MPB = MSB
0 Q2 Q1 Q
 Without a tax, there will be overproduction (Q1 where
D=S) because people ignore the external costs.
 After tax, supply curve shift to the right and new
equilibrium achieved where social cost=social benefit.
Solution 3: Subsidies
 Subsidiesinvolves the government paying
part of the cost to the firm.

 This
reduces the price of the good and
should encourage more consumption.

A subsidy shifts the supply curve to the

right.
Subsidy on positive externalities
P
SS =MPC=MSC
SS2

P2

P1

P3
MSB

DD = MPB
0 Q1 Q2 Q
 Subsidy = P2 –P3
 The supply curve shifts to SS2 and price falls from P1 to P3
 People will now consume more, the quantity increases from Q1 to Q2.
 Q2 = Social Efficiency: because MSC = MSB
Public and private goods
 Public goods
◦ Are goods that characterized by non-rival
consumption and inability to exclude non-tax payer
from receiving benefits.
◦ E.g: Public transport, police and etc.

 Private goods
◦ A product that must be purchased in order to be
consumed, and whose consumption by one individual
prevents another individual from consuming it.
◦ Good that characterized by rivalrous and excludable.
◦ E.g: Private car, private jet and etc.
Public goods
 The problem with public goods is that they
have a free rider problem.

 This means that it is not possible to prevent

anyone from enjoying a good once it has
been provided.

 Therefore there is no incentive for people

to pay for the good because they can
consume it without paying for it.
Public goods
 However this will lead to there being no
good being provided.

 Therefore there will be social inefficiency.

 Therefore there will be a need for the

government to provide it directly out of
general taxation.