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4: Market Failure
Definitions

1. Market failure occurs when resources aren’t allocated in an optimal manner, meaning
that the market isn’t allocatively efficient, and community surplus isn’t maximized.
2. Negative externalities are the ‘bad’ effects that are suffered by the third party, for which
the third party doesn’t get compensated, when a good or service is produced or
consumed.
3. Positive externalities are the beneficial effects that are enjoyed by a third party, but not
paid for by the third party, when a good or service is produced or consumed.
4. Demerit goods are goods or services considered to be harmful to people who consume
them and to society as a whole, that would be over-provided by the free market and so
over-consumed.
5. Merit goods are goods or services considered to be beneficial for people who use them
and society as a whole, that would be under-provided by the free market and so under-
consumed.
6. Tradable permits is a market-based solution to negative externalities of production. They
are permits to pollute, issued by government, which sets a maximum amount of pollution
allowable. Firms may trade these permits for money.
7. Public goods are goods or services which would be under-provided or not provided at all
by the free market. They are non-excludable and non-rivalrous, making it pointless for
private individuals to provide the good themselves.
8. Sustainability/Sustainable development is where consumption needs of the present
generation are met without reducing the ability to meet the needs of future generations.

Types of market failure

1. Lack of public goods

● Since public goods are beneficial to society, lack of public goods → Market failure.
● Examples include roads, flood barriers, street lighting, national defense etc.
● Public goods are non-excludable and non-rivalrous.
● Governments reduce this market failure by:
○ Providing the public goods by themselves.
○ Subsidise private firms, cover all costs to provide the public goods.

2. Over supply of demerit goods

● Goods that government thinks that are bad for consumers and society as a whole.
 ● Examples include cigarettes, alcohol etc.
● Governments reduce the demand and supply for the product depending on how harmful
they are to the consumers and the society.
● Some goods will be illegal, but consumption continues due to black markets.
● Other goods will be taxed so that people can reduce the consumption of the product.

3. Under-supply of merit goods

● Goods that government thinks are beneficial for consumers and society as a whole.
● Examples include education, health care etc.
● Governments increase the supply of the product depending on how beneficial they are to
the consumers and the society.
● Some goods will be subsidized, but the amount of subsidy depends on how beneficial the
merit good is to the society.

4, Existence of externalities
● Production or consumption of a product have an effect on a third party.
● When marginal social cost (MSC) = marginal social benefit (MSB), the market reaches
full social efficiency and maximum surplus.
● If that’s not the case, then it leads to market failure and inefficient allocation of resources.

Negative externalities

1. Of production
● Occurs when the production of a product creates external costs that are harmful for third
parties. Examples include environmental problems.
● Happens when marginal social cost (MSC) > marginal private cost (MPC) + external
costs.
● MPC is below MSC because of the extra cost to society caused by things like pollution.
● The space between Q* and Q1 is a welfare loss to society because MSC > MSB.
● Solutions:
○ Government could tax the firm in order to increase the firm’s costs → Shifts
the MPC curve upwards.
○ Ban polluting firms or restrict their output in some way.
○ Governments could pass laws to meet the environment standards for firms
that pollute → Increasing the firm’s private costs.
○ Governments could issue tradable permits → Allows the government to
control pollution.
○ If a firm pollutes less than they allowed, they can sell permits and make money.
● Costs of implementing the solutions:
○ It is difficult to measure the pollution created and difficult to identify which firms
pollute and how much they pollute the environment.
○ Ban/restriction of output can lead to job losses and non-consumption of a valuable
product.
○ Cost of setting up and policing standards > Cost of the pollution.
○ If a firm pollutes more than they allowed, they can buy permits and it would raise
their costs.
○ Tradable permits and taxes doesn’t necessarily reduce pollution as firms and
individuals still continue to do the action, regardless of paying a higher price.
2. Of consumption
● ‘Bad’ effects suffered by third parties due to consumers consuming the product.
● Examples include cigarettes, cars, loud music and noise pollution.
● Happens where marginal social benefits (MSB) < marginal private benefits (MPB)

● There is a welfare loss to society because MSC > MPB.

● Solutions:
○ Ban cigarette smoking totally.
○ Impose indirect taxes on cigarettes → Reduce consumption of the cigarettes.
○ Provide education about the dangers and produce anti-advertisements about
smoking → Reduces demand for cigarettes → MPB shifts to the left.
● Costs of implementing the solutions:
○ Banning cigarettes wouldn’t be simple due to large effect upon the tobacco
industry for stakeholders and employment.
○ People might not vote for governments that bans cigarettes.
○ Inelastic demand for cigarettes → Less change in quantity demanded, but
doesn’t reach the socially efficient level.
○ If taxes are raised too much, people will look for other sources of supply →
Formation of black market.
○ Educating and anti advertisements aren’t highly effective as people would still
smoke after learning about dangers of smoking, so the costs involved in educating
and advertising against smoking will be a waste.

Positive externalities
1. Of production
● Occurs when production of a product leads to benefits for third parties.
● Examples include training employees.
● Happens where marginal private cost (MPC) > marginal social cost (MSC).

● There’s a welfare gain due to MSC < MPB.

● Solutions
○ Subsidize firms that offer training → Shifts MPC curve downwards by the
subsidy → MPC = MSC at some point → Reaches socially efficient level.
○ Provide vocational training by setting up training centres for workers in
certain industries → Improves quality of labor → Shifts PPC to the right.
● Costs of implementing the solutions
○ Very difficult for the government to estimate the level of subsidy deserved by
every single firm.
○ Cost of subsidies → Opportunity cost involved → Governments cut their
spending on other areas, which are more worthy than the industry they
subsidized.
○ Providing training → High costs, firms might lack expertise or dissuade firms
from offering training on their own.

2. Of consumption
● Occurs when consumption of a product provides external benefits to third parties.
● Examples include health care and education.
● Happens where marginal social benefit (MSB) > marginal private benefit (MPB).
 ● There is a welfare gain because MSB > MPB.
● Solutions:
○ Subsidize services such as health care → Shifts MSC curve to the right →
Reaches the socially efficient level of consumption.
○ Advertize health care to encourage people to use them more → Shifts the MPB
curve to the right → Increase welfare.
○ Governments could pass laws for vaccinations and health checks if they provide it
for free.
● Costs of implementing the solutions:
○ Developing countries might face a problem with providing subsidies due to lack
of resources they have.
○ High costs of advertising and long time to take effect of the positive advertising.
○ People might resent laws for strict health care, which can be seen as an
infringement of civil liberties.

Common access resources

● Natural resources, such as fishing grounds, forests, and pastures, or human-made systems
for managing natural resources, such as irrigation systems.
● Very difficult or very expensive to exclude people from using them.
● Fear that nature of the resource and the inability to charge for them may encourage
overuse or over-consumption → Depletion of the resource.
● Market failure happens because of over consumption of common access resources.
Threats to sustainability
● High levels of poverty and economic growth → Environment problems such as
overuse of land, soil erosion, land degradation and deforestation.
● Problems of common access resources/weak regulations → Massive negative
externalities and threat to sustainability.
● Heavy global demand for fossil fuels.
● Extraction and use of coal, oil and natural gas generate external costs → Immense
threats to future generations.
● Producers and consumers of such fossil fuels aren’t accountable for the external costs
for future generations → Fossil fuels are both over-produced and over-consumed →
Significant market failure on a global level.

Government responses to threats to sustainability

1. Cap and trade systems

● Done where governments set national targets for emission reductions and encourage
firms to meet the targets by creating an economic incentive to reduce emissions.

2. Clean technologies
● Renewable sources of energy use it as a solution to remove negative externalities from
the use and extraction of fossil fuels.
● Governments can subsidize the development of clean technologies or by offering tax
credits to firms that invest in clean technologies.

3. Government subsidies
● Lower a firm’s production costs → Increasing supply.
● Gives firms an incentive to use higher amounts of clean technologies.
● There is an opportunity cost involved as the money spent on the subsidies will not be able
to spend on achieving other objectives.