ECN1014

Introductory Economics
LECTURE 4
THE PRICE SYSTEM: MARKET FAILURES AND
THE PUBLIC INTEREST
READING:
SLOMAN AND GARRATT, CHAPTER 7

Learning Objectives
After this lecture, you should be able to:

Identify the sources of market failure

Explain what externalities are

Explain what public goods are

How they cause inefficient allocation of resources

How market failures caused by externalities can be corrected
Characteristics of public goods
Whether public good can be provided by private sectors

Evaluate whether government intervention is the best solution

to correct market failures

The Price System:

Efficiency Revisited
Reading:
Sloman and Garratt,
Chapter 7, pp.167-168

Competitive Market and Allocative Efficiency

Theoretically, the equilibrium price and quantity in a

competitive markets usually produce a correct or

optimal market outcome from an economic
perspective.

The demand curve reflects the marginal private

benefit (MPB).
The supply curve reflects the marginal private cost
(MPC).
At the intersection of the demand and supply curves,
MPB equals MPC and there is allocative efficiency
(i.e. there is no underallocation or overallocation
of resources).

Price

Competitive Market and Allocative Efficiency

S = MPC

D = MPB
O

Q1
Underallocation,
MPB > MPC

Q1
AllocativeEfficiency,
MPB = MPC

Q2

Quantity

Overallocation,
MPB < MPC

Externalities
Reading:
Sloman and Garratt,
Chapter 7, pp.168-170; 178-180; 183-184

Externalities and Market Failures

Externality is a cost or benefit accruing to a third

party that is not involved in a market transaction.

Externality is a source of market failure since the
market forces of demand and supply fail to consider
the external cost and external benefit imposed by a
producer or a consumer upon the bystander.

Negative Externalities
Negative externalities are the adverse impact or costs

imposed upon a third party.

When there are negative externalities, there is

An overproduction or overconsumption of the related product

(i.e. too much is produced or brought).
An overallocation of resources to this product

Examples:

Alcoholism
Pollution
Tobacco-smoking

Price

Negative Externalities
S2=MSC
S1=MPC

MEC

D
O

Q2

Q1

Quantity

Over-allocation (too much) at Q1, so should decrease activity to Q2.

Producers supply curve, or marginal private cost

(MPC) does not capture all the marginal external

cost (MEC) spilling over to the third party.
Had the MEC been accounted for, producers cost
would have been higher as reflected by marginal
social cost (MSC).
The equilibrium output (Q1) is larger than the
optimal output (Q2).
Resources are overallocated to the activity.

Remedies for addressing negative externalities:

Corrective taxes
Regulatory bodies and direct controls
Individual bargaining: Coase Theorem
Property rights, liabilities and lawsuits

Corrective Taxes
The government may impose taxes or charges

specifically on a related goods which incur negative

externalities.

The firm is forced to pay the tax equivalent to the negative

externality they incur.
The tax raises the firms production cost, thus shifting the
supply curve leftward so that MPC coincides with MSC.
Production which generates negative externalities is thus
reduced from Q1 to Q2.

Price

Corrective Taxes and Negative Externalities

S2=MSC
S1=MPC

Tax =
MEC

1. A tax equivalent
to the size of MEC...

D
O

Q2

Q1

Quantity

2. ...reduces production or consumption from Q1 to Q2.

Advantages

Forcing relevant parties to compensate for the damages they

create (i.e. they would not go unpunished)
Encouraging relevant parties to reduce damaging activities

Disadvantages

A single tax rate may not suitably reflect different levels of

damages created by different parties
Lack of knowledge

Who causes the damage? How much is the damage?

Who should pay for it? How much to pay?

Legal Restrictions
The government may pass legislation limiting or ban

particular activities which generate negative

externalities.
Advantages

Easy to understand and administer

Quick and effective during emergency
Comprehensive coverage against harmful activities

Disadvantages

Relevant parties would only go as far as meeting the minimum

requirement.

Regulatory Bodies
Regulatory bodies identify and investigate possible

cases which require actions, and suggest

recommendations or solutions.
Advantages

Case-by-case investigation allows solutions to be tailored for

each circumstance.

Disadvantages

Investigation may be costly and time-consuming

Limited coverage (i.e. only a few offenders are investigated)
Lack of proper follow up

Changes in Property Rights

In the Coase theorem, government is not needed to

correct externalities if:

Property ownership is clearly defined

The number of people involved is small

Property rights protect property owners from

damages coming from negative externalities.

Owners can sue for compensation should their properties are

damaged by external parties.
Legal penalties discourage others from generating negative
externalities for fear of being sued.

Defining property rights and lawsuits may be

difficult if

Affected properties are collectively owned (for instance,

ocean, rivers, forests)
A large number of parties is involved, thus making a mutually
acceptable solution impossible
Lawsuits are costly (and this only favours the rich)

Positive Externalities
Positive externalities are the beneficial impact

generated for a third party.

When there are positive externalities, there is

An underproduction or underconsumption of the related

product (i.e. too little is produced or bought).
An underallocation of resources to this product

Examples:

Vaccination
Technological advancement
Installation of alarm systems

Price

Positive Externalities

D2=MSB

MEB
D1=MPB
O

Q1

Q2

Quantity

Under-allocation (too little) at Q1, so should increase activity to Q2.

Consumers demand curve, marginal private benefit

(MPB) does not capture all the marginal external

benefits (MEB) spilling over to the third party.
Had MEB been accounted for, consumers benefit
would have been higher as reflected by marginal
social benefit (MSB).
The equilibrium output (Q1) is smaller than the
optimal output (Q2).
Resources are underallocated to the activity.

Remedies for addressing positive externalities:

Corrective subsidies
Direct provision
Sponsorship or charitable organisations

Corrective Subsidies
The government could correct positive externalities

by providing subsidies to the respective consumers

or producers.

Price

Corrective Subsidies and Positive Externalities

1. A subsidy equivalent
to the size of MEB...
MEB =
Subsidy

D2=MSB
D1=MPB

Q1

Q2

Quantity

2. ...raises production or consumption from Q1 to Q2.

Positive externality (e.g. education) and a corrective

subsidy given to consumers

The students education is financed by a subsidy equivalent to

the positive externality he or she generates.
The subsidy reduces the students tuition fees, thus shifting the
demand curve rightward so that MPB coincides with MSB.
Consumption which generates positive externalities is thus
raised from Q1 to Q2.

Direct Provision
The government may directly provide goods and

services which generate positive externalities (e.g.

education and healthcare) for the following reasons:

There are substantial spillover benefits which accrue to other

people.
If they had to pay, consumers may choose to forgo goods and
services whose benefits they fail to recognise.
Consumers may not be able to afford (i.e. the dependants)
goods and services which provide substantial benefits.

Sponsorship and Charitable Organisations

Private organisations or institutions may directly

provide goods and services which generate positive

externalities without imposing any charges.

Free medical check-up or vaccination

Basic dental services at schools
Scholarship

Public Goods
Reading:
Sloman and Garratt,
Chapter 7, pp.172; 180

Characteristics of Public Goods

Unlike private goods, public goods (such as national

defence and street lighting), are non-rival and nonexcludable in its consumption.

Non-rival

One persons consumption does not preclude the consumption of

the goods by others.

Non-excludable

No charge is levied upon the users.

Non-rivalry and non-excludability of public goods

create a free-rider problem.

Everyone (including non-payers) can obtain the benefits.

Most users avoid pay for something they can obtain for free.

As such, public goods are socially desirable but

commercially unprofitable.
The government may have to step in to provide
public goods directly when the private sector lacks
the profit incentive to do so.

Government Failure and the

Case for the Market
Reading:
Sloman and Garratt,
Chapter 7, pp.185-187

Drawbacks of Government Intervention

Government intervention in the market can itself

lead to problems greater than what it seeks to solve

due to the following reasons:

Poor information
Bureaucracy and inefficiency
Lack of market incentives
Shifts in government policy
Lack of individual freedom

Advantages of the Free Market

Imperfect markets may even be more advantageous

over government intervention for the following

reasons:

Automatic adjustments
Dynamic advantages of the markets

Profit incentives and investment

Discovery
Innovation

Competition and choices

Minimal risks of politicisation
Individual freedom