MARKET FAILURE

Introduction
and
reasons for market failure

1
 Market failure
Learning outcomes:
1. Why market mechanism can fail? What is market failure (definition)?
2. Six reasons or circumstances under which the market fails (highly examinable as
major).
3. Characteristics of public vs private goods.
4. Why would these characteristics lead to market failure?
5. Critically examine why the market fails when public goods.
6. Solutions to market failure in case of public goods.
7. Optimal provision of public goods (Samuelson’s conditions) and its numerical
modelling applications (highly examinable as major).

2
 Market failure
• Introduction:
• Recall: Adam Smith posits that in competitive markets, an individual
pursuing private gains would promote the common (public) good.
• We have so far studied the circumstances under which competitive
price/market mechanism would lead to an efficient or Pareto optimal
allocation of resources.
• These conditions coupled with specification of technology, revelation of
preferences, perfect competitive market assumptions) are not likely to
always exist in the real world.
• So, in the real world, markets do produce inefficient allocation of resources
• We’re going to demonstrate that, there are circumstances under which the
market would:
✓produce nothing (e.g. in the case of public goods),
✓misallocate or produce inefficient results (under-produce or over-produce
what is socially optimal as in the case of externalities).
• This situation of suboptimal allocation of resources (nothing, under-produce
or over-produce) is market inefficiency or market failure.
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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/goods 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.
• Definition:
• Market failure is the inability of the competitive market mechanism to efficiently
produce socially optimal quantities of goods and services.
• 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 (i.e. just the level that maximizes society’s
well-being or welfare).
• In principle, whenever the markets fails, government intervention can enhance welfare.
• Market failure issues are of prime interest for two reasons:
➢Market prices do not necessarily reflect social marginal benefits (sMB) or costs (sMC); and
➢market profitability goals do not necessarily reflect net social benefits.

4
 Rationale for Market failure
• Causes of market failure: failure of competition (imperfect
competition), public goods, externalities, incomplete markets,
information failures, and unemployment, income distribution
inequality, increasing returns to scale (huge initial capital reqs).
• Broadly, Market failure occurs because:
➢1. Competition is imperfect (Imperfect Competition). For example,
someone may have monopoly power, oligopolistic cartels, etc.
➢2. The process produces a public good for which it is impossible or
undesirable to levy a charge.
➢3. 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.
➢4. Markets are incomplete (Incomplete markets). They do not extend
infinitely far into the future, and they do not cover all risks.
➢5. 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 (name them!) must also work absolutely. But in reality, there
abound monopolies (1 firm + several buyers), oligopoly (few large 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
that innovate, etc. These are imperfect competition and firms have influence on prices.
• First-best theorem requires perfect competition (no influence on prices) to produce Pareto
efficiency.
• Therefore, market may fail under such circumstance because for equilibrium in a
competitive market MR=MC=P but in a monopoly or imperfect competition (oligopoly) for
instance, it is MR=MC<P or P>MC=MR which leads to under-allocation of resources.
• This makes competition imperfect, and the market will fail.
• Consumer surplus reduces in imperfect competitive market because of influence on prices
by firms (monopolies, oligopolies, monopolistic competition).
• Govt role:
• Government can pass anti-competition laws or assist new firms to increase competition
(e.g. Airbus vs Boeing).
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 Explanation of Market failure Situations
• Incomplete markets
• Whenever a private market fails to provide a good or service even though the cost of
providing is less than what individuals are willing to pay for it, 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
for it (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 premium paid).
• When private market produces this, it takes on huge risks and hence charge higher
rates: e.g. microfinance, private health insurance.
• Misallocation problem: Not provided by the market or under-provided.
• Govt role:
• So health insurance is often provided by govts but if by 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, sale of used
cars, loan contracts, etc.
• Adverse selection occurs when knowledge about the characteristics is hidden 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
for as premium.
• Info asymmetry can lead to market failure in insurance policy. E.g.: If the provider contemplates
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 can make market fail to provide insurance.
• Misallocation problem of Info Asymmetry: Misallocation especially in adverse selection situations
where the market allocate more resources to those who paid less.
• Govt role:
• Governments often provide health insurance, pass legislation to force more information.

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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 block entry of smaller firms’ production cost
structures. This violates the free entry and exit conditions in perfect competition that
results in efficient market. The larger firm also have great influence on price.
• The market may end up being a monopoly. Eg: Airlines, railways, and utilities generally.
• Misallocation problem of the market: Under-production of socially optimal.
• Govt role:
• Govt intervention to break the monopoly or to make govt production with social welfare
in mind.
• Example: Boeing vs Airbus.

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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 is to redistribute what is fair and in 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. A
doctor smoking even though he knows it’s 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.
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Formative assessment question (FAQ):

• Explain four distinct reasons for market failure in

developing economies and justify government
intervention in those respects.

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 Market Failure

•PUBLIC GOODS

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 Public Goods Xtics
Learning outcomes:
• Compare public goods vs private goods.
• Explain how the xtics of public goods lead to market failure.
• Explain how each xtic of public goods lead to unwillingness to pay for them
• Explain how the xtics of public goods lead to free ridership.
• Explain and model Paul Samuelson’s condition for optimal provision of
public goods.
• Suggest private sector and public sector solutions to public goods market
failure.

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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.: streetlights,
• 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.
• 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, streetlights, 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 MC=P=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 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
applies it 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. 14
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

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 Why Public goods cause market failure
• 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 reluctance 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 price, 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. Price=MC=0, will a private individual produce that?
• We will have a numerical example to demonstrate how these matter for public policy.
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 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.
No, 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 will provide for equity reasons.
• 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!
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 Market Efficiency for Public goods
• Efficiency in the provision of a public good requires that
• MRSAG,X + MRSBG,X + … + MRSZG,X = MRTG,X=MCG (This was formulated by Paul Samuelson) whereas
• Consumption 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) or payments 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 a public good ( this is the MC or the Marginal Rate of Transformation (MRT). When DD=SS,
then the ∑P=∑MRS=MRT=MC produces Pareto efficient output of a public good. This is the so-called
Samuelsonian condition.
• 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.

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 Private good and demand
•

19
 Public goods and market demand
•

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 Solutions to Public goods Market Failure
• Summary of public good problem:
• 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 a public good). Free ridership
because of non-excludability.
• 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 also 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 them
or unable to provide efficient levels if some willingness to pay is exacted.
• Govt intervention by providing public goods is necessary as a solution. Why?
Compulsion to pay indirectly through taxes.
• Can perfect price discrimination (PPD) solve free rider problem? Possible market solution!
• 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):
• 1. Transform the public good into private good through metering, road tolls, etc.
• 2. Government provision of public goods for equity reasons eg. to bridge the gap between the rich and
the poor.
• Government action is justified because government can compel indirect payment through taxation, user
charges, etc. Private market cannot compel!
• Private solution: Private markets can use technology (e.g. DSTV inducing excludability of a public good)
and bundling of public goods with others (e.g. public seats at super malls).
• Some review questions:
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 for the market, eg
DSTV, etc?.
3. Under what circumstances will private firms provide an efficient level of a public good? To the extent of
the number for which payment is made: ∑MRS= ∑Pi=MRT=MC. Thus, Samuelsonian condition for
efficient provision of public goods.
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 Public goods conundrum insights
• Read this interview (Q & A) with a hypothetical private market on public good conundrum:
• Q: If you are a private entrepreneur, what will make you produce or provide public goods?
• A: When people are will to pay for it or government is willing to pay for it on behalf of the people.
• Q: How many units of a public goods will you provide if possible?
• A: The number of units that people’s total payments can cover (I will sum what they are willing to pay and equate that to MC).
• Q: Are you aware people can free ride the number of unit produced above?
• A: Yes, but once I have recovered my cost through such payments, I don’t care.
• Q: Can government adopt your strategy (“Samuelsonian condition”) to provide the public goods?
• A: No, because the government can compel people to indirectly pay for the public goods through taxes, user charges, or bundling
such payments with payment for other vital services like utilities. So government should provide the socially optimum for equity
reasons.
• Q: Will government always succeed in doing the above?
• A: No, because people might not reveal that they need the public good if they know government will indirectly compel them to
pay for it (problem of benefit revelation or revelation of willingness to pay). What makes the market fail can also make
government fail!.
• Q: Can the government always provide public goods because you the private entrepreneur has failed?
• A: No, because of government failure reasons such as rent-seeking, agency problems, bureaucracies, corruption, etc.
• Q: How can we then avoid the above government failure situations to address the market failures?
• A: Mechanisms should be put in place to ensure accountability and value for money in government expenditures targeted23at
resolving market failures due to public goods.
 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.
(c) State any three government failure issues that could affect the provision of the 80 streetlights.
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 Analytical numerical past question: Public Goods
For the general security, a community requires 300 LED streetlights, and this could be provided at a total
cost of 675Q, where Q is the number of streetlights.

(a) State one reason why the market mechanism cannot provide the 300 streetlights for this community.
[2 Marks]

(b) If four security-loving households reveal their preference for the streetlights as Q=500-P1, Q=200-P2,
Q=300-P3 and Q=150-0.5P4, where Pi with i = 1, 2, 3, 4 are prices respectively, find how many units of
the streetlight a private entrepreneur will provide using the Samuelsonian condition of efficient provision
of a public good. [10 Marks]

(c) Briefly explain why it will be inefficient to prevent other households from using the streetlights once
it is provided. [2 Marks]

(d) Briefly explain why free ridership cannot be avoided by the private entrepreneur. [2 Marks]

(e) Briefly explain why the people of this community will be justified if they petition the government to
provide the 300 LED streetlights. [2 Marks]

(f) Briefly explain two government failure problems that could affect the efficient provision of the 300
LED streetlights by the government. [2 Marks] 25
 Public goods modelling question
Afia and Kojo’s preference for a public good (Q) is given as
Q=500-P1 and Q=200-P2 , respectively, and suppose the
total cost of the public good is 500Q dollars.
(a)What is the total revenue (amount) of producing this
public good?
(b)How much (amount) is Kojo and Afia willing to pay
respectively?
(c)Why will it be inefficient to prevent other people from
consuming this public good with Afia and Kojo?
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 Practice questions
1. Briefly explain three roles of government even if the market is efficient.
2. How is market failure similar to market efficiency or otherwise?
3. Why does the market fail when there is imperfect competition?
4. Why does the market fail when there are externalities?
5. Why does the market fail when public goods are needed?
6. Why does the market fail in incomplete markets?
7. Why does the market fail when there is information asymmetry?
8. Why are externalities a source of market failure? Is there any remedial action by the
government? Illustrate with relevant diagrams.
9. Define the term “Market failure” and explain six conditions that bring about market
failure.
10.Explain five factors that warrant intervention in the economy by the government
with examples from Ghana. 27
 Practice questions
11. Briefly explain how excludability makes the market efficient.
12. Briefly explain the efficiency implication of goods non-rivaled in consumption.
13. Differentiate between a pure public good and an impure public good.
14. What is “free rider problem”? How does it relate to the provision of public goods?
15. Briefly explain how non-excludability leads to free ridership of a pure public good.
16. Briefly explain how non-rivalriness in consumption leads to free ridership of a pure public good.
17. Briefly explain the Samuelsonian condition for efficient provision of a public good.
18. Define “Public good” and explain how the efficient output of a public good is determined with
the help of a diagram.
19. Briefly explain how technological advances can change a pure public good into an impure public
good and give one example.
20. Briefly explain why private entrepreneurs are able to provide some public goods like radio
broadcast.
21. Briefly explain two ways by which private market induces payment for public goods.
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 Market Failure

•EXTERNALITIES

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 Learning outcomes
• By the end of this lecture, you should be able to:
• 1. Explain externality from different angles or notions and types
• 2. Explain how positive externality and negative externality leads to misallocation and
market failure.
• 3. Explain the reasons for misallocation due to externalities.
• 4. Distinguish public policy solutions from private solutions to externality.
• 5. Distinguish externalities and public goods similarities.
• 6. Model the externality problem and show how market-based solutions can be
estimated.

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 Different definitions of Externality concept
• 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 (i.e. lead markets to overproduce).
• Positive externalities lead markets to produce a smaller quantity than is
socially desirable.
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 Different Externality defns …..service or disservice
• 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
but not paid for, 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.

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 Types and variations 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
33
 Why Positive Externalities cause market failure
• 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
(pMB = pMC), thus ignoring the MBs jointly accruing to other parties (positive
externalities) and so, pMB<sMB because of the external benefits (MEB).
• Thus, sMB = pMB + MEB and hence pMB<sMB.
• This leads 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.
• The reason for the underproduction is because pMB<sMB.
• Underproduction is a misallocation problem by the market (Market failure).
• Producing the socially desirable output requires that pMC=sMB because the
pMC remains the same. It is the MB that changed because of the MEB.
• Check diagram! 34
 Positive Externalities (Education) and the Social Optimum

Price of
Education sMB
Supply
pMB
(private cost)

P* External
subsidy benefits
P

pMC Demand
(private value)

0 QMARKET QOPTIMUM Quantity of

Education
 Positive Externalities: Diagram Explanation
• The intersection of the supply curve (pMC) and the social-value curve (sMB)
determines the socially optimal output level.
• The socially optimal output level is more than the equilibrium quantity (market output).
• The market produces a smaller quantity than is socially desirable (under-production) because
of the positive externality.
• The social value (sMB) of the good exceeds the private value (pMB) of the good.

• Solutions to positive externality misallocation problem:

• Internalizing Externalities: Subsidies
• Used as the primary method for attempting to internalize positive externalities.
• Subsidies will compensate the producer of the positive externalities to produce socially
optimal output.
• 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.

36
 Why Negative Externalities cause market failure
• 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, the market output will only equate the private
MB from the activity to the private MC (pMC=pMB) neglecting the cost imposed on
others (MEC) and so, pMC<sMC because of the external costs (MEC) to society.
• Thus, sMC = pMC + MEC and hence 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 (MEC).
• The reason for the overproduction is because pMC<sMC.
• Overproduction is a misallocation problem by the market (Market failure).
• Producing the socially desirable output requires that pMB=sMC because the pMB
remains the same. Check the diagram!
• Externalities bring a discrepancy between private cost and social cost or private
benefit and social benefit leading to over-production and under-production
respectively. 37
 Negative Externalities (Pollution) and the Social Optimum

Price of
Aluminum
Cost of
pMB pollution
Supply
(private cost)

Optimum
P*
tax
P Equilibrium

sMC

pMC Demand
(private value)

0 QOPTIMUM QMARKET Quantity of

Aluminum
 Negative Externalities: Diagram Explanation
• The intersection of the demand curve (pMB) and the social-cost curve
(sMC) determines the optimal output level.
• The socially optimal output level is less than the market equilibrium quantity
(market output).

• Solutions to negative externality misallocation problem:

• Internalizing an externality involves altering incentives so that people
take account of the external effects (MEC) of their actions.
• Achieving the Socially Optimal Output: The government can
internalize an externality by imposing a tax on the producer to reduce
the market 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 (Govt) 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. Example: Quotas: Stipulations on pollution emission levels set by the
Environmental Protection Agency (EPA).
• Require certain behaviors. Example: Requirements that all students be immunized.
• Market-Based Policies
• Government uses taxes and subsidies to align private incentives (MB or MC) with social
efficiency.
• Pigovian taxes are taxes enacted to correct the effects of a negative externality.
• Pigovian subsidies to correct the effects of a positive externality.
• Application 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)

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 Public policy solutions to externalities
• Market-Based Policies
• Creating market for (trading) the externality: e.g. Recent intl carbon
market.
• Tradable pollution permits allow the voluntary transfer of the right to
pollute from one firm (or country) 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 to Ghana. It's
not actually a donation, because the Koreans are generating
carbon credits by donating the clean cookstoves 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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 Summary of 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. Coase Theorem: 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: This will make the externality part of the cost structure of the parent firm.
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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 (market output: pMC=pMB) (ii). Efficient quantity (socially
desirable output: pMB=sMC)
(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 (market output: pMC=pMB) (ii). Efficient level of output
(socially desirable output: pMC=sMB)
(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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 Analytical numerical past question: Externalities
• In a competitive constant cost industry, the marginal cost is GHS205 and the
private demand function of individuals of a product whose production generates
negative externalities is P=800-7Q. If the marginal external cost (MEC) function is
MEC= -305+8Q where Q is the quantity of output produced.

• (a) Show that the market overproduces because of the negative externality. [5
Marks]

• (b) Compute the level of per unit Pigouvian tax imposition that is required to force
the production of socially optimal output. [5 Marks]

• (c) Compute the marginal external cost before and after the per unit tax and
comment on your result. [5 Marks]

• (d) Explain why there is an incentive to overproduce in (a) above. [5 Marks]

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 Government Intervention
• In principle, there is a strong rationale for govt or 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.
• To a large 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? Provoke your thoughts!

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 Government Failure
• Government failure is the inability of government actions or interventions
to enhance the efficiency of the market.
• 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.

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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.

• Empirical observation: Generally,

• Developing economies have market failures and sadly, more government failures.
• Developed economies have market failures and less government failures. Do you agree?
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