Market failure and externalities

Learning objectives
 meaning and types/causes of market failure
 meaning of private costs, external costs and social costs; private benefits, external
benefits and social costs.
 positive and negative externalities in production and consumption and inefficient
allocation of resources.
 cost-benefit analysis as an aid to decision making

Market failure occurs when the free market economy (price mechanism) does not achieve an
efficient allocation of scarce resources. It fails to make the optimum use of resources.
Types of market failure
Type/cause of market Explanation.
failure
Non-provision of Goods that would not be provided in a market economy
public goods because it would be impossible to charge a price for
them because of the “free rider” problem; non-rival
and non-excludable - no resources are allocated
to their production due to the free-rider problem.
Under-production of Goods or services which are regarded to be socially
merit goods desirable but which would be under-consumed and
under-produced in a market economy due to
information failure. Not enough resources are
allocated to their production
Overproduction Goods regarded to be socially undesirable but which
demerit goods would be over-consumed and over-produced in a
market economy. Too many resources are put into
their production
Information failure Lack of full information lead to a less efficient allocation
of resources than it would be. This is a major reason
why consumers make wrong decisions in relation to
the consumption of merit and demerit goods
Externalities Costs and benefits which can affect third parties and
are sometimes referred to as “spill-over”
effects/third party effects. They are related to both
production and consumption.
Imperfect When one firm (monopoly) dominates a market, it
competition produces a lower output and charges a higher price
(monopoly power) than would be the case in perfect competition. Less
resources are used to produce the good.
Asymmetric  Asymmetric information occurs when one party,
information (Adverse usually the producer, has more or better information
selection and than another in a business transaction.
moral hazard)  Adverse selection exists when sellers/buyers have
They result into information a that the other party does not have e.g.

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 inefficient resource people may not declare bad habits like smoking and
allocation drinking when applying for health insurance.
 Moral hazard is a tendecy to take greater risks
when some other party is covering the risks. It is
common in banking and was partly responsible for
the 2008/2009 financial crisis.

Unequal distribution of This would have the effect of giving some people (high-
income and wealth income group) more influence in resource allocation
than others in the economy.

Externalities
An externality is a spillover or third party effect of a production or consumption activity that
results in benefits or costs to third parties. The spill-over effects are not paid for by the
producer or the consumer.
Externalities are third party effects. A third party is someone who is not directly involved, but
who is affected by the actions of producers or consumers. Thus, external costs and external
benefits are external to the market.

Positive and negative externalities

External cost (negative externality)

It is a harmful effect (cost) to a third party which arises from a production or
consumption activity that is not paid for by the producer or consumer e.g. air and
noise pollution by toxic fumes from a factory or aeroplane.
External benefit (positive externality)
It is a beneficial effect to a third party which arises from a production or
consumption activity e.g. protection of neighbours from infection when a person
takes a COVIQD-19 vaccine.

Externalities are an example of market failure. The price mechanism does not take into account
the wider external costs and benefits to society that result from production and consumption
activities. Market prices do not reflect externalities. As a result the market fails to achieve an
efficient allocation of resources.
Private and social costs and benefits

Private cost
It is the cost of a good or service to a producer or consumer e.g.
price of an air ticket or cost of raw materials and wages a firm
pays to employees.

Social cost
The sum of private costs and external costs.
Social cost = private costs + external costs

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 Private benefit
It is the benefit to an individual producer or consumer e.g. profit made by a
producer or comfort and convenience of using one’s private car.

Social benefit
The sum of private benefits and external benefits.
Social benefit = private benefits + external benefits

Negative production externalities

These are harmful spillover effects of a production activity on third parties e.g. environmental
pollution by firms as they emit toxic fumes into the atmosphere and dump toxic waste into
rivers or the disposal of plastic waste that ends up in rivers and oceans.
These spillover effects are additional costs imposed on the society. Toxic fumes released into
the atmosphere lead to diseases and respiratory problems to people who live in the
neighbourhood and in the long run they will lead to global warming. There will be no cost to
the polluting firm.
 Diagram: Negative production externalities (page 330 – Fig.33.5)
The demand curve represents the marginal private benefit (MPB) to consumers; the supply curve
represents the producer’s marginal private cost (MPC).
The marginal social costs (MSC = MPC + MEC. Thus MSC>MPC. Assuming there are no
consumption externalities MPB=MSB.
The socially optimum (efficient) output is Q where MSC=MSB at point x. The free market output
is Q1 where MPC=MPB at point z. The market output is above the optimum level. This implies
overproduction which is a market failure. Too many resources are being put into a production
activity that causes too much damage to the environment through toxic fumes or waste
disposal. This results into a deadweight welfare loss shown by tringle xyz - excess social costs
over social benefits.
Positive production externalities
These are beneficial spillover effects to third parties created by producers e.g. medical research
leading to the development of a new vaccine to combat a serious disease like Covid-19. People
who get the vaccine benefit directly but there will be wider benefits to society and the economy
in form of higher output and productivity from a healthy workforce.
Another example could be where a firm trains its workers and some of them leave to go and
work in other firms. This will reduce the training costs of other firms and increase productivity in
the community.
 Diagram: Positive production externalities (page 330 – Fig.33.6)
Due to positive production externalities, MSC is less than MPC (MPC>MSC and MSC=MPC-MEB).
Assuming there are no consumption externalities MPB=MSB along the demand curve. The
socially efficient output level is Q where MSC=MSB. However, the free market output level
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would be Q1 leading underproduction. The market output level is below the socially efficient
level. Fewer resources are put into the production of a good that benefits society. This leads to
market failure and a deadweight welfare loss shown by triangle xyz – excess external benefits
over external costs that would have improved welfare in society.

Negative consumption externalities

They harmful spillover effects on third parties created by consumers e.g. costs of passive
smoking to non-smokers in the form of discomfort and respiratory diseases due to exposure to
cigarette smoking. The cost of treating the affected people is not paid by the smokers.
Noise pollution and visual pollution caused by sporting events and wild parties are other
examples of negative consumption externalities.
 Diagram: Negative production externalities (page 331 – Fig.33.7)
The MSB is lower than the MPB, MPB>MSB. MSB=MPB-MEC . The MSB curve is below the MPB
curve. Assuming there are no production externalities MPC=MSC along the supply curve. The
free market output level Q1 (MPC=MPB) will be greater than the socially optimum output level
Q (MSC=MSB). This results in market failure; too many resources are used to produce a good
that is harmful to society. The over-consumption results into a deadweight welfare loss shown
by triangle xyz.

Positive consumption externalities

These are beneficial spillover effects of consumption on third parties and the main reason why
governments provide merit goods.
High school and university education have private benefits to students in form of more
employment opportunities, higher pay and higher standard of living. However, there are
external benefits of the education to their families and the economy in form of higher
productivity and higher rate of economic growth.
Free provision of healthcare has private benefits to people who receive treatments and external
benefits to their families and the economy. A healthy population will be more productive and is
likely to raise the standard of living and the rate of economic growth.

 Diagram: Negative production externalities (page 331 – Fig.33.8)

Due to positive externalities MSB>MPB. The MSB curve is above the MPB curve. The vertical
distance between the two curves is the MEB. Assuming there are no production externalities
MPC=MSC. The free market output level Q1 (MPC=MPB) will be below the socially optimum
output level Q (MSC=MSB). This results in under-consumption and a deadweight welfare loss
shown by triangle xyz.
Individual students and patients only consider their private costs and benefits. This results in
under-consumption and under-provision of education and healthcare. Less resources are

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allocated to their production in a free market (market failure). This is why governments
intervene to ensure that the socially optimum levels of these services is provided.

Case study
The benefits of vaccination to a community in Kenya
A good example of a positive externality is when people in a community are
vaccinated against particular diseases. Individuals are only likely to consider
the benefits to themselves of being vaccinated, i.e. they are less likely to
contract the disease and so less likely to be ill. In Kenya, for example, there
is vaccination against covid-19, tetanus and polio.
There is however a wider aspect that needs to be taken into account. There
will be wider benefits to the whole community if a greater proportion of
people in a community are vaccinated against particular diseases. If the
vast majority of the population, or indeed everybody, is vaccinated, there is
much less likelihood of people in the neighbourhood catching the disease.
Everybody will be able to live a healthier life.
1. Describe what is meant by a positive externality.
2. Explain, with the aid of a diagram, how vaccination could be
encouraged in a community.

Cost-benefit analysis (CBA)

A method of decision-making that takes into account the costs and benefits involved in setting
up and running public projects. It takes a long term and wide view to assess the desirability of
an investment project by taking into account the social costs and benefits involved.
It has been used to assess proposed roads, rail lines, airports and housing projects e.g. UK’s HS2
Rail link: London – Leeds – Manchester; the Thika Super High Way and Nairobi Express Way.

Stages of CBA
- identification of the likely costs/benefits - private and external
- putting monetary values on the costs and benefits identified.
- forecasting future costs and benefits of the project in terms of current values.
- interpreting results
- decision making
 A project will only be worthwhile if its social benefits exceed its social costs; no one should
be made worse off as a result of the project (Pareto optimality)

Advantages of CBA
1. It takes into account all likely costs and benefits of a proposed project. It is thus a practical
aid to decision making and takes a wider view of such projects.

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2. It promotes allocative efficiency because resources are put to uses that maximize social
benefits/welfare.

Limitations of CBA
1. It is difficult and expensive to identify the relevant costs/benefits of a project some of which
may not be anticipated.
2. It is difficult to measure and to put monetary values on externalities like pollution; this leads
to uncertainty.
3. It is very difficult to estimate/forecast future costs and benefits of projects in terms of
present values.

4. Political interference could influence decisions with some projects could be recommended
for political reasons even when their long-term social benefits are less than the social costs
e.g. construction of sporting facilities to hosting World cup.

Case study
The Nairobi Expressway
It is an example a major infrastructure project that used cost-benefit analysis
before a decision was taken to go ahead with the building of the road. It is a 50
km toll road that will connect Jomo Kenyatta International Airport to Rironi, along
the Nairobi-Nakuru Road.
The $550m project is set to dramatically change Nairobi city’s skyline. When
finished, the highway, some of it elevated, is meant to ease traffic flows in and
out of the city. The aim of improving Nairobi’s roads seems like a laudable cause
but some argue it could worsen the city’s traffic problems and cause
environmental damage. Hundreds of trees have been cut down to make way for
the new road. This means loss of some green areas and destruction of bird
habitats. The Expressway will also widen the economic divide because low income
groups will not afford the toll fees to use the highway.
1. Justify, with reasons, why you would or would not support the building of the
Nairobi Expressway.

Student activity
Exam-style MCQs textbook Qs 1-7 pages 335-337
Past paper MCQs
1. Jun 2018/31 - 1 2. Jun 2018/31 - 2 3. Jun 2018/32 - 1 4. Nov 2018/31 - 1
5. Nov 2018/31 - 2 6. Jun 2019/31 - 3 7. Jun 2019/31 - 2 8. Jun 2019/32 - 2
9. Jun 2019/32 - 3 10. Nov 2019/31 - 1 11. Nov 2019/31 - 2 12. Jun 2020/31 - 1
13. June 2020/32 - 1 14. Nov 2020/31 - 1 15. Nov 2020/31 - 2 16. Nov 2020/32 -
2
17. Mar 2021/32 - 2 18. Mar 2021/32 - 3 19. Jun 2021/31 - 1 20. Jun 2021/31 –
3
21. Nov 2021/31 - 2 22. Nov 2021/32 - 3 23. Mar 2022/32 - 2
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24. A government is considering improving the rail links in its country. It also to choose one of
four high-speed routes. The benefits and costs of each route are shown below.
Which route should be chosen?

private benefits external benefits private costs external costs

($bn) ($bn) ($bn) ($bn)
A 14 20 0.4 0.1
B 16 22 1.6 0.4
C 18 12 0.2 1
D 20 18 2 4

25. The table shows the expected costs and benefits from four government projects. The
government can afford only one project.
Which project should the government choose?

private benefits external benefits private costs external costs

($bn) ($bn) ($bn) ($bn)
A 40 200 60 70
B 60 160 100 20
C 100 210 100 120
D 150 90 120 140

Essay
Economic efficiency can never be achieved in a market economy.
To what extent do you agree with this statement? [20]

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