Chapter Four: Market Failure and the Role of Government

4.1. Concepts of market failures

 In reality, even in those industrialized and market-based economies‟, there exist various
forms of market failures.
 Market failure refers to those situations in which the conditions necessary to achieve the
efficient market solution fail to exist or contravened in one way or another.
A market failure is a situation in which the market fails to achieve an efficient allocation.
4.2. Why market fails and the role of governments
 Even a perfectly competitive market may fail because of externalities and/or public goods.
Thus, market failure is a commonplace in the real world. Generally, markets fail for four
reasons:
1. Externalities,
2. Public goods,
3. Market power, and
4. Asymmetric information.
4.2.1. Externalities
 An externality is a situation in which the consumption or the production of goods has
positive or negative effects on other people’s utility where these effects are not reflected in
the price.
 Externality is said to exist when the production/consumption activities of one party enter the
production/consumption activities of other party, without any payment for the effect.
 The market system (mechanism) is capable of achieving Pareto-efficient allocations when
there are no externalities.
 In the presence of externalities, however, market prices do not reflect the activities of either
producers or consumers and thus market outcomes would be Pareto inefficient.
 Externalities may be classified as consumption externalities and production
externalities.
 Each of these types may be negative (external costs) or positive (external benefits).
Negative consumption externalities (external diseconomies of consumption)
Production and consumption activities of a firms imposed cost other consumer who not
involve in production and consumption activity.

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 refer to uncompensated costs imposed on others (consumers) by the consumption or
production activities of some individuals or firms.
Examples of negative consumption externalities include:
 pollution produced by local automobiles,
 a smoker smoking a cigar next to an individual dining in a restaurant, and
 playing a loud music in one’s neighborhood.
Positive consumption externalities (external economies of consumption)
refer to uncompensated benefits conferred on others (consumers) by the increased
consumption or production of a commodity by some individuals or firms.
Examples for this sort of externalities embrace:
 pleasure from observing a flower garden of one’s neighbor,
 pleasure from listening to music of one’s taste from a neighbor (or roommate).
 You do not pay for enjoying your neighbor’s flower garden or for listening to some
music of your taste from a CD-player of your roommate.
Negative production externalities (external diseconomies of production)
refer to uncompensated costs imposed on others (producers) by the expansion of
consumption or production by some individuals or firms.
This type of externality is exemplified by:
 water pollution by a steel industry for a fishery down the stream.
 If a steel industry disposes its wastes to a river, this will damage the school of fish in the
stream and consequently affect people living on fishing or the fishing industry at large.
Positive production externalities (external economies of production)
refer to uncompensated benefits conferred on others (producers) by raised consumption or
output expansion of some individuals or firms. An example for such an externality is:
 an orchard (land area of fruit trees) located next to a beekeeper.
 This example reflects a bi-directional externality where both the beekeeper and the
owner of the orchard benefit.
 The beekeeper would benefit since the orchard is a source of ingredients for the
production of honey.
 On the other hand, the bees would help the pollination (and thus the reproduction) of the
flower trees.

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 Note that consumption externalities could be imposed or conferred by consumption or
production activities of agents, but the effects are seen on consumption. Similarly,
production externalities could result from production or consumption activities of agents, but
the effects are seen on production.
We will use the following notation to denote these costs and benefits
MPC = marginal private cost Similarly MPB = marginal private benefit
MEC = marginal external cost MEB = Marginal external benefit
MSC = Marginal social cost MSB = Marginal social benefit
Hence; MSB = MPB + MEB Hence; MSC = MPC + MEC
 The overall economic efficiency requires that MSC = MSB for each product.
 The reason is that as long as MSB>MSC, production should be expanded because additional
benefit exceeds additional cost. Similarity,
 If MSB<MSC, then production should be decreased since only private cost and benefit is
covered by the producers of externalities, the economy will not reach economic efficiency.
 For economic efficiency consumers and producers must weigh the full social benefits of
consumption or production.
Perfect competition leads to a Pareto optimum outcome only when private costs equal
social costs and private benefits equal social benefits. However, if there are externalities,
there is divergence between private and social benefits and/or private and social costs.
For a private decision-maker, the optimality (equilibrium) condition is given by the
equality of marginal benefit and marginal cost of the agent.
 That is, optimal decision of a private agent requires the condition MPB = MPC
 For the society at large, on the other hand, an efficient allocation requires that MSB =
MSC.
 In general, external economies (positive externalities) result in production or
consumption of commodities to a level less than socially optimal. To the contrary,
 external diseconomies (negative externalities) result in production or consumption of
commodities to a more than socially optimal level.
Let us illustrate market failure resulting from externalities with the help of one of the
categories of externality discussed earlier.
1. EXTERNALITIES IN CONSUMPTIONS

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  The economic efficiency in consumption is attained when marginal rate of substitution
of commodities must be the same for any of two consumers.
 If we assume there are no externalities in consumption
 the marginal social cost and marginal private costs are equal, and
 the competitive supply curves reflect the common marginal cost. Similarly,
 MSB and MPB are equal, and the demand curve reflects the benefits.
 on the demand side, the demand curve reflects only the MPB in which the economic
agent does not take in to account the externalities However,
 in case of externality the two graphs differ. In the case of consumption, we have
explained above that there are two forms/types of consumption externalities (negative
and positive).
 If we assume there are no externalities in consumption is marginal social cost and
marginal private costs are equal, and the competitive supply curves reflect the
common marginal cost.
 However, on the demand side, the demand curve reflects only the marginal private
benefit (MPB) in which the economic agent does not take in to account the
externalities. Hence the marginal social benefit (MSB) differs from MPB.
External benefits = social benefits - private benefits or
We will look at the impact of the difference between MPB and MSB on resource allocation
under two scenarios.
A. NEGATIVE EXTERNALITY OF CONSUMPTION.
Recall that the marginal private benefit is the demand curve for the firm and the marginal
cost is the supply curve of the firm as well as the society.
In this case the MSB is below that of MPB. as can be seen from the figure 4.1-A below.
The reason is that the economic agent consume something that result in lower benefit to the
society than to the private as he/she pursue his self-interest.
There is an over production of the commodity as the individual is not take in to account all
the cost and benefit.
Accordingly, the amount of goods and services an economic agent want to consume is at
point where MPB =MPC which is point Q1 at price is P1 is the market equilibrium where as
the optimal quantity for the society is Qo (where MSB =MSC) with the corresponding C0.

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Figure 4.1-A: Negative externality in Figure 4.1-B: Positive externality in
 At the socially optimum point the MSB = MPB + MEB
 private demand curve; the external social cost is XC at all level of production.
 Hence it is not at the socially optimal level of production as it leads to overproduction on
the part of private.
B. POSITIVE EXTERNALITIES OF CONSUMPTION
 Again, the MSC (equal to MPC) curve is the supply curve.
 The demand curve D is the marginal private benefit that is different from that of the
society‘s as shown by figure 4.1-B above.
 Since there are external benefits, MSB >MPB, and the MSB curve was above the demand
curve.
 The socially optimal quantity is given by Q o where MSB=MSC. However, for the private
economic agent point of view the equilibrium attained when Q 1 is produced with
corresponding prices is P1 which is smaller than the socially optimal level.
 Hence, there is underproduction as compared to the socially optimal level.
 The socially optimal, Qo is the output level at which MSC = MSB is obtained by adding
the external benefit, XB, to every value along private demand curve.
2. EXTERNLITIES IN PRODCUTIONS

Under ideal circumstances producer‘s private cost or benefit will encompasses all the
attendant social costs and social benefits.

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 Hence, the production decision will be consistent with our social welfare. Unfortunately, this
happy identity does not always exist as social cost differ from private costs by certain amount
termed as external social costs.
External cost= social costs- private costs.
Let us consider first the case of negative production externalities and then positive production
externalities.
A.NEGATIVE EXTERNALITY IN PRODUCTION
 Figure 4.2(A) illustrate the case of negative externality in production.
 Assume there are no externality in consumption, the demand curve D shows the marginal
private and social benefits (MPB=MSB) as identical.
 The competitive supply curve, however, reflects only the marginal private costs(MPC) but
 the MSC curve lie above the competitive curve as it includes marginal external costs to every
volume along private MC by ‘XC."
 The optimal output is Qo with a price Po. At this level all possibilities from exchange is
exhausted. But
 the competitive market, if it left alone, will produce Q 1, with a price of P1. Thus, there is a
tendency to over produce by XC amount.

Figure 4.2-A: Negative externality in Figure 4.2-B: Positive externality in

production

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B. POSTIVE EXTERNALITY IN PRODUCTION
 This case is illustrated in Figure 4.2 –B above.
 The demand curve represent identical the marginal social and private benefit curve, but
 supply curve differs in that the MSC curve is below the MPC curve (MSC < MPC).
 The socially optimal level of output is given by the intersection of the demand curve with
the MSC curve as shown by point e‘ with Qo output and Po price.
 However, if left alone the competitive market will produce Q 1 with price P1 where the
demand curve intersect the MPC curve, Thus, too little will be produced from the social point
of view.
 At output level Qo, producers received a prices or Po, but there marginal cost is Co the
difference between the two is the amount BX is the external benefit generates from the action
of economic agent in production.
REMEDIAL MEASURES OF EXTRNALITIEIS
We have seen that externalities lead to inefficient allocation of resources. What are the measures
to be taken to reduce the inefficiencies generated by externalities? What are government policies
or concerned bodies action to reduce its effect?
With external diseconomies of consumption and production
 governments might try to intervene by directly limiting the level of consumption and
production (direct control) or with a tax on consumers and producers (effluent fee).
 As an example, for the direct control, pollutants might be forced to produce a lesser amount
of pollution than they could do if based on their (private) marginal benefits and costs.
 Imposing taxes would increase the private marginal cost of the agents thereby making them
internalize the effects of their actions and rendering a lower level of production/consumption
to be optimal. On the other hand,
With negative externalities (external economies) of production and consumption
 Pareto optimality in production and consumption would require a subsidy for the
producers and consumers.
However, the corrective tax or subsidy (for correcting positive or negative externalities) may
have some unintended side effects that lead to inefficiency. That is, an attempt to correct
inefficiency resulting from externalities may itself result in inefficiency.

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4.2.3. Public goods
In concluding that a perfectly competitive economy results in an optimal allocation of resources,
excludability and rivalry in consumption were assumed. Excludability was assumed in the sense
that a person consumes a good only if he/she pays the price. Rival consumption was assumed in
the sense that if one person consumes a particular good (say, drinks a bottle of beer), someone
else cannot consume it too. In the real-world situation, however, not all goods have these two
characteristics. Indeed, many very important goods like the quality of the environment and
national security do not have them – they are non-excludable and non-rival.
A public good is a good that fulfills both of the following two criteria:
 Non rival. One individual’s consumption of the good does not affect any other
individual’s consumption of the same unit of the good. Examples include lighthouses,
television, parks, military defense, and streets with little traffic.
 Nonexclusive. It is not possible to exclude anyone from consuming the good. The
examples above are usually nonexclusive.
A private good is, instead, a good that does not fulfill any of the two criteria, i.e. one that is both
rival and exclusive. Most goods are private goods.
Public goods are goods that are non-rival: the marginal cost of provision to an additional
consumer is zero. That is, once provided (made available), the addition of consumers up to
capacity constraint does not reduce the availability of the good. Examples of public goods are
national defense, law enforcement, national TV, streetlights, sidewalks, etc.
Though many public goods are non-excludable (i.e., even if it is technically difficult or
prohibitively costly to exclude others from using these goods), some are excludable. For
example, it is possible to allow only paying customers to view cable TV; it is also possible to
charge a fee for using an uncrowded bridge and to prevent people who do not pay from crossing
it. Still, these items are public goods as additional customers could consume them with no extra
(marginal) cost.

The market mechanism will not work properly for a public good even if it conforms to the
exclusion principle. Because there is non-rivalry in consumption (the marginal cost of the
additional consumer is zero), there is welfare improvement if people are added to the

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consumption of the good without any payment. That is, excluding those who do not pay reduces
the satisfaction of the excluded but does not increase the satisfaction of the others (those who
paid).
4.2.3. Market Power

Inefficiencies arise when a producer (supplier) of a commodity has market power. This might
result from the fact that markets for some goods and services are characterized by economies of
scale operating over a large range of output implying the inevitability of having a single firm or a
few firms supplying the entire market – technical externality.
Inefficiency (market failure) may also result from market power or imperfection in input market.
For instance, an economy with perfectly competitive labor market but imperfectly competitive
capital market cannot maximize social welfare. For example, suppose there is a monopoly power
in one of the two industries in a hypothetical economy. At equilibrium (where MR = MC), a firm
in the industry with monopoly power will produce and sell less units of output at a higher price
as compared to a firm in a perfect competitive industry (i.e., P > MR). If this industry
characterized by some monopoly power is labeled as industry X, then we would have the
condition MCX = MRX < PX at equilibrium.
In sum, the existence of firms with market power in some sector of an economy is one reason for
the failure of market in producing or yielding maximum social welfare.
4.2.4. Asymmetric Information
Asymmetric information: A situation in which different agents have different amounts of
information about a good.
Asymmetric information is a situation in which a buyer and a seller of an item possess different
amounts of information about a transaction. There are certainly many real world markets in
which it may be very costly or even impossible to get accurate information about the quality of
the goods being sold.
The following situations (examples) are intended to clarify how economic agents on the two
sides of a transaction may possess differing level of information:
1. Labor is assumed to be a homogeneous factor in almost all cases we referred to it. For
instance, in Chapter Four, we assumed that everyone had the same "kind" of labor and
supplied the same amount of effort per hour worked. In reality, it may be very difficult for a

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 firm to determine how productive its employees are. On the other hand, each employee has a
better (or full) knowledge of his/her own labor quality.
2. When a consumer buys a used car, it may be very difficult for him/her to determine whether
the car is a good car or a poor quality or defective one (a lemon). By contrast, the seller of the
used car possibly has a pretty good idea of the quality of the car.
3. An insurance company will not get an unbiased selection of customers, and/or cannot
observe the action of insured customers. That is, the insurance company faces a difficulty in
choosing good-risk customers from the very beginning, and also has a difficulty in observing
the level of care each customer takes. Yet, the customer knows his/her risk category as well
as the level of care he/she is actually taking.
4. A financial institution will not get an unbiased selection of borrowers and/or cannot observe
the action of the borrowers while using the fund. This situation is similar to the situation of
the insurance company in the third example except that now the agent facing the problem is a
financial institution.
Asymmetric information may cause significant problems to the efficient functioning of a market.
In the presence of asymmetric information, there may be too few transactions. Besides, some
transactions may completely fail.
There are two common problems associated with asymmetric (imperfect) information: adverse
selection and moral hazard.
4.2.4.1.Adverse Selection (The Hidden Information Problem)
Adverse selection. Depending on the fact that one side in a contractual agreement, the buyers or
the sellers, have information that the other part does not have, only some buyers or sellers will
want to enter into the contract. Only the ones that will profit the most from the contract will do
so. Moreover, those are, typically, the ones the other part wants to avoid.
Adverse selection is the situation where low-quality products drive high-quality products out of
the market because of the existence of asymmetric information between buyers and sellers. It
arises when one side of the market cannot observe the type or quality of the goods on the other
side of the market. The problem of adverse selection could arise in all markets characterized by
asymmetric information. The market for “lemons” (defective products such as used cars) and all
insurance markets represent good examples. In general, equilibrium in a market involving hidden
information will typically involve too little trade taking place because of the externality between

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the "good'' and "bad" types. Such equilibrium will be inefficient relative to the equilibrium that
could have prevailed with full information.
4.2.4.2 Moral hazard Moral Hazard (The Hidden Action Problem)
Moral hazard. Sometimes, one’s counterpart cannot check whether one fulfills one’s
obligations after having agreed on a contract. One may them be tempted to exploit the other’s
lack of knowledge. Moral hazard refers to a situation where one side of the market cannot
observe the action of the other side. It exists, for instance, when an insured party whose actions
are unobserved can affect the probability or magnitude of a payment associated with an event. In
general, it arises whenever an externality is present in that an economic agent can shift some of
its costs to others.
Note the difference between the two types: Adverse selection is about what happens before the
agreement has been made. Moral hazard is about what happens after it has been made.
4.2.4.3 market signaling
Market signaling is the process by which sellers send messages (or signals) to buyers conveying
information about the quality of their goods and services. What do you expect to happen if
sellers of high-quality products, lower-risk individuals, better-quality borrowers, or more-
productive workers can somehow inform or send signs of their superior quality their buyers
(customers)? The logical outcomes are:
 individuals would be able to identify high-quality products;
 insurance and credit companies would be able to distinguish between low- and high-risk
individuals and firms; and
 firms would be able to identify higher productivity workers.
As a result,
 sellers of high-quality products would be able to sell their products at higher prices;
 lower-risk individuals could be charged lower insurance premiums;
 better quality borrowers would have more access to credit; and
 higher-productivity workers could be paid higher wage

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 Summary
1. The market mechanism sometimes fails to maximize the welfare of a society. The reasons behind
such a failure are the prevalence of market power and asymmetric information in at least some parts
of an economy, and the existence of externalities and public goods even in otherwise perfectly
competitive markets.
2. Externalities are harmful and beneficial side effects borne by those not directly involved in the
production or consumption of a commodity. Market prices do not correctly reflect the activities
of either producers or consumers (there will be divergence between MSB and MPB or MSC and
MPC) in the presence of externalities.
 With positive externalities (external benefits) of production or consumption, the
benefit to the society (as measured by the price the society is willing to pay) exceeds the
full social cost of the commodity (on marginal basis) and too little of the commodity is
produced or consumed.
 With negative externalities (external costs) of production or consumption, the MSB
falls short of the MSC and too much of the commodity is produced or consumed.
3. Public goods are goods that are non-rival in consumption. Non-rivalry in consumption means
consumption of a good by some individual does not reduce the amount available for others (at
zero marginal cost). Some public goods, such as national defense, are also non-excludable, i.e.,
once provided, it is impossible or prohibitively costly to confine its use to only those paying for
it. Because of the free-rider problem, public goods are usually under produced or under
consumed.
4. Whenever there is a firm (or firms) with some monopoly power in either the product or input
market, there will be no Pareto-optimality in the economy in general. Monopoly in the product
market implies divergence between price and marginal cost at equilibrium [P > MR (= MC)].
Assuming perfect competition in the market for Y and imperfect competition in the market for X,
MRPTXY = MCX/MCY < PX/PY (because PX > MCX and PY = MCY at equilibrium).
Analogous arguments can be made for imperfect competition in the market for an input
5. Asymmetric information is a situation in which the two sides of a market transaction possess
different levels of information. It gives rise to problems like adverse selection and moral hazard,
which in turn result in too few (or no) transactions for goods and services.
 Adverse selection (the hidden information problem) is the situation where low-quality

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 products drive high-quality products out of the market due to the existence of asymmetric
information between buyers and sellers. The markets for used-cars, insurance markets, and
the labor market are the usual examples where such a problem is faced. Sellers of goods or
services usually send messages (or signs) to buyers in order to convey information about the
quality of their goods or services. The process of conveying such information is termed
market signaling and helps much in making markets perform better.
 Moral hazard refers to a situation where one side of the market cannot observe the action
of the other side as in the insurance market where the insured party (without being observed
by the insurance company) can affect the probability or magnitude of a payment associated
with an event. The problems of adverse selection and moral hazard, together with huge
transaction and monitoring costs, are responsible for malfunctioning of financial institutions.
These problems in the financial sector have largely been reduced by the introduction of
group lending.

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