Chapter-Two: Market Failure,

Public Goods and Externalities:

Issues to be discussed
 Understanding, Market Failures and the role of
Government
 Public Goods, Types of Public Goods
 Efficiency Conditions for Public Goods,
 Private Goods
 What is Externalities? Types of Externalities
 How to Internalized Externalities?
i) Private Solutions to Externalities,
10/22/2024 ii)Public Sector Solutions to Externalities. 1
 2.1 Understanding Market Failures
Market failure refers to the inefficient distribution of goods and
services in the free market. Market failure is the economic situation
defined by an inefficient distribution of goods and services in the free
market. In market failure, the individual incentives for rational behavior
do not lead to rational outcomes for the group.

The market mechanism may fail to provide the optimal mix of output:

– The optimal mix of output is the most desirable combination of

output attainable with existing resources, technology, and social

values.

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 2.1 Understanding Market Failures
In other words, each individual makes the correct decision for
him or herself, but those prove to be the wrong decisions for
the group. In traditional microeconomics, this can
sometimes be shown as a steady-state disequilibrium in
which the quantity supplied does not equal the quantity
demanded.
Market failure occurs
 when individuals acting in rational self-interest produce a
less than optimal or economically inefficient outcome.
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 Contd.
 Market fails to produce the right
amount of the product;

 Market failure can occur in explicit markets where goods and services
are bought and sold outright, which we think of as typical markets.

 Market failure can also occur in implicit markets as favors and special
treatment are exchanged, such as elections or the legislative process.

 Resources may be

• Over-allocated
• Under-allocated
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 Demand-Side
2.2 Types of M. Failure Failures
i) Demand-side failures
• Impossible to charge consumers what they are willing
to pay for the product
• Some can enjoy benefits without paying
ii) supply-side failures

• Occurs when a firm does not pay the full cost of

producing its output

• External costs of producing the good are not reflected

in the supply price.
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 2.3 Reasons of M. failure
Market failure may occur in the market for
several reasons, including:
o 1. Externality-An externality refers to a cost or benefit
resulting from a transaction that affects a third party that did
not decide to be associated with the benefit or cost. It can be
positive or negative.
o 2. Public goods-Public goods are goods that are consumed by
a large number of the population, and their cost does not
increase with the increase in the number of consumers.
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 Contd.
Public goods create market failures if a section of the
population that consumes the goods fails to pay but
continues using the good as actual payers.

3. Market control- Market control occurs when either the

buyer or the seller possesses the power to determine the
price of goods or services in a market. The power
prevents the natural forces of demand and supply from
setting the prices of goods in the market.
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 Contd
On the supply side, the sellers may control the prices of goods and

services if there are only a few large sellers (oligopoly) or a single large

seller (monopoly).

4. Imperfect information in the market-Market failure may also result

from the lack of appropriate information among the buyers or

sellers. This means that the price of demand or supply does not
reflect all the benefits or opportunity cost of a good. The lack of
information on the buyer’s side may mean that the buyer may be
willing to pay a higher or lower price for the product because they
don’t know its actual benefits.
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 2.4 Solutions for market Failure
There are many potential solutions for market
failures.

These can take the form of :

 government-imposed solutions,

 private market solutions, or

 voluntary collective action solutions.

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i) government-imposed solutions,
1. Impose Regulations
Governments can enact legislation as a response
to market failure. For example, if businesses hire
too few teenagers or low skilled workers after a
minimum wage increase, the government can
create exceptions for younger or less-skilled
workers. Radio broadcasts elegantly solved the
non-excludable problem by packaging periodic
paid advertisements with the free broadcast.

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 Contd.
2. Impose Tax and subsidies
Governments can also impose taxes and
subsidies as possible solutions.
Subsidies can help encourage behavior that can
result in positive externalities.
Meanwhile, taxation can help cut down negative
behavior. For example, placing a tax on tobacco
can increase the cost of consumption,
therefore making it more expensive for people
to smoke and so to reducing demand.
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 Government Intervention

P Negative P
externalities St St
b
a a
S S

c T
D D
Overallocation
0 0
Qo Qe Q Qo Qe Q

(a) (b)
Negative externalities Correct externality with
tax

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LO4 5-12
 Market Failure Due to Negative
Production Externalities in the
Steel Market
A negative production externality of $100 per
unit of steel produced (marginal damage, MD)
leads to a social marginal cost that is above
the private marginal cost, and a social
optimum quantity (Q0) that is lower than the
competitive market equilibrium quantity (Qe).
There is overproduction of Qe - Q0, with an
associated dead- weight loss of area BCA.

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 Government Intervention

Methods for Dealing with Externalities

Resource Allocation
Problem Outcome Ways to Correct
Negative externalities Overproduction of output 1. Private bargaining
(spillover costs) and therefore 2. Liability rules and lawsuits
overallocation of 3. Tax on producers
resources 4. Direct controls
5. Market for externality rights

Positive externalities Underproduction of output 1. Private bargaining

(spillover benefits) and therefore 2. Subsidy to consumers
underallocation of 3. Subsidy to producers
resources 4. Government provision

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LO4 5-14
 ii) Private solutions
There are several types of private solutions to
market failures: Moral codes: Moral codes
guide individuals' behavior. Charities: Charities
channel donations from private individuals
towards fighting to limit behaviors that result in
negative externalities or promoting behaviors
that generate positive externalities.
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 iii) Voluntary Collective action solutions

Voluntary environmental programs are institutions (i,e

BELA)* that seek to induce firms to produce positive
environmental externalities beyond what government
regulations require. Effective programs have rule structures
that mitigate two central collective action problems
inherent in producing positive environmental externalities
Like:
* https://www.elaw.org/content/bangladesh-bela-v-government-
10/22/2024bangladesh-and-others-wp-2003-tannery-case-original-petition16
 Contd.
attracting firms to participate in the program and
ensuring that participating firms adhere to program
obligations.

Because program efficacy can be undermined by

collective action problems associated with free riding
and shirking,

Effective voluntary clubs should be designed to mitigate

these challenges.
10/22/2024 17
 2.5 Public goods and M. Failure
Public goods are goods or services which, if produced, the
producer cannot limit its consumption to paying customers
and for which the consumption by one individual does not
limit consumption by others.

National defense is one such public good because each

citizen receives similar benefits regardless of how much
they pay. It is very difficult to privately produce the optimal
amount of national defense.

10/22/2024 18
 Contd.
Since governments cannot use a competitive
price system to determine the correct level of
national defense, they also face major
difficulty producing the optimal amount. This
may be an example of a market failure with no
pure solution.
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2.5 Role of Government in Market Failure

Main role of government is to correct problems of

market failure associated with public goods, external
costs and benefits, and imperfect competition.
Government intervention to correct market failure
always has the potential to move markets closer to
efficient solutions, and thus reduce deadweight losses
created from consumer surplus and producer surplus.

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 2.5 Role of Government

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 2.6 Public Goods, Types of Public Goods

In economics, a public good refers to a commodity or

service that is made available to all members of a society.
Typically, these services are administered by governments
and paid for collectively through taxation.

Examples of public goods include: law enforcement,

national defense, and the rule of law. Public goods also
refer to more basic goods, such as access to clean air and
drinking water.
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 Characteristics of Public Goods

10/22/2024 23
10/22/2024 24
 contd
• Examples of public goods include fresh air,
knowledge, lighthouses, national defense,
flood control systems, and street lighting.

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10/22/2024 26
 Contd
RQ1 : Why should Government provide

public goods? (Answer : see

previous slide)
RQ2 :Define pure public goods with
examples

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 Types of public Goods

i) Pure public goods are those that are perfectly non-

rivalrous in consumption and non-excludable. Impure
public goods are those that satisfy the two conditions
to some extent, but not fully. The production of
public goods results in positive externalities for which
producers don't receive full payment.

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 Pure Public Good Issues
6 Issues arise out of Pure Public Goods:
1) Different Values
2) Public Goods Aren’t Absolute
3) NONRIVAL ≠ NONEXCLUDABLE
4) Unconventional Public Good
5) Private Provision
6) Private Production

10/22/2024 29
 Types public goods
i) Knowledge is a pure public good: once
something is known, that knowledge can be
used by anyone, and its use by any one person
does not preclude its use by others.
As an example, our use of calculus to study
economics does not prevent millions of other
people from simultaneously applying calculus
to entirely different problems in industry and
science.
10/22/2024 30
 Contd.
ii) Quasi-public goods have characteristics of both
private and public goods, including partial
excludability, partial rivalry, partial
diminishability and partial rejectability.
Examples include roads, tunnels and bridges.
A quasi-public good is a near-public good. It
has some of the characteristics of a public good
especially when it becomes rival in
consumption at times of peak demand. Quasi
public goods. Share: Facebook.
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 iii)Impure Public Goods
Anything with a positive consumption externality.

Congested goods: Roads

Club Goods: Excludable with congestion = Museum

Local Public Goods: Parks, libraries etc.

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 Contd.
iv) Merit goods are those goods and services
that the government feels that people will
under-consume, and which ought to be
subsidized or provided free at the point of use
so that consumption does not depend primarily
on the ability to pay for the good or service.
Example

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 Contd
The concept of a merit good introduced in
economics by Richard Musgrave (1957, 1959) is a
commodity which is judged that an individual or
society should have on the basis of some concept
of need, rather than ability and willingness to pay.
The term is, perhaps, less often used today than it
was in the 1960s to 1980s but the concept still
lies behind many economic actions by
governments which are not performed
specifically for financial reasons or by supporting
incomes (e.g. via tax rebates).
10/22/2024 34
 contd.

Examples include in-kind transfers such as the

provision of food stamps to support nutrition,
the delivery of health services to improve
quality of life and reduce morbidity, subsidized
housing and education.

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 Contd
v) Congestible goods
In fact, some goods, called congestible or
impure, act as public goods when demand is
low, and like common-pool resources when
crowded. A prominent example of a
congestible goods is parking space.

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 Contd

These are public goods that become rival when

they are heavily used e.g. during rush hour the
usage of roads by each additional car causes
congestion that diminishes the utility of other
drivers. By charging a toll to control congestion
the good becomes excludable during toll hours.
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2.7 Efficiency condition of Public goods

MSB=MSC
MSB= MPB+MEB
MSC= MPC+MEC

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 2.8 What is a Private Good?
A private good is a product that must be purchased
to be consumed, and consumption by one individual
prevents another individual from consuming it. In
other words, a good is considered to be a private
good if there is competition between individuals to
obtain the good and if consuming the good
prevents someone else from consuming it.
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 2.8 What is a Private Good?
A PRIVATE GOOD has two features:
1) Rival – once consumed, another person
cannot consume it
2) Excludable (exclusive) – others can be
prevented from consuming it

Food (ie: pizza or sushi) is a good example of

a private good. Once I eat it, it’s gone.
(YUM!)
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 Maka Susan Market demand
P P P

100

40

Q Q Q
2 5 7

@ P=$40, QM+QS=QD
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2+5=7
41
 When market supply intersects market demand,
we find equilibrium price and individual demand.
Maka Susan Market
P P P
S
100
65
40

2 Q 3.5 5 Q Q*=5 7 Q

1.5
@ P*=$65, QM+QS=Q*
10/22/2024
1.5+3.5=5
42
 Efficient Provision of Private Goods
- It says that, if the allocation is efficient, then the
sum of all people's marginal rates of substitution
(MRS) between a pure public good and a pure
private good should equal the marginal rate of
transformation between the goods.
- Efficiency requires that the marginal benefit
equal the marginal cost. With a private good,
people with a strong taste for a good will consume
higher quantities of that good, if the allocation is
efficient. The high quantities they consume drive
down their MRS, to equal that of other people.
Pareto Efficiency Condition
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 2.9 Externalities
An externality is a cost or benefit caused by a
producer that is not financially incurred or received
by that producer.

An externality can be both positive or negative and

can stem from either the production or consumption
of a good or service. The costs and benefits can be
both private—to an individual or an organization—or
social, meaning it can affect society as a whole.
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 Externalities

• A cost or benefit accruing to a third party

external to the transaction
• Positive externalities
• Too little is produced
• Demand-side market failures
• Negative externalities
• Too much is produced
• Supply side market failures
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LO4 5-45
 Contd
The action of an individual or organization often
results in positive private gains but detracts from
the overall economy.

Many economists consider technical externalities to

be market deficiencies, and this is the reason
people advocate for government intervention to
curb negative externalities through taxation and
regulation.
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 Negative and Positive Externalities

Most externalities are negative. Pollution is a well-

known negative externality. A corporation may decide
to cut costs and increase profits by implementing new
operations that are more harmful to the environment.
The corporation realizes costs in the form of
expanding operations but also generates returns that
are higher than the costs.
10/22/2024 47
 Contd.
Positive externality- A positive externality (also called "external
benefit" or "external economy" or "beneficial externality") is the

positive effect of an activity imposes on an unrelated.

• Positive externalities occur when there is a positive gain on both
the private level and social level. Research and development
(R&D) conducted by a company can be a positive externality.
• R&D increases the private profits of a company but also has the
added benefit of increasing the general level of knowledge within
a society.

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 How to Internalize Externality
1) Government Intervention
Negative Externality- Imposing Tax
Positive Externalities- Providing subsidy
2) Private Initiatives

3) Voluntary Initiatives

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Negative Externality- Imposing Tax

Demand curve with external costs; if social costs are not accounted for price is too
low to cover all costs and hence quantity produced is unnecessarily high (because the
producers of the good and their customers are essentially underpaying the total, real
factors of production.)
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 Contd
• The graph shows the effects of a negative externality.
For example, the steel industry is assumed to be selling
in a competitive market – before pollution-control laws
were imposed and enforced (e.g. under laissez-faire).
• The marginal private cost is less than the marginal social
or public cost by the amount of the external cost, i.e.,
the cost of air pollution and water pollution.
• This is represented by the vertical distance between
the two supply curves. It is assumed that there are no
external benefits, so that social benefit equals
individual benefit.

10/22/2024 51
 Contd.
• If the consumers only take into account their own private cost, they will end

up at price Pp and quantity Qp, instead of the more efficient price Ps and

quantity Qs. These latter reflect the idea that the marginal social benefit

should equal the marginal social cost, that is that production should be

increased only as long as the marginal social benefit exceeds the marginal

social cost.

• The result is that a free market is inefficient since at the quantity Qp, the social

benefit is less than the social cost, so society as a whole would be better off if

the goods between Qp and Qs had not been produced. The problem is that

people are buying and consuming too much steel.

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 Positive Externalities(Subsidy)

10/22/2024 53
 (Supply curve with external benefits; when the
market does not account for the additional social
benefits of a good both the price for the good and the
quantity produced are lower than the market could)
• The graph shows the effects of a positive or beneficial
externality. For example, the industry supplying
smallpox vaccinations is assumed to be selling in a
competitive market.
• If consumers only take into account their own private
benefits from getting vaccinations, the market will
end up at price Pp and quantity Qp as before, instead
of the more efficient price Ps and quantity Qs.

10/22/2024 54
 Contd
• This latter again reflect the idea that the marginal social benefit

should equal the marginal social cost, i.e., that production should be

increased as long as the marginal social benefit exceeds the

marginal social cost.

• The result in an unfettered market is inefficient since at the quantity

Qp, the social benefit is greater than the societal cost, so society as a

whole would be better off if more goods had been produced. The

problem is that people are buying too few vaccinations. If these

externalities were internalized, the manufacturer would be

encouraged to provide more.

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 2.10 Government Intervention
• Correct negative externalities
• Direct controls
• Specific taxes
• Correct positive externalities
• Subsidies
• Government provision

10/22/2024 56
LO4 5-56
 Contd.
Governments can also implement regulations to
offset the effects of externalities. Regulation is
considered the most common solution.

The public often turns to governments to pass and

enact legislation and regulation to curb the
negative effects of externalities. Several examples
include environmental regulations or health-
related legislation.
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 Government’s Role in the
Economy
• Government can have a role in correcting
externalities
• Officials must correctly identify the
existence and cause
• Has to be done in the context of politics
•
•

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LO5 5-58
 Key Issues

10/22/2024 59
 Review Questions

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