Market Failure

Definition of Market Failure This occurs when there is an inefficient allocation of

resources in a free market. Market failure can occur due to a variety of reasons, such as
monopoly (higher prices and less output), negative externalities (over-consumed) and
public goods (usually not provided in a free market)

Types of market failure:

1. Positive externalities – Goods / services which give benefit to a third party, e.g. less
congestion from cycling
2. Negative externalities – Goods / services which impose cost on a third party, e.g.
cancer from passive smoking
3. Merit goods – People underestimate the benefit of good, e.g. education
4. Demerit goods – People underestimate the costs of good, e.g. smoking
5. Public Goods – Goods which are non-rival and non-excludable – e.g. police, national
defense.
6. Monopoly Power – when a firm controls the market and can set higher prices.
7. Inequality – unfair distribution of resources in free market
8. Factor Immobility – E.g. geographical / occupational immobility
9. Agriculture – Agriculture is often subject to market failure – due to volatile prices and
externalities.
10. Information failure – where there is lack of information to make an informed choice.

Key Terms in Market Failure

 Externalities: These occur when a third party is affected by the decisions and actions of
others.
 Social benefit: is the total benefit to society =
Private Marginal Benefit (PMB) + External Marginal Benefit (XMB)
 Social Cost: is the total cost to society =
Private Marginal Cost (PMC) + External Marginal Cost (XMC
 Social Efficiency: This occurs when resources are utilised in the most efficient way. This
will occur at an output where social marginal cost (SMC) = Social Marginal Benefit.
(SMB)

Overcoming Market Failure

 Tax on Negative Externalities – e.g. Petrol tax
 Carbon Tax e.g. tax on CO2 emissions
 Subsidy on positive externalities – why government may subsidies public transport
 Laws and Regulations – Simple and effective ways to regulate demerit goods, like ban
on smoking advertising.
 Buffer stocks – aim to stabilize prices
 Government failure – why government intervention may not always improve the
situation

Remedies
In order to reduce or eliminate market failures, governments can choose two
basic strategies:

Use the price mechanism

The first strategy is to implement policies that change the behaviour of
consumers and producers by using the price mechanism. For example, this
could mean increasing the price of ‘harmful’ products, through taxation, and
providing subsidies for the ‘beneficial’ products. In this way, behaviour is
changed through financial incentives, much the same way that markets work
to allocate resources.

Use legislation and force

The second strategy is to use the force of the law to change behaviour. For
example, by banning cars from city centers, or having a licensing system for
the sale of alcohol, or by penalising polluters, the unwanted behaviour may be
controlled.

In the majority of cases of market failure, a combination of remedies is most

likely to succeed.

What is the difference between private and social costs, and how do they relate to pollution and
production?

November 2002
This is an important distinction to understand. Private costs to firms or individuals do not always
equate with the total cost to society for a product, service, or activity. The difference between
private costs and total costs to society of a product, service, or activity is called an external
cost; pollution is an external cost of many products. External costs are directly associated with
producing or delivering a good or service, but they are costs that are not paid directly by the
producer. When external costs arise because environmental costs are not paid, market failures
and economic inefficiencies at the local, state, national, and even international level may result.

Let’s start by defining private costs, external costs, and social costs. Next, we will briefly
examine the impact external costs can have on prices, production, resource allocation, and
competition.

Key Concepts:

Private Costs + External Costs = Social Costs

If external costs > 0, then private costs < social costs.

Then society tends to:

– Price the good or service too low, and

– Produces or consumes too much of the good or service.

Different Costs Matter:

Private costs for a producer of a good, service, or activity include the costs the firm pays to
purchase capital equipment, hire labor, and buy materials or other inputs. While this is
straightforward from the business side, it also is important to look at this issue from the
consumers’ perspective. Field, in his 1997 text, Environmental Economics provides an example
of the private costs a consumer faces when driving a car:1

The private costs of this (driving a car) include the fuel and oil, maintenance, depreciation, and
even the drive time experienced by the operator of the car.
Private costs are paid by the firm or consumer and must be included in production and
consumption decisions. In a competitive market, considering only the private costs will lead to a
socially efficient rate of output only if there are no external costs.

External costs, on the other hand, are not reflected on firms’ income statements or in
consumers’ decisions. However, external costs remain costs to society, regardless of who pays
for them. Consider a firm that attempts to save money by not installing water pollution control
equipment. Because of the firm’s actions, cities located down river will have to pay to clean the
water before it is fit for drinking, the public may find that recreational use of the river is
restricted, and the fishing industry may be harmed. When external costs like these exist, they
must be added to private costs to determine social costs and to ensure that a socially efficient
rate of output is generated.

Social costs include both the private costs and any other external costs to society arising from
the production or consumption of a good or service. Social costs will differ from private costs,
for example, if a producer can avoid the cost of air pollution control equipment allowing the
firm’s production to imposes costs (health or environmental degradation) on other parties that
are adversely affected by the air pollution. Remember too, it is not just producers that may
impose external costs on society. Let’s also view how consumers’ actions also may have
external costs using Field’s previous example on driving:2

The social costs include all these private costs (fuel, oil, maintenance, insurance, depreciation,
and operator’s driving time) and also the cost experienced by people other than the operator
who are exposed to the congestion and air pollution resulting from the use of the car.

The key point is that even if a firm or individual avoids paying for the external costs arising from
their actions, the costs to society as a whole (congestion, pollution, environmental clean up,
visual degradation, wildlife impacts, etc.) remain. Those external costs must be included in the
social costs to ensure that society operates at a socially efficient rate of output.

Aside from the obvious environmental issues, one might ask why external costs are of interest
to economists?

Resource Implications

A socially efficient output rate in a competitive market is reached when social costs (both
private and external costs) are considered in production and consumption decisions.3
The existence of external costs has implications for product prices, output levels, resource
usage, and competition. When significant external costs are associated with a good (or service),
then the price of the good is too low (because external costs are not being paid) and its output
level is too high, relative to the socially efficient rate of output for the good. The bottom line,
unless costs and prices include external costs, the market will not produce a socially efficient
result.

Consider also the competitive issues: At the individual firm level, as well as across states or
nations, failure to pay for external costs would provide those firms or nations with a competitive
advantage over producers who are paying the external costs associated with the production of
their products. If you’re interested, a graphic examination of the issue follows!

Here’s the Graphic Illustration (for those who like charts!)

In the graphic illustration, the intersection of the demand curve and marginal cost curve
represents the socially efficient rate of output in a competitive market. However, in the case
where external costs exist, we need to plot two curves: The marginal private cost curve and the
marginal social cost curve (equals the marginal private cost curve plus the marginal external
cost curve).

Comparing prices and outputs illustrates how external costs affect resource allocation. If a firm
(or nation) pays only the private costs and avoids paying the external costs associated with
their product, then output and prices would be determined at point P where the marginal
private cost curve (heavy solid black line) meets the demand curve (thin purple line). At P (thin
dashed green lines) price equals Pp and output equals Op.

When private and external costs are paid by the firm, the marginal social cost curve (dotted red
line) is created by adding the marginal external costs to the marginal private costs. In this case,
the intersection of the marginal social cost curve and the demand curve occurs at point S (thin
blue lines), with price Ps and output Os. Point S denotes the socially efficient rate of production.

From a resource standpoint, the important point of this comparison is that including the
marginal external costs of production and allocating resources based on the full social cost
results in a higher price for the good (Ps > Pp) and less output (Os < Op) than only including
the private costs. Lower output typically would also reduce the amount of pollution generated
by the activity.
Summary

Society is better off when production and consumption decisions are based on social costs that
include external costs, because external costs really do matter in the real world. Policy makers
look for ways to make firms and consumers ‘internalize’ or take into account the external costs
they create when they make production and consumption decisions.