Market Failure

Market Failure

Indeed, our particular concept of private property, which deters us from exhausting the positive

resources of the earth, favors pollution.-Garrett Hardin

Slide 1 of 22

Review: Societal Surplus

A

B

C

Economists are typically proponents of free markets because they benefit

society. When a market sets the price, Consumer and Producer (i.e. societal)

surplus is maximized.

Slide 2 of 22

Review: Society’s benefits and Dead Weight Loss

If a market is unable to reach equilibrium…for any reason…then some

of these benefits disappear.

This “Dead Weight Loss” is lost to society!

Slide 3 of 22

Market intervention

So you are probably wondering…

If intervening in markets can create dead weight loss, then why do governments

intervene in markets?

Do they even have a role in the economy?

The answer is yes. Sometimes markets fail and governments need to intervene to

correct for it.

So what is market failure? See an example on the next slide….

Slide 4 of 22

An example of market failure

Perhaps demand and supply would dictate that this combination

of goods are produced.

…And what if that intense level of

manufacturing caused acid rain (a factor

unaccounted for by producers because they do not have to

pay for it)?

Perhaps this would be a more “optimal” mix of

goods. However, If we

leave production decisions to the market… will we ever get there?

Notice that at the point, the amount of manufactured

goods is relatively high…

I doubt it…this economy will probably stay

here, despite the fact that this is not

desirable for society.

That is market failure. It is an

outcome determined by the market that is not optimal to

society.

Slide 5 of 22

When private sector markets fail, Government can intervene

“Laissez Faire!”

He was referring to the economy and suggested that an economy unbothered by a government would outperform one that

was interfered with.

Adam Smith, a famous 18th century economist, coined the term “Laissez-Faire”

which means “leave it alone”.

He did realize, though that there were situations where a government must

intervene.

Slide 6 of 22

We’ll discuss two types of Market Failure

We’ll look at examples of each.

Public Goods

External Costs

Slide 7 of 22

These are common causes of market failure, which is a key

learning outcome!

#1 Public goodsPublic Goods

Nonrivalry means that when one person buys and uses a product, it is still available for other

consumers.

Nonrivalry Example: Flood control. By using a system of levees to protect my house

from floods, I do not consume those levees.

Nonexcludability means that sellers cannot keep the people that did not pay for the product from

using it.

Nonexcludability Example: National defense.The military cannot threaten to exclude certain households from protection if they do not pay.

Public goods are characterized by nonrivalry and nonexcludability.

Slide 8 of 22

An example of a public good: A lighthouse

Public Goods

Assume that this captain paid for

the lighthouse. By using it, She

wouldn’t consume it. It is

nonrivalrous.

And what is to stop this captain from using the

light? It is nonexcludable.

This is a public good.

Slide 9 of 22

Should there be a lighthouse?

Public Goods

But…should there be a lighthouse?

Imagine, prior to construction, these

three ships were lost because there was no

lighthouse.

What if the lighthouse cost $16 million to

build.

No single firm would be willing to produce

it.

It costs more than anyone’s individual

ship.

Because of nonrivalry and nonexcludability, private firms cannot

profitably produce public goods so they don’t.

Slide 10 of 22

Clearly, there should be a lighthouse (MB>MC or in other words, $37 million>$16 million)

• Think of it like this- who will build the light house if:• Anyone could use it regardless of whether they paid

» This is called the “Free Rider Problem”. Any single user would not deem it worthwhile to build it.

• Examples of public goods provided by government are:

» National defense» Space programs» National health program» Flood control

Public Goods

The free rider problem is a situation where an

individual reaps the benefits of someone else’s purchase of a good. Example: a Fireworks Show!

But the private market won’t build it – this market has failed.

I think you’ll agree that these are good

to have.

But as public goods, the private sector will not provide

them.Slide 11 of 22

Private versus Public GoodsPublic Goods

Private goods do not share these characteristics of nonrivalry and

nonexcludability.

Instead, when a private good is consumed, it is gone.

And businesses can keep non payers from using these goods.

Therefore, the businesses ARE able to charge for these goods.

Businesses are willing to produce private goods so a government does

not have to get involved.There is no market failure!

For example, a drive through will take your money before giving you food.

Slide 12 of 22

# 2 External Costs and Benefits

• Also referred to as “externalities” or “spillovers”, these are costs or benefits of a market activity borne by a third party– Examples include pollution, traffic congestion– Spillovers can also be positive such as apples from your

neighbor’s trees falling over your fence

External Costs

Slide 13 of 22

The polluting factory: an external cost illustration

We’ve learned that three units will be produced in

this market.

But what if this firm was a factory that produced a lot

of air pollution?

And what if that pollution meant that you had to paint your house every

two years?

The polluting company would be imposing a cost

on you. That is an external cost.

The market has failed. You as a third party should

not have to pay those costs.

Perhaps the government can intervene by taxing the polluting company.

Taxes would reduce output and move the

market toward a more socially optimal output.

Note how the tax has increased the firm’s costs and as a result output has

fallen to two units. To further help, the

government might pay you part of the tax revenues to

offset your increased painting costs.

External Costs

Slide 14 of 22

Externalities and production decisions

• The market will over produce goods that produce a negative externality

• The market will under produce goods that produce a positive externality

This should make sense…a third party is paying part

of their costs.

This should make sense too…the producer is not being paid for a benefit

they generate.

External Costs

Slide 15 of 22

Controlling for externalities

We have seen one example of a way a government might control for

externalities (taxes).

The next few slides will explore ways a government can intervene in more

detail.

External Costs

Slide 16 of 22

Government intervention to control for externalities:

Direct Control

Through direct control, the state has taken over all sales of liquor.

Why are liquor stores state run in Virginia? (and other states)

$10

10,000

If this market is left alone, then 10,000 units of liquor would be sold at a price

of $10.

But the consumption of liquor has externality costs not accounted for in

the cost of production.

The consumption of liquor increases crime and domestic violence.

Local governments incur a cost to address this through police and public

safety budgets.

That is market failure. A third party is incurring a cost.

They increase the price (with a price floor) to reduce quantity!

$15

8,000

Price Floor

External Costs

Slide 17 of 22


Specific taxes

A government can tax this industry to reduce production.

What can be done about polluting factories?

$100

2,000

If this market is left alone, then 2,000 units of a product would be sold at a

price of $100.

But the production of this good has externality costs not accounted for in


The manufacturing process causes pollution.

Local residents incur a cost to address this through clean up and health

issues.

That is market failure. A third party is incurring a cost.

The government has reduced production by adding costs to the

producer!

$125

1,500

External Costs

Slide 18 of 22


Subsidies

A government can subsidize this industry to increase production.

Why is it cheaper for in state students to attend college?

$2000

200,000

If this market is left alone, then 200,000 students might attend college

at $2,000 per semester.

But the production of this good has a positive externality not accounted for in


An educated population is healthier and commits less crime.

Local governments and health systems need to provide fewer services to these populations.

That is market failure. A third party is benefitting from education providers.

By giving money to colleges, students can attend at a lower cost…and more

students go!

$1250

250,00

External Costs

Slide 19 of 22


Market Based Approach

P=$100

P=$200

What is the “cap and trade” system?

A government agency (EPA) determines that a pollutant such as emissions of SO2 (that produce acid

rain) produced by all companies must be below a certain level or “cap”.

The Government then issue permits for auction that allow companies to produce some share of the capped

SO2.

Companies bid on these permits and can trade them.

The “cap” prevents environmental damage beyond a certain level and encourages companies to innovate.

Typically, demand would increase and drive costs up encouraging more

innovation.

Note that supply is fixed (capped) and the supply curve is perfectly inelastic)

External Costs

Slide 20 of 22

The market based approach has many advantages

Potential polluters are given an economic incentive not to pollute.

Rising costs stimulate innovation for lesser polluting alternatives.

The program generates revenues that can be devoted to clean up.

Conservatives can buy permits thereby limiting the amount of total pollution available to polluters.

External Costs

Slide 21 of 22

In summary

When markets do not reach equilibrium, a dead weight loss may occur.

Proponents of market systems prefer that markets be left alone.

However, sometimes, markets fail.

When markets are unable to bring us to an outcome that is optimal for society, a government might intervene.

Through taxes, subsidies, or other forms of intervention, a government tries to ensure that we reach (or at least move

towards) a socially optimal outcome!

ABC

Slide 22 of 22

Market Failure

Education

Transcript of Market Failure