MICROECONOMICS
TOPIC 5 – MARKET FAILURE AND GOVERNMENT
INTERVENTION
AFTER LEARNING TOPIC 5, YOU SHOULD BE ABLE TO:
1. Explain what is meant by the term market failure
2. Understand the defining characteristics of public goods and common
resources
3. Understand What are the challenges of providing nonexcludable
goods?
4. Explain why externalities can make market outcomes inefficient
5. Examine the various government policies aimed at solving the problem
of externalities
6. Understand that people can sometimes solve the problem of
externalities on their own
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WHAT IS MARKET FAILURE
• When a market is at equilibrium, total surplus is maximized (from Topic 4).
• This is true when markets are functioning well, and price mechanism sends
correct signals to buyers and sellers (invisible hand).
• Sometimes, this isn’t the case. Market failure occurs when the price signals
are not working correctly
• Consequently, there is an inefficient allocation of resources in a market
• When the market fails the government intervenes to improve efficiency in the
market
• In this course we look at three situation where a market fails
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INSTANCES OF
MARKET FAILURE
• Public goods & common resources
• Externalities
• Market power (Topics 7-9)
FOUR TYPES OF GOODS
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MARKET FAILURE - PUBLIC GOODS
• Public goods:
o Can be consumed by many
o Difficult to exclude nonpayers
from consumption
• Free-rider problem:
o Someone has the ability to receive the benefit of a good
without paying for it
• Solution
o Government provision of the good/service
o Funded through taxes
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MARKET FAILURE - COMMON RESOURCES - 1
• Tragedy of the commons:
o Occurs when a rival (but nonexcludable)
good becomes depleted or ruined.
• Original example:
o Cattle grazing on a common ground
shared by all cattle farmers.
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Over f ish ing
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The commons get destroyed, even though
this was in nobody’s best interest.
• Incentive to neglect
• Incentive to overuse
• Incentive to ignore others
MARKET FAILURE - COMMON RESOURCES - 2
MARKET FAILURE - COMMON RESOURCES – POSSIBLE SOLTIONS
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• Permits (internalise the externality)
• Regulations (command and control)
• Other policies
o Proactive management
o Education
MARKET FAILURE - EXTERNALITIES - 1
• The costs or benefits of a market activity that affect a third party.
• There are two parties directly involved in a market transaction: the buyer
(consumer) and the seller (producer).
• In the case of externalities, either buyer or seller is not considering all the
costs and/or benefits of their actions when they make decisions.
• Which means there are third parties affected either positively or negatively by
their decisions
• And the value of those costs or benefits to the third party is not reflected in the
market price
• This leads to an inefficient allocation of resources.
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• Internal costs:
o The costs of a market activity paid only by an individual participant
• External costs:
o The costs of an activity imposed on people not participating in that market
(Third party)
• Social costs:
o The sum of the internal costs and external costs of a market activity
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An externality exists when
internal cost ≠ social cost.
internal benefit ≠ social benefit.
MARKET FAILURE - EXTERNALITIES - 2
PROPERTY RIGHTS
• Externalities often arise because of a lack of clearly defined
property rights
• Property rights
o Give the owner the ability to exercise control over a resource
• Private property
o Provides exclusive right of ownership that allows for the use and
exchange of property
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PROPERTY RIGHTS CREATE INCENTIVES
1. Incentive to maintain
2. Incentive to protect
3. Incentive to conserve
4. Incentive to trade with others
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CORRECTING FOR EXTERNALITIES - PRODUCTION NEGATIVE – 1
CORRECTING FOR EXTERNALITIES - PRODUCTION NEGATIVE – 2
1. Internalizing the externality: Ensuring that the individual involved in the activity
takes into account the social costs of his or her actions.
o Tax the product.
o Cap and trade:
❖A system of pollution “permits” that are traded on an open market.
❖Firms that can control emissions cheaply will sell their permits.
❖Firms who face very high costs to reduce emissions will purchase permits.
❖Creates property rights for pollution.
o The supply curve shifts to the left
o The firm’s marginal costs will equal the marginal social cost
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2. Command and control
o Regulate production: E.g. Set and enforce pollution standards
3. Other policies
o E.g. Encourage research and development of alternative substitutes to
the product
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CORRECTING FOR EXTERNALITIES - PRODUCTION NEGATIVE – 3
CORRECTING FOR EXTERNALITIES – CONSUMPTION NEGATIVE -1
1. Internalizing the externality: Ensuring that the individual involved in
the activity takes into account the social costs of his or her actions
o Tax the product
❖The demand curve shifts to the left
❖The individual’s marginal (private) costs will equal the marginal social cost
2. Command and control
o Regulate consumption: E.g. Set and enforce drink driving limits
3. Other policies
o E.g. Education
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CORRECTING FOR EXTERNALITIES – CONSUMPTION NEGATIVE -2
Can you
complete the
graph for
correcting a
consumption
negative
externality
CORRECTING FOR EXTERNALITIES - PRODUCTION POSITIVE
• For positive externalities of production:
1. Internalizing the externality: Ensuring that the individual involved in
the activity takes into account the social benefits of his or her actions.
o Finance/subsidise the production costs.
❖The supply curve shifts to the right.
❖The firm’s marginal costs will equal the marginal social cost.
2. Command and control
o Regulate production: Can you think of examples?
3. Other policies: Can you think of examples?
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CORRECTING FOR EXTERNALITIES – CONSUMPTION POSITIVE
For positive externalities of consumption
1. Internalizing the externality: Ensuring that the individual involved in the
activity realises the full (social) benefits of his or her actions.
o Finance and/or subsidise consumption of the good or the service
❖E.g. Education; Vaccination
❖The demand curve shifts to the right
❖The individual’s marginal benefit (value) will equal the marginal social benefit
(value).
2. Command and control
o Regulate consumption: Can you think of examples?
3. Other policies
o E.g. Education re benefits of vaccination
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CORRECTING FOR POSITIVE EXTERNALITIES – CONSUMPTION POSITIVE
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THE COASE THEOREM
• If there are no barriers to negotiations, and if property rights are fully
specified, interested parties will bargain to correct externalities
• Coase determined that whenever the size of the externality is large enough to
justify the expense of bargaining, the externality gets internalized.
• The key point here is that it doesn’t matter who has the property rights.
Bargaining will lead to an efficient outcome.
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COVID – EXTERTANILITES EXAMPLE
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Impacts on
society
Type of Externality The outcome/Government intervention
Disease Negative Masks/Vaccines
The environment Positive Reduced pollution levels due to lower
emissions from factories and automobiles
Economic output Negative High fear levels led to reduced demand and
business shutdowns, closures, and
furloughs – Government stimulus packages
Lockdowns Positive/Negative Positive for those who enjoy time with
family, used the time reflect on life goals,
and complete DIY projects; Negative for
those who are alone, depressed, and
suicidal – Increased mental health services
by the government
PROBLEM SOLVED: VACCINE!
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FREE-RIDING AND MASKS
• Wearing a mask reduces the spread of the virus,
making mask-wearing a public good.
• People who do not wear masks are free-riders,
since they receive some of the benefit of
uncontaminated air without paying the cost of
obtaining and wearing a mask.
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