Market Failure

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Lecture 10

• Market Failure

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In a market

• Demand characterizes
• individual consumers behavior
• personal (private) evaluation of the outputs
  worth
• the benefits consumers receive from consuming the
  good

• Supply characterizes
• individual producers behavior
• firms (private) evaluation of the resources used
  in production
• the cost of producing the good

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In a market equilibrium
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MB MC can be a market success because
value of last (marginal) unit of output
produced value of resources used to produce it
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MB MC can be a market failure
market failure the private market produces an
outcome that is not best when considered from
societys viewpoint.

• Market failure
• happens when private market evaluation of costs
  or benefits differ from society's evaluation
• results in a misallocation of resources
• occurs when there are externalities

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Externality cost or benefit of a private market
activity that spills-over onto a third party.
Positive Externality
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• The private market allocates too few resources to
  the production of the good.

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• Internalize by

• the socially efficient quantity of output (Qs)
  is produced
• consumers pay a lower price
• since the subsidy is paid via taxation, society
  pays part of the cost of production because
  society enjoys some of the benefits.

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• Sometimes the external benefit is so great the
  product or service is made available for free.

• Society pays the entire cost because the benefit
  is so significant.
• Providing the product or service free maximizes
  consumption.

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• Negative Externality
• a cost spills over from a consumption or
  production activity.
• the private market supply (MC) understates the
  cost to society (MCS)

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• The private market allocates too many resources
  to the production of the good.

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• Internalize by
• taxing consumption or production

• the socially efficient quantity of output (Qs)
  is produced
• consumers pay a higher price
• taxation is a method of pricing the externality

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Controlling Pollution
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Pricing Pollution Who benefits from
pollution? MBpollution Who bears the costs
of pollution? MCpollution
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• Conclusions
• The price (P) at which MBpollution MCpollution
  is the size of the tax needed to internalize the
  externality.
• Often, the optimal level of pollution (Q) is not
  zero.

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• Conclusions
• In some instances, the optimal level of pollution
  is zero.

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Coase Rule Assigning property rights to the
environment results in a level of pollution
that is optimal.
Assign rights to non-polluters
Assign rights to polluters
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Public Good products and services that are
consumed jointly

• Characteristics of public goods
• Consumption of the good by one party does not
  reduce the availability to others.
• No effective way to restrict the benefits to
  those who directly pay for the good.
• The market fails because societys benefit (MBS)
  far exceed the cost of production (MC).
• The government produces most public goods because
  i.e., society pays the entire cost because the
  benefit is so significant.

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Joint consumption means the market demand is the
vertically sum of all individuals demand.
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Under certain circumstances the private market
will produce some public goods but fails to
produce the socially efficient quantity .
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In most circumstances the private market fails to
produce any public goods and government
production is necessary to achieve the socially
efficient quantity .
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EOP Assignment

• Explain why the market outcome of MBMC is an
  efficient allocation of resources.
• What is market failure?
• What is an externality?
• What is the reasoning behind subsidizing a
  product or service that creates a positive
  externality?
• What is the reasoning behind taxing a product or
  service that creates a negative externality?
• What is a public good?
• Why does the government produce most public goods?