AF1605
Introduction to Economics
Topic 6 Market Failure
Sources of Market Failure
A perfectly competitive market is able to maximize social surplus and
achieve allocative efficiency.
Market failure is a situation in which the market is inefficient (cannot
achieve allocative efficiency).
Inefficiency can occur because:
Too little is produced – underproduction.
Too much is produced – overproduction.
Sources of market failure:
Monopoly power (discussed in Topic 5).
Externalities.
Public good.
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Externalities
Private benefit: The benefit enjoyed by an individual who takes the action.
Private cost: The cost incurred by an individual who takes the action.
Social benefit: The benefit enjoyed by the whole society.
Social cost: The cost incurred by the whole society.
Social benefit = Private benefit + External benefit
Social cost = Private cost + External cost
Externalities occur when there is a divergence (a) between private benefit
and social benefit, and/or (b) between private cost and social cost .
Allocative efficiency occurs when marginal social benefit (MSB) equals
marginal social cost (MSC).
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Externalities
Negative externalities
A production or consumption activity that creates an external cost.
Positive externalities
A production or consumption activity that creates an external
benefit.
Types of externalities:
Negative production externalities: e.g., factories generate pollution
during the production process.
Positive production externalities: e.g., academic research.
Negative consumption externalities: e.g., smoking.
Positive consumption externalities: e.g., education.
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How to Solve Externalities
Coase Theorem
The proposition that if property rights exist, only a small number of
parties are involved, and transaction costs are low, then private
transactions are efficient and the outcome is not affected by who is
assigned the property right.
It is not easy to meet the above conditions.
Remedies by government to solve externalities
When there are negative externalities: Taxation by government.
When there are positive externalities: Subsidy by government.
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Negative Externalities: Pollution
During the production of
chemicals, the factories also
generate pollutants and the
amount of pollutants is
increasing with the output level
of the factories.
When output is 4,000 tons of
chemicals per month:
Marginal private cost is $100 a
ton.
Marginal external cost is $125 a
ton.
Marginal social cost is $225 a
ton.
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Negative Externalities: Pollution
Without regulation, the
market is in equilibrium (S=D)
at a price of $100 a ton and
4,000 tons of chemicals a
month.
The efficient quantity is 2,000
tons of chemicals, where
marginal social cost (MSC)
equals marginal benefit.
The gray triangle shows the
deadweight loss created by
overproduction.
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Correction by Pollution Charges or Taxes
A pollution charge or tax
is imposed by the
government that is equal
to the marginal external
cost of pollution.
The supply curve
becomes the marginal
private cost (MC) curve
plus the tax.
Because the charge or tax
equals the marginal
external cost, the MSC
curve becomes the supply
curve.
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Correction by Pollution Charges or Taxes
After the imposition
of pollution tax, the
market can produce
at the efficient
quantity (S = MSC =
D = MB).
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Positive Externalities: Education
When 15 million students
attend university:
Marginal private benefit
is $10,000 per student.
Marginal external benefit
is $15,000 per student.
Marginal social benefit is
$25,000 per student.
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Positive Externalities: Education
Without regulation, the
market is in equilibrium at a
quantity of 7.5 million
students per year.
The efficient number of
students is 15 million, where
marginal social benefit
(MSB) equals marginal cost.
The gray triangle shows the
deadweight loss created by
underproduction.
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Government Subsidizes Education
Government gives the
university a $15,000
subsidy per student.
The subsidy shifts the
supply curve to S = MC –
subsidy.
Student pays $10,000 for
tuition fee.
The market equilibrium is
efficient with 15 million
students enrolled in
university.
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Classifying Goods and Services
All goods and services can be classified according to whether they are (a)
excludable or nonexcludable, and (b) rival or nonrival.
Excludable vs Nonexcludable
A good, service, or resource is excludable if it is possible to prevent
someone from enjoying its benefits.
A good, service, or resource is nonexcludable if it is impossible to
prevent someone from enjoying its benefits.
Rival vs Nonrival
A good, service, or resource is rival if its use by one person decreases
the quantity available for someone else.
A good, service, or resource is nonrival if its use by one person does
not decrease the quantity available for someone else.
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Fourfold Classification of Goods and Services
Rival Nonrival
Private Goods Natural Monopoly Goods
Excludable Example: Food and drinks, Example: Cable TV
Houses
Common Resources Public Goods
Nonexcludable Example: Fishes in ocean Example: National defense,
Street lights
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Public Good
Public goods create a free-rider problem.
A free rider is a person who enjoys the benefits of a good or service
without paying for it.
Because of the free-rider problem, the provider of a public good is
difficult to collect the revenue.
The quantity of public good provided by the private market will be
insufficient.
To produce the efficient quantity, government action is required.
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Marginal Benefit of Public Good
To find the economy-wide
value of the public good, we
add together the marginal
benefits of everyone who
enjoys the benefits.
Lisa’s marginal benefit curve is
MBL.
Maxs marginal benefit curve is
MBM.
The MSB curve for the
economy is the vertical sum of
the marginal benefit curves of
everyone in the economy –
Lisa and Max.
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Efficient Quantity of Public Good
The marginal cost curve of
public good is upward sloping.
The efficient quantity of the
public good occurs at the level
where MSB equals MSC.
Because of the free-rider
problem, private provision leads
to underproduction – in the
extreme case, to zero
production.
Very often public provision of
public good is required.
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