CHAPTER SIX

MARKET FAILURE AND THE ROLE OF GOVERNMENT

6.1. INRTODUCTION

The interactions among economic agents (consumers, firms, and government agencies) in
market through invisible hand of Adam smith influence their behavior. Market through its
incentives in the form of prices, profits, and cost differentials helps economic agent allocate
resources efficiently in the society's best interest. For instances, price reductions can change
consumers buying habits (increases the consumption and hence utility) where as an increase
in prices form high profit margin for the firm that encourages productions of desired goods
and services… etc.

But there are quite a lot of areas where the market outcomes are not as such efficient for the
economy. That is, the invisible hand pushes in such a way that individual decisions do not
lead to socially desirable outcomes. Economists call this situation a market failure where
the market outcomes lead to inefficient resources allocation. There are three common
sources of market failure:-

A. Externalities

B. Public goods

C. Imperfect information

Any time the market fails government interventions are among the possible remedial measures.

6.2. EXTERNALITY

When individuals or firms impose costs or benefits on others for which the market
assigns no price, then an externality exists

"There’s so much pollution in the air now that if it were not for our lungs there’d be
no place be place to put it all” Robert Orben

Have you ever heard of, faced with or see;

• An evil entrepreneur who dumps deadly toxins in children's play grounds,

• A firm whose production process lets off fumes that harms its neighbors,
• Global warming as a result of the advanced countries industrial emission
etc.
These are some examples of externalities.

Then what is externality. What do you think of pollution?

Economics in part has answer to these and other related questions. Everyone wants a
cheaper and safer environment; activities free of any effect on the other’s decisions that lead
to self-maximization of objective function and that of the society. However, many activities
generate certain effect on people not directly in actions. Those effects are generally
unintended and not taken in to account by the doer of the activities. To be more specific
when two parties (People, group whatever type of economic agent) pursue their own
interest and do some activity, their action may produce unintended effects or impacts on
people not directly engaged in the activity (or third party). Economists call the effects on
the third party not taken in to account by the doer of the action externality. The above are
some example of externalities that affects the third party not involved in the actions.

An externality occurs when a person's wellbeing or a firm’s production capability is directly

affected by the actions of others consumers or firms rather than indirectly through changes
in prices as compared to the action determined by the market system. It is the external effect
on the third party not involved in the actions. A person smoking in the middle of meetings,
for instance, affects those peoples in the meeting who may not have interest for smoking.

6.2.1 TYPES OF EXTERNALITIES

Externality can be of two types based the effects that it has on other economic agents. It may
either help or harm others. Accordingly, it is of two type:

A. Positive externality

B. Negative externality.

Positive externality:). arise when an individual or firm provides benefits for which it is not
compensated. it is a benefit of an activity received by peoples other than those who pursue the
activity. For example, honey bees where someone earns his living as keeper of honey bee and his
neighbors on all sides grow apples. Because bees pollinate apples trees as they forage for nectars.
The more hives he keeps, the larger the harvest will be in the surrounding orchards. Honey bee
keeper generates external benefits to the other parties. By installing attractive shrubs and outdoor
sculpture around its plants, a firm provides externalities to its neighbors. The person (party) that
creates it is not paid for for these benefits (external).

Negative externality:- arise when an individual or firm does not bear the costs of the harm
it imposes (pollution, for example The externalities harm someone. You are harmed if your
neighbor keeps you awake by screaming at each other late at night. It is the negative effect
of an activity that falls on people other than those who pursue the activity. The activity
involves cost on those not directly involved. These negative externalities generate extra cost
on the third party for which they have not compensated for the effects. One can mention
quite a lot of this type of externalities, but the most common negative externality arise due
to different type of pollution. For instance, air pollution and acid rain as a result of burning
high sulfur fuels (coals) in industrial plants and electric utilities that destroys vegetation and
forests.

Note that: A single action may confer positive externalities on some people and negative
externalities on others. The smell of pipe smoke pleases some people and annoys others.
Some people think that their wind chimes please their neighbors, whereas anyone with an
ounce of sense would realize that those chimes make us want to strangle them. It was
reported that efforts to clean up the air in Los -Angeles, while helping people breath more
easily, caused radiation levels to increase far more rapidly than if air had remained dirty.
On the other hand, we have said that all economic activities of economic agents are related
to production and consumption activities based on their respective objective function in
previous chapters. We discussed the conditions for objective function optimization by
implicitly assuming the actions of economic agent have no external effect on the others.
However, some activities have spillover effect or neighborhood effects. These are two
common economic activities or decisions of economic agent that are sources of
externalities. In other word, externalities are by products of consumption and production
that may be benefits or harm other peoples.

I. CONSUMPTION EXTERNALITIES

It rises if one consumer does not care directly about another agent's production or consumption.
These are of two types according to their effect:

A. External economies of consumption (positive externality) that occurs when an

action taken by a consumer, rather than a producer results in an uncompensated benefit
to others. For examples, pleasure that one gets from observing one's beautiful flower
garden.
 B. External diseconomies of consumptions (negative externality) that occur when
action taken by a consumer results in an uncompensated cost to others. For examples,
my neighbor playing loud music at 3 hour in the morning or in the even when the
neighbor go to sleeping or person next to me in a restaurant smoking a cheap cigarette.

PRODUCTION EXTERNALITIES

These types of externality arise when the production possibilities of one firm are influenced
by the choice of other firms. Like that of consumption it is either harm or benefit the third
party.

A. External economies of production occur when firm’s production may benefits the
other not directly involved in the actions. For example, training workers who
eventually go to work for other firms who do not pay training costs but lead to
increased output.

B. External diseconomies of production that arise when the action taken by a

consumer result in an uncompensated cost to others. For instance, a firm on the
upstream might pollute many parties such as fisherman and irrigation along
downstream used by dumping out waste materials.

REMEDIAL MEASURES OF EXTRNALITIEIS

We have seen that externalities lead to inefficient allocation of resources. What are the
measures to be taken to reduce the inefficiencies generated by externalities? What are
government policies or concerned bodies action to reduce its effect? Under ideal conditions a
firm or an economic agent that generate external activities must include external costs or
benefits in its calculations of private gains and costs. The internalization can be
through private price tags placed on external costs (or benefits) so that private and social
costs (or benefits) coincide. Other possible way is through quantity of product adjustment
in which one can increase or decrease depending on the type of externalities. For
instances, pollution can be reduced either by reducing the activity of the polluting agents or
paying the cost of pollution abatement. What is the optimal level of externality? What is
the optimal level of pollution abatement?

The optimization of externality is just like the production and consumption issues we have
discussed so far employ the concept of marginality analysis. In dealing with any form of
externalities the cost and benefits matters and optimal level of production depends on the
marginal cost and benefits of producing additional good. It is until the marginal external
social benefit of externality is equal to the marginal external social cost.

This can be illustrated with our pollution examples. Figure 6.3 shows the marginal social
costs and marginal social benefits of different amount of pollution abatement – the number of

Gallons of water purified thought filtration and how it is determined. The marginal social
cost of each successive unit of abetment increases as more and more water is purified.

Figure Optimal pollution

The marginal social benefit curve is downward sloping whereas the marginal social cost of
pollution is assumed to be constant. The marginal social benefits decline as the abetment
intensifies because we value the first unit of abatement more highly than subsequent units.
The optimal level of abetment occurs when the marginal social cost of extra units of
abetment equals its marginal social benefits. If the abatement is undertaken beyond this
optimal level, the extra benefits fall shorts of the extra opportunity costs. On the contrary,
if the abatement is undertaken below this optimal level, the extra costs fall shorts of the
extra opportunity benefits.

From our analysis one may think whether the optimal level of pollution should be greater than
zero. The optimal externality is greater than zero does not mean any positive level of negative
externality (pollution) is good. It is merely to recognize that society has an interest in cleaning up
the environment, but only up to the certain point. If you aim for the total elimination of pollution
we would have to devote more and more scarce resources to abetment, until the marginal social
benefits are zero. Hence, the last dollars spent on pollution abatement will yield zero benefits
and will have a high marginal cost.

The idea can be seen from dirt in an apartment even if you spent the whole day, every day,
vacuuming your apartment, there would be some dirt that left in it. You probably tolerate
substantially more than the minimal amount of dirt. Furthermore, the society will incur cost
that exceed the benefit by trying to make it zero. However, the efficient level of pollution
would be zero if the pollutant were so damaging that the marginal cost of even the first unit
released into the environment exceeded the marginal cost of not allowing releases.

The above optimum level of externality can be attained thought internalization of the cost and
benefits as we indicated above. The internalization can be accomplished by the

A. Redefinition of property rights

B. Voluntary agreements
C. Government action

A. REDEFINITIONS OF PROPERTY RIGHTS

Poor definition of property right is a prominent source of externalities. Property rights are
social arrangements that govern the ownership, use, and disposal of resources, goods and
services in modern society. It is a legally established title that is enforceable in the courts. If
we do not know who owns the property right to the river, there is no one to limits its use
and resources will likely be exploited and abused. For instances, fishing business will be
over fishing ocean water, factors will pollute more…etc.

However, if private property right can be clearly defined, the private owner will make sure
that the resource is efficiently used as (the assigning property rights) give an exclusive
privileged to use assets. For instances, by owning this test book (module), you have a
property right to read it and to stop others from reading or taking it. If you had a property
right that assured you of the right to be free from noise pollution, you could get the courts to
stop your neighbor to play the music. The owner of hunting land can set fees high enough
to prevent games from being depleted. The assignment of may not matter on individual
preferences.

B. VOLUNTARY AGREEMENT

Voluntary agreements are another means of internalizing externalities. When property rights
are well defined, voluntary agreements can internalize external costs. The proposition that
voluntary agreements can solve externality problems was first introduced by R.H. Coase
and termed as Coase theorem. He profoundly changed the way economists, legal scholars,
politicians, philosophers and others think about externalities and the legal and social
institutions that have evolved to deal with them. The Coase theorem states that externalities
(costs/benefits) can be internalized by negotiation among the affected parties as long as the
cost of bargaining is very small or null and the numbers of parties are small.

To illustrate the Coase theorem, we consider our steel mill and fishery. Finger 6.4 show
such externality. Firms unit of waste disposed is given along the horizontal axis. The
marginal benefits (MB) to the firm of producing this waste are given in dollar terms on the
vertical axis. For the sake of this analysis, marginal benefit can be thought of as the net
profit of producing additional unit of waste (in terms of the steel produced) and hence it is
demand curve. The MB schedule therefore declines with increases in output because the
rate of return on addition production generally declines. The curve tells us what the factory
is willing to pay for dumping the respective amount.

The marginal external cost (MC) curve represents the externality caused by the firm’s production
and is given in dollar term along the vertical axis.

A
200
Cost and benefits of waste
)
150
MSC
dollars per tones

E
100(

50
MB

O xx
2 Q =4 6 8 Quantity of waste in

Figure 6.4: optimal waste based on voluntary

Now we apply Coase’s analysis. As an experiment, we give the ownership right to fishery.
Assuming that bargaining cost is nothing, we can predict what will happen with the help of
figure. For the amount of waste up to, we observe that MB>MSC. The firm’s profit on
additional units of waste are greater than the additional pollution cost born by the
neighborhood (fisher) would be willing to sell the right of using the water to produce these
units. Since the total cost of the externality caused by this output is represented by the area
under the MSC curve, a bargain can be truckle between the firm and the fishery to produce by
agreement on how to divide the surplus marginal benefits AEO. The factor can pay the
fishery and hence both can gain from voluntary agreement up to = 4 waste disposal.

Beyond MSC>MB, a bargain to produce these units cannot be reached between the firm and
fishery as firm would not be willing to bid enough to obtain the right to produce these units
hence, the fishery would not sell the right. So Q, where MB=MSC is the equilibrium outcome
when the neighborhood is given the transferable right to use of river.

Suppose that a judge decided instead to award the firm the right to use the air as it choose. What
happens?
We go through the same analysis, but now we see that the fishery must pay the firm to
produce less waste. For up to units of output (waste) MB> MC, implying the fishery cannot
offer a large sum of money to induce the firm to reduce it. But beyond Q, firm would be
willing to accept any offer but the fishery is not willing to make it as it costs him more. It is
worthwhile for firm to reduce pollution up to where MSC= MB. The result shows that no
matter who has the legal right to use, the amount of pollution is the same. This is the central
insight offered by the Coase theorem.
D. GOVERNMENT ACTIONS

Many real-world externality problems can be analyzed with Coase theorem, as long as the
bargaining and transaction costs are low. Nevertheless, the parties may not be able to bargain
successfully for at least three important reasons. First, transaction cost is not very small, if the
numbers of plants are numerous, it is difficult to organize and reach on the solution. Imagine the
transaction costs if 50 factories and 10 fishers as compared to the one we have seen so far.
Second, if firms engage in strategic bargaining behavior, an agreement may not be reached.
Third, if either side lacks information about the costs or benefits of reducing pollution, a non
efficient outcome may occur. It is difficult to know how much to offer the other party and to
reach an agreement if you do not know how the polluting activity affects the other party. For
these reasons, Coasian bargaining is unlikely to occur in relatively few situations. So the cost of
defining and enforcing a system of ownership can be so high that some system could be adopted.

Under theses condition government intervention is one of the option for solution. The
government can cope with the problems in two ways /approaches.

A. Regulatory approach

B. Incentive based approach

 A. Regulatory approach

The government requires externality producing agent (pollution agent) to limit the level of externality
to a certain level. Usually the limits are set to the optimal level based on the marginal or the cost -
benefit calculation analysis. There are two major approach through which the government can cope
with externalities problems under these . These are:

I. Limiting the level of externalities

II. Incentive based approach

I .Limiting the level of externalities

Under this case the government limits the amount of externality generated by each economic
agent. Each factory, for instances, would have a limit on the amount of pollutant allowed to
discharge. Let’s substantiate our analysis with our specific examples mention above using
graph. Figure: 6.5 below show the total social cost of each level of discharge of an industry’s
wastes. The more, the industry cut down on the amount of waste it discharges, the higher are
its costs of pollution control at each low of discharge of the industry’s wastes.

Specifically, the efficient level of the pollution in the industry is R. Because increasing
pollution from a level lower then R would improve social welfare. Discharging one more
unit of pollution would increase the cost of pollution, but it would reduce the cost of pollution
control by more. Hence, the optimal level of pollution is R.
 cost
Pollution cost control

Pollution cost

R Quantity of pollution

Figure 6.5: optimal pollution discharge

In the United States, various state, locals, and federal agencies are responsible for pollution
control. The agencies derive its legislatives authority from a number of Congressional Acts,
including the Clear Air Act, the Water Pollution Control Acts, and the National
Environmental policy….etc. In enforcing Federal Environmental laws, the Environmental
Protection Agency (EPA) has usually followed the regulatory approach. It specifies standard
for wastes discharge with respect to air, water, and noises pollutions. It issues permits setting
ceiling on the amount of pollution discharged.

II. Incentive based approach

This is the case where governments uses economic incentives or penalties (such tax or subsides)
to encourage polluting agents to restrict emissions to efficient levels.

Some of these are:

- Emission charges
- Tax and subsidies
Emission changes

The government (the regulatory agency established by the government) sets the emission
charges, which are in effect, a price per unit of pollution. The more pollution a firm creates,
the more it pays in emission charges. To work out the emission charge that achieve
efficiency, the regulator must determine the marginal social cost and marginal social benefit
of pollution. The optimum level is where price per unit of pollution must be set to make the
marginal social cost of the pollution equal to its marginal social benefit.

In practice, it is hard to determine the marginal benefit of pollution, and people who are best
informed about the marginal benefit, the polluters, have an incentive to mislead the
regulators. As a result, if a pollution charge is used, the most likely outcome is for the price
to be set too low.

Government taxes: Efficient fee

Effluent fee is certain money that a polluter must pay to the government for discharging
waste. The tax system is a mechanism through which the amount of external costs (the
deviation between private and society) is imposed on private that create externality. Taxes
provide incentives to producers or consumers to cut back on activities provide that create
external cost. An appropriate tax with externality will force the business firm to take in to
account the costs imposed on others. Accordingly, reduces the amount of production to the
efficient level where marginal social costs equal marginal social benefits .

6.3. COMMON PROPERTY AND ITS TRAGEDY

6.3.1. TYPES OF PROPERTY

There are different types of goods and services that can be produced and consumed by
economic agents. Some of these goods and services are termed as private goods, common
goods, collective goods and public goods. They are classified as such based on their
property: varying degree of exclusion and rivalry. Rivalry means that only one person can
consume the goods: the good is used up in consumption-it is depletable. If an individual
consumes a particular quantity of a good, such as apples, these same apples are no longer
available for the others to consume. Exclusion means that others can be prevented from
consuming the good. Only the person who owns the candy bar may eat it. For instances,
when you eat a cheeseburger, it is no longer available for anyone else. Moreover, people
can be easily prevented from consuming cheeseburgers that the individual do not pay for.

The classification scheme defined by the non-rival and non-excludable property is

summarized on table XY. These are explained below in four classifications with relevant
examples. The columns of the table indicate the extent to which one person's consumption
of a good fills to diminish its availability for others. Goods in the right column are non-
rivals and those in the left columns are not. Likewise, goods on the top are highly non
excludable as compared to the bottom once. The two hybrid categories are common goods
which are rival but non excludable and collective goods which are excludable but
nontrivial.
 The first type of good is private good. Private goods have the properties of the rivalry and
exclusion. Private goods are on the upper - left column. Second, there are resources with
rivalry but without exclusion. These are most of the called common good or common
property resources. Common goods (pure) is one for which non-payers can not easily be
excluded and for which each unit consumed by one person means one less unit available for
the others. In an open access ocean with fishery, any one fish (no exclusion), but once a fish
is caught, no one else can catch it (rivalry).

Exclusion No exclusion

Rivalry Private good Common good

Wheat Fishery

Candy bar, etc Hunting

Highway, etc

No Rivalry Collective good Public goods

Pay per viewu TV National defense

Clean water, etc
Club goods( concert,
tennis) ,etc

The third type of good is collective goods. They are goods with strong non-exclusive and
non-rivalry. Club goods (concert, tennis club) are typical example of these types. For

instances, club-goods, security guards prevent people who don't have a ticket from entering a

concert hall. Until the concert hall is filled, the cost (marginal) of providing the concert to one
extra person is zero. Adding another person creates congestion or other externalities that harm
concert goers once the concert hall is filled. Similarly, allowing more people to join a swim
club does not inflict extra costs until members start getting in each other's way. These are
goods with both private (exclusion) and public property (non- rivalry). These are collective

goods.
That is goods or services that at least some degree is nonrival but excludable (exclude
nonpayers). They are provided sometimes by government, sometimes by private companies

The fourth types of resources are public goods. Public goods are those goods or services that
are in varying degrees, non-rivalry and non –excludable. The Good that are highly non-
excludable and non -rival are often called pure public goods. First, some public goods are
exclusive but lack rivalry in consumption. The consumption by one person does not diminish
its availability for others. That is, once the good is provided for someone other can also
consume it at no extra cost (the marginal cost of providing the good to the additional consumer is
zero). And it is technically difficult or extremely costly to exclude nonpayers from
consuming it.

For example, the national defense, Law enforcement, fire and police protection, and flood
control, the Ethiopian Radio broadcasting… etc. The fact that it is a public good does not
necessarily mean that government ought to provide it. Sometimes, private companies can find it
profitable way of producing goods with both characteristics

Some goods even changes characteristics over time and some vary back and forth. Consider, for
example, an uncrowned bridge. If you crossed an uncrowned bridge, it would not interface with
my crossing, so the use of this bridge could be labeled "no rival" .It is, however, not a non-
exclusive good because it is perfectly feasible to charge a fee for crossing the bridge and to
prevent people who do not pay from crossing it. At the peak times during the day, it is not even
non rival; because your crossing during a congested time could easily interfere with my crossing.
Markets for public goods exist only if non purchasers can be excluded from consuming it.

Other goods lack rivalry or exclusion or both. Furthermore, many goods differs in the degree to
which they have non -rivalry or non- exclusive and hence their name. Many goods are hybrids,
with properties of both private and public goods not all non-trivial goods are non- exclusive, and
not all non-exclusive goods are non-rivals. Most of them are exclusive but lack rivalry in
consumption.

6.4. PUBLIC GOODS

In the previous topic we have seen production good consumption externalities and tragedy of
commons.
As an example, smoker’s fishers and chemical factory, problem of grazing common land, and
the way to deal with them such as assigning property right, voluntary agreement and so on.

Unfortunately, not all externalities only limited to them and can be handled in that manner. As
long the numbers of economic agent increase (more than two economic agents involved)
things become much more difficult. Suppose, instead of one factory (steel mill) and one
 fishery, the number of factories producing chemical increases to about 50 or 100 and fisher 20
or 50. Then the externalities that result as the number producers increase become common for
the country, certain portion of the society. They are particularly troublesome kind of
externality, for the decentralized market solution and costly even for non-market solution that
we have discussed so far with the other forms of externalities. This is an example of a good
with the characteristics of public good.

Having said these it is appropriate to ask question related to public goods.

Some of these are:

What are public goods?

How do we identify public goods from private goods?

What are the optimality conditions for the provision of public goods?

Who is responsible for the supply of public good and how?

As it is explained above public goods are those goods or services that are in varying degrees,
non-rivalry and non –excludable. Consider the case of national defense. A specific citizen’s
interest in the nation can be protection by the nation’s military without reducing the protection
that it offered to any other Ethiopian citizens. Further more, once a country has created
military establishment, all of its citizens enjoy its protection at the sometime. Since there is no
practical way of excluding citizens from its protection, national defense is non exclusive good.

6.4.1. INEFFICIENCY OF PUBLIC GOODS UNDER MARKET PROVISIONS

Markets for the public goods exist only if non purchasers can be excluded from consuming them. Thus
markets do not exist for nonexclusive public goods. The market tend to produce too little of an
exclusive public good because of the lack of rivalry. In the absence of rivalry, the marginal cost of
providing public good to one extra person is zero. Firms have no incentive to produce at a zero prices,
if firms set a price above zero, consumers buy too little of this public.

This is a complicated issue whose answer is best explored initially with in the context of partial
equilibrium analysis. However, we can illustrate with simple diagram.

We have constantly argued that the competitive market will provide optimal quantity of
private goods because output will be expanded just to the point where D=S .And the demand
curve represents the social benefits of additional units MSB and the supply curve reflect the
marginal social cost of production MSC. Suppose, to this and for simplicity, that there were only
two consumers, the Ababe family and Bekele family. Let DA in figure 6.6 be the Abebe's
family demand curve for some goods, DB be the Bekel's demand curve for the same good.
The supply curve, S, is also noted. If we assume the good in question is private good we
follow an ordinary efficiency criteria of We have constantly argued that the competitive market
will provide optimal quantity of private goods because output will be expanded just to the point where
D=S .And the demand curve represents the social benefits of additional units MSB and the supply curve
reflect the marginal social cost of production MSC.

Suppose, to this and for simplicity, that there were only two consumers, the Ababe family and Bekele
family. Let DA in figure 6.6 be the Abebe's family demand curve for some goods, DB be the Bekel's
demand curve for the same good. The supply curve, S, is also noted. If we assume the good in question
is private good we follow an ordinary efficiency criteria of competitive market. The optimum quantity
of a private good is at point when market demand for the product equals the market supply for the
product.

A. private good B. Public goods

We would than derive the market demand curve D by summing horizontally the demand curves of the
two consumers. Furthermore, the social marginal benefit of a private good is the same as the marginal
benefit to the individual who consumes that good. Hence, the demand curve represents the full social
benefits of additional units MSB and the supply curve reflect the marginal social cost of
production MSC. The efficient output could be Q, where market demand market intersects the
market supply curve. At this point the marginal benefit that each consumer would obtain from
an extra unit of the good would equal it marginal cost.

If on the other hand, the good were public goods, though the efficiency /optimality criteria are
the same, there is modification of the supply/demand model used. The key to understanding
the difference is to recognize that once a pure public good is supplied by one individual, it is
simultaneously supplied to all, and where as a private good is supplied only to individual who
purchased it. In contrast with the case of private good, where the social marginal benefit of a
public good is the sum of the marginal benefit to each person who consumes the good,it is
marginal social benefit of one individual. Because a public good lack rivalry, many people can
get pleasure from the same unit of output. As a consequence, the social demand curve or
willingness to pay curve for a public good is a vertical sum of the demand curves of each
individual.

In this case, the market demand curve would be obtained by summing the individual demand
curves vertically as a given amount of public good can be consumed by both of our
consumers (in our example) at the same time. The combined prices that indicate willingly paid
by the two consumers for the provision of good should be the sum of the prices that each
would pay individually.

Thus, aggregate demand curve for product X, (D) is obtained by vertical summation of DA and
DB. Given the market supply curve (SX) for product X, the optimal amount of X is R unit per
period at point M. To see this point more precisely, recall the marginal benefit of each
consumer from the goody is reflected by the individual demand curve. If output is R, then the
marginal social benefit from an extra unit of output would be vertical sum of L (the marginal
benefit to Abebe) and N (the marginal benefit to Bekel); that is L+N = T, It follows that R
must be efficient output, since marginal social benefits at R (OT) equals the marginal social
cost at R (RM).

The above analysis reminds us that economic efficiency for a private good requires that each
consumers marginal benefit equals marginal cost. As shown in panel A. By contrast, panel B,
shows that economic efficiency for public good requires that the sum of marginal benefits of
all consumers must equal marginal cost.

MBA+ MBB = MC
Thus, note once again the marginal principle is at work. The problem is that in general, less
than the optimal amount of public good will be supplied under perfect competition, and this
prevents the attainment of maximum efficiency and Pareto- optimum.
 While public goods output should be expanded to the point where the MSB=MSC, but the
market demand curve which is derived by vertical horizontal summation of individuals
demand curve is no longer reflect the MSB. In addition, even if people could be selectively
excluded from consuming it, the non-rivalry in consumption means that it is inefficient to
exclude any one. Because it costs noting to provide the good to each additional consumer after
the first social welfare is maximized by giving away the good free. This implies that once a
good is produced, the marginal cost of provision of the good to any additional individual is
zero. These create an incentive for the economic agent not to pay for the good that lead to free
rider problem.

6.4.2. DEALING WITH PROBLEM PUBLIC GOOD

We have seen that market mechanism of dealing with public lead to inefficient allocation of
the pubic goods. There are different mechanisms to handle the problem depending upon the
situation at hand.
Remedial measures are more or less similar with what we discussed under externalities and tragedy of
commons and hence one can apply those means of solving the problem. However, among the
mechanism the following four are the most commonly ways of dong with the problem. These are:

A. Social pressure
B. Mergers
C. Compulsion and Privatization

Social pressure is the action through which the local people forces the person to act in
appropriate manner. Sometime, especially when the group is small, social pressure eliminate
free riding. Social pressure results in at least minimal provision of some public goods. Such
pressure man causes most firms at a using public to contribute "voluntarily" to a fund for
protections and optimal provisions.

A direct way to eliminate free riding is by merging firms and thereby internalizing the positive
externality. Privatization (exclusion) that restricted the access to the resources

Compulsion, some outside entity such as government may dictate a solution. The
governments intervene in the function of the marker through a series of regulation. Some
examples are:

 antitrust laws aimed at preserving competition in the economy

 minimum wage laws
 agricultural product prices support program
 motor vehicle pollution control act
  a host of regulation on consumer protections
 regulation regarding licensing of occupations

Furthermore, the government affect the allocation resources through imposing taxes
reasonable for compensation as well as retarding affect them .to pay "taxes" that are assessed
through tenants’ "votes". If the majority votes to hire guars, all must share the costs or
government may impose certain amount of taxes.