Lecture#4: Market Failure & Externalities as a Source

of Market Failure

Table of Contents
MARKET FAILURE ....................................................................................................................................... 2
1. MONOPOLIES, CARTELS AND MARKET POWER (DISCUSSED IN PREVIOUS LECTURE).......................................................2
2. COMMON-POOL RESOURCES(CPRS) AND PUBLIC GOODS........................................................................................2
Examples .......................................................................................................................................................2
Common-pool resources (CPR) ......................................................................................................................2
Public goods ..................................................................................................................................................2
3. IMPERFECT INFORMATION ................................................................................................................................3
Solution..........................................................................................................................................................3
4. EXTERNALITIES ...............................................................................................................................................3
Example of negative externality:...................................................................................................................4
Examples of positive externality: ..................................................................................................................4
EXTERNALITIES AS A SOURCE OF MARKET FAILURE ...................................................................................... 4
NEGATIVE EXTERNALITIES ..........................................................................................................................................4
Private costs: .................................................................................................................................................4
External costs: ...............................................................................................................................................4
Social costs: ...................................................................................................................................................4
Example of negative externality:...................................................................................................................5
Market failure
Market failure occurs when one or more of the required conditions for a well-
functioning competitive market are not met.

Main problem: Market failure results in an inefficient allocation of goods.

There are many reasons for the occurrence of market failure. Some of the
reasons for market failure are:

1. Monopolies, cartels and market power (Discussed in previous lecture)

2. Common-pool resources(CPRs) and public goods

Some goods and services are collectively produced and/or consumed, and
individual property rights are not assigned to such goods. The two
categories of collectively consumed/produced goods that we will discuss
are:
1. Common-pool resources
2. Public goods

Examples
Parks, highways, public radio, wilderness areas, and recreation sites are
examples of public goods whereas marine fisheries, rivers, and air are
examples of CPRs.

Common-pool resources (CPR)

It is distinguished by the characteristics that
1. It is difficult to exclude multiple individuals from using/appropriating the
resource stock, and
2. The resource features rivalry in consumption or subtractability, meaning
that resource units appropriated by one subtract from what is available
to others.

Public goods
In contrast, while it is difficult to exclude multiple individuals who benefit from
public goods, these goods differ from CPRs in that they lack rivalry in
consumption e.g., public television broadcasts are public goods. One person’s
reception of the broadcast does not subtract from what is available to other
viewers.

Problem: One of the conditions for a well-functioning competitive market is

that property rights are well defined for all goods and services provided. In
case of CPRs and public goods this condition is not met as property rights are
not well-defined for such goods. And because of this these goods are
overexploited and tend to be
• Overconsumed (CPRs) and/or
• Underproduced (Public goods)
when they are allocated in markets, which causes market failure e.g., coastal
fishery is a CPR. Fishes harvested by one, subtract from what is available to
others at a given point in time.

3. Imperfect information
If people are poorly informed of product quality, safety, or availability, then
their willingness-to-pay is distorted, which in turn implies that market demand
is either too large or too small. Consequently, either too much or too little is
produced relative to the full-information benchmark, leading to inefficient
resource allocation.
• If buyers are poorly informed about a product’s quality prior to purchase,
there is an incentive for a seller to overstate the quality. In this case,
demand is overstated because buyers think quality is higher than it actually
is, and so the equilibrium quantity traded is inefficiently large.
• If employers understate workplace hazards, then the supply of labour to
these employers will be overstated, leading to a wage below what workers
would demand if true workplace safety were known.

Solution
If market participants do not resolve the imperfect information problem
through things such as product warranties and reputation, then either
government or non-government organizations may intervene by providing
information. Examples include content labels required on processed food, or
product testing services.

4. Externalities
Externalities are positive or negative impacts on society that occur as a by-
product of production and exchange. They can be unpaid-for benefits or
uncompensated costs. The costs and benefits can be both private—to an
individual or an organization—or social, meaning it can affect society as a
whole but it is important to note that externalities only impacts a third party
that is not directly related to the production or consumption of that good or
service. The term externality refers to the fact that these benefits or costs are
not reflected in market demand and supply, and their omission leads to the
market failing to efficiently allocate resources.

Example of negative externality: Pollution. Profit maximizing firms have an

incentive to pollute if doing so allows them to reduce their own costs and thus,
raise their profits.

Examples of positive externality:

1. Research and development (R&D) conducted by a company can be a
positive externality. R&D increases the private profits of a company but
also has the added benefit of increasing the general level of knowledge
within a society.
2. Similarly, the emphasis on education is also a positive externality.
Investment in education leads to a smarter and more intelligent workforce
which benefits the economy as a whole.

Externalities as a source of market failure

Negative Externalities
A negative externality can be defined as an uncompensated harm or cost to
others in the society that is generated as a by-product of production and
exchange.

Private costs: The private cost is any cost that a person or firm pays in order to
buy or produce goods and services.
External costs: An external cost is the cost incurred by an individual, firm or
community as a result of an economic transaction which they are not directly
involved in. External costs are also called 'spillovers' and 'third-party costs'.
Social costs: Costs borne by the society. Where, social cost is equal to the sum
of private cost and external costs.

𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 = 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 + 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐶𝑜𝑠𝑡

Example of negative externality:
Consider cabinet manufacturers that can use two alternative production
processes for making finished cabinets.
• Process A costs the firm less but allows toxic volatile organic compounds
from the wood-finishing process to escape into the atmosphere.
• Process B is a non-toxic process but costs the firm more than process A.
Private costs: Cost of production process A. Since process A has lower private
costs, profit-maximizing firms will usually choose it over the nontoxic
alternative, which allows them to supply furniture at lower prices to
consumers.
External costs: More polluted air is the external cost imposed on the society.
These volatile organic compounds contribute to smog and thus cause harm to
people who breathe the polluted air but they are not compensated for it.

The sum of these two costs is the social cost.

Figure 1: Diagrammatic analysis of a negative externality on the market.

The supply curve represents the marginal cost. The marginal cost of
production is the change in total production cost that comes from making or
producing one additional unit. Similar to social cost, marginal social cost is the
sum of marginal private cost and marginal external cost.
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 = 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 + 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐶𝑜𝑠𝑡

When there are external costs there are two market supply curves.
• Private marginal cost curve(PMC): This is the supply curve based on the
firms’ marginal private costs. This is operational in the market when firms
are allowed to freely pollute.
• Social marginal cost curve(SMC): This supply curve is based on marginal
social costs, which considers both private and external costs. This supply
curve will only be operational if firms internalize the external costs of
production i.e., firms are held accountable for the external costs.

Since the supply of cabinets in the competitive furniture market does not
reflect the external costs borne by members of society the market supply
curve is the PMC curve. In this case the market price will be lower and demand
for cabinets will be higher than if the supply curve was based on the SMC
curve. When market exchange generates negative externalities, market supply
fails to reflect the true social cost of producing the good generating the
externality, thus more than the socially optimal number of cabinets are
produced with the more polluting technology

Marginal external cost: It is the vertical difference between the two supply
curves denoted by C in Figure 1.

Market equilibrium when firms are allowed to freely pollute:

Equilibrium is established when the private-cost supply curve crosses the
demand curve. The equilibrium quantity of cabinets is 𝑄p and equilibrium price
is 𝑃p in Figure 1.

Market equilibrium when firms are forced to fully internalize all their external
costs:
Equilibrium is established when the social-cost supply curve crosses the
demand curve. The equilibrium quantity of cabinets is 𝑄s and equilibrium price
is 𝑃s in Figure 1.
This difference in output when firms freely pollute vs when they are forced to
produce along the SMC curve reflects the excess production due to presence of
negative externality and it is denoted by the letter A in Figure 1.

The difference in the two equilibrium prices indicates the distortion of the
price signal sent to consumers in the market place and this is denoted by the
letter B in Figure 1. This distorted price signal creates an incentive for
consumers to buy too much of the good in question which leads to market
inefficiency. Allowing firms to pollute for free amounts to society granting
these firms a production subsidy on each cabinet produced. We know that a
subsidy causes DWL in the society. Thus, the DWL caused due to a negative
externality is like the DWL caused by a subsidy.

Figure 2: DWL caused due to a negative externality.

Whenever firms freely pollute or cause environmental harm in otherwise

competitive markets, firms are essentially being subsidized by society (in the
form of lower cost) and consumers are sharing in this subsidy by way of a
lower product price. This subsidy makes it particularly difficult for cleaner
alternative technologies to succeed in the marketplace because if one firm
were to adopt a more expensive clean technology then it would be at a price
disadvantage in the market place relative to other firms unless consumers
recognize and reward products made with the use of cleaner technologies such
firms will struggle and fail in the competitive marketplace.