Definition of Market Failure – This occurs when there is an inefficient allocation of resources in a free market. Market failure can occur due to a variety of reasons, such as monopoly (higher prices and less output), negative externalities (over-consumed and costs to third party) and public goods (usually not provided in a free market)
Types of market failure
- Positive externalities – Goods/services which give benefit to a third party, e.g. less congestion from cycling.
- Negative externalities – Goods/services which impose a cost on a third party, e.g. cancer from passive smoking.
- Merit goods – People underestimate the benefit of good, e.g. education. It may also have positive externalities
- Demerit goods – People underestimate the costs of a good, e.g. smoking. It may also have negative externalities.
- Public Goods – Goods which are non-rival and non-excludable – e.g. police, national defence. Public goods are often not provided in a free market.
- Monopoly Power – when a firm controls the market (with high market share) and can set higher prices.
- Inequality – unfair distribution of resources in free market, e.g. some experiencing poverty and homelessness
- Factor Immobility – E.g. geographical / occupational immobility. For example, when there are pockets of high unemployment, but it is difficult for the unemployed to move and get a job.
- Agriculture – Agriculture is often subject to market failure – due to volatile prices, fluctuating weather and externalities.
- Information failure – where there is a lack of information to make an informed choice.
- Principal-agent problem – Two agents with different objectives and information asymmetries. For example, adverse selection where a buyer has less information than the seller.
- Moral hazard. When individuals have incentive to change their behaviour when others take the risk. For example, when banks are insured by the government, bankers take risky decisions which can cause bank losses.
- Macroeconomic instability – When an economy enters into prolonged recession and high unemployment – or inflationary boom which is unstable.
A way to remember several types of market failure
Key Terms in Market Failure
- Externalities: These occur when a third party is affected by the decisions and actions of others.
- Social benefit: the total benefit to society =
Private Marginal Benefit (PMB) + External Marginal Benefit (XMB) - Social Cost: is the total cost to society =
Private Marginal Cost (PMC) + External Marginal Cost (XMC - Social Efficiency: This occurs when resources are utilised in the most efficient way. This will occur at an output where social marginal cost (SMC) = Social Marginal Benefit. (SMB)
Overcoming Market Failure
- Tax on Negative Externalities – e.g. Petrol tax
- Carbon Tax e.g. tax on CO2 emissions
- Subsidy on positive externalities – why the government may subsidies public transport
- Laws and regulations – Simple and effective ways to regulate demerit goods, like a ban on smoking advertising.
- Buffer stocks – aim to stabilise prices
- Government failure – why government intervention may not always improve the situation
Market failure and behavioural economics
Behavioural economics examines how individuals often act in a non-rational manner – contrary to the expectation of conventional economic models. These types of ‘irrational behaviour’ can lead to a type of market failure where people make poor choices. For example.
- Irrational exuberance – people getting carried away by good news leading to boom and bust.
Positive Externalities
Definition of Positive Externality: This occurs when the consumption or production of a good causes a benefit to a third party. For example:
- When you consume education you get a private benefit. But there are also benefits to the rest of society. E.g you are able to educate other people and therefore they benefit as a result of your education. (positive consumption externality)
- A farmer who grows apple trees provides a benefit to a beekeeper. The beekeeper gets a good source of nectar to help make more honey. (positive production externality)
- If you walk to work, it will reduce congestion and pollution; this will benefit everyone else in the city.
Social Benefit
- With positive externalities, the benefit to society is greater than your personal benefit.
- Therefore with a positive externality the Social Benefit > Private Benefit
- Remember Social Benefit = private benefit + external benefit.
Diagram of Positive Externality (consumption)
- In this case, the social marginal benefit of consumption is greater than the private marginal benefit. For example, if you take a train, it reduces congestion for other travellers.
- In a free market, consumption will be at Q1 because demand = supply (private benefit = private cost )
- However, this is socially inefficient because at Q1, social marginal cost < social marginal benefit. Therefore there is under-consumption of the positive externality.
- Social efficiency would occur at Q2 where social cost = social benefit
For example, in a free market without government intervention, there would be an under-consumption of education and public transport.
Examples of positive externalities (consumption)
- Good architecture. Choosing a beautiful design for a building will give benefits to everybody in society.
- Buying flowers for front garden gives benefits to others who walk past
- Consuming a healthy diet ultimately will benefit others in society because less health care costs, higher productivity
- Education or learning new skills. With better education, you are more productive and can gain more skills. But, also the rest of society benefits from your new skills.
Positive externality (production)
- This occurs when a third party benefits from the production of a good. For example, building a train station may provide shelter for the homeless when it is raining.
- If a company develops new technology, such as a database programme, this new technology can be implemented by other firms who will gain a similar boost to productivity.
- Tim Berners Lee who developed the World Wide Web, made it freely available, creating a very large positive externality.
Diagram of positive externality in production
- Because there are positive externalities in production, the social marginal cost of production is less than the private marginal cost of production.
- In a free market, a firm will ignore benefits to third parties and will produce at Q1 (free market outcome)
- However, the socially efficient level will be at Q2 (where social marginal cost = social marginal benefit)
More examples of positive externalities
- Getting a vaccination provides a benefit to other people in society because you do not spread infectious diseases.
- A decision to stop smoking causes benefits to other people in society who longer suffer passive smoking.
- Switching from conventional farming to organic farming helps the environment as there are fewer chemicals in the environment.
- Picking up litter makes the environment nicer for everyone.
Dealing with positive externalities
Positive externalities lead to under-consumption and market failure. Government policies to increase demand for goods with positive externalities include
- Rules and regulations – minimum school leaving age
- Increasing supply – the government building of council housing to increase the stock of good quality housing.
- Subsidy to reduce price and encourage consumption, e.g. government subsidy for rural train services.
Diagram to show the effect of subsidy on good with positive externalities
A subsidy of P0-P2 shifts supply curve to the right (S2) and the new quantity demand will be Q2 (where SMB=SMC)
In this case, the subsidy has overcome the market failure. Though government intervention itself could be subject to government failure.
Subsidies for positive externalities
Subsidies involve the government paying part of the cost to the firm; this reduces the price of the good and should encourage more consumption. A subsidy shifts the supply curve to the right and can be justified for goods which offer benefits to the rest of society.
What is the justification for subsidising goods with positive externalities?
In a free market, people ignore the positive externalities of consumption, e.g. when cycling to work, you don’t consider the reduction in pollution your decision creates. In a free market, there is under-consumption of goods with positive externalities because people usually ignore the ‘external benefits’ their decisions make.
Examples of goods with positive externalities in societies
- Health care – free universal health care can ensure everyone gets vaccinated; this prevents the spread of infectious disease, which benefits everyone. In other words, you have a personal benefit from other people being healthy.
- Collecting refuse and litter – If litter is picked up, it benefits everyone else who can enjoy a more beautiful environment. It also helps improve public health.
- Education. If the long-term structurally unemployed workers gain useful training and education, it enables them to find work. This has benefits for other people in society – The government receives more tax revenue and pays less unemployment benefit. There is also a less tangible benefit of a more cohesive society.
Diagram showing market failure when there is a positive externality
- The free market equilibrium is at Q1. because S=D. People maximise their welfare where private marginal benefit = private marginal cost.
- But, social efficiency occurs at Q2 (where SMB = SMC), therefore, at the free market equilibrium, the social marginal benefit is greater than the social marginal cost. Society would benefit from increasing output until Q2.
- To increase consumption and production, the government can offer a subsidy to reduce the price and increase quantity.
Diagram of subsidy on positive externality
- Subsidy = P0-P2
- The supply curve shifts to S2 and price falls from P1 to P2
- People will now consume more; the quantity increases from Q1 to Q2.
- The output (Q2) is social efficient: because here Social marginal cost (SMC) = Social marginal benefit (SMB)
Advantages of subsidies
- Enables greater social efficiency. Consumers end up paying the socially efficient price which includes the external benefit.
- If you subsidise public transport, it will encourage people to drive less, and reduce their negative externalities. In the long term, subsidies for a good will help change preferences. It will encourage firms to develop more products with positive externalities.
Potential problems of subsidies
- The cost will have to be met through taxation. Some taxation, e.g. income tax, may reduce incentives to work. Though the most efficient way to raise revenue for subsidising positive externalities would be to tax goods with negative externalities, e.g. tax cars driving in city centres (congestion charge) and use the money to pay for public transport.
- Difficult to estimate the extent of the positive externality. Therefore the government may have poor information about the service and how much to subsidise.
- There is a danger that government subsidies may encourage firms to be inefficient and they come to rely on subsidy rather than improve efficiency. (see: government failure)
- The effect depends on the elasticity of demand
- If demand is price elastic, a subsidy leads to large increase in demand
- If demand is price inelastic, a subsidy is relatively ineffective in increasing demand.
Which diagram to draw?
Either (production or consumption externality) is acceptable to show the principle of positive externalities. Generally, I advise using the positive externalities of consumption. To simply economics for some students (who often get confused by these diagrams), I will only teach one positive externality diagram. (consumption)
Extra How to define externalities?
A reader asks the question if a farmer switches from conventional to organic farming is this really a positive externality?
“Conventional and organic farming both have negative externalities. One has less than the other, but switching doesn’t mean a positive externality, it just means a reduction or even mitigation of a negative externality. In the same way driving an electric car is not a positive externality.”
Negative Externalities
- Negative externalities occur when the consumption or production of a good causes a harmful effect to a third party.
Examples of negative externalities
- Loud music. If you play loud music at night, your neighbour may not be able to sleep.
- Pollution. If you produce chemicals and cause pollution as a side effect, then local fishermen will not be able to catch fish. This loss of income will be the negative externality.
- Congestion. If you drive a car, it creates air pollution and contributes to congestion. These are both external costs imposed on other people who live in the city.
- Building a new road. If you build a new road, the external cost is the loss of a beautiful landscape which people can no longer enjoy.
The externalities of driving a car to work
- The personal cost of driving are buying car, petrol, your time
- The negative externalities are – pollution to other people, possible accident to other other people, and time other people sit in traffic jams
Social cost
- Social cost is the total cost to society; it includes both private and external costs.
- With a negative externality the Social Cost > Private Cost
Negative production externality
- When producing a good causes a harmful effect to a third party. Therefore the social cost is greater than the private cost.
Examples of negative production externalities
- Burning coal for energy creates pollution.
- Producing conventional vegetables with pesticides causes carcinogens to get into the environment.
- Producing beef in South America involves cutting down Amazon rainforest, which has an impact on global climate and local environment
- Because of the external costs the social marginal cost is greater than the private marginal cost.
- In a free market, producers ignore the external costs to others. Therefore output will be at Q1 (where Demand = Supply).
- This is socially inefficient because at Q1 – SMC> SMB
- Social efficiency occurs at Q2 where Social marginal cost = Social marginal benefit
The red triangle is the area of deadweight welfare loss. It indicates the area of overconsumption (where SMC is greater than PMC)
Negative externality of consumption
This occurs when consuming a good causes a harmful effect to a third party. In this case, the social benefit is less than the private benefit.
Examples of negative externalities of consumption
- Consuming alcohol leads to an increase in drunkenness, increased risk of car accidents and social disorder.
- Consuming loud music late at night keeps your neighbours awake.
- Consuming cigarettes causes passive smoking to others in the vacinity.
Diagram of negative externality in consumption
- In a free market, we get Q1 output. But at this output, the social marginal cost is greater than the social marginal benefit.
- The red triangle is the area of dead-weight welfare loss.
- Social efficiency occurs at a lower output (Q2) – where social marginal benefit = social marginal cost.
Implications of negative externalities
If goods or services have negative externalities, then we will get market failure. This is because individuals fail to take into account the costs to other people.
To achieve a more socially efficient outcome, the government could try to tax the good with negative externalities. This means that consumers pay close to the full social cost.
Economists on negative externalities
Arthur Pigou 1920 introduced the concept of externalities in The Economics of Welfare. Pigou used the example of alcohol having external costs, such as creating more demand for police and health care.
In 1975 William Baumol and W. Oates provided a comprehensive review of the literature on externalities in Theory of Environmental Policy. In particular, they applied economic concepts of externalities to the emerging issue of environmental costs. For example, in 1975, they mentioned some of the environmental costs which were considered to be pressing.
a. Disposal of toxic wastes,
b. Sulfur dioxide, particulates, and other contaminants of the atmosphere,
c. Various degradable and nondegradable wastes that pollute the world’s waterways,
d. Pesticides, which, through various routes, become imbedded in food products,
e. Deterioration of neighborhoods into slums,
f. Congestion along urban highways, g. High noise levels in metropolitan areas
Merit and Demerit Goods
Definition of Merit Good
A merit good has two characteristics:
- People do not realise the true personal benefit. For example, people underestimate the benefit of education or getting a vaccination.
- Usually, these goods also have a positive externality.
Therefore in a free market, there will be under consumption of merit goods.
Examples of Merit Goods
- Health Care – people underestimate the benefits of getting a vaccination. If people do get a vaccination, then there will be a personal benefit in protecting against diseases. Also, there will be external benefits to the rest of society because it will help reduce the prevalence of disease in the rest of society.
- Museums – the educational benefit of museums may be unappreciated.
- Eating fruit and vegetables – A diet of raw fruit gives health benefits to the consumers but we may prefer unhealthy food.
- Education – People may undervalue the benefits of studying, and decide to leave school early or not get good grades.
Demerit Good
A demerit good has two characteristics:
- A good which harms the consumer. For example, people don’t realise or ignore the costs of doing something e.g. smoking, drugs.
- Usually, these goods also have negative externalities. If you smoke you harm yourself, but also the smoke negatively affects other people.
Therefore in a free market, there will be overconsumption of these goods.
Examples of Demerit Goods include:
- Smoking – People underestimate health costs or risks of getting addicted.
- Drinking – Health costs to drinkers. Costs to society include more expenditure on health care and policing.
- Taking drugs – Health costs to drug users – people underestimate risks of getting addicted. External costs of more crime.
- Driking sugary softdrinks – which damage teeth and cause obesity.
Value judgement on merit goods
Merit and demerit goods involve making a value judgement that something is good or bad for you. Classification is not always straightforward. For example:
Cannabis
- Cannabis is widely considered a demerit good – it contributes to lung cancer and can lead to psychological problems, such as paranoia.
- However, supporters of cannabis might argue cannabis is a harmless drug which can help people deal with physical pain and enjoy life more.
Contraception
- Supporters of family planning may argue contraception is a merit good because contraception can help prevent the personal costs of unwanted pregnancy.
- However, the Catholic church views contraception as a sin and may argue it is actually a demerit good because contraception encourages sexual promiscuity and undermines family values.
Demerit good definition
A demerit good is defined as a good which can have a negative impact on the consumer – but these damaging effects may be unknown or ignored by the consumer. Demerit goods also usually have negative externalities – where consumption causes a harmful effect on a third party.
Examples of demerit goods
- Alcohol
- Cigarettes
- Drugs
- Junk food
- Gambling
The classification of demerit goods is a normative judgement. In defining demerit goods, we may assume that people are irrational and make poor choices – often consuming goods which are harmful, degrading or damaging in the long-term. This may be due to poor information or poor decision making. In other words, people may underestimate the private costs and over-estimate the private benefits.
Demerit goods have these two characteristics:
- Harmful, unhealthy to the individual consumer.
- Also, they usually have negative externalities. (Costs imposed on third parties)
Why alcohol is considered a demerit good
- Consuming alcohol can cause personal health problems, e.g. long-term liver problems or hangover the next morning. But, individuals may ignore these costs or think they don’t apply to them.
- Consuming alcohol can also cause costs to other people (external costs), such as increased levels of crime and the cost of treating disease.
Good with negative externality in consumption
With a good like alcohol, you could say it only becomes a demerit good when consumed in excess. e.g. one unit a day is unlikely to cause either much personal damage or negative externality. But, when consumed in excess, the personal and external costs can be very high.
The distinction between demerit goods and negative externalities
A good with negative externalities (e.g. driving a car) isn’t necessarily a demerit good. Driving a car causes pollution (negative costs to other people). But, we don’t usually assume that driving a car is bad for you. Therefore it would not be classed as a demerit good, just a negative externality.
Uncertain classification of demerit goods
For some goods, it is not clear whether it is a demerit good or not.
For example to some people, contraception would be considered a demerit good (contraception a sin according to the Catholic church).
However, to others, contraception may be considered beneficial (contraception helps prevent the spread of STD) and therefore a merit good.
Dealing with demerit goods
To reduce demand for demerit goods, the government may:
- Place a tax on the good, e.g. tobacco tax
- Place regulations on the consumption, e.g. legal minimum age of 18.
Prohibition of alcohol
In the early Twentieth Century, the US introduced prohibition – banning the sale of alcohol. The logic for banning alcohol was that it was a demerit good. The economist, Irving Fisher, supported prohibition because consumers often made a mistake in fulfilling desires rather than maximising satisfaction.
“Today I would like to see a study, partly economic and partly psychological, showing how the human animal following his desires often misses satisfactions instead of attaining them. The star example is narcotics.”
(Quoted in I. N. Fisher 1956, 339)
Public Good
Definition of Public Good
A public good has two characteristics:
- Non-rivalry: This means that when a good is consumed, it doesn’t reduce the amount available for others.
– E.g. benefiting from a street light doesn’t reduce the light available for others but eating an apple would. - Non-excludability: This occurs when it is not possible to provide a good without it being possible for others to enjoy. For example, if you erect a dam to stop flooding – you protect everyone in the area (whether they contributed to flooding defences or not.
A public good is often (though not always) under-provided in a free market because its characteristics of non-rivalry and non-excludability mean there is an incentive not to pay. In a free market, firms may not provide the good as they have difficulty charging people for their use.
Free rider problem
The problem with public goods is that they have a free-rider problem. This means that it is not possible to prevent anyone from enjoying a good, once it has been provided. Therefore there is no incentive for people to pay for the good because they can consume it without paying for it.
- However, this will lead to there being no good being provided.
- Therefore there will be social inefficiency.
- Therefore there will be a need for the govt to provide it directly out of general taxation.
Examples of Public Goods
Both a public bridge and street lighting exhibit characteristics of a public good.
- National defence. If you protect the country from invasion, it benefits everyone in the country.
- Street lighting. If you provide light at night, you can’t stop anyone consuming the good. Walking under a street light doesn’t reduce the amount of light for others.
- Police service. If you provide law and order, everyone in the community will benefit from improved security and reduced crime.
- Flood defences – Protecting the coastline against flooding provides benefits for the whole community.
- The internet. Once websites are provided, everyone can see the website for free, without reducing the amount available to others. (assuming an individual can access for free, which is not always the case)
Quasi-Public Goods
These are goods which have an element of non-excludability and non-rivalry. Roads are a good example. Once provided most people can use them, for example, those who have a driving licence. However, when you use a road, the amount others can benefit is reduced to some extent, because there will be increased congestion.
Market provision of public goods
Although classical economic theory suggests public goods will not be provided by a free market, there are cases when groups of individuals can come together to voluntarily provide public goods.
Behavioural economics suggests that individuals can have motivations other than just money. People may volunteer to contribute to local flood defences out of a sense of civic pride, peer pressure or genuine altruism. Therefore, in the real world, enough people may contribute to paying for a public good, even if – from a narrow self-interest point of view – it may be rational to avoid paying.
Examples of market provision of public goods include:
- Local communities providing private policing
- Local communities raising money to pay for a local school, new garden or new statue.
Difference between public spending and public goods
One possible area of confusion. We talk about public spending. This is spending done by the government. E.g. UK public spending
However, not all government (public) spending is on ‘public goods’, e.g. the government will also spend on other goods and services, .e.g. – merit goods, like education and healthcare.
