Market Failures

• Market failure can be viewed as a scenario in which individuals' pursuit of self-interest leads to bad results for society as a whole.

• Sources of Market Failure:1. Externalities: 2. Imperfect Information. 3. Market Power.4. Public Goods.

Externalities: A case Study

• Aluminium Industry.• Can the Market Provide Adequate Protection

for the Environment?

Figure 1 The Market for Aluminum

Quantity ofAluminum

0

Price ofAluminum

Equilibrium

Demand(private value)

Supply(private cost)

QMARKET

S (social cost)

Figure 1 The Market for Research

Quantity ofResearch

0

Price ofResearch

Equilibrium

Demand(private value)

Supply(private cost)

QMARKET

S (social cost)

Figure 1 The Market for Cigarettes

Quantity ofResearch

0

Price ofResearch

Equilibrium

Demand(private value)

Supply(private cost)

QMARKET

D (social value)

EXTERNALITIES AND MARKET INEFFICIENCY

An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander.

• Externalities cause markets to be inefficient, and thus fail to maximize total surplus.

• Two types of externalities1. Negative : Adverse Impact on the bystander.2. Positive: Beneficial Impact on the bystander.

Externalities: Examples

Negative Externalities:– Automobile exhaust– Cigarette smoking– Barking dogs (loud pets)– Loud stereos in an apartment building

Positive Externalities:– Immunizations– Restored historic buildings– Research into new technologies

EXTERNALITIES AND MARKET INEFFICIENCY

• Negative externalities lead markets to produce a larger quantity than is socially desirable.

• Positive externalities lead markets to produce a larger quantity than is socially desirable.

The Market for Aluminum

– The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus.

– If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.

– For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution

Figure 2 Pollution and the Social Optimum

Equilibrium

Quantity ofAluminum

0

Price ofAluminum

Demand(private value)

Supply(private cost)

Socialcost

QOPTIMUM

Optimum

Cost ofpollution

QMARKET

Market Externalities: A Recap

1. Externalities arise when incentives facing individual decision-maker diverge from those of society as a whole

2. Negative externalities in production or consumption Production level is greater than the socially optimal level. Want to alter incentives of producer to consider external costs and reduce production

3. Positive externalities in production or consumptionProduction level is less than the socially optimal level.Want to alter incentives of producer to increase production.

• 5 residents• Each has savings of $ 100• Govt. bonds 13%

Number of cattle

Price per 2 year cattle

Income per cattle

1 126 26

2 119 19

3 116 16

4 113 13

5 111 11

Relationship between herd size and cattle price

Individual choices

• 4 villagers will send• 5th will buy bond• Total income Rs 65• Is this efficient?

No. Price per 2 year cattle

Income per cattle

total marginal

1 126 26 26 26

2 119 19 38 12

3 116 16 48 10

4 113 13 52 4

5 111 11 55 3

Marginal income and socially optimal herd size

Social optimum

• 1 cattle grazes• Rest of the villagers buy bonds• Total income Rs. 78

When is private ownership impractical

• Fruit trees in parks• Harvesting whales in international waters

Case Study

• ABC Ltd.’s factory produces a toxic waste by product

• Harms Raul, a fisherman located downstream• At a cost ABC Lts can filter out toxins

Example 1

Rs 100 Rs. 130

Rs. 100 Rs. 50

Gains to ABC

Gains to Raul

With filter Without filter

• If law does not penalize and they cannot communicate?

• Suppose they can communicate?• What is the largest possible transfer?

Coase Theorem

• If at no cost people can negotiate the purchase and sale of the right to perform activities that cause externalities, they can always arrive at efficient solutions to the problems caused by externalities

Example 2

Rs 100 Rs. 150

Rs. 100 Rs. 70

Gains to ABC

Gains to Raul

With filter Without filter

Economics and law

• Suppose raul has right to insist on filter?• Suppose there is a law preventing pollution?

• When negotiation is costless the task of adjustment falls on the party who can accomplish it at the lowest cost– Why do restrictions on loud party music take

effect later on weekends than on weekdays?

Example to think about

• Neha and Pooja can share a 2 bedroom apartment for Rs. 6000 or take separate one bedroom apartments for Rs. 4000 each. The only problem is that Neha talks constantly on the phone. She values this privilege at Rs 2500 a month. Pooja would pay Rs. 1500 to have better access to the phone. If they cannot install a second phone should they live together or apart?

Implications of Coase

• From point of efficiency it does not matter how property rights are defined– How about equity?

• If communication is not costless then property rights need to be defined appropriately?

• Where feasible communication costs should be controlled

Public Goods

Closely related to an externality is the case of a Public Good, which is a commodity defined as follows:

1. Non-rival in consumption – meaning that one persons consumption does not prevent anyone else from doing so as well.

2. Non-excludable – it is impossible (or very expensive) to prevent anyone else from benefiting or consuming the good.

Combined cause of market failure

  Non excludable Excludable

Non rival Public Club goods

Rival Common goods Private

Examples of Public Goods

Excludable

No Yes

No National defense, mosquito control

Bridges, swimming

pools

Yes Fishing grounds,

Hot dogs, cars,

houses

Rival

CONSEQUENCES

Non-excludable:Very difficult for the private sector to provide it.Information and R&D

Non-rivalryDo not want to exclude people as it is inefficient.

Conclusion: Individual Incentives Don’t Work Here.

Need a government to provide the good.

Public Goods

Public Goods cause market failures because private markets will not provide them.

• The basic argument relies on incentive effects and the “free-rider” problem.

• If the good is nonexclusive, no consumer has an incentive to pay.

Public Goods

• In other words, each consumer has an incentive to be a “free-rider”.

• As an example, if societies relied on the private market to provide national defence, lighthouses or public parks, these Public Goods would likely not be provided for at all.

Public Goods

• Governments can provide Public Goods that will not be provided by the private sector because governments can coerce payment from individuals.

• Through taxation and other means, government can force individuals to contribute to the provision of public goods.

Free Riding Problem– Free Riding occurs when people are not honest in

stating their marginal benefit, because if they understate it, they can get a slightly reduced level of the public good while paying nothing for it.

Free-riding is easier with• Anonymity: If everyone knows who contributes,

there can be powerful social stigmas applied to shirkers.

• Large numbers of people: It’s easier to determine the shirkers in a small group and the punishment is more profound when people close to you shun you for not paying your share.

• Any examples?

Efficient Provision of Public Goods

Private preferences through voting

Efficient allocation for public goods

• Public provision – Taxes– Debt

• Public production• Market creation