Economics Unit 5 - 1457145468349

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Unit - 5
Market Failure
Market Failure
 It is an economic term that encompasses a situation where, in any given market, the
quantity of a product demanded by consumers does not equate to the quantity supplied by
suppliers. This is a direct result of a lack of certain economically ideal factors, which
prevents equilibrium. (D≠S; quantitatively and qualitatively)
 It is the failure of the market economy to achieve an efficient allocation of resources .
 Inefficient allocation of resources is where the unnecessary commodities are produced /
consumed in excess than the essential commodities. (inefficient allocation of
resources; where MSB≠MSC)
 Production and consumption may be beneficial / harmful to the society/third party.
 The pursuit of self-interest by the individuals leads to increase in social costs.
Types of goods
Excludable Non-Excludable
Private goods
Common goods
Rivalrous A seat in an aircraft, a seat in
Fishing area.
cinema theatre, food, dress etc.
Public enterprise goods Pure Public goods
Non-Rivalrous
Art galleries, museum. Police, defence.
1. Rivalrous goods
 A good which can be consumed by only one person at a time (no two people can
consume the same unit).
2. Excludable goods
 A good or service is excludable, if people can be prevented from obtaining it, if they
have not paid for it.
3. Non-Rivalrous goods
 Non-rivalrous goods may be consumed by many at the same time without preventing
simultaneous consumption by others (benefits are not depleted by an additional user).
4. Non-Excludable goods
 A good or service is non-excludable if non-paying consumers cannot be excluded from
consuming it.
 In case of non-excludable goods ‘free rider’ problem arises i.e., people benefit from goods
or services even without paying (the question is ‘how to limit free riding and its negative
effects’).
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o Eg: Wi-Fi facility at Coimbatore Race Course

o Eg: Municipal authority charges Rs. 20 to clean the surroundings. If an household
does not pay, they cannot be prevented from enjoying the benefits of clean
surroundings. Clean surroundings are a public good whose benefits are non-
excludable. As a result, the beneficiary is encouraged to ride for free.
→Common good
 They are rivalrous in consumption but non-excludable (cannot prevent people from
using).
 Often the problem with common goods is overuse (depletes the resources).
o Eg: Fishing; fish caught by one boat reduces the catch available for others
(overfishing is the problem)
→ Public enterprise goods
 They are excludable (could be accessed only after paying).
 The good or service is not depleted.
→Private good
 A private good is one that is both rivalrous and excludable (can be consumed only by one
person; by paying).
→Public good
 A public good is a good / service which is non-rivalrous and non-excludable.
 Public goods have to be provided at no charge.
 Private firms will not provide public goods (unable to charge for consumption)
 Therefore, public goods have to be provided by the government. Eg: Street lights, light
house etc.
 But all that is provided by the government need not be a public good (since government can
provide medical services etc for which they charge).
Other types of goods
(a) Merit goods
 It is a commodity / service which the society values and judges that everyone should have
(whether the individual wants them or not).
 It is based on need, rather than on ability and willingness to pay.
 Consumption of merit goods is believed to generate positive externalities (MSB>MPB).
o Eg: Healthcare, education, public libraries.
(b) Demerit goods

 It is a commodity/service which the society values and judges to be bad for an individual.
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 Consumption of demerit goods leads to a fall in social welfare (MPB>MSB).

 Eg: Alcohol, cigarettes, drugs, addiction to gambling.
Causes of market failure
1. Externalities
 An externality is the cost or benefit that affects a third party (who did not choose to incur
that cost or benefit).
 Positive externality
 Society benefits from the production/ consumption of a commodity or
service.
 Eg: Education, vaccination etc.
 Negative externality
 A negative externality is a negative spillover effect on third parties.
 Costs from the production/consumption of a commodity or service that
are imposed on the society.
 Eg: Second hand smoke/passive smoking
 Eg: Polluting automobiles
 Eg: Polluting firms
 Problem: Increase in social costs
 Government intervention
 Prohibition on public smoking
 Phasing out of 2 stroke engines for 2 wheelers (they burn an oil-gasoline mixture:
they emit more smoke, carbon monoxide, hydrocarbons and particulate matter than
the gas –only four-stroke engines)
 Pollution tax / environmental taxes / green taxes (Delhi collects environmental
taxes from all vehicles passing through Delhi : Rs. 700 on light-duty vehicles and Rs.
1300 on heavy duty; so that the number of vehicles passing through Delhi will get
reduced).
 Regulation (zero emissions are difficult – emission limits are set: if it is violated legal
action is taken). But it is difficult to implement.
2. Lack of public goods / Missing markets
 Failure to meet a need for public goods, such as street lighting, light house, roads,
bridges etc (if people choose to pay or do not pay they will get the benefit – hence markets
are missing).
 Problem: Lack of public goods
 More provision of the public goods based on need (generate sufficient revenue).
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 Public-private partnerships (PPP).

 Contracting out, BOT (build-operate-transfer).
3. Under-production / under-consumption of merit goods (incomplete market)
 Markets may fail to produce enough merit goods, such as education and healthcare.
 Problem: Under-consumption of products with positive externalities
 Subsidies (Government schools & colleges– subsidized education, health
insurance)
 Information campaigns on private benefits
4. Over-provision of demerit goods
 Markets may also fail to control the manufacture and sale of demerit goods like
cigarettes and alcohol, which have less merit than consumers perceive.
 Problem: Over-consumption of products with negative externalities.
 Increase in tax rates
 Statutory warnings are provided
 Ban on the sale of alcohol / stringent licensing norms
 Information campaigns
 Minimum age for consumption
5. Abuse of monopoly power
 Imperfect markets restrict output in an attempt to maximize profit.
 Problem: Exploitation of consumers.
 Measures to encourage new firms into the market.
6. Asymmetric information / Information failure
 Asymmetric information is a situation where one side of a transaction has more
information than the other side.
 Problem: Inefficiency of markets and undesirable outcomes.
 Adverse selection
 It is one of the outcomes of asymmetric information where the informed parties do
not credibly transmit information (uninformed parties get wrong people to trade
with).
 Eg: A buyer of used cars gets only sellers with poor quality cars.
 Eg: A health insurer gets only the sick people buying the policies.
 Information dissemination is made mandatory.
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 Disseminated information (i.e., advertisement) should be true.

 Moral hazard
 Moral hazard is a situation in which one party gets involved in a risky event
knowing that it is protected against the risk and the other party will incur the cost
(someone else bears the burden of those risks).
 Eg: Owners set warehouses on fire to claim insurance.
 Prevention: Co-insurance and deductable (moral hazards can be reduced by
resorting to such practices)
 If co-insurance rate is 20% - The insurer will pay 80% and the insured bears
20% of the cost of accident)
 If estimated damage is to the tune of Rs. 1,50,000 and the deductable is Rs.
40,000, the policy holder pays the initial Rs. 40,000 and the insurance
company bears the rest of the cost of damages. If the damage is Rs. 40,000,
the policy holder pays the entire amount.
Remedies
 In order to reduce or eliminate market failures, governments can choose two basic
strategies:
(i) Use the price mechanism
 Implement policies that change the behavior of consumers and producers by
using price mechanism.
 Eg: Harmful products - Increase the price through taxation
 Eg: Beneficial products - Provide subsidies (behavior is changed through
financial incentives)
(ii) Use legislation and force
 The second strategy is to use the force of law to change the behavior (unwanted
behavior may be controlled).
 Eg: Licensing system for the sale of alcohol, penalizing polluters.
 In majority of cases of market failure, a combination of remedies is most likely to
succeed.

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o Eg: Wi-Fi facility at Coimbatore Race Course

(b) Demerit goods

 Consumption of demerit goods leads to a fall in social welfare (MPB>MSB).

 Public-private partnerships (PPP).

 Disseminated information (i.e., advertisement) should be true.

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