MARKET FAILURES

ECONONE

Market Failure
a

situation where free markets fail to

allocate resources efficiently
only private costs and benefits of
producers/consumers are considered,
thus socially optimum equilibrium is not
achieved

EXTERNALITIES
costs and benefits accrue to other people not involved in the
decision-making process

Negative Externality
Third-party

cost

Your actions have a negative effect to others.

Negative Externality
Example

Smoking

PRIVATE COSTS:
- Price of Cigarettes
- Health Risk

THIRD-PARTY COSTS:
- Annoyance
- Air Pollution
- Health Risk

Negative Externality
Example

Smoking

EFFECT:
Since private costs are low and
most people only think of
themselves, several people will
buy cigarettes.
NEGATIVE EXTERNALITY
causes OVERPRODUCTION.

Negative Externality
Example

Smoking

You have to consider the THIRD-PARTY COSTS in

producing goods.
Private Cost + Third-Party Costs = SOCIAL COST
(Present and Future)
Higher Cost Lower Supply

Negative Externality
Example

Smoking
Supply/ Marginal Cost (Social)
Supply/ Marginal Cost (Private)

Pcigarettes

Poptimum

Socially optimum outcome

Pmarket

Free market outcome

Qoptimum

Qmarket

Demand/ Marginal Benefit

(Social)
Qcigarettes

Negative Externality
Example

Smoking
To reach the socially optimum
level or address
overproduction:
Government can implement
regulations or impose taxes.
*Pigovian Tax a tax enacted to correct the
effects of a negative externality

Negative Externality
Example

Tragedy of the Commons

RIVALROUS

NON-EXCLUDABLE

One persons use diminishes other

peoples use

A person cannot be prevented from

using it.

WHATS THE PROBLEM???

Every individual tries to reap the greatest benefit from a given
resource
Abuse of resources. How will the future generation benefit from
them if they get depleted?

Negative Externality
Example

Tragedy of the Commons

HOW TO ADDRESS?

Government Control
Privatization

Positive Externality
Third-party

benefit

Your decision/actions benefit others.

Positive Externality
Example

- Education

PRIVATE BENEFIT:

THIRD-PARTY BENEFIT:

Better, higher-paying job

in the future

Educated people help the

economy move forward

Positive Externality
Example

- Education

EFFECT:
Private decision makers
dont see the full benefits
that the society sees.
POSITIVE EXTERNALITY
causes UNDERPRODUCTION.

Positive Externality
Example

Education

o You have to consider the Third-Party BENEFITS in

consuming the goods.
o Private Benefit + Third-Party Benefits = SOCIAL BENEFIT
(Present and Future)
o Higher Benefit Higher Demand

Positive Externality
Example

- Education
Supply/ Marginal Cost
(Social)

Peducation

Socially optimum outcome

Poptimum
Pmarket

Free market outcome

Demand/ Marginal Benefit (Social)
Demand/ Marginal Benefit (Private)
Qmarket

Qoptimum

Qeducation

Positive Externality
Example

- Education
To reach the socially optimum
level or address
underproduction:
Government will provide grant
money, lower bank loans, tax
credits.
SUBSIDY

Positive Externality
Example

Public Goods

NON-RIVALROUS

NON-EXCLUDABLE

One persons use does not diminish

other peoples use

A person cannot be prevented from

using it.

WHATS THE PROBLEM???

Free-riders

Positive Externality
Example

Public Goods

HOW TO ADDRESS?

The government
controls public
goods through
TAX
COLLECTION

Adverse Selection
occurs

when buyers have better

information than sellers
Profile: Healthy, Young, Low Health Risk

Willingness to Pay < Price of

Insurance

Seller of
Insurance

Profile: Unhealthy, Smokers, High Health Risk

Willingness to Pay > Price of Insurance

HEALTHY
CUSTOMERS
(LOW-RISK)
<
UNHEALTHY
(HIGH-RISK)

Adverse Selection
Consequences
Existence of low-quality products or high-risk
buyers
Crowding out of high-quality products or
low-risk buyers
How to address:
Target Market Profiling
Price Discrimination

Moral Hazard

The risk that a person has the incentive to take greater

risks after a contract has been agreed upon
Insurance
Bailouts

How to address:
Penalty
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