Market Failure

A market failure occurs when the invisible hand pushes in such a way that individual decisions do not lead to socially desirable outcomes.

It is a situation in which the allocation of goods and services by a free market is not efficient (Demand not equal to Supply equilibrium)

Environmental Economics

Should the government intervene in the market?

Any time a market failure exists, there is a reason for possible government intervention into markets to improve the outcome.

Because the politics of implementing the solution often leads to further problems, government intervention may not necessarily improve the situation.

Market failure

A brief overview of some different types of Market Failures, and examples of each, before going into a more detailed look at Externalities and Public Goods

Types of market failure:

  1. Merit goods
  2. Demerit goods
  3. Externalites: Positive and negative
  4. Public goods
  5. Abuse of Monopoly Power
  6. Asymmetric information/imperfect information

1. Under supply of merit goods 

Merit good are under supplied and under consumed. All public goods are merit goods. Example: Education, healthcare, vaccines, sports facilities 

Government solution to reduce market failure: 

  • Provide services themselves 
  • Subsidise private firms to supply it

2. Oversupply of demerit goods 

Demerit goods are over-provided and over-consumed in the market. It can impose a negative externality, a third cost on third parties. Examples: Cigarettes, alcohol, drugs, child pornography. 

Government solution to reduce market failure: 

  • Tax the good 
  • Ban good 
  • Regulate – age restrictions 

3. Externalities

Externalities are third party effects arising from production and consumption of goods and services for which no appropriate compensation is paid.

How does a free market fail when external costs or benefits are involved? What is the solution to correct that failure?

a. Negative externalities of consumption

Negative externalities occur when consumption impose external costs on third parties outside of the market for which no appropriate compensation is paid.

These occur when consumption of goods or services creates external costs that are damaging to a third party. Example: People who smoke create an external cost for non smokers through second hand smoke. Costs include lung cancer, asthma, and the smell of smoke. 

Government solution to reduce market failure: 

  • Ban cigarettes 
  • Impose indirect taxes on cigarettes 
  • Provide education on effects of smoking 
  • Age restrictions 

FDA wants to ban trans fats nationwide. Cleveland’s ban is already in affect.

b.Positive externalities of consumption/external costs 

When the consumption of goods and services provide a benefit to a third party. Example: Vaccinations, education, healthier population, outdoor music shows, use of deodorant 

Government solution to reduce market failure: 

  • Subsidise health care 
  • Positive advertising (vaccines)
  • Pass laws – insist citizens stay in school/get vaccinated

c. Negative externalities of production

Negative externalities occur when production impose external costs on third parties outside of the market for which no appropriate compensation is paid.

These occur when production of good or service creates external costs that are damaging to a third party. Example: if a factory emits fumes that are harmful, then there is a cost to the local community that is greater than the cost of production paid by the firm. 

Government solution to reduce market failure: 

  • Tax the for in order to increase the firm’s private cost (internalise the cost of externality). This is a way to make the polluter pay
  • Government could legislate and ban polluting firm 
  • Pass laws to meet standards 
  • Issue tradable emission permits 
  • Concrete Block Levy

d. Positive externalities of production 

There are many occasions when the production of a good or a service creates external benefits which boost social welfare. Example: A firm provides quality training for its employees. When employees leave the firm, the new employers don’t have to pay for education or training. 

Government solution to market failure: 

  • Subsidise firms that offer training 
  • Provide vocational training through the state 

5. Public goods

What happens when you can’t prevent people from consuming a commodity, even if they haven’t paid for it? Who ends up providing these kinds of goods and services?

Public goods are goods not provided for in a free market. 

Examples: national defence, flood barriers, public paths, street lights. 

The reason they are not provided in a free market is because: 

  • They are non-excludable: impossible to prevent others from using it 
  • They are non-rivalrous: when one person consumes it, it does not prevent others from using it. 

Government solution to reduce market failure

  • Provide the good themselves, by using tax papers money 
  • Subsidise private firms to provide good 

Public V. Private goods

In this video, you will be introduced to the difference between public and private goods and how this applies to environmental conservation. Concepts include excludability, rivalry, public goods, private goods, collective goods, and common goods/common pool resources.

Tradegy of commons

The Tragedy of the commons can partially describe why people don’t work together and conserve certain resources. If nobody owns the resource and everyone is allowed to use it, or because of the scope of the resource people don’t have power over others, then people just use it as much as they want. It’s basically just found money. Just use it as much as you can before someone else does or you will miss out on the bounty. But if people are able to organize private property rights or work together through communal ownership then they can use the resource for longer.
The Tragedy of the commons works for both extracting resources like trees and fish and sink resources like clean air, clean land, and clean water and is affected by pollution.

  1. Abuse of Monopoly Power

Monopolist and other imperfect markets can restrict output or increase prices to maximise profits. Because they are not producing at socially efficient level output , there is a welfare loss. 

Government solution to reduce market failure: 

  • Regulate markets that abuse monopoly power eg. anti-competition watch dogs 
  • Pass laws to prevent mergers or takeovers. 
  1. Imperfect information (misinformation)

Consumers and producers do not always have perfect information / knowledge they need to make informed purchasing / selling decisions. Asymmetric information: when one part has more information than the other to an economic transaction.

Example: when purchasing a second hand car, the seller has more information than the buyer, they know how well it was serviced. 

Government solution to reduce market failure: 

  • Regulation / laws consumers are protected through laws such as competition and consumer protection commission (CPCC)
  • Other Regulations: Health and safety Authority, Environmental protection agency.

Market Failure and Sustainability 

Producers do not consider costs to others when making business decisions. As a result, they produce more goods with negative externalities than is efficient, which leads to more environmental degradation than is socially desirable. Positive externalities also result in inefficient market outcomes.

Policies to correct market failure 

  1. Tradable permits – they are permits to pollute, issued by a governing body, which sets a maximum amount of pollution allowable. Firms may trade these permits for money.
  2. Direct provision – the provision of a good or service to a market by a government.
  3.  Carbon taxes – taxes levied in the carbon contents of fuel.
  4. Cap and trade scheme – is where a central authority sets a limit or cap on the amount of a pollutant that may be emitted. The limit or cap is allocated or sold to firms in the form of emissions permits which represent the right to emit or discharge a specific volume of the specified pollutant. Firms are required to hold a number of permits equivalent to their emissions. The total number of permits cannot exceed the cap, limiting total emissions to that level. Firms that need to increase their volume of emissions must buy permits from those who require fewer permits. The transfer of permits is referred to as a trade. In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions.
  5. Nationalisation – the process of taking a private industry or private assets into public ownership by a national government or state.
  6. Trade liberalisation – the removal or reduction of restrictions or barriers on the free exchange of goods between nations.

Market Failures, Taxes, and Subsidies: Crash Course Economics

Revise key terms for market failure