Chapter 16
Market Failure?
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Contents:
• Examples of Market Failure
• Counter Argument – the Market Works!
• Government Intervention is Unnecessary
and Inappropriate
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Examples of Market Failure
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Definitions:
 Market failure
is the situation in which the invisible hand (the
market price) fails to allocate resources efficiently.
 Externality
is the situation in which one’s action affects others
(in a non-pecuniary way) without compensation.
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External cost
Private cost
 is the cost borne by the decision maker.
External cost
 is the uncompensated cost borne by others.
Social cost
 is the total cost borne by the whole society
 = private cost + external cost.
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Divergence between private and social costs
 is the situation in which the private cost is
different from the social cost due to the
presence of external cost
Example:
Noise from a
construction site
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Equilibrium & efficiency:
S
Deadweight loss
Private optimum:
MSC
MEC
Qp (MPB = MPC)
MPC
Social optimum:
MPB =
MSB
0
Qs
Qp
Over-production
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Qs (MSB = MSC)
Q
External benefit
Private benefit
 is the benefit obtained by the decision maker.
External benefit
 is the uncompensated benefit obtained by others.
Social benefit
 is the total benefit obtained by the whole society
 = private benefit + external benefit.
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Divergence between private & social benefits
 private benefit  social benefit
 due to the existence of external benefit
Example:
Fundamental
education
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Equilibrium & efficiency:
S
Deadweight loss MPC =
MSC
Private optimum:

Qp (MPB = MPC)
MEB
Social optimum:

Qs (MSB = MSC)
MSB
MPB
0
Qp Qs
Under-production
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Q
Effects of externality
Result
Remedy
(by invisible hand) (by visible hand)
External cost
(e.g., congestion &
pollution)
Over-production
(Qp > Qs)
External benefit
(e.g., public goods
& make-up)
Under-production
(Qp < Qs)
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Impose unit tax
(to internalize the
external cost)
Impose unit
subsidy
(to internalize the
external benefit)
Definitions:
Private good
 is a good of which its consumption by any individual
reduces the amount available for others
 it is exclusive in consumption
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(Pure) Public good
its consumption by any individual
does not reduces the amount available for others
 it is non-exclusive in consumption
Example:
Pure public good:
National
defense
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Impure public good
 can be consumed by many but not all individuals at
the same time
 not all individuals can consume it (or the whole
amount of it) because usually an additional cost is
involved in its consumption
Examples: Impure public good
Radio
broadcast
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Stage
performance
Q16.3:
Explain why the above are examples of
pure public goods & impure public goods.
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Q16.4:
Distinguish between public goods & public services.
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Q16.5:
Some economists define public good as a good
of which the marginal cost of serving an additional
consumer is zero. Comment.
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Demand for a public good
$
MUV1+MUV2
= MSB
MUV2
MUV1
0
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Public good is non-exclusive in
consumption. Once produced,
all individuals consume & pay for
the same stock of public good.
Market demand curve for a public
good = vertical sum of MUV curves
of all individuals in the market (=
MSB curve)
Q
The social optimum
$
MSB =
MUV1+MUV2
MUV2
MSB(=MUV) = MSC(=MC)
MSC Optimal pricing scheme:
Perfect price discrimination
(i.e., Pi = MUVi)
then Pi = MUVi = MSC
P1
MUV1
0
Optimal output:
P2
P1
Qs
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= MSC
P2
Q
Private optimum
If uniform pricing is practised:
1. Cannot attain allocative efficiency
 To high MUV users: MUV > P
To low MUV users: MUV < P and refuse to consume
 MR collected (P) is much smaller than MSB (MUV)
 In equating MR=MC,
private optimum is much smaller than social optimum
 Under-production and allocative inefficiency result
2. Cannot attain consumption efficiency
 Once produced, no additional cost is incurred in consumption,
but low MUV users are excluded from consumption
 Under-consumption and consumption inefficiency result
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If perfect price discrimination is practiced:
 It is extremely costly for a producer to investigate the
MUV of every individual & charge them accordingly.
 Individuals may pretend to be low MUV users to bargain
for a lower price.
 The revenue collected from perfect price discrimination
would also be smaller than MSB.
 Under-production & allocative inefficiency result.
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The free rider problem:
 As public good is non-exclusive in consumption, it is
difficult to recognize & prevent free-riders (non-payers)
from consuming the good.
 This free-rider problem may appear under all kinds of
pricing schemes.
 As a result, the revenue collected would be further
reduced.
 Under-production
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Any remedy?
Pricing

The visible hand faces
similar problems as the
invisible hand.

Under-production
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Zero pricing

Finance the production of
public good by tax revenue

Unfair to taxpayers who bear
the cost but do not consume
the public good.

The sectors being taxed suffer
inefficiency

When the gov’t estimate
MSB from surveys,
consumers may overstate
their MUVs and cause
over-production
Q16.7:
“To achieve consumption efficiency, a private good
should be consumed by the individual with
the highest MUV, while a public good should be
consumed by all individuals with positive MUVs.”
Comment.
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Q16.8:
Radio broadcast is a public good.
What are the problems in its pricing?
What are the ways to overcome the problems so that
it can be provided privately?
Is the situation efficient?
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Counter Argument
--- the Market Works
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Zero transaction cost – Coase theorem
Coase theorem (高斯理論)
 regardless of the initial assignment of property rights
 the market equilibrium is identical and efficient
provided that property rights are well-defined and
transaction costs are negligible.
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Illustration of the theorem
A factory in upstream
Ms. A
Mr. B
A farm in downstream
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Initial situation:
The bleaching factory discharges
sewage into the river.
The sewage pollutes the river and
brings loss to the farm.
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Case I: The farm does not have the right of enjoying
clean water.
Assumptions:
1. No law restricting water pollution (pollution continues)
2. To min. loss, farm owner Mr. B negotiates with Ms. A
and pay her to cut her output and pollution.
 Max. amount that Mr. B is willing to offer to Ms. A
is the marginal external cost he borne = MSC - MPC
 Min. amount that Ms. A is willing to accept is her
net receipt from producing that unit = MPB - MPC
= MSB - MPC
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In equilibrium,
(Max. amount offered by
Mr. B = External cost)
MSC - MPC
MSC
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(Min. amount accepted by
Ms. A = Net receipt)
=
=
MSB - MPC
MSB
Case II: The farm has the right of enjoying clean water
Assumptions:
1. A law restricting water pollution (& prod. is banned)
2. To min. loss, factory owner Ms. A negotiates with
Mr. B and pay him to allow her production & pollution.
 Max. amount that Ms. A is willing to offer to Mr. B
is the her net receipt from production = MPB - MPC
= MSB - MPC
 Min. amount that Mr. B is willing to accept is the
external cost he borne = MSC - MPC
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In equilibrium,
(Max. amount offered
by Ms. A = Net receipt)
MSB - MPC
MSB
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(Min. amount accepted
by Mr. B = External cost)
=
=
MSC - MPC
MSC
Conclusion
If transaction cost is zero, by Coase theorem,
private contracting would occur. As a result,
the private optimum is the social optimum.
Efficiency is achieved.
No deadweight loss.
Notice that the initial assignment of property rights
has no influence on the allocation of resources.
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Remarks: 1. Optimal level of pollution
If pollution cannot be avoided in production,
(because the cost of preventing or eliminating
pollution is extremely high)
 it is efficient to allow pollution provided that
the MSB of production can cover the MSC
(including the loss brought by pollution).
 So there exists an optimal level of pollution.
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Remarks: 2. Reciprocal nature of the problem
There exists no reason why someone should have the
right of a resource (e.g., clean water) instead of others.
Yet, whoever has the right will gain and whoever has
to buy the right will lose.
Which party bears the loss is reciprocal, depending
on the assignment of rights.
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Prohibitively high transaction cost
Achieving efficiency without reallocating resources
 If TC in reallocating resources to restore efficiency &
eliminate the deadweight loss > the deadweight loss itself,
 no private contracting or reallocation of resources is
worth taking place.
 Although the private optimum is different from the ideal
social optimum (under zero TC) & deadweight loss results,
the resource allocation is still efficient (cannot be improved).
 No market failure results & no government intervention
is needed.
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Assignment of property rights affects the allocation of
resources (when TC is prohibitively high)
$
Deadweight
loss
MSC
MPC
If the farm does not
have the right and the
TC is prohibitively high,

MPB=MSB
0
QS QP1
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Q of
factory
the factory will
produced at QP1
$
Deadweight
loss
If the farm has the right
and the TC is
prohibitively high,
MSC

MPC
the factory will be
banned from production,
i.e., QP2 = 0
MPB=MSB
0=QP2
QS
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Q of
factory
Government Intervention is
Unnecessary and Inappropriate
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Gov’t intervention is unnecessary and inappropriate
 As resource allocation by the invisible hand must be
efficient, there is no market failure.
 No government intervention is needed
 The use of visible hand may be of undesirable motive,
involve high administrative and information cost, and
restrict individual freedom.
 So even if there were “market failure”, the use of
visible hand might not be appropriate.
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Correcting Misconceptions:
1. Public good is a good produced by the government.
2. The market demand curve for a public good is
the horizontal sum of MUV curves of all individuals
in the market.
3. To achieve efficiency, private goods should be
provided by the private sector and public goods
should be provided by the public sector.
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Correcting Misconceptions:
4. To achieve efficiency, pollution should be eliminated.
5. The existence of deadweight loss implies inefficiency.
6. Pareto efficiency requires zero transaction costs.
7. Pareto efficiency requires an even distribution of
wealth.
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Correcting Misconceptions:
8. Pareto efficiency implies the maximization of
social welfare.
9. To achieve efficiency, a polluting firm should be
banned from production or it should compensate
the victims.
10. There is no divergence between private and
social costs.
11. As the market fails to allocate resources
efficiently, the government should intervene.
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Survival Kit in Exam
Question16.1:
“A price-searching market allocates resources
inefficiently.” Comment.
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Survival Kit in Exam
Question16.2:
The construction of a rubbish collection point causes
a fall in the value of nearby properties.
To attain economic efficiency, which of the following
options should be adopted?
(a) The rubbish collection point should compensate
the nearby property owners.
(b) The rubbish collection point should install
pollution reduction device.
(c) The rubbish collection point should be relocated.
(d) The nearby properties should be relocated.
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