MARKET FAILURE REVIEW NOTES (pg. 134-146)
Public Goods: Non-exclusive and non-rivalrous goods.
 Non-Exclusive: Once it has been provided, non-payers may benefit from the good as well
 Non-Rivalrous: Consumption by an individual does not inhibit others from consuming it
as well
Ex. Public transportation, parks, statues, street lighting, etc.
Merit Goods: Goods that will be underprovided by the market, and therefore under-consumed;
where the social benefits exceed the private benefits.
 Create positive externalities (See Externalities pg. 3)
Ex. Education, vaccinations
Demerit Goods: Goods that will be overprovided by the market, and therefore over-consumed;
where the social costs exceed the private costs.
 Create negative externalities (See Externalities pg. 3)
Ex. Tobacco, alcoholic beverages
Consumer Surplus: The satisfaction gained for paying the equilibrium price even though they are
willing to pay a higher price.
 In Other Words: The difference between the maximum price a consumer is willing to pay
for a product and the actual price
Producer Surplus: The satisfaction gained for selling at the equilibrium price even though they
are willing to supply at a lower price.
 In Other Words: The difference between the actual price a producer receives and the
minimum acceptable price.
Community Surplus: The combination of consumer and producer surplus.
Community Surplus
The combination of consumer
surplus (red) and producer surplus
(purple) is the community surplus.
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Further Explanation: The producer is willing to produce at a lower price and sell less, and so
their benefit gained is the area where they would be willing to supply for less profit, but are not
required to do so. Inversely, the consumer is willing to purchase at a higher price and purchase
less, and so their benefit gained is the area where they would be willing to consume at a higher
cost, but are not required to do so.
Productive Efficiency: Appropriate output at lowest possible cost.
Allocative Efficiency: Value consumers place on the product is equal to the cost of resources
used to produce it.
 Marginal Benefit = Marginal Cost
 Maximum Willingness to Pay = Minimum Acceptable Price
 Community surplus is maximized
Market Failure: When a market does not reach both productive and allocative efficiency, and
community surplus is not maximized.
 Extrinsic + Opportunity Costs (Marginal Costs) ≠ Price
Market Failure in Perfect Competition
 Both productive and allocative efficiency can only be reached in perfect competition
 Therefore, perfect competition is the only unfailing market
No Market Failure in Perfect
Competition
Market Failure in Imperfect
Competition
Further Explanation: In all forms of competitions, firms operate where marginal revenue (MR)
equals marginal cost (MC). In imperfect competition, the firm operates at price P1 in the above
(right) graph, and not at the point of allocative and productive efficiency, where price (illustrated
by the demand curve) equals marginal revenue. Therefore, imperfectly competitive firms do not
reach either productive or allocative efficiency. In perfect competition, however, the demand
curve (labeled as P=MR=AR) crosses the marginal costs curve at the firm’s point of operation.
Therefore, equilibrium price is equal to marginal cost, and the firm reaches both allocative and
productive efficiency.
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Market Failure in Imperfect Competition
Market Failure in Imperfect
Competition
The yellow areas represent what is known as
the deadweight loss: the total community
surplus lost. The upper yellow triangle
illustrates the consumer surplus lost, and the
lower yellow triangle illustrates the producer
surplus lost.
Further Explanation: The firm produces where
marginal revenue is equal to marginal cost, or at
QM, to maximize profit. However, the optimal
point of production for the community is where
marginal cost is equal to price, or QC, because
that is the point of allocative efficiency. Thus,
the distance between QM and QC holds the
community surplus lost, outlined by the large
yellow triangle.
Externality: Costs or benefits inflicted upon a third party (unrelated to either the consumption nor
the production of the product) outside of a market transaction, caused by the under and over
allocation of resources (See Demerit and Merit Goods pg. 1)
 Positive Externality of Consumption: Consumption of externality impose external benefit.
Ex. Vaccinations (protect others by not transferring sickness)
 Positive Externality of Production: Production of externality imposes external benefit.
Ex. A gardener creates a beautiful garden that his neighbors enjoy at no cost
 Negative Externality of Consumption: Consumption of externality imposes external cost.
Ex. Cigarettes (Second-hand smoke), Alcoholic beverages (drunk driving)
 Negative Externality of Production: Production of externality imposes external cost.
Ex. Textile factories creating pollution (impact on planet- global warming)
Externalities of consumption are the
vertical distance (s) between the
marginal social benefit (MSB) and
marginal private benefit (MPB).
Externalities of production are the
vertical distance between the marginal
social cost (MSC) and marginal private
cost (MPC).
See more on MSB, MPB, etc. in Cost
Theory Study Guide
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Note: Positive externalities tend to be merit goods, and therefore tend to be under allocated.
Negative externalities tend to be demerit goods, and therefore tend to be over allocated (See
Demerit and Merit Goods pg. 1).
Welfare Gain: An increase in community surplus due to more efficient allocation of resources.
Welfare Loss: A decrease in community surplus due to less efficient allocation of resources.
Note: In the following four diagrams, welfare gain/loss is portrayed as a large yellow/red
triangle that consists of two inner triangles. The upper inner triangle illustrates the gain/loss of
consumer surplus, while the lower inner triangle illustrates the gain/loss of producer surplus.
Positive Externality of Consumption in Imperfect Competition
The difference between Q1 and Q*, and
P1 and P* create potential welfare
gain, illustrated by the yellow triangles.
It is a welfare gain because the MSB is
greater than MPB, and is therefore
more beneficial to society in terms of
consumption.
See more on MSB, MPB, etc. in Cost
Theory Study Guide
Positive Externality of Production in Imperfect Competition
The difference between Q1 and Q*, and
P1 and P* create potential welfare
gain, illustrated by the yellow triangles.
It is a welfare gain because the MPC is
greater than MSC, and is therefore
more beneficial to society in terms of
costs and, therefore, production.
See more on MSB, MPB, etc. in Cost
Theory Study Guide
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Negative Externality of Production in Imperfect Competition
The difference between Q* and Q1, and
P* and P1 create potential welfare loss,
illustrated by the red triangles. It is a
welfare loss because the MSC is
greater than MPC, and is therefore less
beneficial to society in terms of costs
and, therefore, production.
See more on MSB, MPB, etc. in Cost
Theory Study Guide
Negative Externality of Consumption in Imperfect Competition
The difference between Q* and Q1, and
P* and P1 create potential welfare loss,
illustrated by the red triangles. It is a
welfare loss because the MPB is
greater than MSB, and is therefore less
beneficial to society in terms of
consumption.
See more on MSB, MPB, etc. in Cost
Theory Study Guide
Further Explanation: In order to remove a negative externality of consumption, the government
may impose a tax on the externality, which forces businesses either to pay fines on the continued
production of their externality or adjust to different production methods, thus shifting the MSC
curve to the left. Because the firm always produces where marginal revenue is equal to marginal
cost, the firm will then produce where marginal social benefit and marginal social cost (labeled
in the diagram as MSC + tax) intersect, which is society’s optimal point of output (at Q*, P2),
thus eradicating the negative externality and ensuring proper allocation of resources.
 In order to counter other externalities, the government could impose taxes/ subsidies to
consumers/producers appropriately
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Government Regulation of Externalities- Summary
 Positive Externality of Consumption: Grant subsidies to consumers.
 Positive Externality of Production: Grant subsidies to producers.
 Negative Externality of Consumption: Impose taxes on consumers.
 Negative Externality of Production: Impose taxes on producers.
Other Solutions to Externalities
 Assigning and Enforcing Property Rights Over an Asset
o Responsibility is taken for that area, thus reducing potential externalities in that
area (See Coase Theorem and Tragedy of the Commons for examples pgs. 6-7)
 Creating a Market for Externality Rights
o Rather than a tax, firms/consumers must pay for a permit in order to continue
producing/consuming a negative externality
Ex. Purchasing a gun requires a paid permit; the additional cost of the permit
balances the potential violent impact of the gun
 Direct Regulation
o Governments may regulate price (price ceilings/floors), output, designated areas
for using the negative externality, etc. to prevent use of the externality
 Note: This is a cost-effective solution with cost-defective outcomes
Ex. Government bans smoking in all public areas; however, when smokers
smoke in private areas they inhale more of the smoke and are more likely to
impose health costs upon the government
 Advertising/ Public Service Announcements
o Using the media to change the practices of consumers and/or firms
Ex. A commercial for programs such as Alcoholics Anonymous
Free Rider Problem: Because non-payers benefit from public goods, there is no incentive for
them to pay for the public good.
 The private sector is unable to profitably provide the good, leading the government to
provide public goods through taxes
Ex. One individual rarely creates a public school; instead, education is provided through the
government, and its upkeep is funded through taxes paid by those attending
Moral Hazard: When a party is protected from risk, the party is more likely to behave differently
in risky situations.
Ex. Insured patients wash their hands less often, and are more prone to disease
Adverse Selection Problem: Only parties with large risks will purchase protection from those
risks; however, they are the least profitable consumers. Because of this, the price for high-risk
consumers is often higher than that for low-risk consumers, creating inequality.
Ex. Only inexperienced drivers purchase car insurance; however, inexperienced drivers
must pay more for car insurance in order to balance the lack of profit from experienced
drivers who do not purchase car insurance.
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Coase Theorem: Government intervention in reducing externalities is unnecessary when property
ownership is clearly defined, a small number of people are involved, and the reduction of the
externality is negotiable with no additional bargaining costs.
Ex. Neighbor disliking the shade of his neighbor’s tree agrees to pay for its removal. In
this case, only two neighbors are involved, the tree clearly belongs to the second neighbor
because of its placement on his property, and the neighbors were able to negotiate easily.
The Tragedy of the Commons: Commonly owned goods and services are not as well cared for as
private goods and services because no one feels responsibility for them.
Ex. Fishermen use the common good of a lake or ocean to fish; however, they are
unafraid to overfish because they don’t own the lake or ocean, believing that if they stop
fishing, then they would lose profit to the competition that will continue fishing. This
could lead to the extinction of certain species of fish in that body of water.
Evaluation of Market Failure
 Market failure only exists in perfect competition, but due to the controversy of the
existence of perfect competition, it could be argued that all markets fail
 Discuss if it is possible to display costs and benefits appropriately through diagrams, for
the extent of the benefit or cost to the individual or society is relative
Ex. The cost of second-hand smoke may be higher for an older individual genetically
predisposed to lung cancer than for a healthy, young individual with no predisposition
 Argue if externalities can never be cured
Ex. Sin tax gives cost compensation to the government, not to the third parties
affected or harmed
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