Market Failure

Before now, we have discussed why uninhibited (free) markets may be desirable. In this
section, we will discuss situations where free markets may not be efficient, and
government intervention may be welfare improving.

Externalities

An externality occurs when someone within a market (be they producer or consumer)
generates a cost or benefit for someone ​outside​ of the market. While the market may be
maximizing the total surplus for those in the market, if they generate benefit or impose
costs on someone outside the market, the quantity and price that the market generates
may be inefficient, they may not maximize total surplus. Let us examine one of the classic
externalities, a negative production externality.

A ​Negative Production Externality i​ s a product whose production imposes a cost on

someone outside of the market (someone who neither produces nor consumes the
product). A classic example is pollution. When we burn coal for electricity, smog is
released into the atmosphere that may cause health and quality of life problems for
people that neither receive electricity nor benefit from selling it. These people would
likely be willing to pay money to avoid these problems, but cannot, so in a sense a cost is
being imposed on them.

We will diagram this, but first we must introduce some important concepts. We have
talked about supply and demand, but these curves can also be thought of as something
else. Supply can be thought of as ​Private Marginal Cost​ of producing a good. Demand
can be thought of the as the ​Private Marginal Benefit​ of consuming a good. These costs
and benefits have social counterparts, which measure the effects imposed on those
outside of the market. The ​Social Marginal Cost​ accounts for all costs of producing a
good, including the private ones. The S ​ ocial Marginal Benefit a​ ccounts for all benefits of
consuming a good, including the private benefit.​ ​ An externality occurs when private
marginal cost is ​not ​equal to social marginal cost or when private marginal benefit is ​not
equal to social marginal benefit. When I add the “social” to the front of these words, it
just means that the external costs or benefits are accounted for in that measure.

Below we have a diagram of a ​negative production externality.​ The market will cause
price and quantity to move to their equilibrium levels, but we need to calculate consumer
and producer surplus with the social curves. In this case, I have market demand “D”
signifying that private marginal benefit is equal to social marginal benefit. However,
social marginal cost is ​higher ​than private marginal cost.
This diagram should look very similar to the overproduction example in the notes on
total surplus. Negative production externalities tend to be o
​ verproduced,​ and often are
priced to ​low​. Is there a government intervention that could eliminate this deadweight
loss?

-A tax could eliminate the deadweight loss. A tax on producers the amount of the
vertical distance between the SMC curve and PMC curve would bring PMC to SMC
and eliminate deadweight loss. A tax of this nature is called a ​Pigouvian Tax​.

Another type of externality is a ​positive consumption externality.​ A positive

consumption externality occurs when a has a higher social marginal benefit than private
marginal benefit.
In this case, the product is underproduced relative to the optimum, which leads to
deadweight loss. Governments may subsidize these goods to increase their consumption,
to eliminate the deadweight loss.
Externalities can be positive (creating an external benefit) or negative (creating an
external cost), and can arise from the production of the good or the consumption of it.
Because social and private costs or benefits do not match, the market leads to a
suboptimal outcome. Externalities cause deadweight loss.

Positive externality: SMB > PMB

Negative externality: SMC > PMC

Intervention in Markets with Externalities and Coase Theorem

While governments can intervene in markets and fix deadweight loss due to externalities,
another solution exists. When property rights are well defined, consumers and producers
can make transactions with one another to arrive at an efficient allocation. For example,
if consumers are given property rights over clean air, and producers must pay to pollute,
their cost of production increases, and quantity decreases. Even if the property rights are
given to the producers(the right to pollute), it still allows consumers to pay to get those
rights, reduce pollution and reduce quantity to the optimal level.

Public Goods

We will now talk about some different types of goods, and why the market may not
provide them optimally. First we will define two different attributes that a good can have.

A good is ​rivalrous ​if one person consuming the good prevents another person from
consuming it. If I eat a slice of pizza, someone else cannot eat that same slice of pizza,
pizza is rivalrous. A lighthouse is non-rivalrous, just because one person is using a
lighthouse for navigation doesn’t mean another person cannot use it.

An ​excludable good​ is a good that consumers can be forced to pay for if they want to
consume it. Iphones are excludable, apple doesn’t have to give you an iphone if you don’t
pay. A public park is not excludable. You generally cannot prevent people from using a
public park.

With these designations, we can place goods into one of four categories, as in the table
below:
 Excludable Non-Excludable

Rivalrous Private Common Resource

Non-Rivalrous Club Goods Public Goods

We have mostly been talking about private goods in this course. Pizza is an obvious
private good. Club goods, like Netflix, are excludable (with password protection for
access) but non-rivalrous (you and I can both watch netflix at the same time). The other
two types of goods lead to specific problems, which we will talk about below.

Common Resource Goods and the Tragedy of the Commons

Common resource goods are non-excludable, but rivalrous. Fish are often an example of
a common resource good. Anyone can go fishing, but when a fish is caught and eaten, no
one else can catch and eat that same fish. When everyone can go fishing, there is no
incentive to conserve the good, as any fish I decide not to catch can be caught by any
other fisherman. Because of this incentive structure, common resources are
overexploited, which we call ​the tragedy of the commons. ​Governments may intervene
in these situations to avoid overexploitation.

Public Goods and the Free Rider Problem

Public goods are non-excludable and non-rivalrous. If public goods are produced in a
market, they will be underproduced. Why is this the case? Once a public good has been
provided, you cannot prevent others from using it. If someone wants streetlights on their
street, so they can drive comfortably at night, once they have installed them, they cannot
stop their neighbors from using those lights. This is called the free rider problem, and
leads to underproduction of public goods when they are produced in the private market.
This is why it is common for governments to provide public goods.