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Chapter 19
MARKET SUCCESS AND
MARKET FAILURE

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Learning Outcomes

A perfectly competitive economy is allocatively efficient

since it operates where price equals marginal cost
Free markets can fail to achieve and efficient outcome for
one of several possible causes of market failure
Private markets will tend to overexploit common property
resources
Goods that are jointly consumed by more than one person
are called public goods and cannot be provided efficiently
by the market
The costs and benefits of production that are external to
the producer cause the level of production that is achieved
by the free market to deviate from the socially optimal
level
Government policy towards competition is designed to
encourage competitive practices and to discourage
monopoly

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The Government in the Economy

Market Efficiency
How Markets work
The efficiency of perfect competition

Productive Efficiency
Productive efficiency implies being on, rather than inside,
the economys production possibility curve

Allocative Efficiency
Allocative efficiency relates to the choice among
alternative points on the production possibility curve

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Allocative Efficiency
The economys allocation of resources is
efficient when the marginal cost of
producing each good is equal to its market
price.
In perfectly competitive economy, Rs.1
worth of resources reallocated from the
production of any one product would
produce Rs.1 worth of value for consumer,
whatever product it was then used to
produce.

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Market Failure
Failure of the market economy to achieve
an efficient allocation of resources.
As the real market has some monopoly
power over the prices, MR>MC, they do
not have perfect allocative efficiency.
This provides the scope for the
Government to intervene to improve
market efficiency.

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Circumstances of Market
Failure
Where producers with excess capacity charges positive

prices.
Where the resources are used by everyone and belongs
to no one common property resources.
Where there are goods whose consumption can not be
restricted to those who are willing to pay for them
Public good.
Where people not party to some market bargain are none
the less significantly effected by it externalities.
Where one party to a market transaction has fuller
knowledge of its consequences than is available to other
party Asymmetric information
Where substantial market power causes prices to
diverge from marginal cost.

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Rivalrous and Excludable Goods.

A good is rivalrous is no two people can
consume the same unit. one apple.
A good is excludable if people can be
prevented from obtaining it the owner
can exercise effective property right over
the good. The consumer only those who
pay for it.
Any normal good will be rivalrous and
excludable.

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Rivalrous and Excludable Goods

Excludability is necessary for a good to be
produced by a firm for sale in the market.
The market works best when goods and
services are rivalrous and excludable.
Art Galleries, museums, parks are
excludable but non-rivalrous.
Common property are non-excludable but
rivalrous.

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Rivalrous

Four Types of Goods

Excludable

Non-excludable

Normal goods

Common property

Apples

Fisheries

Dresses

Common land

TV sets

Wildlife

Computers

Air
Streams

A seat on an aeroplane

Non-rivalrous
[up to capacity]

Public goods
Art galleries

Defence

Museums

Police

Fenced

Public information

Roads

Some navigation aids

Bridges

Broadcast signals

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Four Types of Goods

If one person consumes some of a rivalrous good or service, that
reduces the amount available for consumption by others.
If one person consumes some of a non-rivalrous good or service,
the amount available for consumption by others is not reduced.
Producers of an excludable good or service can prevent people
from consuming it and hence can charge for providing it.
Producers of a non-excludable good cannot prevent anyone form
consuming it and hence cannot charge for providing it.
Normal goods, shown in the top left segment, are rivalrous and
excludable.

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Four Types of Goods

Many goods are non-rivalrous (up to the capacity of the

producing unit) but are excludable (bottom left hand
segment). Examples are listed in the bottom left segment.
These goods can be provided to an additional consumer (up
to capacity) at a zero marginal cost.
Common property resources are rivalrous but nonexcludable (top right hand segment). They will tend to be
over used in free market conditions because additional
users cannot be excluded.
Public goods are non-excludable and non rivalrous. They will
not be provided by the free market.

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Externalities
Externalities are the costs or benefits of a
transaction that are incurred or received
by other members of the society but not
taken into account by the parties to the
transaction.
Externalities are also called as third-party
effect, spillover effect, neighborhood
effect.
Because parties other than the parties in
transaction are affected.

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Externalities
Externalities arise in many ways and may be
beneficial or harmful.
Externalities crates a divergences between
private benefits and costs and social benefits
and costs.
Private costs and benefits: incurred and received
by the parties involved in the activity.
Social costs and benefits: costs and benefits
incurred and enjoyed by whole society.

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Externalities
Societys resources are optimally allocated
when social marginal cost equals social
marginal benefit.
The outputs of firms that create harmful
externalities will exceed the socially
optimal levels.
The outputs of firms that create beneficial
externalities will be less than the socially
optimal levels.

Private and Social Cost

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Price, cost

Marginal
external
cost

MCs

MCp

p1
p0

Market price

Full
marginal
social
cost

Marginal
private
cost

q* q0
Production

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Private and Social Cost

Negative externalities cause marginal social cost to exceed
price in competitive equilibrium.
Marginal social cost, MCs, exceeds marginal private cost,
MCp, by the amount of the external cost imposed on others.
At the competitive output, q0, marginal private cost equals
price, but marginal social cost exceeds it.
The socially optimal output is q*, where MCs = market price.
For every unit between q* and q0, marginal social cost
exceeds price and hence its production involves a social
loss.

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Resource allocation
To achieve the optimal allocation of
resources in the face of externalities, the
production of goods with positive
externalities need to be encouraged and
the production of those with negative
externalities to be discouraged, compared
with what would be produced under free
market condition.

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Externalities and the Coase

Theorem

Externalities arise because of the lack of

property rights.
Theorem: If the two sides to an externality
the one causing it and the one suffering
from it can bargain together with zero
transaction costs, they will produce the
efficient use of resources.

Pollution Abatement

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Cost per tonne eliminated []

Firm A

Firm B
100
80
50

60

90

120

Tons of pollution eliminated

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Pollution Abatement

Efficient methods of abating pollution take account of differences in

costs of abatement among firms.
For any given amount of abatement, firm A has a higher cost of a
further unit of abatement than has B.
(1) Let each be ordered to reduce pollution by 90 units.
As marginal cost of 100 exceeds Bs marginal cost of 50.
This is inefficient.
A could cut its abatement by one unit, saving 100, while B
increased its abatement by one unit, adding 50 to its costs.
Total abatement would then be unchanged but costs would fall by
50.

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Pollution Abatement

(2) Now let an emissions tax of 80 per tonne of pollution

be imposed.
Low-cost firm B now abates pollution by 120 tonnes.
High-cost firm A abates by 60 tonnes.
This is the efficient way of producing 180 tonnes of
abatement since the two firms have the same abatement
costs at the margin, thus minimizing the total cost of
reducing pollution by 180 tonnes.

Tradable Pollution Abatement

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Firm A

Cost per tonne eliminated []

Firm B

120

80

50

30

60

90

Tons of pollution generated

120

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Tradable pollution permits

Tradable permits achieve the same results as the most efficient tax.
Each firm produces 150 tonnes of pollution when no abatement procedures
are followed.
Abatement reduces the amount of pollution but at a rising marginal cost.
Each firm is originally given an endowment of permits to emit 60 tonnes of
pollution.
If no trading is allowed, the marginal costs of abatement are then 120 for A
and 50 for B.
With trading, B sells 30 tonnes worth of permits to A.
Firm A then pollutes by 90 tonnes and firm B by 30 tonnes.
The price of a permit is 80
This is the same as both firms marginal cost of abatement at their new levels
of pollution.

[i] Pricing Policies for Natural Monopolies

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D1

MC
ATC

Price

p2
c1
p1

q1

q1

Output
[i]. Losses in a falling-cost industry

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Pricing policies for natural monopolies (i) falling cost

Marginal cost pricing leads to losses:
The output at which marginal cost equals price is q1
The associated price is p1.
Average costs are falling at output q1 so marginal costs are less than the
average cost of c1.
There is a loss of c1 p1 on each unit making a total loss equal to the dark
blue area.
Average cost pricing is inefficient:
The output at which average cost equals price is q2.
The associated price is p2.
Marginal cost is less than price at q2, so output is less than the socially
optimal level.

[ii] Pricing Policies for Natural Monopolies

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MC

D2

ATC

Price

p1
c1
p2

Output

q1

[i]. Profits in a rising-cost industry

q2

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Pricing policies for natural monopolies (ii) rising cost

Marginal cost pricing leads to profits:

The output at which marginal cost equals price is q1
The associated price is p1.
Average cost of c1 is less than price at output q1.
There is a profit of p1 - c1 on each unit sold, making a total profit
equal to the blue area.
Average cost pricing is inefficient:
The output at which average cost equals price is q2.
The associated price is p2.
Marginal cost exceeds price at q2, so output is greater than the
socially optimal level.

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CHAPTER 19: MARKET SUCCESS AND MARKET FAILURE

Basic Functions of Government

Effective governments have a monopoly of violence.
They also define and protect the rights and obligations
of property owned by individuals and institutions.
Key characteristics of market economies are [a] their
ability to co-ordinate decentralised decisions without
conscious control, [b] their determination of the
distribution of income, and [c] compared with the
alternatives, their minimisation of arbitrary economic
power.

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CHAPTER 19: MARKET SUCCESS AND MARKET FAILURE

Market Efficiency
A perfectly competitive economy is allocatively efficient
because it produces where price, which measures the
value consumers place on the last unit produced, equals
marginal cost, which measures the value to consumers
that the resources used to produce the marginal unit
could produce in other uses.
This maximises the sum of producers and consumers
surpluses.
Free markets can fail to achieve efficiency because of
inefficient exclusion of users from facilities with excess
capacity, common property resources, public goods,
externalities, asymmetric information, missing markets
and market power.

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CHAPTER 19: MARKET SUCCESS AND MARKET FAILURE

Rivalrous and Excludable Goods

The optimal price for the service of a facility
with excess capacity is zero.
Since private owners will charge a positive
price, their facility will be inefficiently
underused.
The private market will exploit a common
property resource to the point where the
average revenue per producer equals the
production cost of a new entrant instead of to
the socially optimal level, where the marginal
addition to total product caused by a new
entrant equals its production cost.

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CHAPTER 19: MARKET SUCCESS AND MARKET FAILURE

Externalities
The Coase theorem shows that if those parties that create an
externality and those that are affected by it can bargain
together with minimal transaction costs, all inefficiencies can
be removed.
Where private bargaining is impossible, the government can
alleviate externalities by imposing rules and regulations or,
more efficiently, by internalising externalities through such
measures as taxes and tradable permits to pollute.

Public Policy Towards Monopoly and Competition

Government policy with respect to market power is designed
to encourage competitive practices and discourage
monopolistic ones.
It seeks to regulate natural monopolies either by running
them as nationalised industries [the UK solution in the past]
or by putting them in private hands and regulating them [the
typical UK solution today].

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CHAPTER 19: MARKET SUCCESS AND MARKET FAILURE

Direct control of pricing and entry conditions of some

key oligopolistic industries has been common in the
past, but deregulation is reducing such control.
The move to deregulation was largely the result of
the experiences that oligopolistic industries are a
major engine of growth, as long as their firms are
kept competing; that direct control of such industries
has produced disappointing results in the past; and
that forced cross-subsidisation can have serious
consequence for some users.
An important issue concerns the effect of market
structure on economic growth.