Chapter 4

Market Failures, Public Goods, and

Externalities

McGraw-Hill/Irwin © 2012 The McGraw-Hill Companies, Inc., All Rights Reserved.

 In this chapter:
1. Market Failure
2. Sources of Market Failure
3. Externalities
4. Public Goods
5. Congestible Public Goods
6. Free rider problem
 Market Failure
• Market Failure: The circumstance where the
market outcome is not the economically efficient
outcome.

• The individual incentives for rational behavior do

not lead to rational outcomes for the group.

• In other words, each individual makes the correct

decision for themselves, but those prove to be
the wrong decisions for the group.

• In traditional microeconomics, this is shown as a

steady state disequilibrium in which the quantity
supplied does not equal the quantity demanded.
3-3
 Possible Sources of Market Failure
• Consumption or production can harm an innocent third
party.

• A market failure occurs when prices do not match

reality. In this distorted market, prices do not represent
the supply and demand of a service or product
correctly, and there’s a mismatch between the individual
needs and supply in a free market.

• The buyer may not be able to make a well-informed

choice.

• A buyer or seller may have too much power over the

price.

3-4
 Possible Sources of Market Failure
• Externalities (Consumption or production can harm an innocent third
party).

• Asymmetric Information (this form of market failure occurs where one

agent in a market transaction has more information than the other).

• Public Goods
• Natural Monopoly (There are products and services where markets
cannot work efficiently, supported mainly by technical reasons. A typical
example is water distribution.

• Business Cycles (Fluctuations in the business cycle, indicated by the up

and down deviations of output from its potential is another form of market
failure, which distorts price mechanism and the flow of goods and
services, and eventually leads to an inefficient allocation of resources.

3-5
 Possible Sources of Market Failure

• As we studied market structures, you learned

that most fall into the broad category of
imperfect competition.

• Because these structures do not allocate goods

and services in the most efficient way, economists
call them market failures.

• Market failure - a situation in which the

market fails to allocate resources efficiently.

• But imperfect competition is not the only form of

economic inefficiency.
3-6
 Is poverty a market failure?

Poverty is considered to be a result of market failure. When a

recession hits, the poverty rate increases because employees
lose their jobs or lose working hours, which results in no income
or less income, respectively.

Inequality, which is a component of market failure, can

eventually lead to poverty when wealth is not distributed
equally throughout society. This can be remedied with
government intervention, such as by taxing the wealthy more or
incorporating subsidies for those below the poverty level.

3-7
 Causes of Market Failures

• 1. Externality
You might think of externalities as spillover
effects, either costs or benefits, resulting from
the actions of companies or individuals.

externality- a cost or benefit that

arises from production or
consumption of a good or service
that falls on someone other than the
producer or consumer
3-8
 Examples
• For example, providing good public education mainly benefits
the students, but the benefits of this public good will spill over
to the whole society.

• On the other hand, a negative externality is a negative effect

resulting from the consumption of a product, and that results in
a negative impact on a third party.

• For example, even though cigarette smoking is primarily

harmful to a smoker, it also causes a negative health impact
on people around the smoker.

3-9
 Negative Externalities
Negative externality - a cost of
production or consumption that
falls on someone other than the
producer or consumer; a negative
side effect
• When a factory dumps
chemical waste into a
river and the polluted
water affects the health
of people who live
downstream.

3-10
 Negative Externalities

• When a neighbor holds a

party with loud music that
keeps you up at night.

3-11
 Positive Externalities
positive externality - a benefit of production or
consumption that falls on someone other than
the
producer or consumer; a positive side effect

3-12
 Positive Externalities

• An person receiving a
vaccination not only
decreases the likelihood
of the individual's own
infection, but also
decreases the likelihood
of others becoming
infected through contact
with the individual.

3-13
 Public Goods
• You might remember public goods & services
as those provided by the government that
benefit all people at the same time.
• When we look at public goods & services as a
market failure, the definition is slightly different.
public goods - goods and services
that are not provided by the market
system because of the difficulty of
getting people who use them to pay
for their use.
3-14
Public Goods

3-15
 Private Goods
• Private goods are different from public goods
in that they are not paid for by the government
and they are sold in markets for a profit. The
business that produce these goods are owned
and operated by private citizens not
governments.

private goods - goods and services

that are sold in markets; distinct
from public goods
3-16
Private Goods

3-17
 Private and Public Goods

• Purely private good: a good with the

characteristics of both exclusivity and
rivalry.
• Purely public good: a good with the
neither of the characteristics
exclusivity and rivalry.

3-18
 Public vs. Private Goods
• Economists make two key distinctions between public
& private goods.

• First, private goods are excludable. This means that

anyone who does not pay for the good can be
excluded from using it. A grocery store, for example,
will sell apples only to customers willing to pay for
them.

3-19
 Public vs. Private Goods
• Second, private goods are said to be rival in
consumption, which means that a good cannot be
consumed by more than one person at the same
time. Thus, for example, if you buy an apple and eat
it, that apple is no longer available for anyone else to
eat.
In contrast, public goods are nonrival in
consumption. One person’s use of a
streetlight’s glow does not diminish another’s
ability to use its light as well.

3-20
3-21
Public vs. Private Goods

3-22
 Congestible Public Goods
• Rivalry but no excludability

• There are public goods where, after a

point, the enjoyment received by the
consumer is diminished by crowding or
congestion.

• These are called Congestible Public

Goods. Examples: roads and parks
3-23
 Private and Public Goods
Issues arise out of Pure Public Goods:
1)DIFFERENT VALUES
- while everyone consumes the same amount, people may value it
differently.
-National defense protects everyone equally. However not all people
appreciate them equally.

2) PUBLIC GOODS ARE NOT ABSOLUTE

- A beautiful view becomes rival if there is a crowd.
- The marginal cost of allowing another person to benefit from a pure public
good is zero, while the marginal cost of providing a greater level of public
good is positive.

3-24
 Private and Public Goods
• 3) THE PUBLIC SECTOR CAN PROVIDE PRIVATE
GOODS
- Medical services, housing, licenses, and utilities can all be
provided by the government and/or private sector.

4) PUBLIC PROVISION ≠> PUBLIC PRODUCTION

- Some public services are contracted out to private contractors

3-25
Private and Public Goods

3-26
Private and Public Goods

3-27


3-28
 Free rider problem
• Free rider problem is a phenomenon associated with
public goods
• It arises because public goods are non-rival and non-
excludable
• Non-rival means consumption of public good does not
reduce or diminish the availability of others
• Non-excludable means it is impossible to exclude others
from consuming the good
• Because of the aforementioned features, some individuals
may use public goods without actually contributing to the
cost of financing the good

3-29
3-30
 The Free Rider Problem

• This would encourage other consumers also

to follow the suit and enjoy the public good
‘free’ of cost
• This phenomenon is called free-rider or
easy-rider problem.
•Because of these two characteristics non-
paying users are not excluded from the use of
public good.

3-31
 The Free Rider Problem
• So, there are considerable free riders for
public goods

• Free rider problem and externalities

associated with public goods are tow sides of
the same coin

• Because of this, public goods are

underprovided causing markets for public
goods to fail.
3-32
 Asymmetric Information
• There are classically two forms of asymmetric information
(information failure) namely adverse selection and moral hazard.

• Adverse selection refers generally to a situation in which sellers

have information that buyers do not have, or vice versa, about
some aspect of product quality.

• The buyer may not be able to make a well-informed choice.

• A moral hazard is an idea that a party protected from risk in some

way will act differently than if they didn't have that protection
(salaried employees who take long breaks)

3-33
 POLICIES TO COMBAT FAILURES
• Legislative measure: This for example has a wider remit as it
involves the establishment of legal powers that identify
loopholes, normally viewed as the responsible factors for
market failures in society .

• Setting Reasonable Taxation measure: in this situation,

governments are considered to be the bed-rock of tax policies,
In this regard, levying taxes on certain products like tobacco
may have its desired good impacts as the cost of future
illnesses from smoking may be used to fund relevant health
care provision or even supporting victims who may be
addictive to nicotine, derived from high consumption of
tobacco products.

3-34
 POLICIES TO COMBAT FAILURES
• Creation of Property Rights: in order to or limit the abusive
utilization of publicly accessible goods or services like lakes,
forest and sea front / beaches, government as a central
authority may need to establish some level of privatisation
measures of these named publicly utilised assets to continue
their usage for both present and future generations.

• In this case, market failure can be prevented by levying fines

to make sure the environment is not overly depleted at the
expense of the present and future generations.

3-35
 POLICIES TO COMBAT FAILURES
• Provision of Subsidies: This in most cases can be a
responsibility for central governments to make sure
opportunities are created for citizens in areas concerned with
facilities like education and public health.

• This is considered to favour positive externality as the

provision of subsidy geared towards reducing high tuition fees
for example, leads to a situation of increased level of access
to post-secondary education, where prospective students are
made to enter universities to improve their knowledge to
compete in the open market. This also comes with the benefit
of improving quality of graduate entry into the world of work.

3-36