The Market Mechanism, Market Failure and Government Intervention in Markets
Externalities and Market Failure
Externality: a cost or benefit for the third parties outside the market.
How externalities lead to the ‘wrong’ quantity of a goof being produced and consumed
When negative externalities are generated in the course of production, part of the true or real costs of production are not borne by the
producer, instead being dumped on others (a ‘spill over’ effect).
This means that, even in competitive markets, if negative production externalities are created, good end up being under-priced. The
market as created the wrong incentives, as the price under-reflects the true costs of production, which include the cost of the negative
externalities, hence over production/consumption.
The opposite happens when firms generate positive production externalities. Prices end up being too high, leading to the ‘wrong’ quantity
of the good being produced and consumed. Once again, the market has created the wrong incentives, which discourages consumption. In
this case, prices over-reflect the true costs of production, hence under production/consumption.
The concepts of marginal private, external and social costs and benefits
At the heart of microeconomic theory lies the assumption that, in a market situation, an economic agent considers only the private costs
and benefits resulting from its market actions, ignoring any costs and benefit imposed on others.
For the agent, private benefit maximisation occurs when: MPB=MPC (free market position on marginal analysis diagram).
However, social benefit maximisation, which maximises the public interest or the welfare of the whole community, occurs when:
MSB=MSC.
Orthodox or traditional economic theory usually assumes that households and firms seek to maximise their private benefit or self-interest,
net of costs, and not the wider social interest of the whole community. They ignore the effects of their actions on other people. However,
when externalities are generated, costs and benefits are inevitably imposed on others, so maximising net private benefit no longer
coincided with the maximisation of net social benefit.
Social benefit = private benefit + external benefit. Hence, MSB=MPB + MEB.
Social Cost = private cost + external cost. Hence, MSC=MPC + MEC.
Using marginal analysis to show how negative production externalities cause market failure.
Using Marginal Analysis to show how negative production externalities cause market failure
Example of pollution emitted by a fossil-fuel burning power station. Initially assumed that when a coal-burning power station generates
electricity, only negative externalities are discharged. Given this simplification, the MPB accruing to the power station from the production
of electricity = MSB received by whole community.
As pollution is discharged in the course of production, the MSC of electricity production exceed MPC incurred by power station. Hence
MSC curve above MPC curve. The vertical distance between the 2 curves shows the MEC at each level of electricity production.
Power station maximises private benefit at output q1, where MPC = MPB. However, socially
optimal level output Q2 (MSC=MSB) not achieved. Thus, the privately optimal level of output
is greater than the socially optimal level of production (market forces over-produce the
amount of electricity by amount Q1-Q2). The market fails as the power station produces the
wrong quantity of the good (too much electricity). At free-market price P1, electricity is too
cheap, the price would have to rise to P2 to reflect the socially optimal level of consumption.
Shaded area represents ‘loss’ of welfare/deadweight loss, exists at free-market output Q1
(MPC=MPB), all the way back to socially optimal level output Q2. Due to for units Q2-Q1,
MSC>MSB. Society better off if units Q2-Q1 not produced, and resources allocated elsewhere.
DWL eliminated at socially optimally level output Q2 (MSC=MSB).
Using Marginal Analysis to show how positive production externalities cause market failure
Whereas negative production externalities lead to the MSC > MPC, positive production
externalities MPC > MSC. Illustrated in figure highlighting costs incurred when a commercial
forestry company plants trees.
Positive production externalities generated by tree planting include improved water retention
in soil and a carbon sink effect, whereby trees absorb greenhouse gases from the atmosphere.
, Vertical distance between the two curves shows a negative MEC at each level of tree planting (exact same as positive MEB enjoyed by
whole of society).
Shaded area DWL, exists at free-market output Q1 (MPC=MPB), all way forward to socially optimal output Q2 (MSB = MSC DWL
eliminated). Net social ‘welfare gain’ if trees between Q1-Q2 are planted as MSB > MSC up to where MSB = MSC.
In order to maximise its PB, commercial forestry plants Q1 trees (free-market level output) where MPC = MPB). However, Q1 less than
socially optimal level output Q2, where MSB = MSB. Hence, figure illustrates fact that, when positive production externalities are
generated, the market fails as under produced/consumed, depicted by distance Q2-Q1.
Negative Externalities and Allocative Efficiency
A perfectly competitive economy can, in theory at least, achieve a state of allocative efficiency when P = MC reached in all markets that
make up the economy. However, allocative efficiency could only occur if:
• There were competitive markets for all goods and services, including future markets
• There were no economies of scale
• Markets were simultaneously in equilibrium
However, impossible for markets throughout the economy – or indeed throughout the world economy - to meet all these conditions, so
allocative efficiency is an abstract rather than a real-life concept. In the context of market failure, we can now add a 4th requirement for
allocative efficiency to be achieved:
• When P = MC there would be no externalities, negative or positive
Ignoring the 4 bullet points, in the long run, profit maximisation occurs in a perfect market at the price where P = MPC. In the absence of
externalities, this also means that the P = MSC. As we have seen, when the production of a good causes pollution, external costs are
generated, MSC > MPC, means when P = MPC, P< MSC.
To achieve allocative efficiency, P = true marginal cost of production; MSC as well as MPC. However, in a market situation, profit-
maximising firms are assumed only to take into account MPC/MPB. When externalities exist, the market mechanism fails to achieve an
allocatively efficient outcome.
Firms evade part of the real cost of production by dumping externalities on third parties. The price the consumer pays for the good reflects
only the private cost of production, and not the true cost, which includes the external cost. Firm’s output hence under-priced, causing
over-consumption, resulting in misallocation of resources (too many scarce resources being used by the industry that is producing the
negative externalities).
Positive Consumption Externalities and Merit Goods
A merit good, such as education or healthcare, is a good or service for which the social benefits of consumption enjoyed by the whole
community exceed the private benefits received by the consumer. Consumption by an individual arguably produces positive externalities
that benefit the wider community. The community benefits from an educated (and civilised) population, and a healthy population means
there are fewer people to catch diseases from.
If educational services were to be provided solely through the market, and the
market prices, too few people would benefit from education. The privately optimal
level of consumption Q1 (MPC=MPB). This is below socially optimal level Q2,
where MSC=MSB. According to this analysis, free-market provision of merit goods
leads to under-consumption.
The MSB of units of education between Q1 and Q2 is greater than the MSC of
these units. Producing and consuming these units will add to the welfare of society.
Suppose the government reacts by providing a subsidy, which reduces
the price of education to P2. At the subsided price, consumption rises to
socially optimal level of Q2. Market failure corrected and DWL
eliminated.
Using Marginal Analysis to show how negative consumption externalities cause over-consumption of demerit goods
The consumption of demerit goods leads to the dumping of negative externalities on others. According to the first characteristic of a
demerit good (negative externalities), the consumption of goods such as tobacco and alcohol by an individual leads to the dumping of
negative externalities on third parties.
Figure shows that too much tobacco is consumed when brought at market prices unadjusted
by taxes of minimum price laws. At least in the short term, the privately optimal level of
consumption is Q1 (MPC=MPB), greater than the socially optimal level of consumption, Q2,
located where MSC = MSB.
Externalities and Market Failure
Externality: a cost or benefit for the third parties outside the market.
How externalities lead to the ‘wrong’ quantity of a goof being produced and consumed
When negative externalities are generated in the course of production, part of the true or real costs of production are not borne by the
producer, instead being dumped on others (a ‘spill over’ effect).
This means that, even in competitive markets, if negative production externalities are created, good end up being under-priced. The
market as created the wrong incentives, as the price under-reflects the true costs of production, which include the cost of the negative
externalities, hence over production/consumption.
The opposite happens when firms generate positive production externalities. Prices end up being too high, leading to the ‘wrong’ quantity
of the good being produced and consumed. Once again, the market has created the wrong incentives, which discourages consumption. In
this case, prices over-reflect the true costs of production, hence under production/consumption.
The concepts of marginal private, external and social costs and benefits
At the heart of microeconomic theory lies the assumption that, in a market situation, an economic agent considers only the private costs
and benefits resulting from its market actions, ignoring any costs and benefit imposed on others.
For the agent, private benefit maximisation occurs when: MPB=MPC (free market position on marginal analysis diagram).
However, social benefit maximisation, which maximises the public interest or the welfare of the whole community, occurs when:
MSB=MSC.
Orthodox or traditional economic theory usually assumes that households and firms seek to maximise their private benefit or self-interest,
net of costs, and not the wider social interest of the whole community. They ignore the effects of their actions on other people. However,
when externalities are generated, costs and benefits are inevitably imposed on others, so maximising net private benefit no longer
coincided with the maximisation of net social benefit.
Social benefit = private benefit + external benefit. Hence, MSB=MPB + MEB.
Social Cost = private cost + external cost. Hence, MSC=MPC + MEC.
Using marginal analysis to show how negative production externalities cause market failure.
Using Marginal Analysis to show how negative production externalities cause market failure
Example of pollution emitted by a fossil-fuel burning power station. Initially assumed that when a coal-burning power station generates
electricity, only negative externalities are discharged. Given this simplification, the MPB accruing to the power station from the production
of electricity = MSB received by whole community.
As pollution is discharged in the course of production, the MSC of electricity production exceed MPC incurred by power station. Hence
MSC curve above MPC curve. The vertical distance between the 2 curves shows the MEC at each level of electricity production.
Power station maximises private benefit at output q1, where MPC = MPB. However, socially
optimal level output Q2 (MSC=MSB) not achieved. Thus, the privately optimal level of output
is greater than the socially optimal level of production (market forces over-produce the
amount of electricity by amount Q1-Q2). The market fails as the power station produces the
wrong quantity of the good (too much electricity). At free-market price P1, electricity is too
cheap, the price would have to rise to P2 to reflect the socially optimal level of consumption.
Shaded area represents ‘loss’ of welfare/deadweight loss, exists at free-market output Q1
(MPC=MPB), all the way back to socially optimal level output Q2. Due to for units Q2-Q1,
MSC>MSB. Society better off if units Q2-Q1 not produced, and resources allocated elsewhere.
DWL eliminated at socially optimally level output Q2 (MSC=MSB).
Using Marginal Analysis to show how positive production externalities cause market failure
Whereas negative production externalities lead to the MSC > MPC, positive production
externalities MPC > MSC. Illustrated in figure highlighting costs incurred when a commercial
forestry company plants trees.
Positive production externalities generated by tree planting include improved water retention
in soil and a carbon sink effect, whereby trees absorb greenhouse gases from the atmosphere.
, Vertical distance between the two curves shows a negative MEC at each level of tree planting (exact same as positive MEB enjoyed by
whole of society).
Shaded area DWL, exists at free-market output Q1 (MPC=MPB), all way forward to socially optimal output Q2 (MSB = MSC DWL
eliminated). Net social ‘welfare gain’ if trees between Q1-Q2 are planted as MSB > MSC up to where MSB = MSC.
In order to maximise its PB, commercial forestry plants Q1 trees (free-market level output) where MPC = MPB). However, Q1 less than
socially optimal level output Q2, where MSB = MSB. Hence, figure illustrates fact that, when positive production externalities are
generated, the market fails as under produced/consumed, depicted by distance Q2-Q1.
Negative Externalities and Allocative Efficiency
A perfectly competitive economy can, in theory at least, achieve a state of allocative efficiency when P = MC reached in all markets that
make up the economy. However, allocative efficiency could only occur if:
• There were competitive markets for all goods and services, including future markets
• There were no economies of scale
• Markets were simultaneously in equilibrium
However, impossible for markets throughout the economy – or indeed throughout the world economy - to meet all these conditions, so
allocative efficiency is an abstract rather than a real-life concept. In the context of market failure, we can now add a 4th requirement for
allocative efficiency to be achieved:
• When P = MC there would be no externalities, negative or positive
Ignoring the 4 bullet points, in the long run, profit maximisation occurs in a perfect market at the price where P = MPC. In the absence of
externalities, this also means that the P = MSC. As we have seen, when the production of a good causes pollution, external costs are
generated, MSC > MPC, means when P = MPC, P< MSC.
To achieve allocative efficiency, P = true marginal cost of production; MSC as well as MPC. However, in a market situation, profit-
maximising firms are assumed only to take into account MPC/MPB. When externalities exist, the market mechanism fails to achieve an
allocatively efficient outcome.
Firms evade part of the real cost of production by dumping externalities on third parties. The price the consumer pays for the good reflects
only the private cost of production, and not the true cost, which includes the external cost. Firm’s output hence under-priced, causing
over-consumption, resulting in misallocation of resources (too many scarce resources being used by the industry that is producing the
negative externalities).
Positive Consumption Externalities and Merit Goods
A merit good, such as education or healthcare, is a good or service for which the social benefits of consumption enjoyed by the whole
community exceed the private benefits received by the consumer. Consumption by an individual arguably produces positive externalities
that benefit the wider community. The community benefits from an educated (and civilised) population, and a healthy population means
there are fewer people to catch diseases from.
If educational services were to be provided solely through the market, and the
market prices, too few people would benefit from education. The privately optimal
level of consumption Q1 (MPC=MPB). This is below socially optimal level Q2,
where MSC=MSB. According to this analysis, free-market provision of merit goods
leads to under-consumption.
The MSB of units of education between Q1 and Q2 is greater than the MSC of
these units. Producing and consuming these units will add to the welfare of society.
Suppose the government reacts by providing a subsidy, which reduces
the price of education to P2. At the subsided price, consumption rises to
socially optimal level of Q2. Market failure corrected and DWL
eliminated.
Using Marginal Analysis to show how negative consumption externalities cause over-consumption of demerit goods
The consumption of demerit goods leads to the dumping of negative externalities on others. According to the first characteristic of a
demerit good (negative externalities), the consumption of goods such as tobacco and alcohol by an individual leads to the dumping of
negative externalities on third parties.
Figure shows that too much tobacco is consumed when brought at market prices unadjusted
by taxes of minimum price laws. At least in the short term, the privately optimal level of
consumption is Q1 (MPC=MPB), greater than the socially optimal level of consumption, Q2,
located where MSC = MSB.
