Monday, March 26, 2012

Market Failure and Public Goods

What is Market Failure?

The quantity of a product demanded by consumers does not equate to the quantity supplied by suppliers. This is a direct result of a lack of certain economically ideal factors, which prevents equilibrium.

Market failures have negative effects on the economy because an optimal allocation of resources is not attained. In other words, the social costs of producing the good or service (all of the opportunity costs of the input resources used in its creation) are not minimized, and this results in a waste of some resources.

Example, the common argument against minimum wage laws. Minimum wage laws set wages above the going market-clearing wage in an attempt to raise market wages. Critics argue that this higher wage cost will cause employers to hire fewer minimum-wage employees than before the law was implemented. As a result, more minimum wage workers are left unemployed, creating a social cost and resulting in market failure.

Basically market failure occurs when markets do not bring about economic efficiency.

Government intervention occurs when markets are not working optimally i.e. there is a Pareto sub-optimal allocation of resources in a market/industry. In simple terms, the market may not always allocate scarce resources efficiently in a way that achieves the highest total social welfare.


There are plenty of reasons why the normal operation of market forces may not lead to economic efficiency.

Public Goods

Public Goods not provided by the free market because of their two main characteristics

Non-excludability where it is not possible to provide a good or service to one person without it thereby being available for others to enjoy

Non-rivalry where the consumption of a good or service by one person will not prevent others from enjoying it
Examples: Street lighting / Lighthouse Protection, Police services, Air defence systems, Roads / motorways, Terrestrial television, Flood defence systems, Public parks & beaches

Because of their nature the private sector is unlikely to be willing and able to provide public goods. The government therefore provides them for collective consumption and finances them through general taxation.

Merit Goods

Merit Goods are those goods and services that the government feels that people left to themselves will under-consume and which therefore ought to be subsidised or provided free at the point of use.

Both the public and private sector of the economy can provide merit goods & services. Consumption of merit goods is thought to generate positive externality effects where the social benefit from consumption exceeds the private benefit.

Examples: Health services, Education, Work Training, Public Libraries, Citizen's Advice, Inoculations


Few modern markets meet the stringent conditions required for a perfectly competitive market. The existence of monopoly power is often thought to create the potential for market failure and a need for intervention to correct for some of the welfare consequences of monopoly power.

The classical economic case against monopoly is that

Price is higher and output is lower under monopoly than in a competitive market
This causes a net economic welfare loss of both consumer and producer surplus
Price > marginal cost - leading to allocative inefficiency and a pareto sub-optimal equilibrium.
Rent seeking behaviour by the monopolist might add to the standard costs of monopoly. This includes high (possibly excessive) amounts of spending on persuasive advertising and marketing.
Libenstein's X-inefficiency may also result if the monopolist allows cost efficiency to drop. An upward drift in costs because of a lack of effective competition in the market-place can lead to consumers facing higher prices and a reduction in their real standard of living

Any exam question on market failure must make some reference to externalities. What are the potential market failures arising from externalities?

The social optimum output or level of consumption diverges from the private optimum.

Main problem is the absence of clearly defined property rights for those agents operating in the market. When property rights are not clearly defined, market failure is likely because producers & consumers may not be held to account

Don't forget that positive externalities can also justify intervention if goods are under-consumed (social benefit > private benefit)


Market failure can also be caused by the existence of inequality throughout the economy. Wide differences in income and wealth between different groups within our economy leads to a wide gap in living standards between affluent households and those experiencing poverty. Society may come to the view that too much inequality is unacceptable or undesirable.

Note here that value judgements come into play whenever we discuss the distribution of income and wealth in society. The government may decide to intervene to reduce inequality through changes to the tax and benefits system and also specific policies such as the national minimum wage


Government intervention may seek to correct for the distortions created by market failure and to improve the efficiency in the way that markets operate:-

1.Pollution taxes to correct for externalities
2.Taxation of monopoly profits (the Windfall Tax)
3.Regulation of oligopolies/cartel behaviour
4.Direct provision of public goods (defence)
5.Policies to introduce competition into markets (de-regulation)
6.Price controls for the recently privatised utilities


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