 Topics  Activities 2

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1: TOOLS OF ECONOMIC ANALYSIS Welcome to

2: TOOLS OF ECONOMIC ANALYSIS
Economics
3: ECONOMIC RESOURCES

4: ECONOMIC RESOURCES

5: ENTERPRISING

6: DEMAND THEORY

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7: DEMAND THEORY

8: SUPPLY THEORY

9: THEORY OF THE FIRM

10: SUPPLY THEORY

11: DISTRIBUTION THEORY

12: THEORY OF THE FIRM

13: GOVERNMENT INTERVENTION IN THE ECONOMY

14: THEORY OF DISTRIBUTION

15: INTERNATIONAL TRADE

16: GOVERNMENT INTERVENTION IN THE ECONOMY

17: MEASUREMENT OF ECONOMIC PERFOMANCE

18: INTERNATIONAL TRADE

19: MONEY AND PRICE LEVEL

20: MEASUREMENT OF ECONOMIC PERFORMANCE

21: MACRO ECONOMIC PROBLEMS AND POLICIES

22: MONEY AND PRICE LEVEL

23: MACRO-ECONOMIC PROBLEMS AND POLICIES

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 SOURCES OF MARKET FAILURE

By the end of this sub-topic, learners should be able to:

1. Explain market failure

2. Explain the reasons why th e gove rnme nt should inte rve ne in the
economy

Market failure
Market failure refers to a situation where there is inefficient allocation of resources
in an economy.
Market failure can be due to various factors like monopolies who charge high
prices and produce less output, under provision of public goods and negative
externalities.
It usually occurs when the price mechanism fails to allocate resources in an
efficient manner or when there is social welfare losses.

Public goods
Public goods have two main characteristics. These are non-rivalry and non-
excludable.
Non-rivalry means that any consumption by one party does not reduce the
consumption by another party, neither does it reduce someone's enjoyment or
increase the cost of production.
This means that the good is non-depletable.
Non-excludable means that everyone can enjoy or consume the goods even those
who have not paid for them.
Therefore, public goods are products whose consumption by an additional
individual does not reduce the amount consumed by existing consumers.
Once a public good is produced, the marginal cost of production for adding an
individual is zero.
Public goods can also be non-rejectable goods and this means that, one may not
be able to avoid the consumption of the good, for example air.
Public goods are different from private goods that are excludable, rivalry and
rejectable.
Private goods are scarce in supply, they have an opportunity cost and the
marginal cost of supply is positive.
Some of the examples of public goods are national defence, police services, street
lights and public drainages.
If there is a street light, then everyone will be able to use the light without
reducing the amount of light available for others.
During a war, the national defence cannot protect just a certain group but they
protect the whole nation, thus national defence is a public good.
When there is a flood, the government can construct a dam to protect the flooding
area. This can benefit everyone who is in that area despite the fact that they pay
tax or not.
There are goods like roads that have some elements of non-rivalry and non-
excludability but they have some limitations, for example to use a road one is
required to have a driver's licence. These are called Quasi-Public goods.
These goods are not produced by the price mechanism because they are non-
excludable. This means that producers may not be able to refrain non-payers from
consuming.
Also, it may not be possible to measure the amount of consumption by an
individual hence a market price cannot be established.
Under price mechanism, the main aim is to make profits hence they may fail to
produce public goods.
Public goods are also affected by the free rider problem.
Free rider problem is a market failure that usually occurs when people take
advantage of using common goods without paying for them.
Since anyone can consume the good, individuals will have no incentive of paying 100%
for the good.
Some may benefit from public goods and services without even paying tax to the
 government.
People may also pay small amounts that are less than the benefits they are
getting.
Therefore, price mechanism will not produce public goods or will under produce
public goods lest they run into losses.
When businesses fail to produce public goods, it leads to market failure.
In order to close that gap, the state is supposed to provide public goods since they
are highly demanded by individuals.
Also, the government will have to decide on the appropriate amount they can
produce to meet the needs of people thus they estimate the social benefits of
making public goods.
The optimal amount of public goods that are supposed to be produced is that
quantity at which the marginal cost of the last unit is equal to the sum of price
that consumers are willing to pay for that unit.
This can be shown in Fig 7.1.1.

Fig 7.1.1

Optimum Public Goods

At point e the social marginal cost (SMC) of an additional unit is equal to the sum
of values that is placed by individuals.

Efficiency is then achieved where SMC is equal to SMB.

Externalities
An externality refers to a cost or a benefit that is carried by individuals who are
not directly involved in production or consumption of a product.
They can be illustrated as the difference between social costs and social benefits,
and private costs and private benefits.
Externalities can either be positive or negative.

Positive externalities

These are the benefits that are enjoyed by the third party and they can also be
called external benefits.
Take for instance, a company can train its workers but if the workers leave the
company soon after training, then that will be a positive externality to the new
firm that will employ those people.
This is because the new firm will not compensate the previous employer for the
training done but they will enjoy the results of the training.

Negative externalities

Negative externalities can also be called external costs and they are costs that are
imposed to the third party.
Take for instance, the production of cars can result in noise and air pollution at an
area where the factory is located.
Therefore, noise and air pollution are the external costs that are passed to the
third party.

Social Costs
Social costs are the costs to the society attached to an economic activity.
They can also be referred to as the full opportunity cost or what consumers and
producers forego, for example price paid for the economic activity, plus what third
parties forego, for example clean air.
Therefore, social cost (SC) is equal to private costs (PC) plus negative externalities 100%
or external costs.
SC = PC + Negative externalities
 If there are no negative externalities, social costs will be equal to private costs.
However, in most cases external costs are usually greater than private costs.
Take for instance, smoking. The social cost of one individual smoking is the price
that is paid for the cigarettes (PC) plus air pollution and the burden imposed on
the health sector (negative externality).
Fig 7.1.2a and 2b illustrates social costs.

Fig 7.1.2

Negative Externalities

From fig 7.1.2a, it can be noted that a negative externality is created when
marginal social costs (MSC) are greater than marginal private costs (MPC).
In Fig 7.1.2b, when marginal private costs (MPC) are greater than marginal social
benefits (MSB) there is a negative externality.

Social benefits

This is the total benefit that is enjoyed by the society from an economic activity.
Social benefit (SB) is equal to private benefit (PB) plus positive externalities or
external benefits.
SB = PB + posive externalities

If an economic activity has no positive externality, then social benefit will be equal
to private benefits.
If benefits to the society from production and consumption are greater than private
benefits, then there is a positive externality.
Also, if the society carries less costs than the individual consumers and producers
there will be a positive externality as well.
This can be illustrated by Fig 7.1.3a and 3b.

Fig 7.1.3

Positive Externalities

Optimum output

Optimum output is the socially efficient output or the allocative efficient output.
This output is achieved where the marginal social benefit (MSB) is equal to
marginal social cost (MSC).
Allocative efficient output = MSB + MSC

Fig 7.1.4 illustrates allocative efficiency.

Fig 7.1.4

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 Positive Externalities

From Fig 7.1.3, at equilibrium (e), the marginal social costs will be equal to the
marginal social benefits.
At that point, the value that is placed on the last unit produced will be equal to
the full cost of producing that last unit.

Therefore, a point where MSC is equal to MSB indicates Pareto optimality.

Pareto optimality is a point where it is impossible to make someone better off
without making someone worse off.
On the other hand, in order for the firms to maximize their profits they produce
where marginal private cost (MPC) is equal to marginal private benefit (MPB).

If the output produced is where MSC is greater than MSB, then there will be
allocative inefficiency or socially inefficient allocation of resources.
This is also known as the welfare loss and it arises because the value placed by
consumers on the production of an extra unit will be less than what the society is
supposed to forego (MSC).

Welfare loss can also be seen where MSB is greater than MSC.
This means that the consumers will be putting more value on the product than on
the MSC of producing that product.

Market imperfections

Market imperfections occur when the production is mainly determined by producers

rather than consumers.
Market imperfections can also be referred to as imperfect competition.
Most firms operate under the conditions of imperfect competition.
These firms include monopolists, duopolies and oligopolists.
They restrict their output, increase their prices and produce where price exceeds
marginal costs.
The firms may also restrict entry of new firms in the industry and they are most
likely to do persuasive advertising.
People may end up buying products that are being sold instead of what they really
want.
Firms may also lack innovation hence they may not supply improved products to
their consumers in order to cut their costs.
Monopoly also exists in imperfect competition.
Monopoly is when there is a single supplier of a certain product or service in an
economy.
These firms usually produce one range of products and they charge very high
prices.
This can lead to an inefficient allocation of resources in an economy.

Common properties

These are resources that are not effectively owned by one individual and everyone
in the society has the right to use them.
Access to these resources is not controlled, hence no-one pays for the resources.
Since no one controls the use of common properties, people may end up misusing
the resources hence they are more likely to get depleted.
Take for instance, a common property like a fishing dam.
If no one is in control of the dam, then the economy is more likely to run out of
fish since people are not controlled.
Forests can also be common properties and people may destroy trees or even kill
animals because they are not monitored.
The government then needs to regulate the use of these common properties so as
to avoid market failures.

Merit goods

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These are goods that are highly desirable for the welfare of the society.
They can be classified as private goods, for example health services, education and
insurance
 insurance.
Consumer spending on merit goods is determined by private benefits in a pure
market system and the production is determined by private costs.
Merit goods have external benefits or positive externalities.
This means that the social benefits of consuming the product will be greater than
the private benefit of consuming that product.
However, consumers may fail to recognize their private benefits of consuming
certain products.
Take for instance, people may fail to recognize the benefits of vaccination.
When an individual is vaccinated, that person would have been protected from
diseases and the society will also benefit due to a reduction in diseases that can
be contagious.
People may also undervalue the importance of education and they may decide to
leave school, thus private and social benefits are lost.
The government is supposed to intervene so as to ensure that merit goods are
produced and consumed in the economy for the welfare of people.
Also, the government has to ensure that even those with low incomes benefit from
those goods.
There is under provision of merit goods when the price mechanism is in place.
This can make merit goods too expensive hence a need for government's
intervention to ensure efficient allocation of merit goods.
Therefore, the government may also subsidise private firms that produce merit
goods or reduce their taxes so as to boost their production.
This may lead to the reduction of the firm's prices to ensure affordability of those
goods to everyone in the society.
Fig 7.1.3 shows under consumption of merit good.

Fig 7.1.5

Under Consumption of
Merit Goods

Demerit goods

Demerit goods are products that are socially undesirable.

These goods are most likely to be overproduced by the price market system and
they are over-consumed by consumers.
Examples of demerit goods include alcohol, cigarettes and addictive drugs like
cocaine.
The price system is mainly focused on profits, hence they will produce goods that
are highly demanded.
If the society highly demand demerit goods, then the price mechanism will increase
their production.
However, demerit goods have negative externalities or external costs on the
society.
This means that the private costs incurred by a consumer are less than the social
costs that are experienced by the third party.
External costs and benefits are shown by Fig 7.1.5.

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