Module -I : Introduction to public economics (15 Hours)

Sources of market failure

A market failure is a case in which a market fails to efficiently provide or allocate goods and
services. Market failures can be viewed as scenarios where individuals' pursuit of pure self-
interest leads to results that are not efficient– that can be improved upon from the societal
point of view. In neoclassical economics, market failure is a situation in which the allocation
of goods and services by a free market is not Pareto efficient, often leading to a net loss of
economic value. Market failures are often associated with public goods, time-inconsistent
preferences, information asymmetries, non-competitive markets, principal–agent problems,
or externalities. Mainstream economic analysis widely accepts that a market failure (relative
to Pareto efficiency) can occur for three main reasons: if the market is "monopolised" or a
small group of businesses hold significant market power, if production of the good or service
results in an externality (external costs or benefits), or if the good or service is a "public
good".

A monopoly exists when a specific person or enterprise is the only supplier of a particular
commodity. This contrasts with a monopsony which relates to a single entity's control of a
market to purchase a good or service, and with oligopoly which consists of a few sellers
dominating a market. Monopolies are thus characterized by a lack of economic competition
to produce the good or service, a lack of viable substitute goods, and the possibility of a high
monopoly price well above the seller's marginal cost that leads to a high monopoly profit.
The verb monopolise or monopolize refers to the process by which a company gains the
ability to raise prices or exclude competitors. In economics, a monopoly is a single seller. In
law, a monopoly is a business entity that has significant market power, that is, the power to
charge overly high prices.[3] Although monopolies may be big businesses, size is not a
characteristic of a monopoly. A small business may still have the power to raise prices in a
small industry (or market). Agents in a market can gain market power, allowing them to
block other mutually beneficial gains from trade from occurring. This can lead to inefficiency
due to imperfect competition, which can take many different forms, such as monopolies,
monopsonies, or monopolistic competition, if the agent does not implement perfect price
discrimination. It is then a further question about what circumstances allow a monopoly to
arise. In some cases, monopolies can maintain themselves where there are "barriers to
entry" that prevent other companies from effectively entering and competing in an industry
or market. Or there could exist significant first-mover advantages in the market that make it
difficult for other firms to compete. Moreover, monopoly can be a result of geographical
conditions created by huge distances or isolated locations. This leads to a situation where
there are only few communities scattered across a vast territory with only one supplier.
Australia is an example that meets this description. A natural monopoly is a firm whose per-
unit cost decreases as it increases output; in this situation it is most efficient (from a cost
perspective) to have only a single producer of a good. Natural monopolies display so-called
increasing returns to scale. It means that at all possible outputs marginal cost needs to be
below average cost if average cost is declining. One of the reasons is the existence of fixed
costs, which must be paid without considering the amount of output, what results in a state
where costs are evenly divided over more units leading to the reduction of cost per unit.
Externalities

In economics, an externality is the cost or benefit that affects a third party who did not
choose to incur that cost or benefit. Externalities often occur when the production or
consumption of a product or service's private price equilibrium cannot reflect the true costs
or benefits of that product or service for society as a whole. This causes the externality
competitive equilibrium to not be a Pareto optimality.

In simple terms, a negative externality is anything that causes an indirect cost to individuals.
An example is the toxic gases that are released from industries or mines, these gases cause
harm to individuals within the surrounding area and have to bear a cost (indirect cost) to get
rid of that harm. Conversely, a positive externality is any difference between the private
benefit of an action or decision to an economic agent and the social benefit. A positive
externality is anything that causes an indirect benefit to individuals. For example, planting
trees makes individuals' property look nicer and it also cleans the surrounding areas.

Voluntary exchange is by definition mutually beneficial to both business parties involved

because the parties would not agree to undertake it if either thought it detrimental to their
interests. However, a transaction can cause effects on third parties without their knowledge
or consent. From the perspective of those affected, these effects may be negative (pollution
from a nearby factory), or positive (honey bees kept for honey that also pollinate
neighboring crops). Neoclassical welfare economics asserts that, under plausible conditions,
the existence of externalities will result in outcomes that are not socially optimal. Those
who suffer from external costs do so involuntarily, whereas those who enjoy external
benefits do so at no cost.

A voluntary exchange may reduce societal welfare if external costs exist. The person who is
affected by the negative externalities in the case of air pollution will see it as lowered utility:
either subjective displeasure or potentially explicit costs, such as higher medical expenses.
The externality may even be seen as a trespass on their lungs, violating their property rights.
Thus, an external cost may pose an ethical or political problem. Negative externalities are
Pareto inefficient, and since Pareto efficiency underpins the justification for private
property, they undermine the whole idea of a market economy. For these reasons, negative
externalities are more problematic than positive externalities. [11]
Positive externalities, while Pareto efficient, are still market failures that undermine
allocative efficiency because less of the good will be produced than would be optimal for
society as a whole in a theoretical model with no government. If those externalities were
internalized, the producer would be incentivized to produce more. Goods with positive
externalities include education (believed to increase societal productivity and well-being,
though some benefits are internalized in the form of higher wages), public health initiatives
(which may reduce the health risks and costs for third parties for such things as
transmittable diseases) and law enforcement.

Positive externalities are often associated with the free rider problem. For example,
individuals who are vaccinated reduce the risk of contracting the relevant disease for all
others around them, and at high levels of vaccination, society may receive large health and
welfare benefits (herd immunity); but any one individual can refuse vaccination, still
avoiding the disease by "free riding" on the costs borne by others.

There are a number of theoretical means of improving overall social utility when negative
externalities are involved. The market-driven approach to correcting externalities is to
"internalize" third party costs and benefits, for example, by requiring a polluter to repair any
damage caused. But in many cases, internalizing costs or benefits is not feasible, especially if
the true monetary values cannot be determined.

Examples[edit]
Classification of externalities

Consumption Production

Negativ Negative externalities in

Negative externalities in production
e consumption

Positive Positive externalities in consumption Positive externalities in production

Negative[edit]
Light pollution is an example of an externality because the consumption of street lighting has an effect on
bystanders that is not compensated for by the consumers of the lighting.
A negative externality (also called "external cost" or "external diseconomy") is an economic
activity that imposes a negative effect on an unrelated third party. It can arise either during the
production or the consumption of a good or service. [12] Pollution is termed an externality because
it imposes costs on people who are "external" to the producer and consumer of the polluting
product.[13] Barry Commoner commented on the costs of externalities:
Clearly, we have compiled a record of serious failures in recent technological encounters with the
environment. In each case, the new technology was brought into use before the ultimate hazards
were known. We have been quick to reap the benefits and slow to comprehend the costs. [14]
Many negative externalities are related to the environmental consequences of production and
use. The article on environmental economics also addresses externalities and how they may be
addressed in the context of environmental issues.
"The corporation is an externalizing machine (moving its operating costs and risks to external
organizations and people), in the same way that a shark is a killing machine." - Robert
Monks (2003) Republican candidate for Senate from Maine and corporate governance adviser in
the film "The Corporation".
Examples for negative production externalities include:

Negative Production Externality

 Air pollution from burning fossil fuels. This activity causes damages to crops, materials
and (historic) buildings and public health. [15][16]
 Anthropogenic climate change as a consequence of greenhouse gas emissions from the
burning of fossil fuels and the rearing of livestock. The Stern Review on the Economics of
 Climate Change says "Climate change presents a unique challenge for economics: it is the
greatest example of market failure we have ever seen."[17]
 Water pollution by industries that adds effluent, which harms plants, animals, and
humans. Water usage from growing plants could impose a negative externality on citizens of
counties or states who are harmed by decreased water.
 spam during the sending of unsolicited messages by email. [18]
 Noise pollution during the production process, which may be mentally and
psychologically disruptive.
 Systemic risk: the risks to the overall economy arising from the risks that the banking
system takes. A condition of moral hazard can occur in the absence of well-
designed banking regulation,[19] or in the presence of badly designed regulation. [20]
 Negative effects of Industrial farm animal production, including "the increase in the pool
of antibiotic-resistant bacteria because of the overuse of antibiotics; air quality problems; the
contamination of rivers, streams, and coastal waters with concentrated animal waste; animal
welfare problems, mainly as a result of the extremely close quarters in which the animals are
housed."[21][22]
 The depletion of the stock of fish in the ocean due to overfishing. This is an example of
a common property resource, which is vulnerable to the Tragedy of the commons in the
absence of appropriate environmental governance.
 In the United States, the cost of storing nuclear waste from nuclear plants for more than
1,000 years (over 100,000 for some types of nuclear waste) is, in principle, included in the
cost of the electricity the plant produces in the form of a fee paid to the government and held
in the nuclear waste superfund, although much of that fund was spent on Yucca
Mountain without producing a solution. Conversely, the costs of managing the long-term
risks of disposal of chemicals, which may remain hazardous on similar time scales, is not
commonly internalized in prices. The USEPA regulates chemicals for periods ranging from
100 years to a maximum of 10,000 years.
 Increased usage of antibiotics propagates increased antibiotic-resistant infections.
 The development of ill-health, notably early-onset Type II diabetes and metabolic
syndrome, as a result of companies over processing foods - primarily the removal of fiber
and the addition of sugars.
Examples of negative consumption externalities include:

Negative Consumption Externality

 Noise pollution: Sleep deprivation due to a neighbor listening to loud music late at night.
 Antibiotic resistance, caused by increased usage of antibiotics: Individuals do not
consider this efficacy cost when making usage decisions. Government policies proposed to
preserve future antibiotic effectiveness include educational campaigns, regulation, Pigouvian
taxes, and patents.
 Passive smoking: Shared costs of declining health and vitality caused by smoking or
alcohol abuse. Here, the "cost" is that of providing minimum social welfare. Economists more
frequently attribute this problem to the category of moral hazards, the prospect that parties
insulated from risk may behave differently from the way they would if they were fully exposed
to the risk. For example, individuals with insurance against automobile theft may be less
vigilant about locking their cars, because the negative consequences of automobile theft are
(partially) borne by the insurance company.
 Traffic congestion: When more people use public roads, road users experience
(congestion costs) such as more waiting in traffic and longer trip times. Increased road users
also increase the likelihood of road accidents. [23]
 Price increases: Consumption by one consumer of goods in addition to their existing
supply causes prices to rise and therefore makes other consumers worse off, perhaps by
preventing, reducing or delaying their consumption. These effects are sometimes called
"pecuniary externalities" and are distinguished from "real externalities" or "technological
externalities". Pecuniary externalities appear to be externalities, but occur within the market
mechanism and are not considered to be a source of market failure or inefficiency, although
they may still result in substantial harm to others.[24]
 Second-hand smoke from cigarettes or marijuana: As cannabis legalization is
considered, one potential negative consumption externality associated with legalization
policy could be the second-hand smoke that could harm other's lungs, or second-hand highs.
Positive[edit]
A positive externality (also called "external benefit" or "external economy" or "beneficial
externality") is the positive effect an activity imposes on an unrelated third party. [25] Similar to a
negative externality, it can arise either on the production side, or on the consumption side. [12]

Positive Production Externality

Examples of positive production externalities LTM

 A beekeeper who keeps the bees for their honey. A side effect or externality associated

with such activity is the pollination of surrounding crops by the bees. The value generated by
the pollination may be more important than the value of the harvested honey.
 The corporate development of some free software (studied notably by Jean
Tirole and Steven Weber [26])
 An industrial company providing first aid classes for employees to increase on the job
safety. This may also save lives outside the factory.
 Restored historic buildings. Visitors enjoy visiting historic buildings. Preserving historic
buildings provides an anchor to the past, as well as an incentive to the future. [27]
 A foreign firm that demonstrates up-to-date technologies to local firms and improves their
productivity.[28]
Positive Consumption Externality
Examples of positive consumption externalities include:

 An individual who maintains an attractive house may confer benefits to neighbors in the
form of increased market values for their properties.
 An individual receiving a vaccination for a communicable disease 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. (See herd immunity)
 Increased education of individuals, as this can lead to broader society benefits in the
form of greater economic productivity, a lower unemployment rate, greater household
mobility and higher rates of political participation.[29]
 An individual buying a product that is interconnected in a network (e.g., a smartphone).
This will increase the usefulness of such phones to other people who have a video
cellphone. When each new user of a product increases the value of the same product owned
by others, the phenomenon is called a network externality or a network effect. Network
externalities often have "tipping points" where, suddenly, the product reaches general
acceptance and near-universal usage.
 In an area that does not have a public fire department, homeowners who
purchase private fire protection services provide a positive externality to neighboring
properties, which are less at risk of the protected neighbor's fire spreading to their
(unprotected) house.
The existence or management of externalities may give rise to political or legal conflicts. [citation needed]
Collective solutions or public policies are implemented to regulate activities with positive or
negative externalities.

A good or service could also have significant externalities, where gains or losses associated
with the product, production or consumption of a product, differ from the private cost.
These externalities can be innate to the methods of production or other conditions
important to the market. Traffic congestion is an example of market failure that
incorporates both non-excludability and externality. Public roads are common resources
that are available for the entire population's use (non-excludable), and act as a complement
to cars (the more roads there are, the more useful cars become). Because there is very low
cost but high benefit to individual drivers in using the roads, the roads become congested,
decreasing their usefulness to society. Furthermore, driving can impose hidden costs on
society through pollution (externality). Solutions for this include public transportation,
congestion pricing, tolls, and other ways of making the driver include the social cost in the
decision to drive. Perhaps the best example of the inefficiency associated with
common/public goods and externalities is the environmental harm caused by pollution and
overexploitation of natural resources.

Non-excludability
Some markets can fail due to the nature of the goods being exchanged. For instance, some
goods can display the attributes of public goods[16] or common goods, wherein sellers are
unable to exclude non-buyers from using a product, as in the development of inventions
that may spread freely once revealed, such as developing a new method of harvesting. This
can cause underinvestment because developers cannot capture enough of the benefits from
success to make the development effort worthwhile. This can also lead to resource
depletion in the case of common-pool resources, where, because use of the resource is rival
but non-excludable, there is no incentive for users to conserve the resource. An example of
this is a lake with a natural supply of fish: if people catch the fish faster than the fish can
reproduce, then the fish population will dwindle until there are no fish left for future
generations.

Public, private and merit goods are interlinked in the economy. They satisfy the consumer in
different ways. Due to competition for resources question arises as to what should be
produced in the economy. In the course of production/consumption of some goods,
externalities a rise in the market, which leads to inefficiencies whereby the consumption
and production quantities do not match. An example of externality is pollution, where
market fails to provide solutions. The government in many ways can tackle inefficiencies due
to market failure. Because of non-rival and nonexcludability features of Public Goods, they
are not produced efficiently in the market.

Information asymmetry
information asymmetry deals with the study of decisions in transactions where one party has
more or better information than the other. This asymmetry creates an imbalance of power in
transactions, which can sometimes cause the transactions to go awry, a kind of market failure
in the worst case. Examples of this problem are adverse selection, moral hazard, and
monopolies of knowledge. Information asymmetry models assume that at least one party to a
transaction has relevant information, whereas the other(s) do not. Some asymmetric information
models can also be used in situations where at least one party can enforce, or effectively
retaliate for breaches of, certain parts of an agreement, whereas the other(s) cannot.
In adverse selection models, the ignorant party lacks information while negotiating an agreed
understanding of or contract to the transaction, whereas in moral hazard the ignorant party lacks
information about performance of the agreed-upon transaction or lacks the ability to retaliate for a
breach of the agreement. An example of adverse selection is when people who are high-risk are
more likely to buy insurance because the insurance company cannot effectively discriminate
against them, usually due to lack of information about the particular individual's risk but also
sometimes by force of law or other constraints. An example of moral hazard is when people are
more likely to behave recklessly after becoming insured, either because the insurer cannot
observe this behavior or cannot effectively retaliate against it, for example by failing to renew the
insurance.
Information asymmetry within societies can be created and maintained in several ways.
Firstly, media outlets, due to their ownership structure or political influences, may fail to
disseminate certain viewpoints or choose to engage in propaganda campaigns. Furthermore, an
educational system relying on substantial tuition fees can generate information imbalances
between the poor and the affluent. Imbalances can also be fortified by certain organizational and
legal measures, such as document classification procedures or non-disclosure clauses.
Exclusive information networks that are operational around the world further contribute to the
asymmetry. Lastly, mass surveillance helps the political and industrial leaders to amass large
volumes of information, which is typically not shared with the rest of the society. [

The existence of a market failure is often the reason that self-regulatory organizations,
governments or supra-national institutions intervene in a particular market. However,
government policy interventions, such as taxes, subsidies, wage and price controls, and
regulations, may also lead to an inefficient allocation of resources, sometimes called
government failure. An ecological market failure exists when human activity in a market
economy is exhausting critical non-renewable resources, disrupting fragile ecosystems
services, or overloading biospheric waste absorption capacities. In none of these cases does
the criterion of Pareto efficiency obtain.

Given the tension between the economic costs caused by market failure and costs caused
by "government failure", policymakers attempting to maximize economic value are
sometimes (but not always) faced with a choice between two inefficient outcomes, i.e.
inefficient market outcomes with or without government interventions. Most mainstream
economists believe that there are circumstances (like building codes or endangered species)
in which it is possible for government or other organizations to improve the inefficient
market outcome.

Policies to prevent market failure are already commonly implemented in the economy. For
example, to prevent information asymmetry, members of the New York Stock Exchange
agree to abide by its rules in order to promote a fair and orderly market in the trading of
listed securities. The members of the NYSE presumably believe that each member is
individually better off if every member adheres to its rules – even if they have to forego
money-making opportunities that would violate those rules.

A simple example of policies to address market power is government antitrust policies. As

an additional example of externalities, municipal governments enforce building codes and
license tradesmen to mitigate the incentive to use cheaper (but more dangerous)
construction practices, ensuring that the total cost of new construction includes the
(otherwise external) cost of preventing future tragedies. The voters who elect municipal
officials presumably feel that they are individually better off if everyone complies with the
local codes, even if those codes may increase the cost of construction in their communities.

CITES is an international treaty to protect the world's common interest in preserving

endangered species – a classic "public good" – against the private interests of poachers,
developers and other market participants who might otherwise reap monetary benefits
without bearing the known and unknown costs that extinction could create. Even without
knowing the true cost of extinction, the signatory countries believe that the societal costs
far outweigh the possible private gains that they have agreed to forego.
Some remedies for market failure can resemble other market failures. For example, the
issue of systematic underinvestment in research is addressed by the patent system that
creates artificial monopolies for successful inventions.

Prisoner’s Dilemma and Lindahl pricing techniques have helped us to understand how the
consumer behaves in the society and also an action of one person affects the action of
another person. Public good theory is widely applied in the day to day market where it can
be converted into a private good. It thus states that a good at one time can be public and
the same good at another time can be converted into private good.
Strategy for the prisoner's dilemma[edit]
Two prisoners are separated into individual rooms and cannot communicate with each other. The
normal game is shown below:

Prisoner B
Prisoner B stays
Prisoner B betrays
silent
(defects)
(cooperates)
Prisoner A

Prisoner A stays
Prisoner A: 3 years
silent Each serves 1 year
Prisoner B: goes free
(cooperates)

Prisoner A betrays Prisoner A: goes free

Each serves 2 years
(defects) Prisoner B: 3 years

It is assumed that both prisoners understand the nature of the game, have no loyalty to each
other, and will have no opportunity for retribution or reward outside the game. Regardless of what
the other decides, each prisoner gets a higher reward by betraying the other ("defecting"). The
reasoning involves an argument by dilemma: B will either cooperate or defect. If B cooperates, A
should defect, because going free is better than serving 1 year. If B defects, A should also
defect, because serving 2 years is better than serving 3. So either way, A should defect. Parallel
reasoning will show that B should defect.
Because defection always results in a better payoff than cooperation regardless of the other
player's choice, it is a dominant strategy. Mutual defection is the only strong Nash equilibrium in
the game (i.e. the only outcome from which each player could only do worse by unilaterally
changing strategy). The dilemma, then, is that mutual cooperation yields a better outcome than
mutual defection but is not the rational outcome because the choice to cooperate, from a self-
interested perspective, is irrational.

Economics example of PD
The prisoner's dilemma has been called the E. coli of social psychology, and it has been used
widely to research various topics such as oligopolistic competition and collective action to
produce a collective good.[29]
Advertising is sometimes cited as a real-example of the prisoner's dilemma. When cigarette
advertising was legal in the United States, competing cigarette manufacturers had to decide how
much money to spend on advertising. The effectiveness of Firm A's advertising was partially
determined by the advertising conducted by Firm B. Likewise, the profit derived from advertising
for Firm B is affected by the advertising conducted by Firm A. If both Firm A and Firm B chose to
advertise during a given period, then the advertisement from each firm negates the other's,
receipts remain constant, and expenses increase due to the cost of advertising. Both firms would
benefit from a reduction in advertising. However, should Firm B choose not to advertise, Firm A
could benefit greatly by advertising. Nevertheless, the optimal amount of advertising by one firm
depends on how much advertising the other undertakes. As the best strategy is dependent on
what the other firm chooses there is no dominant strategy, which makes it slightly different from a
prisoner's dilemma. The outcome is similar, though, in that both firms would be better off were
they to advertise less than in the equilibrium. Sometimes cooperative behaviors do emerge in
business situations. For instance, cigarette manufacturers endorsed the making of laws banning
cigarette advertising, understanding that this would reduce costs and increase profits across the
industry. This analysis is likely to be pertinent in many other business situations involving
advertising.
Without enforceable agreements, members of a cartel are also involved in a (multi-player)
prisoner's dilemma.[31] 'Cooperating' typically means keeping prices at a pre-agreed minimum
level. 'Defecting' means selling under this minimum level, instantly taking business (and profits)
from other cartel members. Anti-trust authorities want potential cartel members to mutually
defect, ensuring the lowest possible prices for consumers.