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CHAPTER 2 : PUBLIC FINANCE

UNIT 2: MARKET FAILURE

Market failure is a situation in which the free market leads to misallocation of society's scarce
resources in the sense that there is either overproduction or underproduction of particular
goods and services leading to a less than optimal outcome. Market failures are situations in
which a particular market, left to itself, is inefficient.

REASONS OF MARKET FAILURE

(1) Market power,

(2) Externalities,
(3) Public goods, and
(4) Incomplete information

MARKET POWER

Market power is also known as monopoly power. In case of monopoly, producer produces less
and charged high price from the consumer. Market power or monopoly power is the ability of
a firm to profitably raise the market price of a good or service over its marginal cost. Firms that
have market power are price makers. It can cause the single producer or small number of
producers to produce and sell lesser outputs than would be produced in a competitive market.
Market power can cause markets to be inefficient because it keeps price higher and output
lower than the outcome of equilibrium of supply and demand. There is also a danger of non
existence of markets resulting from failure to produce various goods.

EXTERNALITIES

When consumption or production activity of one has an indirect effect on other’s consumption
or production activities and such effects are not reflected directly in market prices, it is called
externalities. The unique feature of an externality is that it is initiated and experienced not
through the operation of the price system, but outside the market. The cost (benefit) of it is
not borne (paid) by the parties. Externalities are also referred to as 'spillover effects',
'neighborhood effects' 'third party effects' or 'side-effects', as the originator of the externality
imposes costs or benefits on others who are not responsible for initiating the effect.

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Unidirectional and Reciprocal Externalities

When one creates externality which affect another and another create externality at the same
time which affect the first, it is called reciprocal. But if one create externality which affect
another and no externality is created by the another person on the first person, it is called
unidirectional.

Positive and Negative externalities

Externalities can be positive or negative. Negative externalities occur when the action of one
party imposes costs on another party. Positive externalities occur when the action of one party
confers benefits on another party. The four possible types of externalities are:

(a) Negative production externalities

A negative externality initiated in production which imposes an external cost on others which
may be received by another in consumption or in production.

(b) Positive production externalities

A positive externality initiated in production that confers external benefits on others which
may be received by another in production or in consumption.

(c) Negative consumption externalities

A negative externality initiated in consumption which imposes external costs on others which
may be received by another in consumption or in production.

(d) Positive consumption externalities

A positive externality initiated in consumption that confers external benefits on others which
may be received by another in consumption or in production.

Market failure by extrernalities (Negative externalities)

Private cost: It is the total cost of production which is to be incurred by producer i.e. raw
material, labour, overhead etc.
Social costs: Social cost are private cost borne by individuals directly involved in a transaction
together with the external cost borne by the third parties not directly involved in the
transaction.

Social cost = Private cost + External cost

External cost is the damages from externalities.

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Price charged by producer is only private cost. It does not include external cost. There is no
consideration of externalities in the price of goods and services. Price is less than social cost so
there is over production of goods. As a result of over production of goods, there is loss of social
welfare which is equal to difference between social cost and social benefit. It is the situation of
market failure. It can be explained with the help of a graph.

Negative Externalities and Loss of Social welfare

PUBLIC GOODS

A public good (also referred to as collective consumption good or social good) is defined as one
which all enjoy in common in the sense that each individual’s consumption of such a good
leads to no subtraction from any other individuals’ consumption of that good.

Types of Goods
GOODS

PRIVATE GOODS
PUBLIC GOODS

Pure public goods

Impure public goods
Quasi public goods
Common access resources
Global public goods
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Private Goods

1) It yields utility to people. Anyone who wants to consume them must purchase them.
2) Owners of private goods can exercise private property rights.
3) Its consumption is ‘rivalrous’ that is consumption by one prevent consumption by other.
4) These are ‘excludable’ i.e. it exclude or prevent consumers who have not paid for them
from consuming them or having access to them.
5) Private goods do not have the free rider problem.
6) It can be rejected by consumers if their needs, preferences or budget change.
7) Additional production and supply require additional resource costs.
8) Whenever there is inequality in income distribution in an economy, issues of fairness and
justice tend to arise with respect to private goods.

A few examples of private goods are food item, clothing, television, car, house etc.

Pure Public Goods

1) No direct payment by the consumer

2) Public good is non-rival in consumption. That is, your consumption of a public good in no
way interferes with its consumption by other people.
3) Public goods are non-excludable. Consumers cannot be excluded from consumption
benefits. If the good is provided, one individual cannot deny another individual’s
consumption.
4) Public goods are characterized by indivisibility. The total amount consumed is the same for
each individual.
5) Public goods are generally more vulnerable to issues such as externalities and free rider
problems.
6) Once a public good is provided, the additional resource cost of another person consuming
the goods is ‘zero’.

A few examples of public goods are: national defense, public education, scientific research
which benefits everyone, law enforcement, lighthouses, fire protection, disease prevention
and public sanitation etc.

Impure Public Goods

There are some goods which is neither pure private goods nor pure public goods. Some
characteristics of public goods are there and some characteristics of private goods are there.
These are called impure public goods. Example, club goods( excludable but non rivoulrous –
cinema theaters) and variable use public goods (non excludable but rivalrous – National
Highways)

Quasi Public Goods

The quasi-public goods or services, also called a near public good (for e.g. education, health
services) possess nearly all of the qualities of the private goods and some of the benefits of
public good. It is easy to keep people away from them by charging a price or fee. However, it is

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undesirable to keep people away from such goods because the society would be better off if
more people consume them. This particular characteristic namely, the combination of virtually
infinite benefits and the ability to charge a price, results in some quasi-public goods being sold
through markets and others being provided by government.

Common Access Resources

Common access resources or common pool resources are a special class of public goods. Some
important natural resources fall into this category. For example fisheries, rivers, sea, earth
atmosphere etc. These are non-excludable as people cannot be excluded from using them.
These are rival in nature as their consumption lessens the benefit available to others. They are
generally available free of charge. Since price mechanism does not apply to common
resources, producers and consumers do not pay for these resources and therefore, they
overuse them and cause their depletion and degradation. This creates threat to the
sustainability of these resources and, therefore, the availability of common access resources
for future generations.

Global Public Goods

There are several public goods benefits of which accrue to everyone in the world. These goods
have widespread impact on different countries and regions, population groups and
generations. These are goods whose impacts are indivisibly spread throughout the entire
globe.

The Free Rider Problem

The incentive to let other people pay for a good or service, the benefits of which are enjoyed
by an individual is known as the free rider problem. In other words, free riding is ‘benefiting
from the actions of others without paying’. A free rider is a consumer or producer who does
not pay for a nonexclusive good in the expectation that others will pay.

Consumers take advantage of public goods without contributing sufficiently to their

production. The absence of excludability in the case of public goods and the tendency of
people to act in their own self-interest will lead to the problem of free riding. Briefly put, there
is no incentive for people to pay for the good because they can consume it without paying for
it. As such, if the free-rider problem cannot be solved, the following two outcomes are
possible:

1) No public good will be provided in private markets

2) Private markets will seriously under produce public goods even though these goods
provide valuable service to the society

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INCOMPLETE INFORMATION

Incomplete information arises due to the followings:

(1) Complex nature of product and services
(2) High cost of acquiring information and time consuming.
(3) Ignorance of people etc.

Information failure is widespread in numerous market exchanges. When this happens

misallocation of scarce resources takes place and equilibrium price and quantity is not
established through price mechanism. This results in market failure.

Asymmetric Information

Asymmetric information occurs when there is an imbalance in information between buyer and
seller. This can distort choices. Example, landlords may know more about their properties tha
tenants, a used car seller knows more about vehicle quality than a buyer etc.
These are situations in which one party to a transaction knows a material fact that the other
party does not.

Asymmetric information can result either in:

1. Adverse selection or
2. Moral hazards.

Adverse Selection

Adverse selection is a situation in which asymmetric information about quality eliminates high -
quality goods from a market. This phenomenon, which is sometimes referred to as the ‘lemons
problem’, is an important source of market failure.

Moral hazard

Moral hazard is opportunism characterized by an informed person’s taking advantage of a less

- informed person through an unobserved action. It arises from lack of information about
someone’s future behaviour. Moral hazard occurs when a party to an agreement knows that
he need not bear the consequences of his bad behaviour and that the consequences, if any,
would be borne by the other party.

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