Module 5: Market Failure and the Role of the Public Sector

• Principle 5: Markets are good, except when they fail
• Market Failure

  When a market by itself, fails to allocate resources efficiently.

  Market failure can happen due to externalities or products
• Externality - The uncompensated impact of one person’s action on the well-being of a bystander
• Negative Externality

  • One agent’s action (which cannot be priced) adversely affects another’s welfare
  • Ex: smoking, firms that produce plastics → plastics are thrown

  Positive Externality

  • One agent’s action (which cannot be priced) benefits another
  • Ex: Research (firms can take advantage of research), education 
• Positive Externality

  • Social Marginal Cost < Private Marginal Cost
  • PMC fails to internalize the external benefits of production to other firms
  • Ex: Development of production processes that spillover to other firms
• Negative Consumption Externality

  • Social Marginal Benefit < Private Marginal Benefit
  • PMB fails to take into account the marginal damage / external costs of consumption
  • Ex: Smoking
• Positive Externality

  • Social Marginal Benefit > Private Marginal Benefit
  • PMB fails to realize that their consumption is beneficial for other people
  • Ex: concerts
• Private Solution to Externalities:

  • Coase Theorem by Ronald Coase
• Coase Theorem

  If private parties can bargain without cost over the allocation of resources, they can arrive at an efficient resource allocation
• For Coasean bargaining to work, at the minimum the following should hold:

  1. Property rights (who owns the property) must be clearly defined
  2. There must be little to no transaction costs (Cost of bargaining or negotiating)
•  Public Solution to Externalities

  1. Regulation

  • Government prohibits an action that generates a negative externality

  1. Pigouvian taxation / Subsidies

  • Impose taxes or subsidies to reflect the true social costs or benefits
  • If taxes can be set equal to the external cost, these corrective Pigouvian taxes can achieve efficient outcomes
  • Caveat: need to know accurate external costs
• Market Solution to Externalities

  1. Tradeable Permits

  • Government sets a cap on an externality (“cap”), issues permits on this quota, and lets firms trade (“trade”) these permits if they need to pollute more
• Excludability

  • The property of a good where people can be prevented from enjoying it
• Rivalry

  • The property of a good where if I use it, it diminishes your use of it
•  Because public goods are non-excludable and non-rival, it is prone to the free-rider problem and therefore, will be underprovided by the market
• Free Riding Problem - When individuals benefit from a good without paying for its production.
• a Private Good is an excludable and rival good
• Club good is an excludeable and non-rival good
• Impure public good is non-excludeable and rival good
• Pure public good is non-excludebale and non-rival
• Negative Production Externality

  • Social Marginal Cost > Private Marginal Cost
  • PMC fails to internalize the negative external cost of the production externality
  • Private firm only faces private costs
  • Ex: factory emitting harmful gasses into the atmosphere
• Non-excludability


  A kind of good that means that it is very costly to prevent the consumption of the good by a subset of individuals
• Non-rivalrous


  A kind of good that means that the consumption of one economic agent does not affect the consumption of another economic agent