1. MARKET FAILURE
And Its DIAGNOSIS

2. MARKET FAILURE CAN OCCUR IN NO.OF WAYS –
 Some products can be under-produced or not at all. Thus
resources are under allocated to their production.
 Some good may be over-produced. Thus resources are
over allocated to their production.
 The production or consumption of some products affects
third parties with spill over, these social cost are not
included in their market price.
Market Failure implies a loss of allocative efficiency.
The potential total surplus in the market is not maximized.
A dead weight loss may exists.

3. Market Failure occurs where:
– Knowledge is not perfect - ignorance
– Goods are differentiated
– Resource immobility
– Market power
– Services/goods would or could not be
provided in sufficient quantity by the
market
– Existence of external costs and benefits
– Inequality exists

4. Reason of Market Failure -
1. Lack of or weak property rights
 Property is an asset that is either tangible( water, land) or intangible( patent, copyrights).
 The govt.estaliblishes property rights to ensure protection of assets and thus provide the
foundation of a capitalists/market based society.
 The owner of property have rights which means they can –
 use property in a way so that it doesn't diminishes the well being of others.
 Derive an income from using property like lease, rent.
 Sell, dispose off or sale the property.
 If there are no property rights on resources, consumers or producers will exploit them and
sometimes generate a negative externality. Eg- air pollution, water pollution.
 Property rights can reduce negative externalities of production.
eg – no property rights – over fishing, free fishing, fish stocks declining.
with property rights – fishing quota purchased, allotted to fishing companies.

5. Property rights regime and 3 different
types -
Good and
services
Public goods
Open access
and common
property goods
Semi-public
goods.
State owned
goods
Pure public
goods
Congestion
goods
Private goods

6. 2. Public goods –
 Private and pure public goods
Private goods Public goods
They are exclusive, transferable,
enforceable
They are non-exclusive ,non
transferable,enforceable-non
Rival in consumption Non-rival in consumption
They have positive marginal cost They have zero marginal cost.
Ex – owning a car, house as you have
rights to your property.
Ex- like national defense, biodiversity,
clean air.
People may have option of consuming it or
not.
People do not have an option of not
consuming

7.  Open access and common property goods
Open access Common property
Rival in consumption Rival in consumption
Non exclusive, non transferable, even
when ownership rights exists.
They are exclusive for group of people.
Rights or us may be transferable by
individual or group.
Non – enforceable There may not be legal title to
ownership but group may be able to
enforce their ownership rights by means
of social sanction.
Ex- ocean fisheries and migratory
wildlife.
Ex- common grazing land

8.  Semi public goods
 Non rival in consumption
 Zero marginal cost of provision
 Non exclusive although ownership rights exists.
 Even though the owner of service provider cannot exclude
others from consumption, consumers can choose not to
cosnume.
 Ex- radio and TV broadcast
In this case the signal strength does not depend on no. of
consumers (i.e.zero MC)
Consumers cannot be excluded but they may choose not to
receive signals by turning it off.

9.  Congestion goods
 The are exclusive
 Can be either rival or non- rival in consumption.
 They may exhibit the characteristics of private goods and public goods at different level of consumption.
 Ex- campsite, roads, bridges, fishing, historic sites. At level ob certain no. of people can enjoy amenities
without reducing other people enjoyment. Here MC=0.therefore public goods. After b congestion sets and MC =
+ve. After c,the MC = infinity. As congestion reaches max.
Cost
quantity
mc
b c0

10. 3.Externalities
 An externality is an effect that is ‘external’ to the causing agent. That is the
person causes an effect that impacts on other people.
 An externality is said to exists when the utility of an economic agent is
affected by the actions of another.
 An externality is often Negative. This occurs when the affected person suffers
a loss in utility that is uncompensated.
 An externality can also be Positive. This occurs when effect is beneficial to
the affected person.
Example –
Negative – air, water and noise pollution.
Positive – where one firms technological breakthrough benefits the other firms in
industry thiugh not contributed in research.

11. A Negative Externality Example
If there are no externalities,
P0Q0 is the equilibrium
If there are externalities,
the marginal social cost
differs from the marginal
private cost, and P0 is too
low and Q0 is too high to
maximize social welfare

12. A Positive Externality Example
If there are no externalities, P0Q0 is the equilibrium
If there are externalities,
the marginal social benefit
differs from the marginal
private benefit, and both
P0 and Q0 are too low to
maximize social welfare

13. Classification of externalities -
 Relevant externality
 An externality is not relevant so long as affected person is indifferent to it.
 It becomes relevant when affected person is made worse-off by activity and wants offending person
to reduce the level of it.
 Ex- chicken farm in backyard interferes with satisfaction you derive then it’s a relevant externality
but if high decibel music does not bother you then its not relevant.
 Pareto relevant externality
 Externality exists when its removal results in a pareto-improvement.
 It is a situation where its possible to take action such that affected person is made better-off
without making the offending person worse- off.
 When level of externality is optimal, it becomes pareto irrelevant.
 Ex – telephone company erects tall tower near forest but it reduces the scenic value of forest. A
pareto relevant externality exists because it is possible for telephone company to color that would
blend with foliage.

14.  Static and dynamic
 It can be explained with help of example.
 2 fishers who are operating under and open access or property rights regime.
 A static externality is when one creates an externality for other by overfishing.
 A dynamic externality if offending party is harvesting fish that nay have some
future value. like a juvenile fish species.
 Pecuniary externality
 The form which is transmitted through the price system.
 Externality is an ‘un-priced’ effect.
 When the externality is transmitted through higher-price or reduced cost.
 Ex- large business move into residential, therefore rentals go high. Thus
creating a negative externality.
when manufacturer benefits as result of a supplier reducing cost of product.

15. 4. Types of market structure
 Market power monopoly
 Inefficiencies
 Higher prices
 Incomplete information
 Imperfect knowledge of the market
can also cause market failure
 The lack of fully informed decision making might
lead to the market failure.
P1
P0
Q1 Q0
E0
E1

16. Failure by market structure
 Due to no.of buyers and seller.
 Entry barriers (licensing, syndicate etc.)
 Natural monopoly or market power
Market may also fail because –
 Market dominance by monopolies can lead to
under-production and higher prices than would exist
under conditions of competition.
 Factor immobility causes unemployment hence
productive inefficiency

17. Measures to correct market failure
– State provision
– Extension of property rights
– Taxation
– Subsidies
– Regulation
– Prohibition
– Positive discrimination
– Redistribution of income

18. Role of government in diagnosis of
market failure
Roles of the Government:
 Regulatory role
 Allocative role
 Distributive role
 Stabilization role

19. Regulatory response to structure failure
i. Control over industry structure – by antitrust policies, for instance,
telecom industry, diary industry, etc
ii.Direct control – by fixing the quantity and price of the products and
services.


20. Allocative Role
The government must determine how some resources are allocated. Collective
goods such as roads, education and health.
Distributive Role
The free market outcome results in an unfair distribution of income, so
the will intervene to assure everyone has a sufficient income. They do this
through benefits, state housing and educational courses.
Stabilization Role
The government intervenes in the market to ensure there is steady
growth. They do this through monetary and fiscal policy.

21. Methods of Dealing with Externalities
• Direct regulation is when the government directly limits the amount of a good
people are allowed to use
• Incentive policies
• Tax incentives are programs using a tax to create incentives for individuals to
structure their activities in a way that is consistent with the desired ends
• Market incentives are plans requiring market participants to certify that they
have reduced total consumption by a certain amount
• Voluntary solutions

22. Correcting Market Failure
• Firms don’t pay the External cost, as they
are not affected by the pollution.
• According to Pigou, if a tax = External cost
is imposed (Tax = EF), then the externality
can be internalised.
• Called Pigovian tax.
• Therefore if External cost is internalised,
then new equilibrium will be at G, and Q
will fall.
• Pollution levels or social costs will fall.

23. How to internalize external costs
• Pigovian taxes:
• Tax the polluter or the creator of the
externality.
Such as: Green taxes on carbon dioxide
releases, or on effluents from factories,
– Raising the prices of more polluting or more
environmentally damaging goods,
– Making polluters bear the cost of controlling or
mitigating their pollution.

24. Pigovian Subsidies:
• Reward by lowering the price and cost of
environmentally safe products, and techniques.
– Green products,
– Alternative renewable energy,
– Bio degradable plastics,
• These measures will send market signals to
reduce environmentally unsafe activities, and
encourage environmentally friendly ones.

25. THE END