2. MARKET FAILURE
• Perfect competition – important assumption of
• The market, left to itself, allocates resources
• Leads to Efficiency in use of resources,
• Equity in distribution of resources.
• Maximises welfare of all economic units.
– There is equal distribution of income,
– Atomistic economic units.
– No imperfections in the market,
– Preferences are denoted through price changes i.e.
only through the market.
– Private ownership of assets and income,
3. • Not all these conditions may apply.
• Market failure occurs when one or more of
the efficiency conditions is not satisfied.
• Causes of market failure:
– Public goods,
– Uncertainties and imperfect information,
– No market for goods or services,
– Ethical considerations – Value Judgements
4. Perfect competition in product and factor
markets lead to:
• Private MC = Social Marginal cost
• Private MB = Social Marginal Benefit.
• All exchanges take place in a well defined
• All goods and services are privately owned.
• All utility comes only from material
• All goods and services are priced, there are
no free goods.
5. • Each good and service is provided individually and
separately, and is consumed individually and
• All consumers have equal incomes and status.
• All firms are of same size. No concentration of
• If these conditions are not satisfied, then:
PB/PA ≠ MRSx
and w/i ≠ MRTSM
K,L ≠ MRSN
But these assumptions do not exist in reality.
Therefore there is always a divergence between
Private and Social Costs and Benefits. These are
discussed in the following pages:
6. Externalities: unintended and uncompensated effects
of actions of one unit felt by other units.
• A consumer buys a commodity, where P = MU of that
• A firm pays hires Labour, where w = MP of labour.
• But there are many different types of consumption or
production for which no price is paid.
A) Positive Impacts: called External Economies or Benefits.
For e.g. a person plants a tree in his compound, others
get benefit of the shade. No payment for use of shade.
B) Negative Impacts: called External Diseconomies or Costs.
For e.g. effluents from a factory affect fishing in the river,
or cause diseases to those who consume the water. No
compensation paid to those who suffer from the
7. • Causes of Externalities:
– Joint consumption/production,
– No clearly defined property rights (common
– Unequal income distribution,
– No markets for these goods and services, not
Leads to divergence between Private and
Social Costs/ Benefits.
Does not lead to Pareto Optimality and
Maximisation of Social Welfare.
Prabha Panth 7
8. 1) External Diseconomy
For a firm Marginal Private Cost, PMC = MR.
But if the firm is emitting pollution, it leads to Social Costs
(Diseconomy). E.g. poisons from a pesticide factory let off
into a river. Fish die, people drinking that water are
poisoned. But this cost is not included in the costs or P of the
product. So Social cost > PMC.
Pigou :- this extra cost should be added to PMC, for each
unit of output produced.
This gives the Social Marginal Cost curve, SMC = MPC +
If a tax equal to the external cost is added, SMC lies above
PMC, and new equilibrium is at lower level of output,
Now the P of the product covers the Social Cost. Output falls
and the pollution is also reduced.
Prabha Panth 8
PMC = MR and rising, at E.
Output is Q0 and Market P = P0.
But pollution adds to social cost
= EE1 = external costs. This is
added to PMC to get SMC.
If Q0 is still produced, society
suffers = EE1. Actual cost to
society = 0P1.
Market P = P0 < SMC
Utility falls, so MSC ≠ MSB.
Pigou suggests Social tax = EE1 =
FF1. Tax = SMC - PMC
Then the firm is on SMC, and
equilibrium is at F. Output falls
to Q1, and pollution levels fall.
Socially acceptable levels. Social
cost FF1 = Pigovian tax, is
included in the price P0. When
SMC > PMC, then govt has to tax
the good to reduce its
Quantity of pesticide
10. Prabha Panth 10
2. External Economies or Benefits:
Q0 is education provided, which is
less than the SMB (Social Marginal
Benefit). E < E1.
Since social benefits > private
benefits, the market is under
supplying the service. If SMB is
included, then equilibrium is at F,
with output = Q1.
At F, PMC = SMB, but cost increases
to P1. If govt gives subsidy of FF1 =
P1P0, then education supply curve
shifts left to S2. Equilibrium at F1.
So where SMB > PMB, government
has to give subsidy, to increase
output at reduced cost/ price.
Thus the market over supplies goods
whose SMC > PMC, and under
supplies when SMB > PMB. Hence the
market is not efficient nor equitable.
Govt intervention is required, no
S1 = PMC = SMC
Figure 2 External
11. 2) Monopoly
• Monopoly does not satisfy Pareto optimal
1) MCx < Px i.e. MRTS x,y ≠ MRS x,y
2) Consumers take P as given, MRS < Px/Py
Taking 1 and 2 together,
MRTSxy < MRSxy
(since MRTS = MCx/Mcy).
In Monopoly P > MC, so MU≠ MC, even under
private cost-benefit analysis.
Prabha Panth 11
12. Prabha Panth 12
Fig.3 Monopoly vs.
In fig.3, Monopoly equilibrium is
at G, where MRM = MC and
MC, with P = PM and Q = QM.
But MC at G < PM. Shows
exploitation by monopolist.
If it was a Perfect Competition
Pc = MC at F, Q = Qc.
So Pc < PM,
And Qc > QM.
In the Edgeworth Box diagram, if
both goods A and B are
produced by monopolists, then:
Pa ≠ MCa ≠ MUa
Pb MCb MUb
In other imperfect markets also, none of the conditions of Pareto
optimality are fulfilled. Social welfare cannot be maximised. P.C. is thus a
crucial assumption of Pareto optimality, but the real markets in capitalist
countries are not of Perfect competition.
13. 3. Public Goods
• Public goods are those which one individual can
consume without reducing its availability to another
individual, and from which no one is
excluded. There is Joint Consumption.
– Non Rivalry in consumption: If one person consumes a
good, others can also consume it. Availability of this
good to others will not be reduced. E.g. defence, parks,
street lights, roads. But Private goods are ‘rival’, one
consumes it, others cannot consume it. The person
who buys the good alone enjoys it.
– Non Excludable: one person consumes a good, cannot
stop others from consuming it. For e.g. if one person
uses a road, he cannot stop others from using it.
Prabha Panth 13
14. – Public goods cannot be priced. What is the
price of defence, police, public roads? There is
no market for Public Goods, where buyers and
sellers meet and exchange.
– No ownership: No one owns the public goods –
they are common property. So there is over use
or exploitation of public goods.
– Taxes can be considered as payment for public
goods. But taxes are not same as prices, where
there is direct exchange for the good or service.
– Free riders: there are people who don’t pay
taxes, but enjoy the benefits of public goods.
Prabha Panth 14
15. 4. Other imperfections
Prabha Panth 15
AR = MR
Decreasing Returns: Even with perfect
competition, if there are decreasing
returns, no equilibrium is possible.
LRMC is always falling, and lies below
MR. Figure 4.
Uncertainty: if there is uncertainty
regarding future prices, availability, or
change in govt policy, then PC
equilibrium cannot be established.
Non existent and incomplete markets:
as seen in the lesson on Market
equilibrium, there could be non
existent markets, or incomplete
In cases of Market Failure, it is the responsibility of the govt to provide these
services to the public. The concept of Pareto Optimality, and the concept of
the Free Market maximising Social and Private welfare, is then only a myth. In
reality, govt intervention in a number of markets is inevitable for Social and
even Private welfare (e.g. ban on smoking).