MARKET FAILURE

INTRODUCTION 

Before we go into the subject matter of market failure which is the focus of this unit, we shall examine two familiar events that are in some way connected with the phenomenon of market failure

Case I

Sarva Shiksha Abhiyan (SSA) is a centrally sponsored scheme implemented by the Government of India in partnership with the state governments, for universalising good quality elementary education for all children in the 6-14 age groups in a time- bound manner. Through this programme, the government aims to provide opportunity for children to learn about and master their natural environment in order to develop their potential intellectually, spiritually as well as materially. The ultimate objective is to bring in social, regional and gender quantity. 

Nearly everyone believes that providing basic education to all citizens is an important responsibility of the government. This is the reason why education is almost entirely administered and extensively financed by government. 

Questions

Why do you think governments should intervene to provide education?

What do you think the outcome will be if it is left to private entrepreneurs?

Case II

In November 2016, the Central Pollution Control Board (CPCB), the nation’s apex pollution  control  body,  has come up with the ‘Guidelines For Environmentally Sound Management (ESM) of End- of - Life Vehicles (ELVs)’ with the recommendation that the Union Environment Ministry draft  the  necessary legislative framework for the sector considering the growing concern about the health and environmental hazards posed by them. CPCB advocates disposing of  such vehicles in an environmentally friendly manner and recommends a system of “shared responsibility” involving all stakeholders—the government, manufacturers, recyclers, dealers, insurers and consumers.

The central board has called  for periodic  review of  the registration of all  vehicles by transport offices so that the environment is not harmed by the continued use of polluting vehicles as well as initiation of a massive awareness campaign aimed at sensitizing stakeholders like consumers about the environmental hazards posed by ELVs.

The above case is an example of how government departments and specifically constituted bodies address different issues to sustain our environment.

Question

Since citizens should ideally know the need for clean environment, why should governments interfere with the system?

THE CONCEPT OF MARKET FAILURE 

• The general belief is that markets are amazingly competent in organizing the activities of an economy as they are generally efficient and capable of achieving optimal allocation of resources.
• However, there are exceptions to this. Under certain circumstances, ‘market failure’ occurs, i.e. the market fails to allocate resources efficiently and therefore, market outcomes become inefficient. 
• 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.
• The reason for market failure lies in the fact that though perfectly competitive markets work efficiently, most often the prerequisites of competition are unlikely to be present in an economy.
•  Market failures are situations in which a particular market, left to itself, is inefficient. We shall first try to understand why markets fail and later, in the subsequent unit, proceed to identify the role of government in dealing with market failure. 
• We need to appreciate the fact that there are two aspects of market failures namely, demand-side market failures and supply side market failures. Demand-side market failures are said to occur when the demand curves do not take into account the full willingness of consumers to pay for a product.
•  For example, none of us will be willing to pay to view a wayside fountain because we can view it without paying. Supply-side market failures happen when supply curves do not incorporate the full cost of producing the product. For example, a thermal power plant that uses coal may not have to include or pay completely for the costs to the society caused by fumes it discharges into the atmosphere as part of the cost of producing electricity. 

WHY DO MARKETS FAIL? 

The pertinent question here is why do markets fail? There are four major reasons for market failure. They are: 

• Market power, 
• Externalities, 
• Public goods, and 
• Incomplete information 

We shall discuss each of the above in detail. 

Market Power 

• 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 and therefore, can charge a price that gives them positive economic profits.
•  Excessive market power causes the single producer or a small number of producers to produce and sell less output 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.
•  In the extreme case, there is the problem of non existence of markets or missing markets resulting in failure to produce various goods and services, despite the fact that such products and services are wanted by people.
•  For example, the markets for pure public goods do not exist. 

Externalities 

• We begin by describing externalities and then, proceed to discuss how they create market inefficiencies. As we are aware, anything that one individual does, may have, at the margin, some effect on others.
•  For example, if individuals decide to switch from consumption of ordinary vegetables to consumption of organic vegetables, they would, other things equal, increase the price of organic vegetables and potentially reduce the welfare of existing consumers of organic vegetables.
•  However, we should note that all these operate through price mechanism i.e. through changes in prices. The price system works efficiently because market prices convey information to both producers and consumers.
•  However, sometimes, the actions of either consumers or producers result in costs or benefits that do not reflect as part of the market price. Such costs or benefits which are not accounted for by the market price are called externalities because they are “external” to the market. 

In other words, there is an externality when a consumption or production activity has an indirect effect on other’s consumption or production activities and such effects are not reflected directly in market prices. 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. Since it occurs outside the price mechanism, it has not been compensated for, or in other words it is uninternalized or the cost (benefit) of it is not borne (paid) by the parties. 

• Externalities are also referred to as 'spillover effects', 'neighbourhood 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. 
• Externalities may be unidirectional or reciprocal. Suppose a workshop creates earsplitting noise and imposes an externality on a baker who produces smoke and disturbs the workers in the workshop, then this is a case of reciprocal externality. If an accountant who is disturbed by loud music but has not imposed any externality on the singers, then the externality is unidirectional.
•  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: 

• Negative production externalities 
• Positive production externalities
•  Negative consumption externalities ,and 
• Positive consumption externalities 

Negative Production Externalities 

• A negative externality initiated in production which imposes an external cost on others may be received by another in consumption or in production.
•  As an example, a negative production externality occurs when a factory which produces aluminum discharges untreated waste water into a nearby river and pollutes the water causing health hazards for people who use the water for drinking and bathing. Pollution of river also affects fish output as there will be less catch for fishermen due to loss of fish resources.
•  The former is a case where a negative production externality is received in consumption and the latter presents a case of a negative production externality received in production. The firm, however, has no incentive to account for the external costs that it imposes on consumers of river water or fishermen when making its production decision. 
• Additionally, there is no market in which these external costs can be reflected in the price of aluminum. 

Positive production externalities 

• A positive production externality initiated in production that confers external benefits on others may be received in production or in consumption. Compared to negative production externalities, positive production externalities are less common. 
• As an example of positive production externality received in production, we can cite the case of a firm which offers training to its employees for increasing their skills. The firm generates positive benefits on other firms when they hire such workers as they change their jobs. 
• Another example is the case of a beekeeper who locates beehives in an orange growing area enhancing the chances of greater production of oranges through increased pollination. A positive production externality is received in consumption when an individual raises an attractive garden and the persons walking by enjoy the garden. These external effects were not in fact taken into account when the production decisions were made. 

Negative consumption externalities 

• Negative consumption externalities are extensively experienced by us in our day to day life. Such negative consumption externalities initiated in consumption which produce external costs on others may be received in consumption or in production.
•  Examples to cite where they affect consumption of others are smoking cigarettes in public place causing passive smoking by others, creating litter and diminishing the aesthetic value of the room and playing the radio loudly obstructing one from enjoying a concert.
•  The act of undisciplined students talking and creating disturbance in a class preventing teachers from making effective instruction and the case of excessive consumption of alcohol causing impairment in efficiency for work and production are instances of negative consumption externalities affecting production. 

Positive consumption externalities 

• A positive consumption externality initiated in consumption that confers external benefits on others may be received in consumption or in production.
•  For example, if people get immunized against contagious diseases, they would confer a social benefit to others as well by preventing others from getting infected. Consumption of the services of a health club by the employees of a firm would result in an external benefit to the firm in the form of increased efficiency and productivity. 
• Having discussed the nature of externalities in production and consumption, we shall now examine how externalities cause inefficiency and market failure. Before we attempt this, we need to understand the difference between private costs and social costs.
•  Private cost is the cost faced by the producer or consumer directly involved in a transaction. If we take the case of a producer, his private cost includes direct cost of labour, materials, energy and other indirect overheads.
•  As we have mentioned above, firms do not have to pay for the damage resulting from the pollution which they generate. As a result, each firm’s private cost would be the direct cost of production only which does not incorporate externalities. 
• Social costs refer to the total costs to the society on account of a production or consumption activity. Social costs are private costs borne by individuals directly involved in a transaction together with the external costs borne by third parties not directly involved in the transaction. 

The presence of externalities creates a divergence between private and social 

Social Cost = Private Cost + External Cost

costs of production. When negative production externalities exist, social costs exceed private cost because the true social cost of production would be private cost plus the cost of the damage from externalities. If producers do not take into account the externalities, there will be over-production and market failure. Applying the same logic, negative consumption externalities lead to a situation where the social benefit of consumption is less than the private benefit. 

• Externalities cause market inefficiencies because they hinder the ability of market prices to convey accurate information about how much to produce and how much to consume. Given that externalities are more often negative, we shall focus on them. 
• A market exchange assumes that the participants have total control over every aspect of their product and that the prices (or fees) they charge represent the full cost of production plus profit. As a matter of fact, the producers of products with extensive negative externalities are not fully accountable for the full cost of their production which includes private as well as social costs. Recall our earlier case of the aluminum factory which causes pollution of river water.
•  As a matter of fact, the prices of aluminum tend to reflect only the private costs of the producer. Since externalities are not reflected in market prices, they can be a source of economic inefficiency. Production remains efficient only when all benefits and costs are paid for. 
• Negative externalities impose costs on society that extend beyond the cost of production as originally intended by the producer. Without government intervention, such a producer will have no reason to consider the social costs of pollution. When firms do not have to worry about the negative externalities associated with their production, the result is excess production and unnecessary social costs. The problem, though serious, does not usually float up much because: 

The society does not know precisely who are the producers of harmful externalities 

Even if the society knows it, the cause-effect linkages are so unclear that the negative externality cannot be unquestionably traced to its producer. 

The problem can be explained with the help of the figure below: 

Figure 2.2.1 

Negative Externalities and Loss of Social welfare 

• The equilibrium level of output that would be produced by a free market is Q1 at which marginal private benefit (MPB) is equal to marginal private cost (MPC).
•  Marginal social cost (MSC) represents the full or true cost to the society of producing another unit of a good. It includes marginal private cost (MPC) and marginal social cost (MSC).
•  Assuming that there are no externalities arising from consumption, we can see that marginal social cost (Q1S) is higher than marginal private cost (Q1E). Social efficiency occurs at Q2 level of output where MSC is equal to MSB. Output Q1 is socially inefficient because at Q1, the MSC is greater than the MSB and represents over production.
•  The shaded triangle represents the area of dead weight welfare loss. It indicates the area of overconsumption. Thus, we conclude that when there is negative externality, a competitive market will produce too much output relative to the social optimum. This is a clear case of market failure where prices fail to provide the correct signals. 

PUBLIC GOODS 

Paul A. Samuelson who introduced the concept of ‘collective consumption good’ in his path-breaking 1954 paper ‘The Pure Theory of Public Expenditure’ is usually recognized as the first economist to develop the theory of 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. 

Before we go on to discuss the distinguishing features of public goods and how they differ from private goods, it is pertinent to first understand the characteristics of private goods. 

Characteristics of Private Goods 

• Private goods refer to those goods that yield utility to people. Anyone who wants to consume them must purchase them. 
• Owners of private goods can exercise private property rights and can prevent others from using the good or consuming their benefits. 
• Consumption of private goods is ‘rivalrous’ that is the purchase and consumption of a private good by one individual prevents another individual from consuming it. In other words, simultaneous consumption of a rivalrous good by more than one person is impossible. 
• Private goods are ‘excludable’ i.e. it is possible to exclude or prevent consumers who have not paid for them from consuming them or having access to them. In other words, those who want to consume private goods must buy them at a price from its sellers. Excludability necessitates that consumers of private goods send the right signals in the market. A buyer of a private good is forced in a transaction to reveal what he or she is willing to pay for a good or a service. 
• Private goods do not have the free rider problem. This means that the private godds will be available to only those persons who are willing to pay for it. 
• Private goods can be parceled out among different individuals and therefore, it is possible to refer to total consumption as the sum of each individual’s consumption. Therefore, the market demand curve for a private good is obtained by horizontal summation of individual demand curves 
• All private goods and services can be rejected by the consumers if their needs, preferences or budgets change. 
• Additional resource costs are involved for producing and supplying additional quantities of private goods.

• Since buyers can be excluded from enjoying the good if they are not willing and able to pay for it, consumers will get different amounts of goods and services based on their desires and ability and willingness to pay.
•  Therefore, whenever there is inequality in income distribution in an economy, issues of fairness and justice tend to arise with respect to private goods. Normally, the market will efficiently allocate resources for the production of private goods.

Characteristics of Public Goods 

• Public goods yield utility to people and are products (goods or services) whose consumption is essentially collective in nature. No direct payment by the consumer is involved in the case of pure public goods. 
• Public good is non-rival in consumption. It means that consumption of a public good by one individual does not reduce the quality or quantity available for all other individuals. When consumed by one person, it can be consumed in equal amounts by the rest of the persons in the society. That is, your consumption of a public good in no way interferes with its consumption by other people. For example, if, you eat your apple, another person too cannot eat it. But, if you walk in street light, other persons too can walk without any reduced benefit from the street light. 
• Public goods are non-excludable. Consumers cannot (at least at less than prohibitive cost) be excluded from consumption benefits. If the good is provided, one individual cannot deny other individuals’ consumption. Provision of a public good at all by government means provision for all. For example, national defence once provided, it is impossible to exclude anyone within the country from consuming and benefiting from it. 
• Public goods are characterized by indivisibility. For example, you can buy chocolates or ice cream as separate units, but a lighthouse, a highway, an airport, defence, clean air etc cannot be consumed in separate units. In the case of public goods, each individual may consume all of the good i.e. the total amount consumed is the same for each individual. 
• Public goods are generally more vulnerable to issues such as externalities, inadequate property rights, and free rider problems. 
• Once a public good is provided, the additional resource cost of another person consuming the goods is ‘zero’. A good example is a Lighthouse near a sea shore to guide the ships. Once the beacon is lit, an additional ship can use it without any additional cost of provision. 
• Public goods are generally divided into two categories namely, public consumption goods and public factors of production. 
• A few examples of public goods are: national defence, highways, public education, scientific research which benefits everyone, law enforcement, lighthouses, fire protection, disease prevention and public sanitation. 
• A unique feature of public goods is that they do not conform to the settings of market exchange. The property rights of public goods with extensive indivisibility and nonexclusive properties cannot be determined with certainty. Therefore, the owners of such products cannot exercise sufficient control over their assets. For example, if you maintain a beautiful garden, you cannot exercise full control over it so as to charge your neighbours for the enjoyment which they get from your garden.
•  As a consequence of their peculiar characteristics, public goods do not provide incentives that will generate optimal market reaction. Producers are not motivated to produce a socially-optimal amount of products if they cannot charge a positive price for them or make profits from them. As such, though public goods are extremely valuable for the well being of the society, left to the market, they will not be produced at all or will be grossly under produced. 

Now that we have understood the difference between private goods and public goods, we shall examine the implications of these characteristics on the production, supply and use of these goods. As mentioned above, ideally competitive markets have sufficient incentives to produce and supply private goods. Because of the peculiar characteristics of public goods such as indivisibility, non excludability and nonrivalry, competitive private markets will fail to generate economically efficient outputs of public goods. That is why public goods are often (though not always) under-provided in a free market economy.