Economics Online Tutor

Market Failure
In order to avoid misconceptions about the term market failure as it applies to the
study of economics, start with a definition:

MARKET FAILURE: When the free market does not allocate resources to their most
efficient uses.

Market failure does not occur just because somebody doesn't agree with the
outcome of free markets.  That would be a normative issue.  
Economic thinking
requires dealing with positive, not normative issues.
Market failure involves the concept of externalities.  Externalities occur when
actions of producers or consumers affect third parties - people not involved in the
production, purchase, or sale of a particular good.  Externalities are sometimes
referred to as spillovers.

Externalities can be positive or negative.  An externality can be a spillover benefit
or a spillover cost.
A few more relevant definitions:

Private benefit: A benefit received by a party to a transaction.
Private cost: A cost paid by a party to a transaction.
Social benefit: Total benefit of a transaction - private benefit plus external benefit.
Social cost: Total cost of a transaction - private cost plus external cost.
An example of a positive externality: Flu vaccinations.

Each year, many people receive flu vaccinations.  The private cost is paid by the individuals receiving
the vaccinations (or their insurance companies).  The private benefit is the lower health risk and the
associated gain in peace of mind for the individuals receiving the vaccinations.  While many people are
involved in these transactions, many others are not.  For a variety of reasons, many people choose not
to receive this vaccination.  Those who do not receive the vaccination still receive a benefit: The larger
the number of people receiving vaccinations, the less likely that those who choose not to receive
vaccinations are to be exposed to the flu.  The general health of the population benefits from flu
vaccinations, not just those individuals who pay to receive them.

With a positive externality, the free market price and quantity does not factor in all of the benefits.  
Resources are under-allocated.  Too little production of the good in question occurs.  The free market
price and quantity will be determined by the equilibrium where the supply & demand curves intersect,
based only on private benefits and costs.  If all of the social benefits were included, the demand curve
would be farther to the right, creating an equilibrium with a higher price and a higher quantity.
An example of a negative externality: Air pollution.

If the unregulated production of a particular good involves polluting the air, this production imposes a
social cost that is not factored into the market price and quantity of the good being produced.  The
market price and quantity will be determined by the private costs and benefits only.  The social costs of
air pollution are many: Poor health for residents and animal life; increased medical expenses; shorter
life expectancies; missed work and production due to illness.  Even obscured scenery is a social cost.

With a negative externality, resources are over-allocated.  Too much production of the good in question
occurs.  If all of the social costs were included, the market supply curve would be farther to the left,
resulting in a higher price and a lower quantity.
The socially optimal level of externalities is not necessarily zero.  In the example of the flu vaccinations,
a solution that involves every single person in the population receiving a vaccine may indeed add in a
cost that exceeds the social benefit.  In the example of air pollution, a law that requires firms to emit
zero pollution may force firms to shut down, resulting in no production.  Shutting down production may
very well involve social costs in excess of the social costs caused by air pollution.
Possible solutions to the problems of externalities:

For positive externalities:
The government could pay a subsidy to consumers who purchase the
good.  This would mean that the cost to consumers would be less than the amount received by
producers.  If the amount of the subsidy is the amount that would induce enough demand to equal the
socially optimal level of production, then this would have the effect of shifting the demand curve to the
right.  This would result in the socially optimal level of production at the socially optimal price.  Efficient
allocation of resources would result.

The problems with this solution: No market exists to determine what level of production is socially
optimal.  That level requires some guesswork, and the result would be rather arbitrary.  Also,
government-paid subsidies involve problems relating to
the methods that governments have for
financing expenditures.

For negative externalities: Three possible solutions for negative externalities are a tax on
production, a government command, and marketable permits.

[In the following discussion, the generic term negative externalities is used, indicating that negative
externalities take many forms.  It might be easier to follow the discussion if you mentally substitute a
more specific term such as "pollution" for the term "negative externalities"].
Tax on production: A tax for a negative externality has the opposite
effect as that of a subsidy for a positive externality.  A tax on production
will increase the cost of production of the good in question, resulting in
a leftward shift in the supply curve.  If the tax is set at the proper level,
the result would be the socially optimal level of production at the
socially optimal price.  Efficient allocation of resources would result.

The problem with this solution: No market exists to determine the
socially optimal level of production.  Guesswork is involved, which
would produce rather arbitrary results.  One added benefit for the
government would be additional tax revenue.
Government command: Instead of imposing a tax on a negative
externality, the government could pass laws setting the legal upper
limits on the amount of the negative externality that is produced.

The problems with this solution: The limit would not be market-based; it
would instead be somewhat arbitrary.  Those who create the negative
externality would have no incentive to lower the production of the
negative beyond the legal limit.  With a tax, a firm would have an
incentive to find new technology that would lower the tax along with the
externality.  With a government command, no such incentive exists.  A
command will not necessarily lead to an efficient allocation of resources.
Marketable permits (also known as cap and trade): Cap and trade is a system that is designed to
eliminate many of the problems associated with the tax and the government command methods for
decreasing a negative externality.  It is the only method of the three that uses market forces to
determine the amount of a negative externality that is produced by any individual firm.  Cap and trade
works like this: The government sets a limit on the maximum amount of a negative externality that will
be allowed, but this limit is on an entire industry instead of an individual firm.  The government then
issues permits for the negative externality.  The total permits issued equal the maximum externality that
is allowed.  Any individual firm can produce as much of the externality as it wishes, as long as it has
enough permits to cover that amount.  If a firm wants to produce more of the negative externality than it
has permits for, it can only do so if it buys more permits from other firms in the industry.  The total of the
externality is controlled by the government industry-wide, but the market for permits determines the
amount of the externality produced by individual firms.  The permits will have their own market, and
their market price will create an incentive for firms to reduce production of the negative externality.

The market for permits could also be used to reduce the industry-wide amount of a negative externality.
 For example, an environmental group could decide to purchase permits with no intention of producing
the externality.  By holding permits, the environmental group could prevent the permits from being
used by firms that would produce the externality.
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