Lesson 02 - Market Failure, Public Goods & Externalities

611: Public Finance and
Taxation
Dr. Mohammed Jamal Uddin FCMA
Topic-2: Market Failure, Public Goods, and Externalities
Text: Stieglitz; chap-4,6,9

MBA, Evening,
Fall 2021
Contents
▪ Market failures and the role of government,

▪ Public goods,
▪ Efficiency conditions for public goods,
▪ Externalities,
▪ Private solution to externalities,
▪ Public sector solutions to externalities.
Market Failure
The economy is pareto efficient only under certain circumstances

or conditions. There are some important conditions under which
markets are not pareto efficient. These are referred to as market
failures, and they provide a rationale for government activity.
Six Basic Market Failures are:
1. Imperfect Competition,
2. Public Goods,
3. Externalities,
4. Incomplete Markets,
5. Imperfect Information,
6. Unemployment and other Macroeconomic Distributions.
Market Failure
1. Imperfect Competition:
• there must be a sufficiently large number of firms that each believes it has no
effect on prices,
• each firm is so small that it believes there is nothing it can do to affect prices.
• There are a variety of reasons why competition may be limited:
a) Natural Monopoly- a situation where it is chapter for a single firm to
produce the entire output than for each of several firms to produce part of it,
b) High Transportation costs- mean that goods sold by a firm at one location
are not perfect substitutes for goods sold at another location,
c) Imperfect information- mean if a firm raises its price it will not lose all of its
customers; it only faces a downward sloping demand curve,
d) Strategic behavior to discourages competition-means threaten to cut
prices if potential rivals enter, and such threats may both be credible and
serve to discourage entry,
e) Imperfections of competition -arise out of government actions.
Market Failure
2. Public Goods:
There are some goods that either will not be supplied by the market or if
supplied, will be supplied in insufficient quantity. An example on a large scale in
national defense; on a small scale, navigational aids. These are called pure
public goods.
Pure public goods have two critical properties :
a) First, it costs nothing for an additional individuals to enjoy their benefits;
formally there is zero marginal cost for the additional individual enjoying
the good.
b) Secondly, it is in general difficult or impossible to exclude individuals from
the enjoyment of a pure public good.
The market either will not supply, or will not supply enough of, a pure public
good.
Market Failure
3. Externalities:
There are many cases where the actions of one individual or one
firm affect other individuals or firms; where one firm imposes a
cost on other firms but does not compensate them, or
alternatively, where one firm confers a benefit on other firms but
does not reap a reward for providing it. These are called
externalities. Air and water pollutions-are examples.
Market Failure
3. Externalities:…
a) Negative Externalities: Instances where one individual’s
actions impose a cost on other are referred to as negative
externalities
b) Positive Externalities: Instances where one individual’s
actions confer a benefit upon others.
Whenever there are such externalities, the resources allocation
provided by the market will not be efficient. Since individuals do
not bear the full cost of the negative externalities they generate,
they will engage in an excessive amount of such activities;
conversely, since individuals do not enjoy the full benefits of
activities generating positive externalities, they will engage in too
little of these.
Market Failure
4. Incomplete Markets:
Whenever private markets fail to provide a good or service even through
the cost of providing it less than what individuals are willing to pay, there
is a market failure that we refer to as incomplete markets (because a
complete market would provide all goods and services for which the cost
of production is less than what individuals are willing to pay). Some
economists believe that private markets have done a particularly poor job
of providing insurance and loans, and that this provides a rationale for
government activities in these areas.
Why capital and insurance markets are imperfect?
a) Innovation
b) Transaction costs
c) Asymmetries of information and enforcement costs
Market Failure
5. Imperfect Information:
A number of government activities are motivated by imperfect
information on the part of consumers, and by the belief that the
market, by itself, will supply too little information. Information is,
in many respects, a public good. Giving information to one more
individual does not reduce the amount others have. Efficiency
requires that information be freely disseminated or, more
accurately, that the only charge be for the actual cost of
transmitting the information. The private market will often
provide an inadequate supply of information just as it supplies an
inadequate amount of other public goods.
Market Failure
6. Unemployment and other Macroeconomic Distributions:
The most widely recognized symptoms of market failure are the

periodic episodes of high unemployment both of workers and
machines. Most economists take the high levels of unemployment
as primary evidence that something is not working well in the
market. To some economists, high unemployment is most
dramatic and most convening evidence of market failure.
Market Failure
Redistribution and Merit Goods:
Even if the economy is pareto efficient, there are two further arguments for
government intervention:-
1. The first is income distribution. The fact that the economy is pareto efficient
says nothing about the distribution of income; competitive market may give
rise to a very unequal distribution, which may leave some individuals with
insufficient resources on which to live. One of the most important activities of
the government is to distribute income.
2. The second argument is that some believe that individuals, even when well
informed, do not make good judgments concerning the goods they consume,
thus providing a rationale for regulations restricting the consumption of some
goods, and for the public provisions of other goods, called merit goods.
Market Failure
Merit Goods:
Goods that the government compels individuals to consume like seat belts and
elementary education, are called merit goods.
Paternalism and Libertarianism:
The view that the governmental should intervene because it knows what is in
the best interest of individuals better than they do themselves is referred to as
paternalism.
The view that government should not interfere with the choices of individuals
is referred to as libertarianism.
Market Failure
Merit Goods:
Two Important Caveats to Economists’ General presumption Against

Government paternalism:-
1. The first concerns children. Someone must make paternalistic decisions

on behalf of children, either the parents or the state. Some treat children
as if they were the property of their parents, arguing that parents alone
should have responsibility for taking care of their children. But most argue
that the state has certain basic responsibilities.
2. The second caveats concerns situations where the government cannot,

at least without difficulty, commit itself to refrain from helping individuals
who make poor decisions.
Market Failure
◼ Two perspectives on the Role of Government:
1. Normative Analysis, 2. Positive Analysis
1. Normative Analysis:
The normative approach to the role of government asks, how can government
address market failures and other perceived inadequacies in the market’s
resource allocation …………….should do.
2. Positive Analysis:
The positive approach asks, what is it that the government does, what are its
effects, and how does the nature of the political process (including the incentives
it provides bureaucrats and politicians) help explain what the government does
and how it does it. So it focuses on describing and explaining both what the
government actually does and what its consequences are.
Market Failure
 Market Failure Approach:
The market failure approach to understanding the role of the government is

largely a normative approach. The market failure approach provides a basis for
identifying situations where the government ought to do something, tempered
by considerations of government failure.
Market Failure
 Public Goods:
Good with benefits that cannot be withheld from those who do not pay
and are shared by large groups of consumers are called public goods.
Public goods are usually made available politically through the ballot box
people vote to decide how much to supply rather than through the market
place, where those who care to pay the price can buy as much as they like
for their own exclusive use. In most cases, government provision of public
goods implies that the goods are freely available to all rather than being
sold in markets. The cost of making the goods available are usually financed
by taxes.
Market Failure
 Properties of Public Goods:
1. Non-rival consumption, 2. Non-exclusion
1. Non-rival consumption:-
Public goods are non-rival in consumption refers to cases for which one
person’s consumption does not detract from or prevent another person’s
consumption. For example, television and ratio transmissions are non-rival
in consumption.
2. Non-exclusion:
Public goods are non-excludable means that goods for which exclusion is
impossible. Air quality improvement has the property of non-exclusion.
Market Failure
 Properties of private Goods:
1. Rival Consumption, 2. Excludability
1. Rival Consumption:
Rival Consumption means that if a good is used by one person, it cannot be

used by another. For example, if Tom drinks a bottle of apple juice, Jerry
cannot drink that some bottle apple juice.
2. Excludability:
Private goods always have the property of excludability. Individuals can be

excluded from enjoying the good unless they pay for it.
Market Failure
 Private Goods vs. Public Goods:
Private goods have the properties of rival consumption and excludability;

public goods are characterized by non-rival consumption and non-
excludability.
Goods for which there is no rivalry in consumption and for which exclusion
is impossible are pure public goods.

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611: Public Finance and

Dr. Mohammed Jamal Uddin FCMA

Topic-2: Market Failure, Public Goods, and Externalities

Text: Stieglitz; chap-4,6,9

▪ Market failures and the role of government,

The economy is pareto efficient only under certain circumstances

6. Unemployment and other Macroeconomic Distributions:

The most widely recognized symptoms of market failure are the

Paternalism and Libertarianism:

Two Important Caveats to Economists’ General presumption Against

1. The first concerns children. Someone must make paternalistic decisions

2. The second caveats concerns situations where the government cannot,

1. Normative Analysis, 2. Positive Analysis

 Market Failure Approach:

The market failure approach to understanding the role of the government is

 Properties of Public Goods:

1. Non-rival consumption, 2. Non-exclusion

 Properties of private Goods:

1. Rival Consumption, 2. Excludability

Rival Consumption means that if a good is used by one person, it cannot be

Private goods always have the property of excludability. Individuals can be

 Private Goods vs. Public Goods:

Private goods have the properties of rival consumption and excludability;

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