Market Failure With Graphical Analysis Economics Essay

As Roral Coase indicated, the question to be decided is: Is the value of fish lost greater or less than the product which contamination of the stream makes possible. Thus, it is understand that concept of social efficiency is difficult to achieve because of unexpected costs. Government intervention to the economy can be justified when market fails to achieve social efficiency (Webster, 2003). Social efficiency occurs when marginal social cost (MSC) is equal to marginal social benefit (MSB) (Sloman and Garratt, 2011). The market demand curve reflects MSB from an economic activity and supply curve reflects MSC of it (Begg, 2009). Instead, markets do not always attain an efficient output because of under-production and over-production of some goods and services. Inefficient level of production causes deadweight lost which represents a decrease in total surplus and this is market failure (Parkins, 2012). Under these conditions, Pareto efficiency cannot exist. According to Verhoef (1997, p. 3) Pareto efficiency is, “a feasible situation, usually in terms of the allocation of goods and production factors, for which exists no other feasible situation that is weakly preferred by all agents”. So, he concludes that markets mostly fail to achieve Pareto efficiency. In the literature, the major causes of market failure are (Parkins, 2012; Sloman and Garratt; 2010; Bregg, 2009; Blink and Dorton, 2007; McAleese, 2004, Morey, 2012):


Public goods

Merit and De-merit goods

Market power

Factor Immobility

Imperfect information

The major causes of market failure with graphical analysis are discussed as follows.


Externalities are economic side effects and can be either positive or negative (Grant, 2003). Externalities are costs/benefits that are imposed on people who are not directly involved in economic activities (Henderson, 2005). Positive externalities (external benefits) have beneficial effects while negative externalities (external costs) have harmful effects on third parties (Grant, 2003). Externalities cause market failure since decision makers generally consider only marginal private cost (MPC) and marginal private benefit (MPB) (Grant, 2003).

There are four main types of externalities (Sloman and Garratt, 2010):

-Negative externalities of production

-Positive externalities of production

-Negative externalities of consumption

-Positive externalities of consumption

Production and consumption externalities cause differences between private and social costs of production and also private and social benefits of consumption (Margetts, 2012). Social cost equals to sum of private costs and external costs while social benefits equals to sum of private benefits and external benefits (Sloman and Garratt, 2010; Parkins, 2012).

Negative externalities of production:

Negative externalities of production occur when the production process imposes external costs on third-parties (Grant, 2003). It exists when MSC of production exceeds MPC of the firm. For example, the production of cars can cause air, noise and visual pollution. Pollution can be harmful for people who are living around the factory.

In Figure 1, MSC of production is above MPC. If a factory is interested in profit maximisation, it produces at Q. It is not producing at Q1, where MSC is equal to MSB, so it is market failure. There is an over-production (Q-Q1) that means misallocation of society’s resources (Blink and Dorton, 2007). Moreover, the overproduction (Q-Q1) causes welfare loss as well.

Positive Externalities of Production:

Positive externalities of production occur when the production or provision of some goods or services creates external benefits for third parties (Blink and Dorton, 2007). In this case, MSC of production is less than MPC. For example, if a car factory provides training to its employees, this raises costs of the factory but increases the productivity of workforce. If these employees leave that firm and start working in another firm, this creates benefits for new employers since they do not have to spend money on the training of their new employees. It is figured out in the following graph.

In the figure 2, MPC is above MSC. So the car factory produces at Q which is less than the social optimum output level at Q1. Between Q1 and Q, there is a potential welfare gain which is shown by the highlighted area. If the output level increases from Q to Q1, welfare would be gained. In this example, there is underproduction or provision of beneficial output that means misallocation of society’s resources and it causes market failure (Blink and Dorton, 2007).

Negative externality of consumption:

Negative externality of consumption occurs when the consumption of some goods and services impose external costs on third parties (Grant, 2003). It exists when MPB is greater than MSB. For example, the consumption of cigarettes has harmful effects on others who are not smoking, called passive smokers. This may cause cancer.

In figure 3, MPB is above MSB. This means that consumers are trying to maximise their private benefits without considering the externalities they create. There is over consumption of cigarettes, so it causes welfare loss to the society. This causes market failure. The welfare loss occurs when MSC is not equal to MSB (Grant, 2003).

Positive externalities of consumption:

Positive externalities of consumption occur when the consumption of some goods and services impose external benefits on third parties (Grant, 2003). It exists when MPB is less than MSB. For example, consumption of health care provides benefits for the whole society. If a person is healthy he won’t transmit diseases to others and healthy people will perform better.

In figure 4, MSB is above MPB. The consumption of health services is at Q1 with price P1. On the other hand, the socially optimum output level is at Q2 where MSC is equal to MSB. If consumption of health care services increase, welfare would be gained.

Public goods:

The two distinct characteristics of public goods are; non-rival and non-excludable (Tataw, 2011; Griffiths and Wall, 2007; McAleese, 2004; Borooah, 2003; Parkin, 2012). Thus, public goods can only be provided by the government and some private firms that are subsidised by the government (Sloman and Garratt, 2010). Lighting and pavement can be given as an example of non-rival goods (Dewar, 2010). Consumption of non-rival goods by one person does not prevent others using/consuming those goods (Grant, 2003). Lighthouses and national defence are examples of non-excludable goods (Johnson-Lans, 2004). Once they are made available for someone, they become available for everyone (Folland et al., 2007; Henderson, 2005). This will give rise to free rider problem. Free riders are the people who receive the benefits from goods and services without paying for them. So public goods are like externality (Begg, 2009). Based on the above conditions, Tataw (2011, p. ?) concludes that, “market failures arise because only a small quantity of public goods will be provided inefficiently in private markets.”

Merit Goods:

Merit goods create positive externalities when they are consumed (Margretts, 2012). This means that MSB exceeds MPB. This is presented in figure 5. The benefits of merit goods are not fully esteemed by typical consumers (Tataw, 2011). This causes under consumption and under provision of merit goods. In figure 5, consumption of merit goods are at Q, that is below the socially optimum output level, so this means misallocation of society’s resources and cause market failure.

De-merit goods:

Contrary to merit goods, consumption of de-merit goods have harmful effects on third parties and create negative externalities (Grant, 2003). Cigarettes and alcohol are examples of de-merit goods (Blink and Dorton, 2007). Consumption of alcohol may make the drinkers feel good but they can create disturbance in public places. This is indicated below.

In figure 6, MPB exceeds MSB. The consumption of alcohol is at Q1 which is above the socially optimum output level, so there is over consumption. This creates welfare loss.

Market Power:

In an imperfectly competitive market, firms are not able to produce at socially optimum output level (Sloman and Garratt, 2010) and it causes market failure. For example, in a monopolistic market, there is a single producer who can achieve profit maximisation in a short-run (Margetts, 2012). In this situation, producers produce where MC=MR, and this is reflected in figure 7.

In figure 7, monopolistic producer produces at Q1 which is profit maximisation level and it also represents privately optimum output level. Also, Q1 is below the socially optimum output level which is at Q2. In this scenario, benefits obtained by producers are much more than what consumers receive. This is represented by the deadweight loss and highlighted within the figure.

Factor Immobility:

Two main types of factor immobility are; geographical immobility and occupational immobility (Blink and Dorton, 2007). Immobility of resources, such as labour and capital, might result in misallocation of resources, an increase in unemployment level and productively inefficiency in the market (Grant, 2003). This is reflected in igure 8 with a PPF’s curve. In figure 8, points on the curve represent the productive efficient levels. The point E represents the productively inefficient point (Grant, 2003).

Imperfect Information:

Buyers and sellers may have inefficient choices if they are not fully informed about costs and benefits of consumption or production of goods and services (Grant, 2003; McAlleese, 2004). Imperfect information makes it difficult for economic decision makers for equate marginal benefit and marginal cost, so this causes market failure (Blink and Dorton, 2007). For example, the contribution of the merit goods to consumers is much more than what they think (Grant, 2003). This is partly because of imperfect information (Riley, 2012).

In figure 9, there is under consumption of merit goods. This prevents social efficiency and causes market failure.

As a conclusion, today’s environmental problems and monopolistic markets encourage government interventions and a need for a central authority to coordinate the market mechanism inevitable, after almost eighty years that was first introduced by Keynesian economics school of taught.

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