Understanding Market Failure

Understanding Market Failure 

Microeconomics deals with the study of decision-making by actors within an economy like individual customers, employees, firms, and households. Microeconomics has a lot to do with understanding efficient and optimal use of resources, consumer behavior, its interplay in the marketplace with a look at market and government failure, and interventions for social good. Macroeconomics deals with national income, inflation, monetary policy, interest rates, business cycles, and various economic aggregates, while microeconomics deals with understanding economics at the smaller level. For example, macroeconomics will look at human beings to understand their economic and social consumption patterns while microeconomics focuses on activities within the human body example interplay of body parts, atoms, etc. The example is cited to explain the analogy between macro and microeconomics. The microeconomic series will feature many concepts with references from multiple books –  Economics by Lipsey and Crystal,  Microeconomics by McConnell, Brue Flynn, Principles of Microeconomics by Mankiw. As any reference to other books is used, the same will be cited.  All material is the copyright material of The middle Road. This educational series focuses on sharing an overview of market failures within the economy with a special focus on externalities. It is recommended that you brief through the first couple of chapters of a good microeconomics book. 

Externalities play a paramount role within our society. Climate change and passive smoking are excellent examples of negative externalities. The harmful emissions from factories release carbon dioxide and methane gas that cause global warming. WHO study estimates that every year more than 8 million people die due to Tobacco use. About 1.2 million deaths are of non-smokers (passive smokers) exposed to tobacco smoke. The costs associated with these externalities are colossal. At the same time, positive externalities increase the social benefit to society. This educational series is designed to make you think like policymakers – how do we lessen poisonous emissions or reduce deaths due to smoking.  

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Law of Diminishing Marginal Utility

In a market, there are three entities/actors or agents Individuals, firms (the private sector), and the government. Firms try to maximize profit and individuals try to maximize wellbeing or utility from the goods or services. The utility has a diminishing characteristic. For example, Top Gun is a long-distance runner. She is preparing for a half marathon and after a practice run, she is thirsty. Top Gun quenches her thirst by drinking lemonade with a tinge of masala. She gulps down the first glass, by the end of the third glass of lemonade, she is no longer thirsty. The first glass of lemonade has the highest utility of satisfaction and it iteratively reduces as the number of glasses increase. This is known as the Law of Diminishing Marginal UtilityRemember from module 1 that demand is downward sloping. Demand is a function of price, price of other products, Income or wealth, consumer preference or tastes, and finally influence of wellbeing, nutrition, environment etc. Any change in these factors shifts the demand curve but any movement in a demand curve indicates a change in the quantity demanded. When the demand curve is plotted, it follows the ceteris paribus i.e. keeping other factors constant.

For example, a product has been there in the market for a while. Recently due to R&D, the firm relaunches the product positioning the product as biodegradable and environment friendly. The relaunched product is approved in the European markets where it has been there for over a decade. That will happen to the demand for this product. The rise of ESG awareness will shift the demand curve to the right, thereby increasing the demand for the product at all price points. An increase in wealth increases the consumption of normal goods viz-a-viz decreasing the consumption of inferior products. An employee doubled his salary by joining a new firm. The person was working in an entry-level job. He was using a plain vanilla mobile. With his salary increase, the person will now buy a smartphone handset. Take mobiles as an example with a non-entry level smartphone as an inferior product. 


Before we venture out on this journey, let’s understand market failure. Market Failure occurs when free markets fail to achieve an efficient and optimal allocation of resources and goods. A mismatch between the optimum allocation of resources leads to a reduction of economic value or social welfare. The failure is when Adam Smith’s invisible hand fails to deliver i.e. the price is a function of the demand and supply equilibrium. At equilibrium, the quantity demanded is equal to the quantity supplied. Refer to the side fig (Q*). The case is notable in the case of perfect competition where there are many buyers and sellers (producers/firms) selling identical products at market price. Perfect competition is very rare, in perfect competition, the producer and consumer surplus are maximum – markets are efficient. (Producer surplus is the difference between the actual price that a producer receives and the minimum acceptable price that a producer is willing to accept.) More will be discussed on perfect competition as we go forward. The other kinds of markets include monopoly, monopolistic competition, and oligopoly. In perfect competition, there are many buyers and suppliers with suppliers (producers) price takers. Producers (Firms) cannot define price as market-driven. In this case, the producers maximize profit by selling at marginal cost.

Marginal Cost = Marginal Revenue

It is also correct to say that optimum allocation of resources happens when marginal benefit = marginal cost. At demand supply equilibrium, marginal benefit = marginal cost. Consider demand curve as function of customers maximum willingness to pay. The customers willingness to pay equates with the marginal benefit the customers derives from the good and/or service. On the other hand, the supply curve is the marginal cost curve for the producers, also the minimum acceptable price that a producer requires for providing the good and/or service. There will be a separate detailed tutorial on these concepts including consumer and producer surplus, efficiency loss or deadweight loss. Marginal Revenue would be the change in total revenue when one unit of goods or service is sold. In these kinds of markets producers manufacture at the lowest price and all firms within an industry have the same marginal cost. An excellent example of perfect competition in commodity markets that are highly sensitive to price increases. Market failures happen due to many reasons. In these cases, the markets are not performing according to their optimal resource allocation. This is because the private sector doesn’t find it economically viable to service a particular need or section of society.

Private Markets do not want to cater to less privileged sections of society. Government intervention is required to resurrect the market failure. The reasons include è Common property resources, Asymmetries of information, Public goods, Externalities Positive Externalities, Negative Externalities, and Lack of an adequate regulatory environment in promoting competition. 

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In this series, externalities shall be covered, in-depth. Let’s begin with market failures before diving into externalities. To understand why market failures occur, let’s check out the figure on the right. Excludablproducts are products that are nonexclusive based on a certain aspect of the offering. Charging products is one of the most significant factors as it alienates a particular section of society. Normal products are excellent examples of these products. The product can be both perishable and durable products.

Externalities are Third party effects : — costs associated with entities not involved in the transaction between producers and consumers.

Internet is another example of a non rival but excludable service.  You need to pay for internet in many countries and have an equipment (smartphone, television, computer, laptop, tablet etc.)  to access the internet. This makes it excludable targeted at a specific market segment as you need to pay to access the service. Access by an audience of the internet does not lessen the experience by another user. Although free PAAS products can be classified public goods, The middle Road doesn’t consider them to be public goods as universal rule everyone doesn’t own a device to access internet. Know more about this topic here. Air is classified as a public good especially clean air. To begin with there are distinctions within air as bad or toxic air and clean air. Example, for a group of people trapped in a Hypoxia (low oxygen conditions) claustrophobic place with restricted access to air, air can become rivalrous. This fact is open to debate as air is considered a public good. Oxygen levels are continuing to decline although not a threat to humans. As air can be rivalrous in exceptional cases, The middle Road has not classified it as a public good but mainstream economics classifies clean air as a public good. The middle Road considers the ambiguity of roads as pure public good, many economists have written different opinions, decided not to include Roads as part of a pure public good. Public Goods are non-excludable and non-rivalrous. Roads can be classified as public good but there are problems with roads being included as public good. Even if ROAD usage is free, as large number of vehicles can cause traffic congestion requiring government to build alternative roads, levy taxes or tolls and regulate vehicle quota system. The congestion on roads has a negative externality example delay for business and personal meetings, roads can have gates and be over supplied or underutilized. Singapore introduced Vehicle Quota System (VQS) in 1990 to limit number of vehicles on roads and encourage citizens to use public transport. This is an excellent example of using policy as a tool to counter external costs to the society. Rival products are those products that are consumed or used by a single user and whose use diminishes the value to other users. On the other hand, nonrival products example street lights or an art painting are examples of non-rivalrous products. Many people can have the benefit of streetlights without diminishing their use for anyone. Armed forces, Police are both non-rivalrous and nonexcludable as both their forces are supposed to protect all citizens of their country equally. This makes it nearly impossible for the private sector to cater to this segment. Common Property like Air or Fisheries is nonexcludable but rivalrous. Fishing by one player would deplete fish for others making them rivalrous. This lack of property rights makes it difficult for private sectors to operate effectively but due to the associated negative externalities, this sector needs to be regulated. Extensive fishing leads to a depletion of the marine ecosystem. An increase in air pollution adds up methane and carbon dioxide within the atmosphere causing global warming.

Negative externalities are external costs to the society while positive externalities are source of positive benefits to the society. Taxing negative externalities at marginal external costs is a public policy used to reduce the consumption of goods or services, subsidizing goods causing positive externalities.

Note: The SAAS designation has been updated to PAAS