Question

1. Identify two major sources of market failure. Carefully explain how each source decreases allocative efficiency. Include well-labelled diagrams that support your explanations. Your explanations and support diagrams should identify the extent of deadweight loss in each case.
2. For both of your identified sources of market failure, describe a standard approach the government can introduce to improve market efficiency. Explain the consequences of each government intervention, supporting your explanations with well-labelled diagrams.

Answer 1

Major two reasons of market failure are the neglected cost incurred due to positive and negative externalities.

A positive externality is a benefit that the society enjoys as a result or consequence of an economic activity, but does not necessarily pay for the benefits enjoyed to the producer or supplier of the commodity with positive externalities.

Negative externalities are costs incurred / borne by a third party due to a consequence of an economic activity to which the affected party may or may not be involved in the first place. This cost is not borne by the producer or supplier of the commodity that has negative externalities.

Market Failure occurs when the price and output mechanism fails to identify this cost / benefit , thus leading to a creation of a resultant dead weight loss in the market. So, as natural price mechanism forces fail to fix the state of the market, the government intervenes and corrects the market, by identifying the costs / benefits and taking necessary actions.

For example, let us take an example of a Company that operates by manufacturing Bio-Degradable and recycled cutlery, Take away boxes, straws etc for fast food joints, Drive Ins and restaurants. Through their product, the level of non-degradable plastic has significantly reduced and the commodity produced by them helps the environment and the eco system as their products are bio degradable.

Thus the society attains a benefit that it does not necessarily pay for. Let us assume that this benefit is worth $10 for every batch of product they produce.

We see that, through the price mechanism in the existing market the equilibrium price and quantity are $50 and 3 million units respectively. But we also know that the commodity has a benefit to society worth $10 per unit.

When we finally equate this Benefit towards the price, we see that the price is at $60 and the equilibrium output is at 4 million units. This difference in the price and the output that the producer could have been producing creates a dead weight loss in the market.

To correct this dead weight loss, The government could intervene the market and grant the company some form of subsidy towards it's inputs so that the cost of producing the product falls , yet the company could sell at the same market price, thus writing off the dead weight loss.

Let us take an other example of a company that operates in manufacturing plastic drinking water bottles that are not degradable. As the company's products cause a form of negative externality towards the environment, the cost of this externality is not borne by the company but the society and the environment. Let us say that this negative externality costs the society $10 per every batch of drink water bottles the company produces.

We see that the Marginal social cost is greater than the benefits towards the society due to the plastic water bottles manufactured by the company. Let us say that the equilibrium price and output is at $40 and 6 million units respectively. Adding the cost of $10 as a negative externality towards to society gives us the price at $50 and output at 4 million units sold, where at point F is the point where the company should have stopped it's production, but as it continues it's production till point E, we get a dead weight loss borne by the society due to the additional units manufactured by the company.

So the government has to intervene this market and as a corrective measure, it has to impose a Pigovian Tax, where the negative externality cost has to identified and a tax to that amount has to be imposed on the company in efforts to reduce the total number of output produced.