Question

1. What is a market failure?

Give an example that shows how the market does not provide the right incentives to limit environmentally damaging behavior (i.e., a market failure). What is the role of government in the case of market failures such as negative externalities or public goods?

Answer 1

I have answered this question for you. I hope it helps.

1) A market failure in a free market is defined as a situation in which inefficient allocation of resources takes place. The equilibrium reached is optimal from the private players' point of view but the society at large suffers as the equilibrium reached is not pareto optimal (i.e. atleast one of the economic agent(s) could be made better off by changing resource allocations). In simpler words, market failure leads to a situation in which quantity supplied and quantity demanded do not become equal thus, there is some side of the market which suffers leading to a Dead-weight loss (i.e. loss in the total welfare of the society). Some common examples of a market failure are:

• Monopoly
• Externalities
• Asymmetric information

2) Let us look at the example of a Production externality arising out of pollution caused during the production of an industrial good. We all know that pollution is bad for environment and even though firms can earn huge profits by increasing production of goods that cause pollution, but in the long run firms are also the part of the human race and pollution affects all of us and poses a threat to the sustainability of our environment. But, does the market gives firms any incentive to think for the better of the society at large instead of thinking about their private benefits? NO. The firms, if choose to produce less in order to reduce pollution, will face huge cuts in their profits and no matter how appealing philanthropy be, the marginal benefits for the firms from such a decision will be lesser than the marginal costs incurred. Firms, just like any other economic agent, think on the margin. And, therefore, there is no incentive for them to reduce pollution. Let us look at this in a more formal manner.

The production decision of a firm is based on the Cost-Benefit analysis. They compare the Marginal benefits (MB) of a production decision with its marginal cost (MC) and choose to produce as long as MB>MC. The catch is that while calculating these costs, firms do not evaluate the MC of their production decisions on others. This is known as externality, when an outsider or external party (not involved in the exchange) gets affected (negatively or positively) by the decision of one economic player. Thus, there is something called the Social marginal benefit (SMB) and Social marginal cost (SMC) along with the Private marginal benefit (PMB) and Private marginal cost (PMC) that we know of. Firms make their decision of the basis of PMB and PMC. Clearly, the SMC will be more than the PMC (As SMC involves PMC). Therefore, it is a miscalculation of the marginal costs which leads to a larger quantity of good being produced than socially desired (underestimated costs lead to overestimation of pollution production). Thus, any negative externality leads to an overproduction of the good which is causing that externality. Hence, industrial goods causing pollution get overproduced than the socially desirable level. The market fails to give the firms an incentive to reduce their production to the socially optimum levels. Thus, causing a market failure.

{NOTE: Positive externalities like Provision of free education by govt. lead to overestimation of costs thus leading to an underproduction of such public goods.}

3) Since market cannot function effectively and efficiently on its own in the case of a market failure, there is a need for a social benevolent planner to create incentives for the firms to reduce their production levels to the socially desired levels. The government acts as this socially benevolent planner and tries to create incentive mechanisms to encourage firms to reduce pollution. One of the best incentive will be to compensate firms for their loss which would arise out of a production level that is socially optimum. However, this solution is not very realistic as it requires large amount of funds.

The govt could tax the pollution producing firms according to the negative impact it creates on the environment with pollution. However, govt need to have knowledge of the externality function (how much production of an industrial good produces how much externalities) which might be a little hard to acquire. But, if govt's have this knowledge, there is no need to tax. They can simply put restrictions on output accordingly.

Another important aspect to consider is that the market failure occurs because there are missing markets for pollution. There are suppliers of pollution (firms) but no channel for the society to express their demand for the level of pollution. Govt is required to create this demand channel by providing a market for pollution. This can be done by fixing property rights on pollution. Firms can sell their pollution rights to the society for a price which works as an incentive for them to not pollute.