Market Failure

Unit 5 - Lesson 1

Learning outcomes:
Analyze the concept of Market Failure as the failure of
the market to reach allocative efficiency resulting in an
over/underallocation of resources to the production of a
good.
Describe the concepts of MPC, MPB, MSB, MPC and
MSC.
Describe the meaning of externality as the failure of the
market to achieve a social optimum where MSB = MSC

Market Failure
Any situation either positive or negative
where the allocation of resources by a free
market is not allocatively efficient.

What we know... S = MC
MC = Marginal Cost = the cost of each
additional unit.

D = MB
MB = Marginal Benefit = the benefit received
by the consumer by consuming an additional
unit

MC = MB we allocative efficiency

When discussing Market Failure:

S = MC = MSC
MSC = Marginal Social Cost
The additional cost of production each unit to
producers and society

D = MB = MSB
MSB = Marginal Social Benefit
Total benefit to consumer and society from the

MSC = MSB
When the MSC = MSB in a free market, the
market is said to be allocatively (socially)
efficient.
producing the goods/services for society such that not
to make one individual better off at the expense of
another.

The Community Surplus (consumer & producer

surplus) is being maximized.

Market Failure occurs...

Any point that the market is not producing the
socially optimal amount (MSC = MSB) it is
considered a Market Failure.
Some type of Market Failures we will examine:

Negative Externalities (Production & Consumption)

Positive Externalities (Production & Consumption)
Lack of Public Goods
Common access resources & the threat to sustainability.
Asymmetric Information
Abuse of Monopoly Power

Externalities
What is an externality:
Transaction where
someone other than the
buyer or seller (3rd party),
experiences a benefit or
loss as a result of the
transaction.

Positive Externality
When the actions of the consumer or producer
has a positive effect on the 3rd party.
We consider it to have a spillover benefit.
Positive Externalities in a free market tend
to be under allocate their resources to the
production of the good.

Negative Externality
When the actions of the consumer or producer
has a negative effect on the 3rd party.
We consider this to be a spillover cost.
Negative Externalities in a free market tend
to over allocate their resources to the
production of the good/service.

Summary
Externality
Social Benefits = Private Benefit + External Benefit
Social Costs = Private Cost + External Costs

No Externality
Social Benefit = Private Benefits
Social Costs = Private Costs

Negative Externality
Negative Externality of Consumption
Consumption of product/service creates spillover
costs to the 3rd party.
Negative Externality of Production
Production of Product creates a spillover cost to the
3rd party.
Over allocation of resource to the production of the good.

Positive Externality
Positive Production Externality
Production of a product creates a spillover benefit
to the 3rd party.
Positive Consumption Externality
Consumption of a product/service creates a
spillover benefit to the 3rd party.
Under allocation of resources to the production of the good.