Introduction

Markets do not always allocate resources effectively to meet the needs of society. Although in theory markets can guide the allocation of resources, they will only do so efficiently if market prices reflect the full costs and benefits associated with transactions. A precondition of effective market allocation is that prices convey accurate information about the costs of production and the benefits of consumption. In reality, there are many situations where this does not hold. Costs or benefits may spill over to parties outside the immediate buyer and seller, or essential information may be missing, or the incentives faced by firms may distort the allocation of resources. In such cases, the outcome of the market mechanism will fail to maximise society’s welfare.

This chapter introduces the concept of market failure, explains why it may arise, and considers in detail one of the most important causes: externalities. Externalities occur when costs or benefits fall on third parties who are not directly involved in a transaction. The presence of such external costs or benefits means that private decisions, based solely on individual costs and benefits, do not reflect the true impact on society as a whole.

Market failure

A central question in microeconomics is whether markets achieve outcomes that are good for society overall. In a perfectly functioning market, the allocation of resources would be socially optimal: the marginal social benefit of consuming a good would equal the marginal social cost of producing it. At this point, the welfare of society would be maximised, as there is no extra cost due to consumption and no additional benefit that can be gained.

However, in practice, there are significant situations where this equality does not hold. Too much or too little of a good may be produced and consumed relative to what is best for society. When actual output diverges from this socially optimal point, economists describe the situation as market failure. Market failure is thus a situation in which the free market equilibrium does not lead to a socially optimal allocation of resources, such that too much or too little of a good is being produced and/or consumed.

To analyse this more closely, we distinguish between marginal private benefit and marginal social benefit, and between marginal private cost and marginal social cost. The marginal private benefit is the gain to an individual consumer from consuming an additional unit of a good. The marginal private cost is the cost to an individual producer of producing that additional unit. By contrast, marginal social benefit includes not only the private benefit but also any external benefits to society, while marginal social cost includes the private costs together with any external costs.

Types of Market Failure

Externalities

An externality is a cost or benefit that falls on third parties rather than being reflected in the market price. Externalities are the key focus of this chapter because they are a major source of market failure. If firms and consumers face only their private costs and benefits, they will make decisions that ignore these external impacts, and the resulting outcome will not be socially efficient.

Externalities can occur on either the production side or the consumption side of the market. A production externality arises when the act of producing a good imposes costs or benefits on others not directly involved in the production. A consumption externality arises when the act of consuming a good creates costs or benefits for others not directly involved in the consumption. Externalities can also be positive or negative, depending on whether the spillover effects benefit or harm others.

For example, suppose your elder sister owns a car and you persuade her to give you a lift to university. The journey clearly involves costs, the time it takes, the wear and tear on the car, and the value of fuel used. However, not all of these may be included in the amount she charges you for the lift. If she only charges you for the petrol, then the depreciation of the car and the time cost to her are external to the transaction. Similarly, if a factory emits fumes that affect nearby residents, the health costs borne by those residents are external costs not paid for by the producer.

Information failure

For markets to allocate resources efficiently, economic agents must be well informed. If buyers or sellers lack key information, decisions will be distorted. For example, consumers may not fully perceive the long-term benefits of education, or may underestimate the harmful effects of smoking. Sellers, on the other hand, may possess more information about the product they are supplying than buyers can easily discern. Such asymmetries of information can lead to outcomes that are not socially optimal.

Public goods

Some goods are underprovided in a free market because their characteristics mean private firms cannot profitably supply them. These are known as public goods. Street lighting is an example. Since no individual can be excluded from benefiting, and since one person’s use does not diminish another’s, private provision is unlikely. Without government provision, such goods would be underproduced.

Merit and demerit goods

Governments often classify some goods as merit goods or demerit goods. Merit goods, such as education or healthcare, generate external benefits that individuals may undervalue when making decisions. As a result, left to themselves, individuals may underconsume these goods relative to the socially optimal amount. Conversely, demerit goods such as cigarettes or addictive recreational drugs impose external costs that individuals may not fully recognise. In a free market, these are likely to be overconsumed.

Market power and other causes

Markets may also fail because of the exercise of market power by dominant firms. If one or a few firms can restrict output and raise prices, resources will not be allocated efficiently. Other forms of market failure occur where relevant costs and benefits are external to market transactions, where firms or consumers are not well informed, or where public goods are not provided.

This chapter will cover externalities in detail, and other types of market failure will be covered in further chapters.

Externalities

Negative production externalities

A negative production externality arises when the act of producing a good imposes a spillover cost on third parties not directly involved in the production process. These costs are not paid by the producer and so are not included in the market price. As a result, output in the free market is greater than the socially optimal amount.

A common example is industrial pollution. Suppose a steel factory emits toxic fumes into the air. The firm considers its private costs of production, such as wages for labour, rent on the land, and interest on borrowed capital. However, it does not pay for the health costs borne by local residents, nor for the environmental damage that reduces quality of life for society at large. These additional spillover costs are external to the firm.

This situation can be illustrated with a diagram.

(The shaded triangle between Qm and Qs indicates the welfare loss from underproduction)

In this diagram, the supply curve based only on private costs is labelled MPC, the marginal private cost. The true cost to society, which includes both private and external costs, is labelled MSC, the marginal social cost. The demand curve reflects private and social benefits and is labelled MPB = MSB. In the free market, equilibrium occurs at the intersection of MPC and demand, giving output Qm and price Pm. However, the socially optimal output is at the intersection of MSC and demand, which is Qs and Ps. Since Qm is greater than Qs, there is overproduction of the good. The shaded welfare loss triangle represents the net harm to society due to this overproduction.

The essential causal chain is this: producers decide output based only on private costs, ignoring external spillover costs. This leads to a divergence between MPC and MSC. The outcome is overproduction relative to the socially efficient level. The difference between Qm and Qs represents the excess output, and the shaded triangle shows the welfare loss caused by that overproduction. The negative externality thus leads to market failure because the market alone does not account for the full social cost of production.

Positive production externalities

A positive production externality occurs when producing a good creates a spillover benefit for third parties. These benefits are not captured by the producer and so are not reflected in the market price. In such cases, the free market outcome is underproduction relative to the socially optimal level.

Consider an orchard near a beekeeper. The trees provide nectar for the bees, improving honey production, while the bees pollinate the trees, improving fruit yields. The beekeeper and the orchard owner each make production decisions based only on their own private benefits and costs, but there is an additional external benefit that spills over to the other party and to society at large. This external benefit means that the true social benefit of production is greater than the private benefit.

This can be represented in a diagram.

(The shaded triangle between Qm and Qs indicates the welfare loss from underproduction.)

Here the private supply curve is labelled MPC. Because there are positive external benefits to production, the true cost to society is actually lower than the private cost, so the marginal social cost curve, MSC, lies below MPC. Demand reflects both private and social benefits and is labelled MPB = MSB. In the free market, equilibrium occurs at MPC intersecting demand, giving output Qm at price Pm. However, the socially optimal output is where MSC intersects demand, at Qs and Ps. Since Qm is less than Qs, there is underproduction in the free market. The shaded welfare loss triangle shows the net benefit to society that is forgone because production is too low.

The causal reasoning is that producers face only their private costs and so choose to supply a smaller quantity than is socially desirable. Because they cannot capture the external benefits their production generates, output is restricted below the efficient level. The divergence between MPC and MSC creates underproduction, and the resulting welfare loss means the market fails to allocate resources efficiently.

Negative consumption externalities

A negative consumption externality arises when the act of consuming a good imposes a spillover cost on others. These costs are not considered by the consumer, who makes decisions based only on private benefits and costs. The result is overconsumption relative to the socially optimal level.

An example is smoking in public. The smoker gains private benefit from consuming cigarettes. The private cost is the price paid for them. However, smoking creates second-hand smoke, which damages the health of non-smokers nearby. These health costs are borne by third parties and are not reflected in the market price. This means that the marginal social benefit of consumption is lower than the marginal private benefit.

This can be shown in a diagram.

(The shaded welfare loss triangle between Qm and Qs shows the external cost of overconsumption.)

In this diagram, the supply curve reflects both private and social costs and is labelled MPC = MSC. The demand curve based on private benefits is MPB. The true social benefit, however, is less because of the external cost to others, so the MSB curve lies below MPB. In the free market, equilibrium occurs where MPB intersects MPC, at Qm and Pm. The socially optimal equilibrium is where MSB intersects MPC, at Qs and Ps. Since Qm exceeds Qs, there is overconsumption. The shaded triangle represents the welfare loss to society from this overconsumption.

The logic is that consumers consider only their private benefit from smoking and ignore the spillover harm to others. This leads them to consume more than is socially optimal. The divergence between MPB and MSB means that too much of the good is consumed, resulting in market failure.

Positive consumption externalities

A positive consumption externality occurs when consuming a good creates a spillover benefit to others. These benefits are not taken into account by the consumer, who considers only private benefits. As a result, the free market leads to underconsumption.

Education is a clear example. For the individual, the private benefit of education is higher income and better job opportunities. However, there are external benefits to society, such as increased technological progress, higher productivity, and higher average incomes. Because these spillover benefits are not fully perceived by individuals, they tend to underconsume education compared to the socially optimal level.

The diagram for a positive consumption externality is as follows.

(The shaded triangle between Qm and Qs represents the welfare loss from underconsumption.)

In this diagram, supply reflects both private and social costs and is labelled MPC = MSC. The demand curve based on private benefit is MPB. The true social benefit is greater, so MSB lies above MPB. The free market equilibrium occurs at Qm and Pm. The socially optimal equilibrium is at Qs and Ps, where MSB intersects MPC. Since Qm is less than Qs, the free market results in underconsumption. The shaded triangle shows the welfare loss from this underconsumption.

The reasoning is that consumers base their decision only on the private benefits they receive, ignoring the spillover benefits to society. As a result, they consume less than the socially optimal amount. The divergence between MPB and MSB leads to underconsumption, which is a form of market failure.

Externalities and market failure

The four types of externality demonstrate how spillover effects distort resource allocation. Negative production and negative consumption externalities result in too much of a good being produced or consumed, while positive production and positive consumption externalities result in too little. In each case, the free market equilibrium diverges from the socially efficient equilibrium. The shaded triangles on the diagrams represent the welfare losses that result from these misallocations.

The essence of the problem is that private decision-makers consider only their own costs and benefits, not the external spillovers their actions generate. This divergence between private and social measures of cost and benefit means that the market outcome fails to maximise welfare. For this reason, externalities are a central example of market failure.