Market Failure Notes

1. Public Goods 1.1. The Free-Rider Problem and Complete Market Failure Public goods are goods with features of non-rivalry and non-excludability in consumption and thus, would not be provided by the free market. Non-excludability suggests that it is technically impossible or economically unfeasible to exclude anyone from the benefit of the good once it is provided. In the case of street lighting, it is impossible to provide the lights and yet prevent passers-by from enjoying the benefits from seeing the light. Hence, once street lighting is provided, it will benefit everyone who walks under it, regardless of whether the person has paid for it or not. Since non-payers would be able to enjoy the benefits of street lighting for free, this would deter anyone from deciding to pay for it in the first place and this creates the free-rider problem. Thus, the demand for public good is concealed. Therefore, in a free market, there is no price signal for producers to charge a price and given there are costs of providing the good (thus making a loss), producers will not allocate resources to produce it i.e. under allocation of resources causing allocative inefficiency. Non-rivalry suggests that the consumption of the good by one person does not reduce the benefit of the good available to others. In the case of street lighting, when one person walks under the streetlamp, the brightness level will be the same as when two or three people were to walk under it. This suggests that an additional consumption of the good does not deplete its benefits. Hence, the marginal cost (MC) of providing street lighting for an additional user is zero. To achieve allocative efficiency where P = MC, street lighting has to be provided at no charge i.e. P = 0. However, no private firms will be willing to produce street lights at P = 0 given there are costs of providing it. Alternatively, if they were to provide street lights, they would have to charge a price above zero. If so, P > MC thus resulting in allocative inefficiency. Therefore, in a free market, allocative efficiency cannot be achieved due to non-rivalry of street lights. Overall, given that street light is a good that has net benefits to the society but it will not be provided in a free market, there will be complete market failure (i.e. maximum deadweight loss) as the price mechanism fails to allocate resources efficiently to produce street light i.e. allocative efficiency is not achieved. * There is not really any analysis of government policy to address market failure as a result of the failure of the free market to allocate resources to produce public goods since the only policy is for the government to provide the goods directly. Hence, cost-benefit analysis from Chapter 1 should be applied to determine what the socially optimal level of output is.

2. Externalities 2.1. Externalities in Consumption Traffic congestion in Singapore caused market failure because of the negative externalities in consumption from the usage of roads. Step 1: Before ● Consumers enjoy private benefits when they use roads such as lower time opportunity cost via shorter travelling time to reach destinations, illustrated by the marginal private benefit (MPB) curve. ● They incur private costs in consumption such as the cost of fuel needed to power the vehicles to commute via the roads, illustrated by the MPC curve. ● The free-market equilibrium is achieved at Ep where MPB = MPC with free market output Qp and free market price Pp. Step 2: During ● However, the usage of roads exhibits negative externalities in consumption, which are spillover costs associated with the consumption of the goods to third parties who are not directly involved in the transaction of the goods and with no compensation involved. ● For example, there are external costs like the decrease in the productivity level of the economy due to the late coming as the workers are stuck in the traffic congestion thus productive time wasted. Since these are not internalised by self-interested consumers, there is a divergence between MPC and marginal social cost (MSC) by the amount marginal external cost (MEC). ● Assuming no external benefits, MPB=MSB and the socially optimal level of consumption is Qs where MSC=MSB with output Qs and price Ps. Step 3: After ● Hence, since Qp > Qs, there is an over-consumption illustrated by distance QsQp. ● Between QsQp, MSC > MSB so the additional social cost illustrated by area AEsQsQp is larger than the additional social benefit illustrated by area EpEsQsQp. ● Hence, there is an over-allocation of resources to the consumption of roads. and the current combination of goods and services produced and consumed does not allow the society to attain the greatest level of satisfaction since there is deadweight loss illustrated by triangle AEsEp. Hence, there is allocative inefficiency and market failure.

2.2. Externalities in Production The provision of street lighting also caused market failure because of the negative externalities in production from the generation of electricity and from the effect of bright street lights on wildlife. Generation of electricity for street lights has private benefits in production such as additional revenue (It is NOT the benefits of consuming the streetlamps. I.e. It is NOT “visibility at night” because it is externalities in production ) that firms enjoy when producing electricity for streetlights. It also has private costs in production such as the cost of electricity to power the street light. The private benefits and private costs can be illustrated by the marginal private benefits (MPB) curve and marginal private costs (MPC) curve in Diagram 1 respectively. The free-market equilibrium is achieved at Ep where MPB=MPC with free market output Qp and free market price Pp. However, the generation of electricity exhibits negative externalities in production. Negative externalities in production are spillover associated with the production of the good to third parties who are not directly involved in the transaction of the good and which have no compensation involved. Exemplify who are the third parties and what are the external costs to them: In the case of the provision of street light, there could be