Market Failure, Externalities, Public Goods and Government Intervention
Questions here ask you to identify why free markets fail, draw or explain welfare loss, and evaluate remedies. Cameroonian examples such as fuel subsidies, logging and urban pollution are examinable applications.
Sources of market failure
- Public goods are non-rival and non-excludable, so private firms cannot charge and free riding produces a missing market. National defence and street lighting are standard cases.
- Merit goods are under-consumed and demerit goods over-consumed because of imperfect information.
- Externalities: costs or benefits falling on third parties. Negative production externalities such as pollution make marginal social cost exceed marginal private cost.
- Common pool resources are rival but non-excludable, producing overuse, as with open-access fisheries.
- Asymmetric information causes adverse selection and moral hazard; market power, factor immobility and inequality are further failures.
Government remedies
- Pigouvian tax equal to marginal external cost at the social optimum; subsidy for positive externalities; regulation and standards; tradable permits; direct provision; information campaigns.
- Property rights can internalise externalities through bargaining when transaction costs are low, the Coase result.
- Government failure occurs through poor information, administrative cost, rent-seeking and unintended effects.
Worked example
Cement demand and supply give a free-market output of 100,000 tonnes at 60,000 XAF per tonne. Dust imposes an external cost of 10,000 XAF per tonne, so marginal social cost equals marginal private cost plus 10,000. The social optimum is 80,000 tonnes at 65,000 XAF.
- The market overproduces by 20,000 tonnes at a price that is too low.
- Welfare loss is the triangle between the curves from 80,000 to 100,000 tonnes: half of 20,000 tonnes times 10,000 XAF equals 100 million XAF.
- A tax of 10,000 XAF per tonne at the social optimum corrects the price signal; taxing at the free-market output would over-correct output.
Traps that cost marks
- Equating public goods with goods provided by the state; state-provided private goods are not public goods.
- Forgetting that positive externalities cause underproduction, so market output is below the social optimum.
- Placing the Pigouvian tax at the old free-market quantity instead of the social optimum.
- Ignoring that Coase bargaining needs clearly defined rights and low transaction costs.
- Treating subsidies to loss-making state enterprises as correction of market failure without evidence of an externality.