Notes on market failure, focusing on externalities and public goods

Market Failure: A situation in which the market economy equilibrium leads to inefficiency (the presence of a deadweight loss).  This means that either too many or too few resources are being allocated to a specific endeavor, and that the outcome can be improved by introducing smart government regulation.

The two types of market failures discussed here will be externalities, and public goods.

Externality: When a market transaction occurring between two parties has an effect on a third party not involved in the transaction.  Pollution and education are two types of externalities.

Negative externality: Social cost is higher than private cost.

Positive externality:  Social benefit is higher than private benefit.

How the government can correct this market failure:

Through the introduction of special taxes, regulation, government owned industry,  or subsidies.

Public goods:  Goods that are non-rival, and non-excludable.  Non-rival means that one person’s consumption of a good does not reduce the available amount to be consumed by another person (for example, an apple is rival because if I eat it you cannot eat it, but if I listen to the radio, you can also listen to the radio).  Non-excludable means that someone cannot be stopped from consuming the good.  For example, if there is a road, it is non-excludable because anyone can drive on it, but if I put up a toll booth, it becomes excludable because those who do not pay the toll cannot use it.

A common problem with the allocation of public goods is the free rider problem.

Free riders: individuals assume that others will pay for the good, so they do not pay and receive the benefits for free.  If everyone becomes a free-rider, then the good is not provided and everyone loses.  Typically public goods are underfunded because of the free-rider problem.

Examples of goods and services with public good aspects are parks, health care, and education.

The government receives taxes, and pays for these public goods because society is better off with them, but they probably would not be supported in the private market.  Consider the externalities of health care, education, and the environment and you will see that it is necessary for the government to get involved to fix these market failures.
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