Chapter 10

Market Failures
Introduction
The price system has been used by many economies, mostly market economies, in their
allocation process. With the determination of the price using the forces of the market the
price is determined through the interaction of the demand and supply.
In a competitive market, it is said that the price determined by the market is
efficient in allocating resources particularly in answering the three basic questions in
economics, what to produce, how to produce, and for whom to produce. These answers
were explored in detailed in the previous nine chapters. The price is considered
appropriate in the allocation of resources because the price reflects the marginal utility of
consumers, on the one hand, and the marginal cost of producers, on the other hand. From
this efficient allocation the consumers are able to maximie their consumer surplus while
the producers are able to maximie producer surplus. These surpluses accrue to the
society at large and social welfare is maximied.
The maximiation of social welfare is an important ob!ective of a society since
resources are limited and have alternative competing uses by various sectors of a society.
Thus, the loss in social welfare due to inefficiencies must be minimied as much as
possible in the light of limited resources and the competing uses for these resources.
"owever, there are instances when the market system is inadequate in allocating
resources efficiently. This means that the price set by the market does not reflect the
benefit en!oyed #marginal social benefit$ and the cost #marginal social cost$ incurred by
society at large. %ecause of these inadequacies resources are not efficiently utilied. &nd
when resources are not efficiently allocated social welfare is not maximied.
In this chapter, we will analye what are the conditions and situations when the
market fails as a social mechanism for efficient allocation of scarce resources.
'pecifically, we will discuss in this chapter the concept of market failures, situations
when the market fails and alternative measures in addressing market failures.
II. Concept of Market Failure
(arket failures are instances when the market mechanism fails to account for the correct
benefits and costs to society of transactions made by consumers and sellers. This implies
that the price determined by the interactions of the buyers and sellers is not reflective of
social benefits en!oyed #marginal social benefit )('%$ and social cost #marginal social
cost )('*$ incurred.
When the price determined by the market mechanism does not reflect social
benefits and social costs, this may lead to inefficient allocation of resources.
Inefficiencies may surface when there are over consumption or under consumption, over
production or under production of goods and services. When the production and
consumption of goods and services are not optimal the inefficiencies in production and
consumption may result in wastage and misuse of scarce resources.
It is assumed that a competitive market is a good candidate for optimal allocation
of resources since the price set in a competitive market reflects marginal private
benefits+utility and marginal private cost and at the same time equivalent to the marginal
social benefits and marginal social costs #In symbols, (,% ) ('% and (,* )('*$.
"owever, a competitive market may also lead to market failure if there are divergences
between social marginal benefits and private marginal cost, on the one hand, and the
social marginal costs and private marginal cost, on the other hand. This may occur when
there are externalities in transactions in the market.
&side from the existence of externalities, government regulations, market
imperfections, existence of public goods, and asymmetric information can contribute for
market failure to surface. We will discuss these causes in the following section of this
chapter.
2.1. Externalities
-xternalities are spill over effects of any transaction to third parties. These
spillover effects may have either positive consequences or negative impact on the third
parties outside the transaction. For example, education of children may have positive
effects on the community as it decreases the incidence of !uvenile delinquency and
enhances the human capital of the community. &lthough business enterprises are external
to the transaction since they did not participate in the transaction for the educational
services they are, however, affected positively since they are exposed to a lower level of
criminality and the availability of qualified workers. In this case, the market for
educational services has beneficial spillover effects or has positive externality.
'imilarly, a firm engaged in manufacturing of leather or raising hogs may pollute
the environment as they dump their wastes in the river. In such a situation, those families
dependent on the river as a source of income may be adversely affected by the pollution
caused by their indiscriminate dumping. Thus, although these families are external to the
transactions of the manufacturing of leather and hog raising, they suffer the cost of such
transactions. This is an example of an adverse spillover effects or negative externality.
To illustrate this effect of positive externality on the price, production and
consumption of educational services let us examine Table ./... For simplicity, we
assume that the supply curve is denoted by equality of marginal private cost and marginal
social cost #(,*)('*$. To highlight the positive externality of education, the ('% is
higher than the (,%.
#I0'-1T 21&," ./..$
Graph 10.1
Positive Externality
Demand for Education
Normal Competitive
Situation
With Social
Benefits
Price <
Quantity <
Consumer
Surplus
<
Producer Surplus <
Net Welfare Gain
'ince consumers do not consider the social benefits of education, their demand
3curve is reflected by the marginal private benefit #(,%$ curve. 2iven the supply curve,
(,* )('*, the price will settle at ,c and output will be at -c. *onsumer surplus is
denoted by ,c(%* and producer surplus is denoted by T,c*.
%
W
(
('%
*
(,%
T
(,*)('*
/
,rice
-ducation
"owever, if the social benefits are considered, price will settle at ,w and at a
higher output of -w. *onsumer surplus will be ,w(W while producer surplus will be
T,wW. %y ignoring the positive social benefits of education, society has lower level
production and consumption of educational services. %ecause of this under4production
and under4consumption the possible welfare gains denoted by triangle *%W are not
realied. Thus, if the market is left with its normal price determination mechanism it will
yield lower levels of social benefits.

To illustrate the effects of a negative externality let us examine Table ./.5 with
the demand for hogs as an example. For simplicity, we assume that the demand curve is
shown by the curve where there is equality of (,% ) ('%. The supply curve faced by
the producers is shown at (,*. "owever, because hog raising has a negative externality,
the marginal social cost is higher with the cost of pollution borne by the third parties.
#I0'-1T 21&," ./.5$
Graph 10.2
Demand for Hogs
1
%
W
6
0
&
2
*
,rice
('*
7)(,%)('%
(,*
/
"ogs
Normal
Competitive
Situation
With Social
Benefits
Price
Quantity
Consumer
Surplus
Producer Surplus
oss !ue to
"verconsumption
Accrues to
Producer
urplus
Accrues to
!onsumer
urplus
#rian$le W%C " A#$! % &A#G! ' G(!)
8nder normal competitive situation, the producer will equate his marginal private
costs with the demand conditions and the market will settle at equilibrium at point * with
price at ,c and output at "c when (,% ) ('% ) (,*. *onsumer surplus is shown by
,c%* while the producer surplus is &,c*.

"owever, if we consider the adverse effects or negative externality of this
activity, the marginal social cost, ('* will be higher than the (,*. The optimal level of
production is at "w and price at ,w as determined by the equilibrium point W. *onsumer
surplus is shown by triangle ,w%W while the producer surplus is only 0,wW.
*omparing the production and consumption levels with a competitive market, there is an
over production and over consumption of hogs.
%y producing "c, the cost was computed based on (,* equivalent to 9&*"c.
"owever, the cost to society was really 901"c. & portion of the difference &01* has
been en!oyed by producers in terms of producer surplus #&02*$ with higher production
and the consumers in terms of consumer surplus #2W*$ with lower price. This social
costs equivalent to &0W* has been offset by producer surplus and consumer surplus
#&02* : 2W* ) &0W*$. Thus, the net social welfare loss due to over4production and
over4consumption of a commodity with a negative externality is shown by the triangle
W1*.
2.2. Government Reulations
2overnment interventions and regulations can also create market failures since the
price paid by the consumers may not reflect their marginal social benefits and marginal
social costs. Taxes for example can limit production and consumption by increasing the
price beyond the marginal social cost. ,rice ceiling can limit production and can cause
divergence between marginal social cost and marginal private cost. In the same light the
provision of subsidies through price floors can encourage production beyond what is
optimal. These government interventions can lead to wastage, misallocation of resources
and lower social welfare.
To illustrate the impact of government regulations, let us examine Table ./.; with the
imposition of price ceiling on rice consumption. <et us assume for simplicity that the
demand curve is represented by a downward sloping curve where (,* ) ('%. 9n the
other hand, the supply curve is represented by an upward sloping curve where (,*
)('*.
#I0'-1T 21&," ./.;$
Graph 10.&
Price !eiling on $ice
With Price Ceilin$ "ptimal
Price
"utput
Consumer Surplus
Producer Surplus
oss !*(
(,%)('%
(,*)('*
,rice
1ice
2iven these assumptions, under competitive market, the price would settle at point W
with price at ,w and quantity at 1w. *onsumer surplus is ,w%W while producer surplus
is &,wW.
"owever, if the price ,w is perceived to be too high for the consumers, the
government may impose a price ceiling with ,c as the maximum price. &t this price,
producers will only supply 1c even if consumers are willing to consume more and pay a
higher price. &s a result, the price ceiling ,c ) (,* ) ('* but lower than the (,% )
('% #,c = ,!$. With this consumer surplus will now be ,c%6* while producer surplus is
&,c*. &lthough consumers have increased their consumer surplus with a reduction in
price, they also reduced their consumer surplus with the reduction in consumption. 9n
the other hand, price ceilings hurt the producers most since their producer surplus is
reduced with lower price and lower production.
2.!. Market Imperfections
We have discussed the impact of market imperfections in the previous chapters. The
reason why non4competitive markets are not ideal market structures and may lead to
market failure is because the price they set may not reflect the social costs and social
benefits. %ecause these markets have some degree of market power, they can set the price
in order to maximie their producer surplus or profit at the expense of consumers who
have to pay higher prices and contend with lower levels of output and consumption.
In a monopolistic market, the control of the seller or buyer can limit production and
consumption. &lthough the profits of a monopolistic firm is maximied, social welfare is
not since the price ) ('% > ('*. 'ee Table ./.? for illustration.
#Insert 2raph ./.?$
Graph 10.'
+onopoly
Competitive
(ar)et
(onopoly !ead Wei$ht oss
Price
*+!
Quantity
Consumer Surplus
Producer Surplus
9ligopolistic firms as well as monopolistically competitive markets determine their
output that will maximie profit with the dictum that (* ) (8. "owever, the price in
these markets is higher than the marginal costs. &gain, some degree of social welfare is
lost as a consequence of this.
(
6
&
*
%
/
(1
@uantity
,rice
(,%)('%
(*
2.". Existence of pu#lic oods
The existence of public goods may also contribute to the failure of the market in
allocating resources efficiently. The market system is very effective in allocating
resources if the goods and services provided are mostly private goods and services. The
price set in the market system reflects the private benefits en!oyed and internalied by the
buyers, on the one hand, and the private costs incurred and internalied by the sellers, on
the other hand. 'ince the consumption of public goods does not exclude others, the
benefits from the consumption of public goods cannot be fully internalied. 'ince these
goods are !ointly consumed it may be difficult to measure its marginal social benefits. In
addition, because of the non4exclusion of its consumption, once an individual finances its
production other consumers may not be able to internalie the social costs of providing
this public good. %ecause of this situation a free rider problem can emerge since once the
product is produced, it is en!oyed by every one. If this is the case, no one is willing to pay
for the cost of its production. In an environment where consumers can free ride and their
satisfaction is not reflective of the true social benefits from public goods, there will be an
underproduction of public goods if the provision of these goods is left to the market
system.
The incentive to free ride is inherent in public goods because these goods are !ointly
consumed. The en!oyment of the product or service is not exclusive. The non4exclusivity
of the product implies that if one individual consumes, the product is there for others to
en!oy and consume it as well. There are many examples of public good including national
defense, provision of security, among others.
Thus, because of the inadequacy of the market to provide for public goods, it is not
the market that provides the provision of these goods but the government. 8sually, the
government taxes its citiens and from the revenues collected they use it to produce
public goods and services.
2.$. Imperfect Information
9ne of the conditions for perfectly competitive market is the provision or access to
full or perfect information to all players. "owever, this condition is an ideal one because
in reality, the information to the actors of a market is not evenly distributed. This
imbalance or uneven distribution of information is called asymmetric information. It
means the distribution of information is uneven to the players. We know that all perfect
information is not possible but even there is full information, the available information is
not evenly distributed among the players.
This imbalance can lead to market failures because it can lead to decisions that may
lead to inefficient allocation of resources. 'ometimes the failure of the market is due to
imperfect information among the players in the market. The imbalance in the information
provided to the consumers and producer lead to inefficient results. There three main
examples where information asymmetry may occurA adverse selection, moral haard, and
agency problem.
In adverse selection, without proper disclosure of information about the product a
consumer may end up with low quality product as products with high quality are mixed
with low quality products. &s such, the demand for the product may decrease as some
consumers end up with low quality products. With the decline in demand, the price of the
good will likewise decrease. With this decline, the supply of high quality products may
decline as well since they are perceived as well as low quality products and therefore
should demand lower price. In order to address this problem of adverse selection, the
government may require producers to disclosure information, such as labels, about the
product they produce and service they provide. *ompanies may also want to signal using
advertising to market their products and enhance information.
&nother example of disclosure is through signaling mechanism which is done by
college graduates when they apply for !obs. They signal their productivities by enhancing
their resume through the enumeration of curricular and extra4curricular activities as well
as the academic performance. With this enhanced resume, employers are in a better
position to select the quality graduates from the rest.
&nother example of adverse selection can occur in the insurance industry where
people, healthy as well as terminally ill, can purchase medical and life insurance. To
address the problem that people with terminal illness may cause the insurance company
all people who wanted medical insurance coverage are asked to disclose information
about their health and medical history through medical examinations. Those found with
terminal illness may not be covered or they have to pay a higher insurance premium if
they want to be covered.
(oral haard, on the other hand, are decisions made by market participants to
undertake unnecessary behavior because they are protected or insured or covered in their
behavior. The most classic case is the case of insurance. %ecause individuals are insured
they can be careless in their behavior. They may drink or may not take care of their health
because they are covered by medical insurance. %ecause of this possible behavior of
those insured, insurance companies, covering medical and car insurance, are now asking
those insured to pay the initial amount in case of an illness or a car accidents. In this case
those insured will be forced to temper their behavior because there is an additional cost in
getting ill or being careless in driving.

The agency problem, on the other hand, arises due to the dichotomy of the interests of
the principal and the agents. In many transactions, it is possible that a main actor of a
transaction is not directly involve in the transaction but assigns it to an agent to do the
specific and dirty tasks. This is well pronounced in the separation between the owners
and the managers of modern business enterprises particularly corporation. There are also
examples that you assign agents to represent your interest in certain transactions. &s far
the principal is concern, aside from paying his agent, he will be satisfied if a set of his
concerns are fulfilled. &s far as the agent is concern so long as the needs of the principal
are fulfilled, he can focus his attention in maximiing his own interest. "owever,
promoting the agentBs interest may lead to uneven information.
In pursuing his interest, the agent may maximie his own utility while giving the
principal a level of utility that would satisfy him and not necessary the maximum utility.
The agency problem arises because of the governance structure of companies. <arge
corporations are managed by a select group of professionals who are not actually owners
of the company. &lthough they are report to the owners, they can conceal information
from the owners as long as they maintain the utility of the owners. &s long as the owners
are satisfied, they may not exert enough effort to be efficient in the operation of the
corporation. There is a case of under4performance or sub optimal results. %ecause of the
unevenness of information between the agent and the principal, the agency problem can
also lead to unethical behavior.
III. %o& do 'ou address the market failure(
;... 1ole of 2overnment
9ne of the reasons for the existence and relevance of the government sector is to address
market failures. In the promotion of public interest and enhancement of the social
benefits of commodities with positive externalities, the government can use its fiscal
powers by giving incentives or subsidies to these activities, commodities and services
that promote social welfare.
The government can use its taxing powers to temper the production of private
goods with huge negative externalities. It can tax pollutants to make the corporations or
companies polluting the environment to internalie the social costs it has brought as a
consequence of its production. With the internaliation of the tax which is an additional
cost, the supply curve shifts to the left implying higher cost at every level of production.
With this shift, the price will set at a higher level and production and consumption will
settle at a lower level than what used to be market determined. For products and services
that have positive externalities, the government can provide incentives to encourage the
production and consumption of these merit and socially beneficial commodities.
For market imperfection as manifested by monopolistic and oligopolistic market
structures the government can also use its regulatory power to temper the monopolistic
power of big corporations. It can set a price limit to make sure that the monopolist can
charge the price it wants that will maximie its profits. &nother way of addressing the
monopoly power of these companies is to have higher or progressive taxes or their
corporate income or profits.
<astly, the government can provide public goods as in the case of public order,
national defense, the conduct of foreign policy and the management of the monetary
affairs that can be en!oyed by all its citiens. 8sing tax revenues, the government can
directly provide these publicly or !ointly consumed commodities.
For imperfect information, the government can use its regulatory power to set
standards for the disclosure, protection of the consumers from unscrupulous companies,
sellers and service providers by requiring them to label their products and services,
mandating warranty and other consumer protection measures.
!.2. Role of collective action
There is also a strong possibility that the government may fail in its programs in
addressing market failures. Instead of addressing the inefficiencies caused by market
failures, the government may not able to address these problems but somehow worsens
the situation through the incompetence of government personnel, graft and corruption,
inefficiencies, lack of institutional capability and other problems associated with
government intervention.
In such a situation, what option is left to a society in the management of its
resources so that it can produce the highest social welfareC In this case we may need to
seek other societal alternatives. 9ne possible alternative is the use of culture as a
mechanism for allocation. 'pecifically, the role of collective action and the use of social
capital may be crucial alternative allocation mechanisms in the light of market and
government failures.
To illustrate this option, consider a situation where a place has been devastated by
a natural disaster. &s a consequence, the normal functioning of the market is not
operative. This means that the basic needs of people are not meet because the institutions
of the market are impaired. The government is likewise damaged and may not also be
able to response to the needs of the people. To make it worse, because of inefficiencies,
red tape, restrictions, and institutional weaknesses the government becomes powerless in
providing the needs of the people. 8nless a national emergency or police power is
imposed, the government may not be able to function and deliver what it is suppose to
deliver.
In such an extreme and unfortunate situation, societies usually tend to culture and
the operation of the social capital to provide the needs of the people. This is done usually
through volunteerism, community contributions, support from extended family and other
social action programs. &nother example where collective action can work is the
protection of public goods, like environmental protection. The market mechanism of
environmental taxes failed the degradation of the forest. -ven the use of government
police power is inadequate in protecting the environment because the institutions are
weak. "owever, through cooperative actions, done through community effort, they are
able to protect the environment because the community sees the value of its protection.
%ecause of the economic and tourism value of a river members of the community are not
polluting it. There are not government agents that monitors or checks the pollutants but
people still keep the river clean because in the end, it attract more tourists and tourism
brings income to the community and to their households.
;.;... Role of culture and social capital.
There are many aspect of Filipino society that we can explore to form social
capital and pursue to answer failure of the market and failure of the institutions or
government. For one we have the bayanihan. This concept is very difficult to translate
literally because it captures beyond community cooperation. The word is rooted in
bayani or heroD thus bayanihan is community cooperation plus a tinge of local heroism.
This has been ingrained in our society for centuries. %ut lately, we have cooperatives
that espouse mutual assistance among members at the community level. The family ties
are also very strong in the ,hilippines but we have not extended their positive
contributions beyond our families. The inability of our young individuals to go to school
because of inadequate family income, lack scholarship and limited access to credit can be
addressed by the provision of assistance from the generosity of family members and other
relatives. The role of hermano/hermana mayor in the celebration of the town fiesta is
another example of cooperation at the community level. If we could only extend these
community cooperative measures and traits to the national level we can evolve a national
consciousness which can be our own social capital.
Conclusion
In this chapter we have discussed various manifestations when a market fails. &lthough
many economies in the world today use the market system as a mechanism for allocation
of their scarce resources we know that the presence of externalities, public goods,
asymmetric information and market imperfections can lead to market failures.
This means that price set by the market in the interactions of demand and supply,
or consumers and buyers, they may not account for the true social costs and social
benefits of the production and consumption of these goods.
There is a need for government intervention to mitigate these problem that bring
about market failure. %ut even the government can fail because it is not really meant to
provide private goods and does not have its institutional capacity to allocate resources
efficiently. In such a situation, we may turn to culture or collective action, social capital
to have efficient allocation.
)e' *erms

*onsumer surplusEEEE.. benefits derived by the consumers arising from the
difference between the marginal utility and the prevailing
market price of the commodity
-xternalityEEEEEE benefits and costs incurred by a third party that is
independent from the actors of any transaction
(arket failureEEEEE.. a situation when the price of a commodity does not reflect
the marginal social benefits and marginal social costs of a
product due to market imperfections, information
asymmetry and presence of externalities
(arket imperfectionsEEE a situation when actors of any transaction exercise their
market power to extract more surplus resulting in the
divergence of the price and the marginal cost or marginal
benefits.
,roducer surplusEEEEE. benefits derived by the producers arising from the
difference between the marginal cost and the prevailing
market price of the commodity
,ublic goods EEEEEE. goods and services produced in the economy but whose
consumption does not exclude others.

'ocial capital EEEEEEtype of wealth arising from the positive effects of the
interactions of people in a society
Exercises
Exercises
+. Evaluate if the follo&in are true or false statements,
.. The price determined in a competitive market will always reflect the marginal
social benefits and marginal social costs.
5. When the government imposes a subsidy in the production of a commodity,
there is an overproduction of the commodity since the price is lower than the
marginal private cost.
;. When the marginal social cost is higher than the marginal private cost while
the marginal social benefit is equal to marginal private benefit, the price
determined by the market will lead to under4production of the commodity.
?. In adverse selection, with proper disclosure of information about the product a
consumer may end up with low quality product as products with high quality are
mixed with low quality product.
F. The government cannot do anything about market failures because government
intervention is what leads to inefficiencies in the market.
-. +ns&er the follo&in .uestions
.. What type of externality is present in the following activities, and explain why is it an
externalityA
a. Gour next door neighbor is playing rock music on high volume in the evening.
b. Gou decided to buy beautiful garden fixtures for your front lawn.
5. Why is the existence of a monopoly considered a market failureC If that is so, is it
good to break up a monopolyC

;. What is information asymmetryC What are the three situations under information
asymmetryC Why is it a market failureC
?. What is a public goodC -xplain why it is a market failure. 2ive examples of a public
good.