CHAPTER 9
The Economics Of Information & Market
Failure

INTRODUCTION

Learning Objectives
What will you learn in this module?
 What are the four important sources of market failure?
 Explain why market power reduces social welfare?
 What is deadweight loss created by monopoly? How
public policy aimed at reducing deadweight loss?
 Why externalities can lead competitive markets to provide
socially inefficient quantity of goods and services?
 Why competitive markets failed to provide socially efficient
levels of public goods?
2-3

Market Failure and efficiency
• The socially efficient quantity in a market occurs where
price equals marginal cost. This quantity maximizes the
sum of consumer and producer surplus.
• This socially efficient price and quantity arise naturally
in a perfectly competitive market.
14-4

Market Failure and efficiency
• When a firm in a market produces an output that
is less than the socially efficient level because it
charges a price that exceeds marginal cost, the
firm has market power.
• The value to society of producing another unit is
greater than the cost to produce another unit.
• Government may intervene in the market in
attempt to increase social welfare.
14-5

A VIDEO ABOUT
“Market Failure”
https://www.youtube.com/watch?v=13JOGWzY8kE

Deadweight loss and Market failure
• The figure shows monopolist’s demand, marginal
cost and marginal revenue curves. The profit
maximising output is Qm units and the units are
sold at price Pm, consumers pay more for the last
unit of output than its costs. Total social welfare is
the region W, while the triangle area is the
deadweight loss of the monopoly.
2-7

A VIDEO ABOUT
“Deadweight Loss”
https://www.youtube.com/watch?v=n0LXkA9kat
o

Welfare and Deadweight Loss Under Monopoly
14-9
Price
Quantity
Demand
MR
MC
𝑄 𝑀
𝑃 𝑀
Deadweight loss
Social welfare

CHAPTER 9
The Economics Of Information & Market
Failure

IMPORTANT SOURCES OF
MARKET FAILURE
Market Control - Price Regulation

Price Regulation
• The presence of large scale economies may make it
desirable for a single firm to service an entire market.
• In these instances, government may permit a monopoly to exist,
but regulate its price in effort to reduce the deadweight loss.
14-

Regulating a Monopolist’s Price at the
Socially Efficient Level
Price
Quantity
Demand
MR
MC
𝑄 𝑀
𝑃 𝑀
𝑃 𝐶 Regulated price
Effective demand
𝑄 𝐶

Regulating monopoly price
• Government can regulate monopoly’s price to reduce the
deadweight loss.
• An unregulated monopoly produces Qm units of output at
price Pm. A competitive industry would produce Qc units,
where MC intersects the demand curve
• If government enforced a regulated price Pc then so the
maximum price it can charge for units less than Qc is Pc.
2-

Monopolist’s Break even point
• The welfare loss of monopoly arising from monopoly can
be analysed through its average total cost curve.
• In the diagram monopoly produce at the break even point.
• Unregulated monopoly would produce Qm units and
charge Pm. Since price is equal to the total cost of
production, the monopolist earns zero economic profits in
the absence of regulation
2-

Monopolist’s zero Economic profits
Price
Quantity
Demand
MR
MC
𝑄 𝑀
𝑃 𝑀
𝑃 𝐶 Regulated price
𝑄 𝐶
ATC

CHAPTER 9
The Economics Of Information & Market
Failure

IMPORTANT SOURCES OF
MARKET FAILURE
Externalities

Externalities
• Externalities arises when costs borne by parties who are
not involved in the production or consumption of the good.
• Negative externalities exist when costs are borne by
parties who are not involved in the production or
consumption of a good or service.
• The reason externalities cause a “market failure” is the
absence of well-defined property rights.
• The failure is often resolved when a government defines
itself to be the owner of the environment, and uses its
power to induce the socially efficient levels of output and
pollution.
14-

A VIDEO ABOUT
“Negative Externalities and Market Failure”
https://www.youtube.com/watch?v=nW0Gl_CFo
JUFor

The Socially Efficient Equilibrium in
the Presence of External Costs
Output of steel
Price
of
steel
𝑆 = 𝑖=1
𝑁
𝑀𝐶𝑖 (internal costs)
0 𝑄 𝑆
Demand
𝑃 𝐶
Marginal cost to society of
producing steel
(internal and external costs)
𝑃 𝑆
𝑄 𝐶
Marginal cost of
pollution to society
(external costs)
A
B Free market
equilibrium
C
Socially
efficient
equilibrium

Internalise the externalities
• The supply curve is based on the private costs paid by the
steel firms, if they are allowed to dump pollutant s into the
water for free the market equilibrium is at point B
• At this quantity, society pays marginal price of A, on top of
the price of Pc paid to the steel firms
• The cost of pollution is not internalised by the seller and
buyer of steel products
• The firms who take into account the pollution cost to
society, their marginal cost curve would become vertical
sum.
2-

CHAPTER 9
The Economics Of Information & Market
Failure

IMPORTANT SOURCES OF
MARKET FAILURE
Public Goods

Public Goods
• A public good is another type of good that leads to a
market failure.
• A public good is:
• A good that is nonrivalous and nonexclusionary in consumption,
and therefore, benefit persons other than those who buy the goods.
• Nonrivalous consumption: the consumption
of the good by one person does not preclude
other people from also consuming the good.
• Nonexclusionary consumption: once
provided, no one can be excluded from
consuming the good.
14-

A VIDEO ABOUT
“Public Good”
https://www.youtube.com/watch?v=nsWuzS_dE
M8

Public Goods and Inefficiencies
• Public goods leads the market to provide inefficient
quantities since everyone gets to consume a public good
once it is available, but individuals have little incentive to
purchase the good; they prefer others to pay for it.
• When a group of individuals rely on the efforts or payments of
others to provide a good, we say there is a free-rider problem.
14-

CHAPTER 9
The Economics Of Information & Market
Failure

IMPORTANT SOURCES OF
MARKET FAILURE
Incomplete Information

Incomplete Information
• Efficiently functioning markets require participants
to have reasonably good information about
prices, quality, available technologies, and the
risks associated with working particular jobs or
consuming particular products.
• Market inefficiencies result when participants have
incomplete information.
• One severe source of market failure is asymmetric
information, where some market participants have
better information than others. Then buyers may refuse
to purchase from sellers
14-

A VIDEO ABOUT
“Asymmetric Information”
https://www.youtube.com/watch?v=sXPXpJ5
vMnU

Resource Allocation and Rent Seeking
• Rent Seeking: selfishly motivated efforts to
influence another party’s decision.
• Monopolist’s rent seeking creates a loss of social
welfare and inequality of income distribution.
• Monopolists tend to earn higher incomes than
average, the existence of the monopoly in the
economy will tend to increase the inequality of
income distribution.
• Government policies can improve the allocation
of resources to alleviate market failures and
maximise overall welfare.
14-

Government policy
• Regulation presents a number of problems in the
case of natural monopolies.
• If a monopoly can avoid regulation, it can receive
private gains.
• Monopoly spends much more on lobbying activities
and avoids legislation by engaging in rent-seeking
activities.
• Government enforcement cost will be very high.
• These policies, however, generally benefit some
parties at the expense of others due to ‘free rider’
problem.
2-

What is Quota?
• A quota is a government restriction that limits the quantity
of imported goods that can legally enter the country.
• The implications of quota policy:
• Reduces competition in domestic market
• Higher domestic prices
• Higher profits for domestic firms
• Lower consumer surplus for domestic consumers
• Conclusion: Domestic producers benefit at the expense of
domestic consumers and foreign producers
14-

What is Tariffs?
• A tariff is designed to limit foreign competition in the
domestic market to benefit domestic producers, which
accrue at the expense of domestic consumers and foreign
producers.
• Lump-sum tariff: fixed fee that foreign firms must pay the
domestic government to be able to sell in the domestic market.
• Excise (per-unit) tariff: the fee an importing firm must pay to the
domestic government on each unit it brings into the country.
14-

Conclusion
• Market power, externalities, public goods, and incomplete
information create a potential role for government in the
marketplace to remedy market failures.
• Government’s presence creates rent-seeking incentives,
which may undermine its ability to improve matters.
14-

RECAP
On Key Terms and Concepts
2-37

Key terms
• Deadweight loss
• Incomplete information
• Free rider problem
• Rent seeking
• Negative externalities
• Property rights
• Public goods
• Nonrival consumption
• Social welfare
• Inequality
2-