Sunday, 27 September 2009

Market failure occurs when free markets, operating without any government intervention, fail to deliver efficient allocation of resources.

Market failure results in:

- Productive inefficiency. Firms are not maximising output from given factor inputs and is a problem because the lost output from inefficient production could have been used to satisfy more wants and needs

- Allocative inefficiency. Resources are misallocated when firms produce goods and services not most wanted by consumers, given their costs. This is a problem because resources can be put to a better use making products consumers value more highly so that more wants and needs are satisfied and economic welfare increased.

Markets can fail because of the following factors:

- Externalities either negative (eg pollution) or positive (eg public infrastructure) causes private and social costs and/or benefits to diverge

- Imperfect information means merit goods are under produced while demerit goods over produced

- Markets cannot make an ‘appropriate’ profit from producing public goods such as light houses and quasi-public goods such as roads

- Market power: imperfect competition results in market dominance such as the abuse of monopoly power to set prices higher than if the industry were competitive

- Factor immobilityeg geographical & occupational causes unemployment hence productive inefficiency. This aspect is not really relevant to transport economics

- Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of income and social exclusion where people on low income – the relatively poor - are denied access to essential goods and opportunities considered ‘normal’ by a society eg food, clothing, housing, and education. Note that air rail and private cars are used disproportionately by the rich while those least off are more likely to use public transport

Marginal External & Social cost & benefit curves
Marginal external costs & social costs curves.

In the graph added:
- The marginal private cost curve (MPC) shows the cost of an economic activity to the decision maker eg a firm. MPC is given by the firm’s supply curve.
- The marginal external cost curve (MEC) shows the estimated cost of an economic activity imposed on third parties.
- The marginal social cost curve is the total cost to society of producing an extra unit of a good. (MSC= MEC + MPC)

Also, the MEC does not always have to remain the same. That’s because of an increase in quantity of car use might cause extra congestion making the negative externalities increase marginally.

Marginal external benefit & Social Benefit Curves.

Marginal social benefit (MSC) is the benefit to society of consuming one extra unit of a product and can be illustrated graphically.

- The marginal private benefit curve (MPB) shows the benefit of an economic activity to the decision maker eg a consumer. MPB is given by the market demand curve.

- The marginal external benefit curve(MEB) shows the estimated benefit of an economic activity enjoyed by third parties

- The marginal social benefit curve (MSB) is the total benefit to society of using an extra unit of a good ie MSB = MSB + EMB

It’s like the same as the cost curve shows above.

The efficient allocation of resources requires output to be increased up to the point where social marginal benefit equals social marginal costs.

Note: The supply curve S shows the firm’s marginal private cost of production but ignores the negative externalities. (MPC=S) Given negative externalities such as pollution, marginal external costs must be added to the MPC to give the Marginal social cost curve. (MSC= MPC + MEC) Given no positive externalities the demand curve is D=PMB=MSB
Neg externalities result in MPC differs from MSC, positive externalities result in: MPB differs from MSB.

The equilibrium level of output delivered by a free market, Qmkt, is allocatively efficient. The market is socially efficient at Qeff (SMB=SMC). So the market is overproducing (Qmkt-Qeff)
The overproducing results in the welfare loss triangle(JKL and LMN) which measures the loss to society when markets are allocatively efficient.
In free unregulated markets, externalities cause private and social costs or benefits to diverge so that the equilibrium and allocatively efficient level of output are different and markets fail.

- Negative externalities mean social costs exceed private costs resulting in overproduction

- Positive externalities cause social benefits to exceed private costs resulting in underproduction

Externalities cause market failure because they cause private and social costs and benefits to diverge

- The J off peak is less than the capacity of the road so there is no congestion. The marginal social cost of each extra journey is constant at P1.
- Beyond J capacity the roads become congested causing negative externalities.
- The marginal external cost is a monetary estimate of the externality imposed on third parties by rush hour motorists and operates beyond Jcapacity. It diverges because as extra cars join, the degree of congestion increases.
- The government needs to take measures to reduce congestion to J eff, where MSC=MSB

Markets do not only fail because of allocative efficiency, they also fail because of information failure, this is mainly caused by:

- Misunderstanding over the true costs and benefits of a product. (EG the health benefits of cycling)
- Uncertainty about costs and benefits. (EG hybrid car technology)
- Complex information (EG choosing between petrol or diesel requires specialist knowledge of cars.
- Inaccurate or misleading information (EG some advertising may ‘oversell’ the benefits of private motoring)
Information failure faces two kinds of goods:
1) Merit goods , a product (EG education) of which the government believes consumers undervalue because of imperfect information. A merit good is ‘better’ for the consumer than the consumer might realise. (EG measles inoculation, transport such as walking and cycling which is next to transport also and exercise)

Merit goods’ market failure looks like this:

Note: Consumers Undervalue merit goods! So the welfare loss triangle quantifies the amount of welfare loss resulting from under consumption

2) Demerit goods . This is a product, like tobacco, that he government believes is overvalued by the consumers. A demerit good is ‘socially undesirable’ and ‘worse’ for a consumer than the consumer realises.
This causes the Demerit goods’ market failure to look like this:

Note: Consumers overvalue this product. So the welfare loss triangle quantifies the amount of welfare loss resulting from over consumption

Market failure may also be caused through market dominance.

Market dominance occurs when a firm acquire monopoly power. In the UK monopolies are defined as occurring when firms more than 25% of the market. Monopoly power can result in:
- Productive inefficiency : firms do not minimise costs.
- Allocative inefficiency: the market under produces.

Unregulated dominant firms can be inefficient because of a lack of competition, they don’t need to be efficient. The lack of competition allows them to:

- Produce goods at a quality and price largely determined by the firm. Consumers face restricted choice and have no alternative supplier eg Network Rail.
- Have less incentive to maximise outputs from given inputs causing productive inefficiency.

Monopolist firms seek to maximise profits so they seek to the quantity where MR=MC. The resultant price (SMB) does not equal SMC. The result is market failure because of allocative inefficiency.

Some transport industries are monopolies and so have the potential to abuse their market power. Eg:
- Natural monopolies such as operating the rail track infrastructure.
- Legal monopolies such as Train Operating Companies with an exclusive contract to offer rail tickets over a route.
The market failure through market dominance is graphically illustrated as:

A monopoly will make their output Qmkt, which is where MR=MC, to optimise profits. However, the socially efficient level of output occurs where MSC=MSB, so on Qeff. Market failure occurs because of under production. The loss to society from under production is given by the welfare loss triangle JLM.

Governments try to correct market failure.
In a free market economic system, governments take the view that markets work. Laissez faire approach dominates.

Where markets fail to deliver an efficient allocation of resources there is an argument for government intervention to correct market failure. Governments seek to internalise the external costs & benefits.

There are a few policies the government may use to intervene in a market to attempt to correct market failure:
- Legislation eg laws that prohibit large lorries crossing London at night; parking bans.
- Regulation eg government appointed utility regulators who impose stricts price controls on privatized monopolists eg Train Operating Companies.
- State provision either through:
1) State production eg (re)nationalised Network Rail
2) State funding eg the government might pay private sector bus companies to run late night services to rural areas
- Fiscal measures (financial intervention) that use the tax and benefit system to alter market prices or affect income distribution:
1) Indirect taxes to raise the price of demerit goods and products with negative externalities ie petrol taxes or subsides to lower the price of merit goods and products with positive externalities eg rail journeys
2) Direct taxes on the ‘rich’ and benefits in cash or kind for the poor to improve the distribution of income eg free bus passes for senior citizens


The government tries to intervene in mainly two ways: by demand side policy and supply side policy.
Demand side policies include:

- Use taxes (road) and subsidies (rail) to affect the relative price of journeys and encourage commuters and freight to switch from road to public transport eg rail.
- Congestion charging equal to external marginal cost. Cause peaking where demand exceeds supply to raise price to encourage motorists to:
1) switch to substitutes eg buses and rail
2) or travel at off peak time when peaking is not an issue - especially freight. However where motorists divert to non-toll roads congestion is simply displaced to another geographical area
- Workplace parking charge: tax employees who have a parking space at work
- Introduce quotas to limit the number of cars that can be owned.
- More/improved park & ride schemes (P&R) Cause ineffective integrated transport so locate P&R near motorway nodes
- Improve public transport capacity & quality Cause no substitute to car so make train, trams or buses as convenient as using a car.
- Subsidise substitutes Cause substitutes too expensive so lower price eg increase subsidies or offer tax relief on train/bus season tickets
- Use planning regulations to halt new out-of-town super stores and build houses near work
- Encourage teleworking where employees work from home through tax incentives

Supply side policies include:
- Build more roads Cause too little supply. However, new roads generate extra traffic and new roads are unsustainable.
- Enable constant traffic speed to reduce congestion caused by stop-start driving eg variable speed limits.

Sustainability is very important in transport, to maintain sustainability we will need extra roads. This gives some sustainability issues like:
- It uses up non renewable resources and impacts on land use
- The pollution generated by increased traffic threatens the environment eg contributing to global warming
- New roads mean visual intrusion, loss of land for current and future generations.
- Increased car usage depletes world stocks of fossil fuels and contributes to global warming.
- It is an expansion of Heathrow sustainable? An extra runway at requires the demolition of three villages and 5,000 houses, and will further increase noise pollution.

There are real sustainable forms of transport, like walking and biking because these forms of transport do not use any fossil fuels, causes no negative externalities in use and have very small infrastructure needs.


  1. Thanks you! it is very well explained.

  2. I'm not 100% clear as to why marginal and private benefit/cost curves diverge. Could you explain this?