Prof. Prabha Panth,
• Neo-classical model of perfect competition
is taken as optimum for allocation of
• P = MC = MU,
• All private costs = private benefits
• Maximisation of individual benefits
• Social benefit = Σ individual benefits
• Pareto optimality
What is Market Failure
• Market failure occurs when the market
through the price system cannot obtain an
optimal allocation of resources, due to the
differences between private and social
costs and benefits.
• SMC ≠ Σ Private MC
• SMB ≠ Σ private MB
• Inefficiency of the real market
• Market failure: Private decisions based on
market prices cannot generate an efficient
allocation of resources for Society.
• This is especially true of Environmental
goods and services.
• Difference arises between Private costs
and Social costs, and Private Benefits and
• Most assumptions of perfect competition
do not exist in reality.
ENVIRONMENTAL GOODS AND
Three reasons for market failure:
1) No Markets for Environmental Goods:
Most environmental goods are “Free”
goods – e.g. atmosphere, water, etc.
No one owns environmental goods, so
they cannot be bought and sold.
There is no price for their use or
Therefore they are overused
2. Pure Public Goods: Environmental goods
are pure public goods.
Two characteristics of Pure Public Goods:
a) Non Rival: one person’s use does not
reduce another person’s supply. E.g.
oxygen, sunshine, river
b) Non-exclusive: Cannot exclude another
person from using the environmental
good. For e.g. if one person uses the river,
he cannot stop another from using it.
Since environmental goods are non-rival
and jointly consumed, one person’s
consumption will affect another’s
consumption outside the market.
One user can impose external costs to
For example: paper mill cuts the forest,
affects biodiversity and forest based
industries, climate change, etc.
No payment is made for the misuse of the
AR = MRP
• Production adds environmental costs – for e.g.
thermal plants produce electricity as well as CO2
which leads to Greenhouse effect.
• But the cost of pollution is not added to the
private MC of the firm.
• Pollution imposes an external cost or externality
to society = EF.
• If it is included then the new equilibrium is at F,
and P = FQ1
• Or else, Q should fall to G, where P = SMC.
• Thus perfect competition leads to over
production (Q1>Q2), and charges lower price
Correcting Market Failure
• Firms don’t pay the External cost, as they
are not affected by the pollution.
• According to Pigou, if a tax = External cost
is imposed (Tax = EF), then the externality
can be internalised.
• Called Pigovian tax.
• Therefore if External cost is internalised,
then new equilibrium will be at G, and Q
• Pollution levels or social costs will fall.
How to internalise external costs
• Pigovian taxes:
• Tax the polluter or the creator of the
Such as: Green taxes on carbon dioxide
releases, or on effluents from factories,
– Raising the prices of more polluting or more
environmentally damaging goods,
– Making polluters bear the cost of controlling or
mitigating their pollution.
How to internalise external costs
• Pigovian Subsidies:
• Reward by lowering the price and cost of
environmentally safe products, and techniques.
– Green products,
– Alternative renewable energy,
– Bio degradable plastics,
• These measures will send market signals to
reduce environmentally unsafe activities, and
encourage environmentally friendly ones.