This document discusses market failures and reasons for government intervention in markets. It provides examples of two common types of market failures: public goods and external costs. Public goods are nonrival and nonexcludable, so private markets underproduce them. Examples given include national defense and flood control. External costs occur when a third party bears costs from a market activity, such as pollution from factories. This leads markets to overproduce goods with negative externalities. The document argues government can intervene to correct for market failures through policies like taxes, subsidies, and cap-and-trade systems.

1. Market Failure
Indeed, our particular concept of private property,
which deters us from exhausting the positive
resources of the earth, favors pollution.
-Garrett Hardin
Slide 1 of 22

2. Review: Societal Surplus
A
B
C
Economists are typically proponents of
free markets because they benefit
society. When a market sets the price,
Consumer and Producer (i.e. societal)
surplus is maximized.
Slide 2 of 22

3. Review: Society’s benefits and Dead
Weight Loss
If a market is unable to reach
equilibrium…for any reason…then some
of these benefits disappear.
This “Dead Weight Loss” is
lost to society!
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4. Market intervention
So you are probably wondering…
If intervening in markets can create dead
weight loss, then why do governments
intervene in markets?
Do they even have a role in the economy?
The answer is yes. Sometimes markets
fail and governments need to intervene to
correct for it.
So what is market failure? See an
example on the next slide….
Slide 4 of 22

5. An example of market failure
Perhaps demand and
supply would dictate
that this combination
of goods are
produced.
…And what if that
intense level of
manufacturing caused
acid rain (a factor
unaccounted for by
producers because
they do not have to
pay for it)?
Perhaps this
would be a more
“optimal” mix of
goods.
However, If we
leave production
decisions to the
market… will we
ever get there?
Notice that at the
point, the amount
of manufactured
goods is relatively
high…
I doubt it…this
economy will
probably stay
here, despite the
fact that this is not
desirable for
society.
That is market
failure. It is an
outcome
determined by
the market that
is not optimal to
society.
Slide 5 of 22

6. When private sector markets fail,
Government can intervene
“Laissez Faire!”
He was referring to the economy and
suggested that an economy unbothered by
a government would outperform one that
was interfered with.
Adam Smith, a famous 18th century
economist, coined the term “Laissez-Faire”
which means “leave it alone”.
He did realize, though that there were
situations where a government must
intervene.
Slide 6 of 22

7. We’ll discuss two types
of Market Failure
We’ll look at
examples of each.
Public Goods
External Costs
Slide 7 of 22
These are common causes of
market failure, which is a key
learning outcome!

8. #1 Public goods
Public Goods
Nonrivalry means that when one person buys
and uses a product, it is still available for other
consumers.
Nonrivalry Example: Flood control.
By using a system of levees to protect my house
from floods, I do not consume those levees.
Nonexcludability means that sellers cannot keep
the people that did not pay for the product from
using it.
Nonexcludability Example: National defense.
The military cannot threaten to exclude certain
households from protection if they do not pay.
Public goods are characterized by
nonrivalry and nonexcludability.
Slide 8 of 22

9. An example of a public good:
A lighthouse
Public Goods
Assume that this
captain paid for
the lighthouse.
By using it, She
wouldn’t consume
it. It is
nonrivalrous.
And what is to
stop this captain
from using the
light? It is
nonexcludable.
This is a
public good.
Slide 9 of 22

10. Should there be
a lighthouse?
Public Goods
But…should there be
a lighthouse?
Imagine, prior to
construction, these
three ships were lost
because there was no
lighthouse.
What if the lighthouse
cost $16 million to
build.
No single firm would
be willing to produce
it.
It costs more than
anyone’s individual
ship.
Because of nonrivalry
and nonexcludability,
private firms cannot
profitably produce public
goods so they don’t.
Slide 10 of 22

11. Clearly, there should be a lighthouse
(MB>MC or in other words, $37 million>$16 million)
• Think of it like this- who will build the light house if:
• Anyone could use it regardless of whether they paid
» This is called the “Free Rider Problem”. Any single user
would not deem it worthwhile to build it.
• Examples of public goods provided by government
are:
» National defense
» Space programs
» National health program
» Flood control
Public Goods
The free rider problem
is a situation where an
individual reaps the
benefits of someone
else’s purchase of a
good. Example: a
Fireworks Show!
But the private market won’t build
it – this market has failed.
I think you’ll agree
that these are good
to have.
But as public goods,
the private sector
will not provide
them.
Slide 11 of 22

12. Private versus Public Goods
Public Goods
Private goods do not share these
characteristics of nonrivalry and
nonexcludability.
Instead, when a private good is
consumed, it is gone.
And businesses can keep non payers
from using these goods.
Therefore, the businesses ARE able
to charge for these goods.
Businesses are willing to produce
private goods so a government does
not have to get involved.
There is no market failure!
For example, a drive through will take
your money before giving you food.
Slide 12 of 22

13. # 2 External Costs and Benefits
• Also referred to as “externalities” or
“spillovers”, these are costs or benefits of a
market activity borne by a third party
– Examples include pollution, traffic congestion
– Spillovers can also be positive such as apples from your
neighbor’s trees falling over your fence
External Costs
Slide 13 of 22

14. The polluting factory:
an external cost illustration
We’ve learned that three
units will be produced in
this market.
But what if this firm was a
factory that produced a lot
of air pollution?
And what if that pollution
meant that you had to
paint your house every
two years?
The polluting company
would be imposing a cost
on you. That is an
external cost.
The market has failed.
You as a third party should
not have to pay those
costs.
Perhaps the government
can intervene by taxing
the polluting company.
Taxes would reduce
output and move the
market toward a more
socially optimal output.
Note how the tax has
increased the firm’s costs
and as a result output has
fallen to two units. To
further help, the
government might pay you
part of the tax revenues to
offset your increased
painting costs.
External Costs
Slide 14 of 22

15. Externalities and production decisions
• The market will over produce
goods that produce a negative
externality
• The market will under produce
goods that produce a positive
externality
This should make
sense…a third party is
paying part of their costs.
This should make sense
too…the producer is not
being paid for a benefit
they generate.
External Costs
Slide 15 of 22

16. Controlling for externalities
We have seen one example of a way a
government might control for
externalities (taxes).
The next few slides will explore ways a
government can intervene in more
detail.
External Costs
Slide 16 of 22

17. Government intervention to control for externalities:
Direct Control
Through direct control, the state has
taken over all sales of liquor.
Why are liquor stores state run in
Virginia? (and other states)
$10
10,000
If this market is left alone, then 10,000
units of liquor would be sold at a price
of $10.
But the consumption of liquor has
externality costs not accounted for in
the cost of production.
The consumption of liquor increases
crime and domestic violence.
Local governments incur a cost to
address this through police and public
safety budgets.
That is market failure. A third party is
incurring a cost.
They increase the price (with a price
floor) to reduce quantity!
$15
8,000
Price Floor
External Costs
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18. Government intervention to control for externalities:
Specific taxes
A government can tax this industry to
reduce production.
What can be done about
polluting factories?
$100
2,000
If this market is left alone, then 2,000
units of a product would be sold at a
price of $100.
But the production of this good has
externality costs not accounted for in
the cost of production.
The manufacturing process causes
pollution.
Local residents incur a cost to address
this through clean up and health
issues.
That is market failure. A third party is
incurring a cost.
The government has reduced
production by adding costs to the
producer!
$125
1,500
External Costs
Slide 18 of 22

19. Government intervention to control for externalities:
Subsidies
A government can subsidize this
industry to increase production.
Why is it cheaper for in state
students to attend college?
$2000
200,000
If this market is left alone, then 200,000
students might attend college at $2,000
per semester.
But the production of this good has a
positive externality not accounted for in
the cost of production.
An educated population is healthier
and commits less crime.
Local governments and health systems
need to provide fewer services to these
populations.
That is market failure. A third party is
benefitting from education providers.
By giving money to colleges, students
can attend at a lower cost…and more
students go!
$1250
250,00
External Costs
Slide 19 of 22

20. Government intervention to control for externalities:
Market Based Approach
P=$100
P=$200
What is the “cap and
trade” system?
A government agency (EPA)
determines that a pollutant such as
emissions of SO2 (that produce acid
rain) produced by all companies must
be below a certain level or “cap”.
The Government then issue permits for
auction that allow companies to
produce some share of the capped
SO2.
Companies bid on these permits and
can trade them.
The “cap” prevents environmental
damage beyond a certain level and
encourages companies to innovate.
Typically, demand would increase and
drive costs up encouraging more
innovation.
Note that supply is fixed (capped) and
the supply curve is perfectly inelastic)
External Costs
Slide 20 of 22

21. The market based approach
has many advantages
Potential polluters are given an economic
incentive not to pollute.
Rising costs stimulate innovation for lesser
polluting alternatives.
The program generates revenues that can be
devoted to clean up.
Conservatives can buy permits thereby limiting
the amount of total pollution available to polluters.
External Costs
Slide 21 of 22

22. In summary
When markets do not reach equilibrium, a
dead weight loss may occur.
Proponents of market systems prefer
that markets be left alone.
However, sometimes, markets fail.
When markets are unable to bring us to an outcome that
is optimal for society, a government might intervene.
Through taxes, subsidies, or other forms of intervention, a
government tries to ensure that we reach (or at least move
towards) a socially optimal outcome!
Slide 22 of 22