Market failure and Govt

intervention:
 Lesson One
At the end of Lesson One, you should be able to explain :
Define the term market failure


Using real-life examples, explain the term

common-pool resources
Define the term externalities


Explain the term allocative efficiency i.e



MSB=MSC
 Allocative Efficiency

Price

MPC =MSC • In the absence of

externalities, market
CS equilibrium output is
E described as allocative
PS or socially efficient.
• Why?
MPB = MSB= P

qty
Qe
 Meaning of Market
failure

Refers to a situation where too much

or too little of goods and services
are produced and consumed from
point of view of what is socially
desirable.
p148 Ellie Tragakes
 Welfare loss
• If market produces an output Q1,
there is potential welfare loss given
by the area CDE.
Price
Explanation
B MPC= MSC
• If output Q1Qe is produced, the
total social benefit is Q1DEQe while
D total social cost is Q1CEQe.
E • The difference between total social
M
benefit and total social cost equals
to area CDE.

C • Since output Q1Qe is NOT produced,

MSB =MPB there is potential welfare loss of
A CDE.
• Area CDE is also known as
Qty
0 Q1 Qe deadweight loss or welfare loss
 Welfare loss
Price
• For output Qe Q2, there is welfare
loss given by the area EFG.
MPC =MSC
B Explanation
F • For output QeQ2, the total social
cost is QeEFQ2 while total social
E benefit is QeEGQ2
• The difference between total social
benefit and total social cost
G equals to area -EFG.
• When output Qe Q2 is produced,
A MPB =MSB there is welfare loss given by the
area
Qty EFG.
0 Qe Q2
 Practice: Thinking and
Communication Skills
Price

B MSC • If market produces Qe, what

is the total net welfare ?
F • If market produces Q2, what
E is the total net welfare ?
$1000 $400 • Compare and comment the
net welfare at Qe and Q2.
G

A MSB=P

Qty
0 Qe Q2
 Characteristics of Common
Pool Resources (CPR)
 Rivalrous means the use of the resource by a person
reduces or diminishes the quantity and quality of resources
available to others.
 Non- excludability means that people cannot be excluded from
using it
 An example is fish in open seas pp144-146.
 It is subject to overuse because a person does not take into
account the fact that his/her use depletes the amount available
for others
 Fish are a classic e.g of an overused common resource. This is
known as the tragedy of commons. Sustainability is therefore
threatened. What is meant by term “sustainability”?
 Search the web
1. Search using these terms China fisheries brinkNYT.
You will find a New York Times article [30 April
2013] on overfishing and possible effect on
developing countries

2. To find out more on overfishing and fishing quotas,

search for mackerel plunder collapse nyt. Read the
New York Times[25 Jan 2012] on overfishing. The
article reports how an EU shipping company has
managed to evade the EU quotas.
 Externality

Definition : action of one party may have effect

on another party but no payment is made.

Externalities in production Externalities in consumption

1. Positive : external 1. Positive : external
benefits benefits
2. Negative: external costs 2. Negative: external costs
Meaning of MPC, MSC, MPB and MSB
Read page 149 Ellie Tragakes
 Meaning of Market
failure
Meaning of allocative efficiency
Allocative efficiency is achieved when the sum of consumer

and producer surplus is maximized. It occurs when MSC=

MSB.
In the absence of externalities, MPC=MSC=MPB=MSB.

When there is externalities, the free market leads to an

outcome where MPB=MPC but MSC is not equal to MSB.
 Lesson Two

At the end of the lesson, you should be able to :

1. Using a real-world example, explain(analyse) how activities

that generate negative externalities in production (such as
pollution) lead to market failure.
2. Calculate welfare loss (HL)
3. Using real-life examples, evaluate how govt. policies (such as
indirect taxes, carbon taxes, tradeable permits/cap,
legislation/regulation, collective self-governance and
international agreements reduce overproduction due to
negative externalities in production.
 Overproduction of a good due to ext.
costs in production
Electricity industry
$ S2 =MSC
On the foolscap, explain
how the existence of
B S1 =MPC external cost in
E2 production may lead to
P2 overproduction.
P1 E1

D1 =MPB =MSB
Qty
0 Q2 Q1
Overproduction of a good due to ext. costs in production
1. Define market failure
2. In a free market economy, goods that
generate external cost in production are
overproduced
3. Define external cost in production
4. Consider the market for electricity
5. Explain how the production of electricity using
fossil fuels generate external cost in
production.
6. Mention that because of the presence of
MEC, MSC>MPC
7. Identify the market equilibrium output
8. Identify the socially ideal output
9. Explain the deadweight loss/welfare loss
area of E1E2B
10. Comment on the size of deadweight loss
area
 Search the web
1. To find out more about pollution caused by
industrial activity, search for India pollution ft
2. Read the financial Times article [11 Dec 2018]
[Link]
 Calculating Welfare Loss
(HL)
1. Read pages 151-152 Ellie Tragakes
 Reducing the output of goods that
generate external costs in production
pages 152-161, Ellie Tragakes

Legislation/
Market based solutions
regulations
1. Indirect
Taxes/carbon Self -governance
taxes
International
2. Permits Agreements

•How each policy works.

•Evaluation :How well each policy works: effectiveness,
advantages and disadvantages.
 Reducing output of goods that generate external
costs in production: impose an indirect tax on output

1. How the policy works?

$ S2= MSC =MPC+TaxTax on output

With reference to diagram,
S1 =MPC • Impose indirect tax = MEC
E2
shift MPC curve to MSC eq
P2 price rises from P1 tp P2 and
P1 output falls from Q1 to Q2, the
E1
socially efficient output.
• Welfare loss is eliminated

D1=MPB=MSB

Qty
Q2 Q1
 Reducing output of goods that generate external
costs in production:
Alternative to an indirect tax: carbon tax
How the policy works?
Govt can impose a carbon tax
$ S2= MSC =MPC+Tax where the amount tax is
dependent on the amount of
S1 =MPC carbon released when fuel is
E2 burned. The more carbon
P2 emitted, the higher the tax.
P1 E1 With reference to diagram,
A carbon tax raises the price of
•

fossil fuel  shifts MPC curve

towards MSC eq price rises from
P1 to P2 and output falls from Q1 to
D1=MPB=MSB
Q2, the socially efficient output.
Qty
Welfare loss is eliminated
•
Q2 Q1
 Reducing output of goods that generate
external costs in production: Carbon taxes

 Since fossil fuels do not all emit the same

Price
amounts of carbon when burned, a tax per unit of
MSC 1
carbon emissions of fossil fuels would incentivize
MSC2
MPC producers to switch away from fossil fuels like
E2
coal which emits more carbon emissions to
P2 natural gas which emits less carbon emissions.
 
P3 E3  As a result of using less polluting fuels, the MSC
P1 E1 curve will shift from MSC1 to MSC2 as shown in
D =MPB=MSB figure below, indicating that the external costs are
Quantity lower due to the use of less polluting resources.
QS1 QS2 Q1
With the fall in external costs, the optimum
quantity of output increases from QS1 to QS2 as
For real-world [Link] read Carbon shown in figure.
taxes page 153 Ellie Tragakes
 Evaluation of the use of taxes

Advantages
[Link] that external cost in production can be accurately
measured, the imposition of indirect tax =s the marginal external costs
can internalize the external costs.

[Link] incentives firms to develop and use cleaner methods of

production to reduce the amount of tax firms have to pay.

[Link] helps to reduce distortion by other taxes. For example, the

imposition of indirect taxes (to internalize external cost) has been
accompanied by reduction in marginal income tax on wages. The
latter has potential of increasing the supply of labour in the
economy and promote potential growth.
 Evaluation of the use of taxes

Disadvantages

[Link] it difficult to quantify external cost in production, it is

difficult to determine the actual amount of tax to be imposed
to internalize the external cost in production. If the taxes are
grossly over estimated, welfare loss as a result of govt
internvation may be greater than in the absence of govt
intervention.

[Link] imposition of green taxes may reduce the price

competitiveness of the country’s goods This reduces quantity
demanded of goods and services. Since demand for labour is a
derived demand, fall in demand for goods and services will
lead to fall in employment in the economy.
 Reducing output of goods that generate external
costs in production :tradeable pollution permits

What are tradeable permits?

[Link] emissions permits is a market-based solution to reduce

negative externalities of production.
[Link] decides the level of pollution that it will permit each year
and split the total level of pollution into permits, each allowing a
certain level of pollution.
[Link] emission permits are issued by the govt and give
firms license to create pollution up a set level.
[Link] they are issued, firms can trade (buy or sell) the permits on

the market.
[Link] permits are also known as a cap and trade systems.
 Reducing output of goods that generate external
costs in production :tradeable pollution permits

How does tradeable permit work?

Firms will reduce pollution if they can decrease

their emissions at a lower cost than the cost of
buying the necessary permits to pollute.

On the other hand, firms that find it is cheaper to

buy permits than to reduce pollution will go ahead
and buy permits.
 Thinking and Research skills
1. Find a country with “cap and trade” scheme
and research how effective the scheme has
been in reducing pollution.
 Reducing output of goods that generate external
costs in production :tradeable pollution permits )

Evaluation
Advantages:
Pollution may fall if low polluting firms gain competitive
advantage and drive some high polluting firms out of
business.
it would induce high-polluting firms to develop cleaner and
cheaper methods of production so that they can compete with
low polluting firms in the long run. Hence, the development of
environmentally friendly methods of production would reduce
the overall pollution level in the country.
 Reducing output of goods that generate external
costs in production :tradeable pollution permits )

Evaluation
Disadvantages:
It requires monitoring which is costly to administer; otherwise

firms may cheat by emitting more pollutants than permitted.

If the cap is set too high, it would have very limited or no
impact on reducing emission.

 
.
 Figure 4

Reducing output of goods that generate external

costs in production :regulation)

Price MPC2
MPC 1
1. How policy works
-Govt. to lay down maximum pollution
E2 levels.
P2
E1
P1 -To reduce pollution to legal requirement,
firms are required to install pollution
abatement(i.e reducing) equipment (such
D =MPB=MSB
Quantity as a filters or scrubbers that remove
Q2 Q1 harmful materials from the emissions).
 Figure 4

Reducing output of goods that generate external

costs in production :regulation)

Price MPC2 2. How policy works (continuation)

MPC 1
-The use of clean technology would raise
E2 the MPC of the firms operating in the
P2
E1 industry.
P1
-As shown in the figure, as a result of
the use of cleaner technology the
D =MPB=MSB
Quantity
industry’s MPC would shift from MPC1 to
Q2 Q1 MPC2. This, in turn, will reduce the
market output from Q1 to Q2 and hence
reducing the level pollution in the
country.
 Figure 4

Reducing output of goods that generate external

costs in production :regulation)

2. Evaluation
Advantage(s)
-As long as the inspections are frequent and rigorous and the

penalties for breaking the laws are harsh (such as imposing large
fines on any company that contravenes the law), the desired
amount of pollution reduction can be generally achieved.   

Limitation(s)

-It is expensive to administer. The regulatory agency has to check

factory by factory, firm by firm, how much and what kinds of
pollutants are being emitted. Such constant checks imply high
opportunity costs for the govt.
 
Reducing output of goods that generate external
costs in production : collective self governance

- Collective self-governance is used to manage common-pool

resources such as fisheries and forests.
- Elinor Ostron’s studies in Maine, Kenya, Nepal and Indonesia
have shown that individuals and communities have developed
rules and institutions to manage shared resources in an equitable
and sustainable manner.
- .
 Continuation
Reducing output of goods that generate external
costs in production : collective self-governance

- She argued that since users of resources have the incentive

to ensure the sustainability of resources, they should be the
ones to develop rules for the management of resources.
- Furthermore, users of resources are likely to implement,
monitor, and enforce the rules since they are the ones
involved in the establishment of rules and they are the ones
to gain when rules are followed.
 Search the web
 Search using these terms: Ostram Nobel price
facts. You will find out about first woman to
receive a Nobel prize in economics.
 Reducing output of goods that generate external
costs in production : international Agreements

To control and prevent negative externalities in production and

overuse of resources that have global repercussions such as
climate change and ozone depletion, international collaboration is
necessary.
International Agreements
[Link] Protocol 1987

[Link] trading Systems

[Link] Protocol 2005-2012

[Link] Agreement 2016

 Reducing output of goods that generate external
costs in production : international Agreements

Montreal Protocol 1987

 One such collaboration is the Montreal Protocol signed in 1987. Its aim
was to phase out substances (such as CFCs and HCFCs in air-
conditioners and refrigerators) that caused the depletion of the ozone
layer (i.e thinning of the upper atmosphere that increases UV radiation
that is harmful to human health).

 By 2009 all members states of the UN had ratified the agreement and
significant progress has been made in the area of phasing out ozone-
depleting substances.
 Reducing output of goods that generate external
costs in production : international Agreements

 Another successful example of a regional collaborative

arrangement is the EU Emission Trading System.
 In this system one permit permits the holder to release one
tonne of carbon dioxide.
 According to a major study, while this has helped to reduce
carbon emissions, it has not had negative impacts on
economic performance in terms of revenue, profits and
employment.
 Reducing output of goods that generate external
costs in production : international Agreements

 Another major but less successful international agreement for the

environment was the Kyoto Protocol of 2005-2012. Its objective is
to reduce emissions of carbon dioxide and other GHG to slow
down climate change.
 It also contained provisions for the development of tradeable
emissions permits.
 Only developed countries had emission restrictions but not
developing countries. The US did not sign the agreement on
grounds it was unfair competition since developing countries
faced no restrictions.
 Reducing output of goods that generate external
costs in production : international Agreements

 In 2016, the Paris Agreement came into effect. The

purpose of the agreement is to strengthen international
cooperation on climate change based on the goal to limit
the increase in global temperature to 1.5 degrees.
 Research and communication
skills
1. Search using these terms international agreements
UN. Add “fisheries” then forests.

2. Working in your collaborative groups find

information on international agreements that aim
to limit the sustainability risks associated with
overuse or common pool resources. Keep in mind
the atmosphere is also a global commons. Make
sure include information about the Paris
Agreement of 2015.

1. Present your findings to class

 Self-Assessment- Essay practice

(a) Explain how production that causes pollution leads

to market failure [10]
(b) Using real-world examples, discuss whether
carbon taxes is the most effective way to deal
with the external cost of production.

In your collaborative groups, prepare a full-length

answer to both parts of the question.
Research and Collaborative Work

In your collaborative group,

(a)use a diagram and explain over usage
of fishing grounds.
(b) Evaluate 2 ways to manage fishing
grounds.
 Lesson Three
At the end of lesson 3, you should be able to :

1. Using a real-life example, explain how activities that generate negative

externalities in consumption lead to market failure.
2. Calculate welfare loss (HL)
3. Using a real-world and a diagram, explain why demerit goods are over
consumed
4. Using a real-life example, evaluate how govt. policies such as indirect taxes,
legislation/regulation, education awareness creation and nudges (HL) can
reduce overconsumption of goods that generate negative externalities in
consumption or prevent overuse of common-pool resources
 Overconsumption due to ext. costs in
consumption

1. Define market failure

Price 2. In the real world, goods that emit external cost

in consumption are over consumed
MPC=MSC
3. Define external cost in consumption
4. Explain how consumption of cigarettes
generate external cost in consumption
E1 5. Because of the presence of MEC,
MSB<MPB
P1
E2 6. Identify the market equilibrium output
P2
7. Identify the socially ideal output
B 8. Explain the deadweight loss/welfare loss
MPB area arising from overconsumption of
MSB Q1Q2

Q2 Q1 9. Comment on the size of deadweight loss

Quantity
area
 Overconsumption of
demerit goods

Using a diagram explain why demerit goods are

overconsumed.

[Link] cost in consumption

[Link] ignorance

Refer to page 166

Negative consumption externalities and
over use of common pool resources

1. Explain how negative externalities in

consumption may lead to overuse of common-
pool resources

Page 166 Ellie Tragakes

 Research and communication
skills
In pairs collect information on
external costs of consumption of
sugary drinks or junk food
[defined as food high in calories
but with little nutritional value]
 Search the web
To find out more about public
health policy, search using these
phrases: WHO tobacco, WHO
alcohol [WHO is the World Health
Organisation]
 Reducing consumption of goods that
generate external cost in consumption
including demerit goods

Mkt based Legislation and

regulations Education Nudges (HL)
policies :Taxes

•How each policy works.

•Evaluation :How well it works: effectiveness, advantages
and disadvantages.

•Read pages 167-169 Ellie Tragakes

 Reducing consumption of of goods that generate
external cost in consumption including demerit
good: Impose tax
With reference to the
diagram,
Price of cigarettes
• Impose indirect tax =s to MEC in
consumption  shift supply curve
S2 =S1 + tax
to left from S1 to S2 eq output
decreases from 0Q1 to 0Q2.
S1 = MPC= MSC
• 0Q2 is socially efficient output
a
Advantages:
P2
• Creates incentives for consumers
P1
to change their consumption
E1
patterns.
E2
MSB MPB
• They provide the government with
Quantity of cigarettes tax revenue to finance an anti-
0
Q2 Q1 smoking campaign.
• Disadv: difficult to estimate size of
MEC.
 Other ways of reducing consumption of goods
that generate external cost in consumption
including demerit goods

Enact laws to prohibit or regulate Provide information on harmful

behaviour that impose external effects of consumption of demerit
costs in consumption. goods to discourage
consumption of these goods
Eg. ban smoking in public places and
make it illegal to drive when drunk. How it works: it shifts the demand
How it works: it shifts the demand curve to the left, from D1 to D2,
curve to the left, from D1 to D2, pushing the consumption closer to
pushing the consumption closer to the the socially optimum level.
socially optimum level. Anti-smoking campaigns have
For such policy to be effective, opportunity costs as funds are
impose harsh penalties on those who diverted from other desirable
break these laws and conduct uses
regular and rigorous checks.
 Self Assessment-Essay practice

(a) Explain why demerit goods are overconsumed.[10]

(b) Using real-world examples, evaluate the view that
the most effective way in which the government can
discourage the consumption of demerit goods is
through government regulations. [15]

In your collaborative groups, prepare a full-length answer

to both parts of the question.
 Lesson Four
At the end of lesson 4, you should be able to :

1. Using a real-life example, explain how positive externalities in

production (such as training of workers) leads to market failure.
2. Calculate welfare loss (HL)
3. Using real-life examples, evaluate how govt. policies (such as
subsidies and direct provision) can reduce underproduction due
to positive externalities in production
 Under production due to ext. benefits in
production
1. Define market failure
2. In the real-world goods that generate
external benefit in production are under-
produced
Price of bus trips
S1 = MPC 3. Define external benefits in production
MSC
4. Explain how training of workers generate
E1 external benefit in production
P1
E2
5. Mention that because of the presence of
P2
MEB, MSC<MPC
B

D1=MPB=MSB 6. Identify the market equilibrium output

Q1 Q2
7. Identify the socially ideal output
Quantity of bus trips

8. Explain the deadweight /welfare loss

area
9. Comment on the size of the deadweight
loss area
 Increasing consumption of goods
that generate positive externalities in
production

Direct provision refer to pages 176 and 186 Ellie Tragakes

 Increasing output of goods that generate external
benefit in production: Grant subsidy

With reference to diagram,

Price of bus trips
• Grant a subsidy = MEB shift
S1 = MPC
S2 =MSC= MPC +subsidy
MPC curve to MSC eq output
increases from Q1 to Q2.
E1
P1
• Q2 is socially efficient output
P2 E2 • Adv: Lower prices of goods
B and services
D1=MPB=MSB • Disadv: difficult to estimate the
Quantity of bus trips size of MEB and therefore the
Q1 Q2
correct size of subsidy
• use of govt funds to subsidize
training have opportunity
costs
 Lesson Five
At the end of lesson 5, you should be able to :

1. Using a real-life example, explain how activities that generate

positive externalities in consumption lead to market failure.
2. Calculate welfare loss (HL)
3. Using a real-world example, evaluate how govt. policies such as
subsidies, legislation/regulation, education awareness creation,
nudges (HL) and direct provision can increase consumption of
goods that generate positive externalities in consumption.
 Underconsumption due to ext. benefits in
consumption

Price 1. Define market failure

MPC=MSC 2. In the real world, goods that generate external
benefits in consumption are underconsumed
3. Define external benefits in consumption
B
4. Explain how health care services may
E2 generate external benefit in consumption
P2 5. Mention that because of the presence of
E1 MEB, MSB>MPB
P1
6. Identify the market equilibrium output
7. Identify the socially ideal output
MSB= MPB +MEB
8. Explain the welfare loss area of E1BE2
MPB
Comment on the size of deadweight loss
Q1 Q2 area
Quantity
 Under consumption of merit
goods: health care, education
and housing -

Using a diagram explain why merit goods are

undeconsumed or underprovided.

Refer to page 179

 Watch this
1. Search in YouTube using these terms: Natalya
empower a girl TED. Watch this video of the
talk on the importance of women’s education
 Thinking skills
1. What do you think happens when the govt. Is
forced to cut back on its spending on health
care , education and infrastructure ?
 Calculating Welfare Loss
(HL)
1. Read pages 179 Ellie Tragakes
 Increasing consumption of goods that generate ext
benefit in consumption and merit goods

Subsidies Direct
Legislations/ Education and
awareness Nudges provision
regulations
(HL)
•How each policy works.
•Evaluation :How well each policy works: effectiveness, advantages
and disadvantages.

•Pages 179-181 Ellie Tragakes

Increasing output of consumption of goods that
generate external benefit in consumption -
merit goods :Grant subsidy
With reference to diagram,
• Grant subsidy to producers 
shift supply curve from S1 to S2
 eq output increases from Q1
to Q2.
• Q2 is socially efficient output.
• Adv: makes merit goods
affordable

• Disadv: increase tax rates to

finance subsidy has negative
supply side effects on potential
output
• Use of govt funds have opp
cost……..
 Other ways of increasing consumption of
goods that generate external benefit in
consumption - merit goods

• Direct • Legislation • Provide

provision Enact laws to information on
of merit make the benefits so as
goods by consumption to encourage
govt. of merit consumption
goods of merit
compulsory goods
 Self Assessment -Essay practice

(a) Explain why merit goods are underprovided.[10]

(b) Using real life examples evaluate the view that
the most effective way in which the government
can encourage the consumption of merit goods
is through government regulations. [15]

In your collaborative groups, prepare a full-length answer

to both parts of the question.
 Lesson Six
At the end of lesson 6, you should be able to :
1. Explain the characteristics of private goods

2. Explain the characteristics of public goods

3. Using a real-life example, explain why public goods are not

provided by the free-market economy
4. Using a real-life example, evaluate policies such as govt provision
and contracting out to the private sector can tackle the problem
of missing markets (or no provision of public good)
 Characteristics of a private Good

Rivalry
Excludability
• Rivalry means
consumption by one • Excludability means
consumer will reduce non paying consumers
the amount available to can be excluded from
benefiting from the
other consumers
good
• Rivalry suggests that
there is opp costs

Merit goods are private goods

 Characteristics of a Public Good

Non rivalry Non excludability

• Non rivalry means • Non excludability
consumption by one means non paying
consumer will not consumers (free
reduce the amount riders) cannot be
available to other excluded from
consumers benefitting from the
• Non rivalry implies zero good
opp costs

Examples of public goods include defense and street lighting

 Two reasons why public goods are
not provided in a free market

1. Property of non–excludability
 Property of non–excludability give rise to free-rider problem.
That is people can enjoy the good without having to pay for
it
 People do not reveal their demand, resulting in no demand
for the good.
 Since there is no demand for the good, there is no supply of
the good in a free market/ enterprise economy.
 Two reasons why public goods
are not provided in a free
market
2. Property of non- rivalry
 Property of non-rivalry means there is no opportunity cost
 Assuming no external cost production, MPC=MSC = 0
 This means that at socially optimum output the price is zero
 Since producers are profit motivated, at zero market price, the
market will not supply any public good.
 Govt intervention to correct
market failure to provide public
goods
 Refer to pages 186-187
 Contracting out – Government contracts the private sector to
supply public goods
 Finance – Through taxation, borrowing, or transferring resources
from other uses
 All 3 ways of financing government spending on public goods
have opportunity cost
 Taxation – Rise in income taxes will lead to people having less
incentive to work, output will decrease, growth adversely affected
 Borrowing – Interest rate increases, reduce consumption and
investment, thereby reducing the output of the economy
 Govt intervention to correct
market failure to provide public
goods
 Since there is no provision of public goods in the free
market, govt must step in to provide the good. It may
either provide itself directly or contract it out to a private
firm.
 The govt allows private producers to submit tenders but
the full cost is covered by the govt. which are financed out
of tax revenues.
 
 Govt intervention to correct
market failure to provide public
goods
 Because govt funds are limited and have competing uses, govt
  has to choose which public goods to provide and in what quantities
they should be provided.

 Govt uses cost-benefit analysis to decide which public goods to

provide. Here the govt. compares the estimated benefits to society
expected from public good to the cost of providing it. If total
expected benefits are greater than total costs of providing it, then
the good should be provided. The optimum quantity provided will
be one where MSC= MSB. ( Note : There is no diagram).
 Govt intervention to correct
market failure to provide public
goods
 While the costs of providing a public good are relatively easy to
  estimate, there are difficulties in estimating benefits. This is
because there is no market price for public goods as they are not
provided by private firms. This means the govt. must try to estimate
the demand or price of public goods through such means as votes
or surveys of people who asked how much a good would be worth
to them.

 A major difficulty arising with surveys is that people who really want
something are likely to exaggerate its value. Therefore, cost-benefit
analysis is a very rough and approximate method to make choices
about public goods.
 Thinking skills
 Search some examples of over-the air television
and radio broadcasting based on the following
questions.
1. Do over-the air stations have the properties of a
public good
2. What is the difference between over-the-air
broadcasting and cable television or Netflix?
 Self Assessment Essay practice

(a) Using real life examples explain why public

goods are never provided in free markets[10]
(b) Using real-life examples discuss whether govt
provision is the best way to tackle the problem of
missing markets in a free market economy. [15]
 Lesson Seven (HL)
At the end of lesson 7, you should be able to :
1. Using real-life examples, explain how the problem of
moral hazard and adverse selection due to the existence
of asymmetric information leads to market failure
2. Using real-life examples evaluate how govt policies such
as signaling, screening, and legislation or regulation
address the above problem

Read pages 187-191

 How asymmetric information leads to market failure
Moral hazard (HL)
HL syllabus

• Asymmetric information refers to the situation where one party in the

transaction has more information than another, leading to market failure.

• In the health insurance market, asymmetric information results in moral

hazard and adverse selection problems.

• Moral hazard refers to situations where one party takes risks but does
not face the full costs of these risks.

• The insured (buyer of insurance policy) engaged in riskier behaviour after

buying health insurance.

• The insurer (seller of policy) cannot monitor and obtain full information
of the behaviour of the buyer of policy. As a result buyers make huge
claims.
 How asymmetric information leads to market
failure : Moral Hazard (HL)
HL syllabus

• To protect against such buyers and to maintain their profitability,

insurers charge high prices for health insurance policies.

• The high prices would lead to a fall in the quantity demanded of

insurance.
• There may then be underconsumption of insurance as the
amount of insurance cover taken out by potential buyers may
be reduced to a level that is lower than the socially optimal level

• This results in the under allocation of resources to health insurance

in an unregulated/free market.
 Govt response to Moral Hazard in insurance (HL)
Legislation or regulation

 
• .
•To correct market failure caused by moral hazard, govt. can pass
 
regulations requiring insurers to only offer health insurance with deductible
 
and/or co-payments components.
 
•Deductible refers to the first $x of health insurance claims which must be
paid by the insured. Co-payments require the insured to pay a portion of
their medical costs.

•As such, the insured individuals will be more incentivized to engage in less
risky behavior even after purchasing health insurance. This helps to reduce
the moral hazard problem which causes market failure.

•The effectiveness of this policy depends on the ability of the govt to

enforce such a regulation and prevent insurers from circumventing it. This
policy would render ineffective if deductibles and co-payments are set too
low.  
 How asymmetric information leads to market failure-
Adverse selection (HL)

• Adverse selection arises when buyers of insurance have more

information about themselves than sellers.

• In the health insurance market, buyers of health insurance know

more about the state of their health than sellers of insurance, and
those with health problems are unlikely to tell the full truth to the
insurance company.

• There is incentive for less healthy individuals to conceal their

unfavorable health records so as to be accepted by the insurer and
pay lower insurance premium.

• As the insurer cannot distinguish healthy from less healthy

individuals, it will charge a higher price to cover the possibility of
insuring a less, healthy individual.
 How asymmetric information leads to market failure
HL syllabus

• At this relatively higher price, only the less healthy individuals will
purchase insurance.

• Healthy individuals will not purchase insurance at such a high price.

• This results in adverse selection where the insurer sells health

insurance to less healthy individuals who are more likely to fall ill
and claim for medical expenses against the insurer.

• Hence, in a free unregulated market, there is under consumption of

health insurance by healthy individuals due to adverse selection.
 
 
 
 Govt response to adverse selection in insurance (HL)
Screening and signaling

In this case, screening is the solution to the adverse selection problem in the
health insurance market.

Screening occurs when a less informed party finds a way to get the other
party to reveal relevant information. Here the less informed party is the
insurance companies.

They get customers to reveal information relating to risk factors such as age,
weight, whether the consumer is a smoker, how much alcohol he/she drinks,
how active they are, and whether they have pre-existing conditions.

In this way, insurance companies can sell low premium policies to low-risk
customers and charge high premiums or high-risk customers
 Govt response to adverse selection in insurance (HL)

To correct market failure cause by adverse selection,, govt. can

provide basic universal health insurance to all citizens at zero or low
price.

For example, in Singapore Medishield Life implemented in 2015

provides insurance coverage for both less healthy and healthy at
subsidized rate.
 
The effectiveness of direct provision of universal health insurance
depends on the ability of the govt. to fund low income citizens who are
unable to afford paying for it.
 
 Self Assessment -Essay practice

(a) Using real-life examples explain how asymmetric information

may lead to market failure [10]
(b) Using real-life examples discuss two ways a government might
respond to the existence of asymmetric information in a
market. [15]
 Lesson Eight
At the end of lesson 8, you should be able to :

1. Explain the difference between equity and inequality of income

distribution of income.
2. Meaning of wealth
3. Use a real-life examples, explain why are income and wealth
unevenly distributed in a free market economy?

For explanation refer to pages 191-193

Difference between equity and inequality of income
distribution of income.

 Equity in income distribution refers to an income

distribution which is fair, while equality refers to the extent
to which income is distributed equally.

 Equity is a normative concept, meaning it means

different things to different people.
Difference between equity and inequality of income
distribution of income.

 One way of interpreting fairness is the amount of effort

put in. The more effort one puts in, the more income one
gets.
 One way of interpreting fairness is the amount of effort
put in. The more effort one puts in, the more income one
gets.
 When economists refer to equity in income distribution,
they usually mean equality in income distribution.
 Meaning of wealth

• Wealth refers to money or things of value that people own such

as saving deposits, stocks, bonds, land homes, valuables painting
or jewelry.
• Income gives rise to saving and saving is used to create
wealth. Higher the income, the greater will be savings and
therefore the accumulation of wealth
 Meaning of wealth

• Wealth refers to money or things of value that people own such

as saving deposits, stocks, bonds, land homes, valuables painting
or jewelry.
• Income gives rise to saving and saving is used to create
wealth. Higher the income, the greater will be savings and
therefore the accumulation of wealth
 Reasons why income and wealth unevenly distributed in a
free market economy

 Recap characteristics of market economy

 Reasons for uneven income distribution
a. Quality and prices of labour resources
b. Ownership of other resources
 Market failure is the inability of the market to
achieve allocative efficiency where MSB=MSC

 It is possible to have allocative efficiency and

maximum social surplus with income equality or
extreme inequality
 Self Assessment

(a) Using real-life examples explain the causes of income

inequality in a free market economy. [10]
 Essay practice
(b) Explain how characteristics of common-pool resources lead to market
failure and threaten sustainability. [1]
(b) Using real-world examples, evaluate different approaches to managing
common access resources