Unit II: Market Failure | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


2.22 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT II: MARKET FAILURE 
 
At the end of this unit, you will be able to: 
? Define the concept of market failure  
? Describe the different sources of market failure   
? Explain the role of externalities in welfare loss of markets  
? Distinguish between different types of public goods and 
illustrate how they cause market failure  
? Describe the free rider problem associated with public goods  
? Appraise the role of incomplete information in generating 
market failure  
? Evaluate government interventions for correcting market 
failure  
 
 
Public Finance
Maket Failure
Market Power Externalities Public Goods
Incomplete 
Information
UNIT OVERVIEW 
Page 2


2.22 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT II: MARKET FAILURE 
 
At the end of this unit, you will be able to: 
? Define the concept of market failure  
? Describe the different sources of market failure   
? Explain the role of externalities in welfare loss of markets  
? Distinguish between different types of public goods and 
illustrate how they cause market failure  
? Describe the free rider problem associated with public goods  
? Appraise the role of incomplete information in generating 
market failure  
? Evaluate government interventions for correcting market 
failure  
 
 
Public Finance
Maket Failure
Market Power Externalities Public Goods
Incomplete 
Information
UNIT OVERVIEW 
2.23 
 
MARKET FAILURE 
 2.1 INTRODUCTION 
Before we go into the subject matter of market failure which is the focus of this 
unit, we shall examine two familiar events that are in some way connected with 
the phenomenon of market failure.  
Case I 
Sarva Shiksha Abhiyan (SSA) is a centrally sponsored scheme implemented by the 
Government of India in partnership with the state governments, for universalising 
good quality elementary education for all children in the 6-14 age groups in a 
time-bound manner. Through this programme, the government aims to provide 
opportunity for children to learn about and master their natural environment in 
order to develop their potential intellectually, spiritually as well as materially. The 
ultimate objective is to bring in social, regional and gender quantity. 
Nearly everyone believes that providing basic education to all citizens is an 
important responsibility of the government. This is the reason why education is 
almost entirely administered and extensively financed by government.  
Questions  
• Why do you think governments should intervene to provide education?  
• What do you think the outcome will be if it is left completely to private 
entrepreneurs?   
Case II  
The Ministry Women and Child Development is implementing two Centrally 
Sponsored Umbrella schemes across the country namely: 
1. Integrated Child Development Services and  
2. Mission for Protection and Empowerment of Women.  
There are currently thirteen on-going schemes that target improvements in the 
condition of women and children.  The union budget 2020-21 allocated a total of 
` 28,600 Crores for women-specific schemes for the financial year 2020-21. These 
programmes mainly aim at promotion of greater nutrition security to women, 
increasing women’s economic participation, women’s empowerment and 
promotion of education  of girl child.  
Page 3


2.22 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT II: MARKET FAILURE 
 
At the end of this unit, you will be able to: 
? Define the concept of market failure  
? Describe the different sources of market failure   
? Explain the role of externalities in welfare loss of markets  
? Distinguish between different types of public goods and 
illustrate how they cause market failure  
? Describe the free rider problem associated with public goods  
? Appraise the role of incomplete information in generating 
market failure  
? Evaluate government interventions for correcting market 
failure  
 
 
Public Finance
Maket Failure
Market Power Externalities Public Goods
Incomplete 
Information
UNIT OVERVIEW 
2.23 
 
MARKET FAILURE 
 2.1 INTRODUCTION 
Before we go into the subject matter of market failure which is the focus of this 
unit, we shall examine two familiar events that are in some way connected with 
the phenomenon of market failure.  
Case I 
Sarva Shiksha Abhiyan (SSA) is a centrally sponsored scheme implemented by the 
Government of India in partnership with the state governments, for universalising 
good quality elementary education for all children in the 6-14 age groups in a 
time-bound manner. Through this programme, the government aims to provide 
opportunity for children to learn about and master their natural environment in 
order to develop their potential intellectually, spiritually as well as materially. The 
ultimate objective is to bring in social, regional and gender quantity. 
Nearly everyone believes that providing basic education to all citizens is an 
important responsibility of the government. This is the reason why education is 
almost entirely administered and extensively financed by government.  
Questions  
• Why do you think governments should intervene to provide education?  
• What do you think the outcome will be if it is left completely to private 
entrepreneurs?   
Case II  
The Ministry Women and Child Development is implementing two Centrally 
Sponsored Umbrella schemes across the country namely: 
1. Integrated Child Development Services and  
2. Mission for Protection and Empowerment of Women.  
There are currently thirteen on-going schemes that target improvements in the 
condition of women and children.  The union budget 2020-21 allocated a total of 
` 28,600 Crores for women-specific schemes for the financial year 2020-21. These 
programmes mainly aim at promotion of greater nutrition security to women, 
increasing women’s economic participation, women’s empowerment and 
promotion of education  of girl child.  
2.24 ECONOMICS FOR FINANCE 
The above case is an example of how government and specifically constituted 
bodies address different issues to protect the interests of women and children.  
Question 
Since people should ideally recognize women’s rights and need to establish the 
same, why should governments interfere with the system?  
 2.2 THE CONCEPT OF MARKET FAILURE 
The general belief is that markets are amazingly competent in organizing the 
activities of an economy as they are generally efficient and capable of achieving 
optimal allocation of resources. However, there are exceptions to this. Under 
certain circumstances, ‘market failure’ occurs, i.e. the market fails to allocate 
resources efficiently and therefore, market outcomes become inefficient. 
Market failure is a situation in which the free market leads to misallocation of 
society's scarce resources in the sense that there is either overproduction or 
underproduction of particular goods and services leading to a less than optimal 
outcome. The reason for market failure lies in the fact that though perfectly 
competitive markets work efficiently, most often the prerequisites of competition 
are unlikely to be present in an economy. Market failures are situations in which a 
particular market, left to itself, is inefficient. We shall first try to understand why 
markets fail and later, in the subsequent unit, proceed to identify the role of 
government in dealing with market failure.  
We need to appreciate the fact that there are two aspects of market failures 
namely, demand-side market failures and supply side market failures. Demand-
side market failures are said to occur when the demand curves do not take into 
account the full willingness of consumers to pay for a product. For example, 
though we experience the benefit, none of us will be willing to pay to view a 
wayside fountain because we can view it without paying. Supply-side market 
failures happen when supply curves do not incorporate the full cost of producing 
the product. For example, a thermal power plant that uses coal may not have to 
include or pay completely for the costs to the society caused by fumes it 
discharges into the atmosphere as part of the cost of producing electricity. 
Page 4


2.22 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT II: MARKET FAILURE 
 
At the end of this unit, you will be able to: 
? Define the concept of market failure  
? Describe the different sources of market failure   
? Explain the role of externalities in welfare loss of markets  
? Distinguish between different types of public goods and 
illustrate how they cause market failure  
? Describe the free rider problem associated with public goods  
? Appraise the role of incomplete information in generating 
market failure  
? Evaluate government interventions for correcting market 
failure  
 
 
Public Finance
Maket Failure
Market Power Externalities Public Goods
Incomplete 
Information
UNIT OVERVIEW 
2.23 
 
MARKET FAILURE 
 2.1 INTRODUCTION 
Before we go into the subject matter of market failure which is the focus of this 
unit, we shall examine two familiar events that are in some way connected with 
the phenomenon of market failure.  
Case I 
Sarva Shiksha Abhiyan (SSA) is a centrally sponsored scheme implemented by the 
Government of India in partnership with the state governments, for universalising 
good quality elementary education for all children in the 6-14 age groups in a 
time-bound manner. Through this programme, the government aims to provide 
opportunity for children to learn about and master their natural environment in 
order to develop their potential intellectually, spiritually as well as materially. The 
ultimate objective is to bring in social, regional and gender quantity. 
Nearly everyone believes that providing basic education to all citizens is an 
important responsibility of the government. This is the reason why education is 
almost entirely administered and extensively financed by government.  
Questions  
• Why do you think governments should intervene to provide education?  
• What do you think the outcome will be if it is left completely to private 
entrepreneurs?   
Case II  
The Ministry Women and Child Development is implementing two Centrally 
Sponsored Umbrella schemes across the country namely: 
1. Integrated Child Development Services and  
2. Mission for Protection and Empowerment of Women.  
There are currently thirteen on-going schemes that target improvements in the 
condition of women and children.  The union budget 2020-21 allocated a total of 
` 28,600 Crores for women-specific schemes for the financial year 2020-21. These 
programmes mainly aim at promotion of greater nutrition security to women, 
increasing women’s economic participation, women’s empowerment and 
promotion of education  of girl child.  
2.24 ECONOMICS FOR FINANCE 
The above case is an example of how government and specifically constituted 
bodies address different issues to protect the interests of women and children.  
Question 
Since people should ideally recognize women’s rights and need to establish the 
same, why should governments interfere with the system?  
 2.2 THE CONCEPT OF MARKET FAILURE 
The general belief is that markets are amazingly competent in organizing the 
activities of an economy as they are generally efficient and capable of achieving 
optimal allocation of resources. However, there are exceptions to this. Under 
certain circumstances, ‘market failure’ occurs, i.e. the market fails to allocate 
resources efficiently and therefore, market outcomes become inefficient. 
Market failure is a situation in which the free market leads to misallocation of 
society's scarce resources in the sense that there is either overproduction or 
underproduction of particular goods and services leading to a less than optimal 
outcome. The reason for market failure lies in the fact that though perfectly 
competitive markets work efficiently, most often the prerequisites of competition 
are unlikely to be present in an economy. Market failures are situations in which a 
particular market, left to itself, is inefficient. We shall first try to understand why 
markets fail and later, in the subsequent unit, proceed to identify the role of 
government in dealing with market failure.  
We need to appreciate the fact that there are two aspects of market failures 
namely, demand-side market failures and supply side market failures. Demand-
side market failures are said to occur when the demand curves do not take into 
account the full willingness of consumers to pay for a product. For example, 
though we experience the benefit, none of us will be willing to pay to view a 
wayside fountain because we can view it without paying. Supply-side market 
failures happen when supply curves do not incorporate the full cost of producing 
the product. For example, a thermal power plant that uses coal may not have to 
include or pay completely for the costs to the society caused by fumes it 
discharges into the atmosphere as part of the cost of producing electricity. 
2.25 
 
MARKET FAILURE 
 2.3 WHY DO MARKETS FAIL?  
The pertinent question here is why do markets fail? There are four major reasons 
for market failure. They are:  
• Market power,  
• Externalities,  
• Public goods, and  
• Incomplete information 
We shall discuss each of the above in detail.  
2.3.1 Market Power 
Market power or monopoly power is the ability of a firm to profitably raise the 
market price of a good or service over its marginal cost. Firms that have market 
power are price makers and therefore, can charge a price that gives them positive 
economic profits. Excessive market power causes the single producer or a small 
number of producers to produce and sell less output than would be produced in 
a competitive market. Market power can cause markets to be inefficient because 
it keeps price higher and output lower than the outcome of equilibrium of supply 
and demand. In the extreme case, there is the problem of non-existence of 
markets or missing markets resulting in failure to produce various goods and 
services, despite the fact that such products and services are wanted by people. 
For example, the markets for pure public goods do not exist.  
2.3.2 Externalities  
We begin by describing externalities and then, proceed to discuss how they 
create market inefficiencies. As we are aware, anything that one individual does, 
may have, at the margin, some effect on others. For example, if individuals decide 
to switch from consumption of ordinary vegetables to consumption of organic 
vegetables, they would, other things equal, increase the price of organic 
vegetables and potentially reduce the welfare of existing consumers of organic 
vegetables. However, we should note that all these operate through price 
mechanism i.e. through changes in prices. The price system works efficiently 
because market prices convey information to both producers and consumers. 
However, sometimes, the actions of either consumers or producers result in costs 
or benefits that do not reflect as part of the market price. Such costs or benefits 
which are not accounted for by the market price are called externalities because 
Page 5


2.22 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT II: MARKET FAILURE 
 
At the end of this unit, you will be able to: 
? Define the concept of market failure  
? Describe the different sources of market failure   
? Explain the role of externalities in welfare loss of markets  
? Distinguish between different types of public goods and 
illustrate how they cause market failure  
? Describe the free rider problem associated with public goods  
? Appraise the role of incomplete information in generating 
market failure  
? Evaluate government interventions for correcting market 
failure  
 
 
Public Finance
Maket Failure
Market Power Externalities Public Goods
Incomplete 
Information
UNIT OVERVIEW 
2.23 
 
MARKET FAILURE 
 2.1 INTRODUCTION 
Before we go into the subject matter of market failure which is the focus of this 
unit, we shall examine two familiar events that are in some way connected with 
the phenomenon of market failure.  
Case I 
Sarva Shiksha Abhiyan (SSA) is a centrally sponsored scheme implemented by the 
Government of India in partnership with the state governments, for universalising 
good quality elementary education for all children in the 6-14 age groups in a 
time-bound manner. Through this programme, the government aims to provide 
opportunity for children to learn about and master their natural environment in 
order to develop their potential intellectually, spiritually as well as materially. The 
ultimate objective is to bring in social, regional and gender quantity. 
Nearly everyone believes that providing basic education to all citizens is an 
important responsibility of the government. This is the reason why education is 
almost entirely administered and extensively financed by government.  
Questions  
• Why do you think governments should intervene to provide education?  
• What do you think the outcome will be if it is left completely to private 
entrepreneurs?   
Case II  
The Ministry Women and Child Development is implementing two Centrally 
Sponsored Umbrella schemes across the country namely: 
1. Integrated Child Development Services and  
2. Mission for Protection and Empowerment of Women.  
There are currently thirteen on-going schemes that target improvements in the 
condition of women and children.  The union budget 2020-21 allocated a total of 
` 28,600 Crores for women-specific schemes for the financial year 2020-21. These 
programmes mainly aim at promotion of greater nutrition security to women, 
increasing women’s economic participation, women’s empowerment and 
promotion of education  of girl child.  
2.24 ECONOMICS FOR FINANCE 
The above case is an example of how government and specifically constituted 
bodies address different issues to protect the interests of women and children.  
Question 
Since people should ideally recognize women’s rights and need to establish the 
same, why should governments interfere with the system?  
 2.2 THE CONCEPT OF MARKET FAILURE 
The general belief is that markets are amazingly competent in organizing the 
activities of an economy as they are generally efficient and capable of achieving 
optimal allocation of resources. However, there are exceptions to this. Under 
certain circumstances, ‘market failure’ occurs, i.e. the market fails to allocate 
resources efficiently and therefore, market outcomes become inefficient. 
Market failure is a situation in which the free market leads to misallocation of 
society's scarce resources in the sense that there is either overproduction or 
underproduction of particular goods and services leading to a less than optimal 
outcome. The reason for market failure lies in the fact that though perfectly 
competitive markets work efficiently, most often the prerequisites of competition 
are unlikely to be present in an economy. Market failures are situations in which a 
particular market, left to itself, is inefficient. We shall first try to understand why 
markets fail and later, in the subsequent unit, proceed to identify the role of 
government in dealing with market failure.  
We need to appreciate the fact that there are two aspects of market failures 
namely, demand-side market failures and supply side market failures. Demand-
side market failures are said to occur when the demand curves do not take into 
account the full willingness of consumers to pay for a product. For example, 
though we experience the benefit, none of us will be willing to pay to view a 
wayside fountain because we can view it without paying. Supply-side market 
failures happen when supply curves do not incorporate the full cost of producing 
the product. For example, a thermal power plant that uses coal may not have to 
include or pay completely for the costs to the society caused by fumes it 
discharges into the atmosphere as part of the cost of producing electricity. 
2.25 
 
MARKET FAILURE 
 2.3 WHY DO MARKETS FAIL?  
The pertinent question here is why do markets fail? There are four major reasons 
for market failure. They are:  
• Market power,  
• Externalities,  
• Public goods, and  
• Incomplete information 
We shall discuss each of the above in detail.  
2.3.1 Market Power 
Market power or monopoly power is the ability of a firm to profitably raise the 
market price of a good or service over its marginal cost. Firms that have market 
power are price makers and therefore, can charge a price that gives them positive 
economic profits. Excessive market power causes the single producer or a small 
number of producers to produce and sell less output than would be produced in 
a competitive market. Market power can cause markets to be inefficient because 
it keeps price higher and output lower than the outcome of equilibrium of supply 
and demand. In the extreme case, there is the problem of non-existence of 
markets or missing markets resulting in failure to produce various goods and 
services, despite the fact that such products and services are wanted by people. 
For example, the markets for pure public goods do not exist.  
2.3.2 Externalities  
We begin by describing externalities and then, proceed to discuss how they 
create market inefficiencies. As we are aware, anything that one individual does, 
may have, at the margin, some effect on others. For example, if individuals decide 
to switch from consumption of ordinary vegetables to consumption of organic 
vegetables, they would, other things equal, increase the price of organic 
vegetables and potentially reduce the welfare of existing consumers of organic 
vegetables. However, we should note that all these operate through price 
mechanism i.e. through changes in prices. The price system works efficiently 
because market prices convey information to both producers and consumers. 
However, sometimes, the actions of either consumers or producers result in costs 
or benefits that do not reflect as part of the market price. Such costs or benefits 
which are not accounted for by the market price are called externalities because 
  
 
2.26 ECONOMICS FOR FINANCE 
they are “external” to the market. In other words, there is an externality when a 
consumption or production activity has an indirect effect on other’s consumption 
or production activities and such effects are not reflected directly in market 
prices. The unique feature of an externality is that it is initiated and experienced 
not through the operation of the price system, but outside the market. Since it 
occurs outside the price mechanism, it has not been compensated for, or in other 
words it is uninternalized or the cost (benefit) of it is not borne (paid) by the 
parties.  
Externalities are also referred to as 'spillover effects', 'neighbourhood effects' 
'third-party effects' or 'side-effects', as the originator of the externality  imposes 
costs or benefits on others who are not responsible for initiating the effect. 
Externalities may be unidirectional or reciprocal. Suppose a workshop creates ear-
splitting noise and imposes an externality on a baker who produces smoke and 
disturbs the workers in the workshop, then this is a case of reciprocal externality.   
If an accountant who is disturbed by loud music but has not imposed any 
externality on the singers, then the externality is unidirectional. 
Externalities can be positive or negative. Negative externalities occur when the 
action of one party imposes costs on another party. Positive externalities occur 
when the action of one party confers benefits on another party.   The four 
possible types of externalities are:  
• Negative production externalities  
• Positive production externalities  
• Negative consumption externalities ,and 
• Positive consumption externalities 
Negative Production Externalities  
A negative externality initiated in production which imposes an external cost on 
others may be received by another in consumption or in production. As an 
example, a negative production externality occurs when a factory which produces 
aluminium discharges untreated waste water into a nearby river and pollutes the 
water causing health hazards for people who use the water for drinking and 
bathing. Pollution of river also affects fish output as there will be less catch for 
fishermen due to loss of fish resources. The former is a case where a negative 
production externality is received in consumption and the latter presents a case 
of a negative production externality received in production. The firm, however,