Exercises: Market failures

Explain what a market failure is and name four of its main types with a one-sentence example of each.

Distinguish between a negative externality and a positive externality, and classify these cases: smoke from a factory, childhood vaccination, a neighbour's loud music in the early hours of the morning, and a botanical garden open to the local neighbourhood.

The figure represents the market for a product whose manufacture pollutes: it shows the private cost to producers and the social cost, which also includes the environmental damage suffered by third parties.

1. a) Identify which curve is which and explain the difference between private cost and social cost.
2. b) Compare the quantity produced by the market with what would be socially desirable and explain the difference.

Define externality in your own words. Give an example of a negative externality and one of a positive externality related to your school (building works next door, a new library also used by the neighbourhood) and explain who receives the effect without paying for it or being paid for it.

A public good is non-rival (one person using it does not take it away from others) and non-excludable (those who do not pay cannot be kept out). Classify the following according to whether they meet those two characteristics: a lighthouse, a pizza, street lighting, a cinema ticket and clean air.

Explain what asymmetric information is. Illustrate it with this case: you buy second-year notes from a stranger without knowing whether they are complete and well done. Who has more information and what problems does that create in the market?

What is market power? Explain why the only petrol station in $50$ kilometres of road can charge higher prices than a petrol station on a street with three others, and what market failure it illustrates.

Common goods are rival but hard to exclude: fishing grounds on the high seas or an overcrowded beach. Explain what the "tragedy of the commons" consists of using one of those examples: why does each user have an incentive to make the most of it even though everyone ends up losing?

Lighthouses and national defence are the classic examples of public goods.

1. a) Explain the two characteristics that define a public good.
2. b) Reason why a private firm would have difficulty selling these services: what does the 'free rider' problem consist of?

In the second-hand car market, the seller knows whether their car has hidden faults and the buyer does not.

1. a) Explain what this market failure is called and what consequences it has on prices and the quality of goods offered.
2. b) Propose two solutions, market-based or legal, that help reduce it.

There is only one pharmacy in a village.

1. a) Which market failure does this situation illustrate, and what might happen to prices and the quality of service?
2. b) What instruments does the government have to protect residents? Name two and explain them.

Classify these goods in the rival/non-rival and excludable/non-excludable grid: a cinema ticket, national defence, fish on the high seas and a streaming platform for series.

1. a) Place each one in its cell (private good, public good, common good, club good).
2. b) Explain what provision problem each of the two "difficult" ones has (the public good and the common good).

Every car that enters a city at rush hour delays the others, emits fumes and takes up space: costs that its driver does not pay.

1. a) Analyse traffic as a negative externality: who generates it and who suffers it.
2. b) Compare two solutions: an urban toll for entering the centre or banning the most polluting cars. What advantage and what problem does each one have?

In one country, private health insurance is voluntary: healthy young people do not take it out because "it is not worth it for them", so premiums rise and even more healthy people drop out.

1. a) Explain what this spiral is called (adverse selection) and what information failure causes it.
2. b) Reason why some countries make insurance compulsory for everyone and what effect that has on premiums.

On a village beach, each beach bar moves its sun loungers a little closer to the shore to win customers; in the end no free sand is left and bathers stop coming.

1. a) What failure does this spiral illustrate? Relate it to the tragedy of the commons.
2. b) Compare two solutions: a municipal rule fixing the lines of sun loungers or a single concession with rules. What incentives does each one create?

The only two telephone companies of a fictitious country announce that they are merging.

1. a) What market failure can the merger make worse? Explain its foreseeable effects on prices, quality and innovation.
2. b) What instruments does the competition authority have (banning the merger, imposing conditions, fining practices)? Assess each one.

The City Council of Ribera Alta faces river pollution caused by two paint factories (factory A and factory B). Currently, each discharges $100$ tonnes of waste per year. To restore the river, the municipality needs to reduce total discharges by half ($100$ tonnes in total between the two). Technical studies reveal that reducing each tonne of discharge costs $\text{€}\ 30$ for factory A (which has modern filters), but costs $\text{€}\ 90$ for factory B (which uses outdated machinery).

A councilor proposes: “The fairest and most ecological solution is to legally mandate both to reduce exactly $50$ tonnes each, penalizing any non-compliant factory with closure”.

1. a) Evaluate the councilor's proposal: calculate the total cost to the firms of implementing this command-and-control regulation (symmetric reduction of $50$ t per factory).
2. b) Design a more efficient alternative based on a Pigouvian tax per tonne discharged or a system of $100$ tradable emission permits (allocating $50$ to each factory and allowing them to trade with each other). Demonstrate numerically what reduction each firm will undertake and what the total cost to society will be.
3. c) Economically justify why the free market, without public intervention, would not have managed to reduce a single tonne of discharges.

A advocacy group argues in a public debate that childhood vaccination should no longer be free and should instead be funded entirely by users in the private market: “Each family knows its preferences and should pay the $\text{€}\ 80$ that the dose costs. If the market freely allocates vaccines according to supply and demand, the outcome will be optimal and we will save on taxes”. Epidemiologists warn that at this price, the coverage rate would fall from the current $96\ \%$ to $65\ \%$, whereas herd immunity to curb outbreaks requires at least $90\ \%$.

1. a) Refute the group's arguments using the concepts of marginal private cost, marginal social benefit, and free-rider behavior. Support your answer with conceptual graphical reasoning.
2. b) Predict the medium- and long-term economic consequences for the healthcare system and the country's productivity if this free-market proposal were to succeed.
3. c) Design and compare two avenues of public intervention to achieve a $95\ \%$ vaccination rate: one based on Pigouvian subsidies (free provision funded through general taxation) and another based on a restrictive legal rule (mandatory complete vaccination record to enroll in public and private schools). Assess the efficiency and equity of each.

In a large city, two digital delivery platforms account for $92\ \%$ of home delivery orders. They charge a $30\ \%$ commission to affiliated restaurants, unilaterally set rates for delivery riders, and run an opaque algorithm that penalizes the visibility of venues that do not purchase their extra advertising campaigns. To offset the commission, many restaurants have raised their menu prices by $15\ \%$ both for delivery and on-premise dining.

Faced with social unrest, the restaurant association presents two demands to the city council:

1. Legally cap the platforms' commission at $10\ \%$.

2. Create a free municipal public delivery platform funded by the municipal budget.

1. a) Analyze which market failures justify intervention in this sector (identify at least two among market power from network effects, information asymmetry, or switching costs).
2. b) Predict what unintended or counterproductive economic consequences capping the commission at $10\ \%$ would have on the supply of delivery riders, small suburban restaurants, and final prices.
3. c) Evaluate the proposal to create a municipal public platform: does it solve the problem, or does it generate potential government failures? Design a regulatory alternative that restores competition and transparency without distorting the market.

A sawmill generates high-intensity noise that severely harms an adjacent rural hotel. The sawmill earns an annual profit of $\text{€}\ 50,000$ operating normally; if it installs a soundproofing system, its profit is reduced by $\text{€}\ 14,000$ (it would earn $\text{€}\ 36,000$). For its part, the hotel loses $\text{€}\ 20,000$ annually in cancelled bookings due to the noise.

1. a) Apply the Coase theorem (according to which, if property rights are well defined and transaction costs are zero, the parties affected by an externality can bargain privately until they reach an efficient outcome) to determine the economically efficient outcome and describe the agreement both companies would reach in the following two legal scenarios (assuming zero transaction costs):

1. The law grants the hotel the legal right to enjoy absolute silence.

2. The law grants the sawmill the legal right to emit noise on its property.

Does the final noise level change between one legal framework and the other? What changes between them?

1. b) Now imagine that, instead of a single hotel, the affected parties are $400$ families in a nearby housing development, each of whom values the harm of the noise at $\text{€}\ 50$ per year (totaling $\text{€}\ 20,000$). Predict what will happen in practice if the law grants the sawmill the right to emit noise. What market failures and obstacles prevent the Coase theorem from holding, and what role should the State assume?

A flight between two Irish cities (for example, Dublin and Cork) emits on average $0.1$ tonnes of CO₂ per passenger. The cost of the climate damage generated and not accounted for is estimated at €$50$ per tonne emitted. The current ticket price is €$60$. The Irish Government is considering introducing a Pigouvian environmental tax of €$50$ per tonne of CO₂ (which amounts to a €$5$ surcharge per ticket).

The following data are available regarding the price elasticity of demand on two different routes:

• Route 1 (mainland connection with an Irish Rail alternative taking $2.5$ hours): price elasticity $\varepsilon_p = 2.2$.

• Route 2 (connection to the Aran Islands with no land alternatives): price elasticity $\varepsilon_p = 0.25$.

1. a) Assuming that airlines pass on the entirety of the tax to the ticket price, calculate the expected percentage change in price and predict the percentage drop in passenger demand on each route.
2. b) Interpret the results: on which route does the tax act more effectively as an environmental correction instrument, and on which does it act primarily as a revenue-raising mechanism? Justify your answer.
3. c) A TD representing the islands argues: "This tax is regressive and unfair to island residents, who have no transport alternative." Assess this objection from the perspective of equity and design an adaptation of the measure (through exemptions or the allocation of the revenue raised) that combines ecological efficiency with territorial cohesion.

An economic analyst argues in an opinion column: "Free public university education or tuition subsidised at $80\ \%$ is an economically inefficient and socially regressive policy. Over their lifetime, university graduates earn wages that are $45\ \%$ higher than non-graduates; therefore, the benefit of studying is strictly individual and each student should pay for it through private loans. Moreover, since most university students come from well-off families, the taxes of the working classes are paying for the degrees of the future rich."

1. a) Refute the claim that the benefit of university studies is "strictly individual". Identify and justify at least three positive externalities that a university graduate (in healthcare, science, or education) passes on to the rest of society.
2. b) Critically analyse the columnist's distributional argument: why can subsidising the tuition of all students identically, regardless of their family income, cause a perverse or regressive redistributive effect?
3. c) Design a public university policy proposal that simultaneously resolves the market failure (the positive externality) and the equity problem pointed out by the author, moving beyond both the model of indiscriminate universal free tuition and the model of exclusively private bank loans.

A dominant firm in the social media and online advertising market has acquired more than forty small start-ups over the past five years. Many of them were developing innovative applications that offered messaging or e-commerce alternatives that were more respectful of privacy. After purchasing them, the multinational usually absorbs the patents or the technical team and shuts down the original application. The multinational's executives state: "There is no harm whatsoever: users access our services for free, entrepreneurs obtain capital, and consumer prices have not risen."

1. a) Demonstrate why the classical antitrust criterion (which only intervenes if consumer prices increase in the short term) is insufficient to evaluate free digital platforms. What real harm do consumers and competition suffer with these preemptive acquisitions (killer acquisitions)?
2. b) Explain how "network effects" and the massive accumulation of data (big data) operate as barriers to entry that shield the platform's dominant position against new entrants.
3. c) If you were part of the antitrust authority, what regulatory measures would you propose to address this problem (for example, mandatory interoperability, structural separation, or reversing the burden of proof in mergers)? Assess what regulatory risks should be avoided in order not to disincentivise innovation.

In the municipality of Villaseca (800 inhabitants), a licence is being processed for a mega-farm of $20,000$ head of swine. The developer argues that the facility will provide $16$ direct jobs, lower the price of export meat, and generate $\text{€}\ 35,000$ annually in municipal taxes. Conversely, a technical report warns that the excess nitrates from slurry will render the municipality's drinking water unusable (forcing the town hall to pay for a treatment plant costing $\text{€}\ 55,000$ per year) and that foul odours will force the closure of three rural lodgings that support $10$ tourism jobs and generate $\text{€}\ 130,000$ annually.

The company spokesperson alleges: "We comply with basic commercial regulations. If we cover our operating costs and sell meat at a profit, the project is efficient and the losses to third parties are inevitable collateral damage of progress."

1. a) Refute the company's argument using the concepts of marginal private cost, marginal external cost, and social cost. Using the case data, calculate the net monetary balance that the free-market outcome leaves in the municipality (municipal taxes versus uncompensated external costs) and interpret it.
2. b) Two local councillors hold opposing views: one demands a "total and immediate ban by decree" and the other argues for "placing no obstacles to attract investment". Justify the shortcomings of both extreme positions from the standpoint of economic efficiency.
3. c) Design an intermediate public intervention proposal that combines at least two instruments (for example, mandatory technological standards, a Pigouvian tax based on waste volume, and environmental restoration bonds) and that internalises costs without arbitrarily banning economic activity.

Topic challenge. Should your local council pedestrianise your street or implement a Low Emission Zone? Become a local economic advisor and develop a reasoned proposal.

1. Data collection: Count vehicle traffic outside your home for $15$ minutes or survey $5$ neighbours about nuisances related to noise, fumes, and parking.

2. Identification of market failures: Classify the failures present in your surroundings into a diagram: negative externalities (health, noise) and traffic congestion as a common-access resource.

3. Cost-benefit analysis ($CBA$): Design a comparison table assigning weighted scores (from $-5.0$ to $+5.0$) to expected costs (works, loss of parking) and expected benefits (retail improvement, clean air), clearly separating private costs from social costs.

4. Intervention proposal: Write a brief report recommending the optimal public policy (Pigouvian tax, pedestrianisation, or public transport subsidy) that maximises social welfare.

Assessment criteria:

• Accuracy in classifying market failures based on the collected data.

• Correct quantitative distinction between private versus social costs and benefits in the $CBA$.

• Economic feasibility and consistency of the proposed corrective policy.