11/21/2024

Grade 12 Economics
Unit 3
Market Failure and Consumer
Protection
By: Muhdin Z Secret Training Institute
MUHDIN M. Z SECRET TRAINING INSTITUTE 11/21/2024 1

Part-1
 Market Failure
 Definition of Market Failure
 Common Types of Market Failures
 Solutions to Market Failures
 Public Goods
 Definition and features of Public Goods
 Public goods Vs Private Goods
 Mechanisms of Efficient Provision of Public Goods

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Part-2

Externalities
• Definition of Externalities
• Nature and Types of externalities
• Externalities and Economic Efficiency
• Solutions to avoid externalities

Part-3

• Asymmetric Information
• Definition of Asymmetric Information
• Implications of Asymmetric Information
• Consumer Protection
• Concept of consumer protection
• The need for consumer protection
• Consumer protection experience in Ethiopia

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GRADE 12 ECONOMICS UNIT 3

Part-1
 Market Failure
 Definition of Market Failure
 Common Types of Market Failures
 Solutions to Market Failures
 Public Goods
 Definition and features of Public Goods
 Public goods Vs Private Goods
 Mechanisms of Efficient Provision of Public Goods

By: Muhdin Z Secret Training Institute

Market Failure

Definition of Market Failure

 The equilibrium of a market is determined by the market forces of demand and
supply.

 Although the free market has numerous merits, it may not allocate
resources efficiently or distribute goods and services equitably.

By: Muhdin Z Secret Training Institute

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 Market failure is the economic situation defined by an inefficient distribution of

goods and services in the free market.

 Market failure occurs when the free market fails to allocate resources
efficiently or distribute goods and services equitably.

 Market Failure: occurs when the price mechanism fails to account for all of the costs
and benefits that are necessary to provide and consume a good.

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 Furthermore, market failure implies that the individual incentives for rational
behavior do not lead to rational outcomes for the group.

 Each individual makes the correct decision for himself/herself,

but these may prove to be the wrong decisions for the group.

 Such a group either incurs too many costs or receives too few
benefits.

By: Muhdin Z Secret Training Institute

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 In traditional microeconomics, this is shown as a steady state disequilibrium.

 Steady State: The variables grow at constant rates.

 Disequilibrium: a situation where there is an imbalance in a system.

 A situation when the quantity supplied is not equal to the
quantity demanded.

 “At Steady state disequilibrium a market system maintains apparent stability

while underlying imbalances exist that could lead to future changes or crises.”

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 Under market failure

 The economic outcomes deviate from what economists usually consider
optimal.
 The economic outcomes are usually not efficient.

 Market failure does not describe inherent imperfections in the market economy-
there can be market failures in government activity, too.
 Example: Rent-seeking by special interest groups.

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 The structure of market systems contributes to market failure.

 In the real world that it is not possible for markets to be perfect
due to inefficient producers, externalities, environmental concerns,
and public goods.

 Additionally, not every bad outcome from market activity counts as a market
failure.
 Nor does a market failure imply that private market actors cannot
solve the problem.
 Not all market failures have a potential solution, even with prudent
regulation or extra public awareness.

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 Government responses to market failure include:

 Legislation
 Direct provision of merit and public goods
 Taxation and subsidies
 Tradable permits
 Extension of property rights
 Advertising
 International cooperation among governments.

By: Muhdin Z Secret Training Institute

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Common Types of Market Failures

 Commonly cited market failures include
 Externalities: Occur when the actions of one person or group affect
others without direct involvement.

 Public goods: Occurs when goods and services are non-excludable and
non-rivalrous.
 Example: National defense, Street lighting

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 Monopoly: Occurs when a single firm dominates a market, reducing

competition and potentially leading to higher prices.

 Information asymmetries: Occurs when one party in a transaction has

more information than the other, leading to potential market failures.

 Factor immobility: Occurs when factors of production (e.g., labor,

capital) cannot easily move between industries or regions, limiting
efficiency.

By: Muhdin Z Secret Training Institute

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Solutions to Market Failures

 There are many potential solutions for market failures.

 These can take the form of:

 1-Private market solutions- involve individuals or businesses taking
actions to address market failures.

 Example: Parties can privately agree to limit consumption and

enforce rules among themselves to overcome the market
failure.

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 2- Government-imposed solutions- involve government intervention

to correct market failures.
 Example: Governments can also impose taxes and subsidies as
possible solutions to externalities.

 Taxes (for negative externalities) and subsidies (for Positive

externalities)

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 3- Voluntary collective action solutions- involve individuals or groups

working together to address market failures.

 Example: Consumers and producers can band together to form

co-ops to provide services that might otherwise be
underprovided in a pure market…electric service to rural
homes.

 The choice of solution depends:

 on the specific market failure being addressed and
 the costs and benefits of each option.

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Summary- Market Failure

 Market failure is the economic situation defined by an inefficient distribution of goods
and services in the free market.

 Commonly cited market failures include externalities, public goods, monopoly,

information asymmetries, and factor immobility.

 There are many potential solutions for market failures.

 1-Private market solutions
 2-Government-imposed solutions
 3-Voluntary collective action solutions

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Public Goods

Definition and Features

 Public goods are goods whose benefits are shared.

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 Public goods have two major features.

 Non rivalry in consumption: once the good is provided or supplied,
consumption by one person does not reduce the quantity which is
available for consumption by another.
 This means that the same amount is left for the remaining
consumers.
 This implies that the marginal cost of allowing another person
to consume the good is zero.

 Non-excludability: it is difficult and expensive to prevent or to exclude

someone (non-payers) from consuming the good.
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 Goods that fulfill both these properties are known as “pure public goods”.
 Examples of such goods are national defence, clean air, biodiversity,
wilderness, etc.

 At the other extreme, pure private goods which are rivalrous in consumption and
excludable.
 Most goods around us fall into this category.
 E.g. Food items, clothes, household furniture, houses.

By: Muhdin Z Secret Training Institute

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 There are also goods which fall in between these two extremes.
 These goods satisfy one part of the definition of a public good and not another
 They are called “impure public goods”.

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 Important remarks about Public Goods

 1- Classification of goods as public goods is not absolute; it depends on
market conditions and technology.

Examples
 Radio/ TV Program Subscription
 Toll roads- roads with payment (Adama-Addis Express Road)

Hence, with the help of technology excludability can easily be applied.

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 2- Although everyone consumes the same quantity of Public goods, they may
not value them equally.
 Example: for some individuals, national defence is very
important while others do not care for it, some others still
value it negatively though it is equally available to all.

 3- A number of things that are not conventionally considered to be

commodities have public good characteristics.
 Example: Honesty, fair income distribution, certain information,
polio vaccination, and HIV/AIDS blood tests.

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 4- Private goods are not necessarily supplied by the private sector;

government may provide private goods too.
 Many private goods such as electricity, and telecommunications
are supplied by governments.

 Many pubic goods like protection and guarding are supplied by

the private sector.

By: Muhdin Z Secret Training Institute

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 5- Public provision of a good does not necessarily mean that it is produced

by the public sector/government.
 Example, a government/municipality may collect the garbage
using its own trucks and labour or it may hire a private firm to do
the job.

 In both cases, the government provides the services, but it

produces only in the former case.

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Private Goods Vs Public Goods

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The Free Rider (Social Loafer)

 A person who seeks to enjoy the benefit of public goods without contributing
anything to the cost of financing the amount made.

“a person who benefits from a good or service without contributing to its cost.”

 This problem was first observed in trade union where not-members

benefit from the successful bargaining of unions members.

 As result, they were not willing to become a member and make a

contribution.

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 Free ridership arises because public goods are non-excludable.

 Since it is difficult to exclude non-payers from using/benefiting, there is
an incentive not to pay/to be free rider.

 It is this free rider problem that causes markets to operate inefficiently for public
goods.
 Market failed to supply public goods.
 The private market may provide no output as no one is willing to
purchase it.

By: Muhdin Z Secret Training Institute

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Mechanisms for Providing the Efficient Level of Public Goods

 The provision of public goods requires collective action.

 Mechanisms to provide public goods include the following:

 a. Private provision of excludable public goods (e.g. movies, music
concerts).

 b. Public provision of excludable public goods through the use of

entrance fees (e.g. entrance fees for a National Park).

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 c. Public provision of non-excludable public goods through the use of tax

revenues (e.g. taxes earmarked for national defence).

 d. Religious beliefs (e.g. church/mosque services are public goods; during

the ceremony a basket is passed around for collections).
 Religion can prevent free riding by convincing people that God
is watching.

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Summary-Public Goods

 Public goods are goods whose benefits are shared.

 They have two key characteristics: they are non-excludable and non-
rivalrous.

 At the other extreme, pure private goods which are rivalrous in consumption and
excludable.
 There are also goods which fall in between these two extremes.

By: Muhdin Z Secret Training Institute

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 Classification of goods as public goods is not absolute; it depends on market

conditions and technology.

 Free ridership arises because public goods are non-excludable.

 It is this free rider problem that causes markets to operate inefficiently
for public goods.

 The provision of public goods requires collective action.

GRADE 12 ECONOMICS UNIT 3

Part-2
Externalities
• Definition of Externalities
• Nature and Types of externalities
• Externalities and Economic Efficiency
• Solutions to avoid externalities

By: Muhdin Z Secret Training Institute

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Externalities

Definition, Nature, and Types of Externality

 An externality occurs when the consumption or the production of goods has
positive or negative effects on other people’s utility where these effects are not
reflected in the price.

 “Externality occurs when action of one party affects the other party without in
unintended manner without due compensation.”

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 We distinguish two main types of

externalities.
 Positive externalities: occur when
one person’s consumption of a
good also increases other people’s
utility without them having to pay
for it.

 Positive externalities benefit third

parties.

 Example: Beekeeping and

Vaccination
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 Negative externalities: occur when one

person’s consumption of good decreases,
other people’s utility without them
receiving any compensation.

 Negative externalities harm third parties.

 Example: Smoking, pollution, sewage

discharge

By: Muhdin Z Secret Training Institute

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 The characteristics of externalities

 1. Externalities can be either positive or negative.
 Some externalities are beneficial (PE), while others (NE) are
harmful.

 An economic agent is said to generate positive externalities when

its activities benefit the third party.

 Examples of activities that generate positive externalities: flower

farming, education, street light, neighboring fence, park,
beautifying land escape, neatness of neighborhood, etc.

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 An economic agent generates negative externalities when its

activity harms the third party.

 Example of activities that generate negative externalities:

 Smoking, shouting, and emission of carbon dioxide to the
air and waste into the nearby rivers.

 Pollution, global warming, and climate change are also

negative externalities

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 2-Externalities can be generated by consumers or producers.

 Consumers: E.g, smoking by individuals
 Producers: E.g., pollution by manufacturing industry.

 Externalities can be viewed as special kind of public good or bad.

 They are no rival, and non-excludable.
 And public good generate external benefit.

 NB:
 While public goods always generate external benefits,
externalities can generate either benefits or costs.

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 3. Externalities are reciprocal in nature.

 A firm may impose externalities on residents by creating bad smell.
 on the other hand, resident demand for less aroma which can
be seen as imposing cost upon firm.

 Smoker imposes an extensity on non-smoker.

 But non-smoker also imposes a burden on smoker.

By: Muhdin Z Secret Training Institute

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 This concept is related to the question that whether the injured or injurer is
responsible in car accident.

 Externalities are not the result of one person’s action, but results from
combined action of two or more parties.

 Hence,
 the externality affects both consumers and producers, creating a
reciprocal relationship.
 This can make it more difficult to address externalities through
market-based solutions alone, as both parties may be affected by
the same issue.
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Externality and Efficiency

 In the presence of externality, the free market economy will not allocate resources
efficiently.
 This is because the presence of negative or positive externality
creates a difference between marginal cost (MC) and price (P) as
efficiency requires MC = P.

 1) Negative Externality and Efficiency

 When there is negative externality, MSC>PMC, as there is an external cost of
pollution.

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MSC=MPC+MEC
 MSC is marginal social cost
 MPC marginal private cost
 MEC marginal external cost

By: Muhdin Z Secret Training Institute

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 Profit maximizing condition requires MPC=P

and hence, point e.
 Also called Market Equilibrium

 The social optimal point is at e*.

 Therefore, over production arises to the

amount of Q*Q.

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 Social Welfare: Social welfare is a measure of the

overall well-being of society.
W=Consumer surplus + Producer Surplus

 Consumer Surplus: WTP-Actual Price= “ped”

 Producer Surplus: Actual Price- WTA = “0ep”

 Deadweight Loss: a measure of the economic

inefficiency = “ee*c”….due to overproduction

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2) Positive Externality and Efficiency

 In the presence of positive externality,
MSB>MPB as there is external benefit.

By: Muhdin Z Secret Training Institute

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 Hence, MSB = MPB + MEB

 Profit maximizing condition requires

MPB=MC and hence, point e. (Market
equilibrium)

 The social optimal point is at e*.

 Therefore, under production arises to

the amount of QQ*.

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 Social Welfare: Social welfare is a measure

of the overall well-being of society.

W=Consumer surplus + Producer Surplus

Consumer Surplus: WTP-Actual Price= “ped”

Producer Surplus: Actual Price- WTA = “0ep”

 Deadweight Loss: a measure of the

economic inefficiency = “ee*c”….due to
underproduction

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 In general, inefficiency is created due to over

production and under production or due to the
difference between the profit maximizing and
social optimal levels of output.

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Solutions to Avoid Externality

 1. Solutions for negative externality
 a. Per unit tax equivalent to the amount of the difference between SMC and PMC
corresponding to the socially optimal output.

 This type of solution was proposed for the first time by A.C. Pigou in 1920 on the basis
of the following assumptions.
 Externality is the difference between MSC and MPC.
 There is competitive industry.
 A firm producing output and emitting smoke.
 Pollution per unit of output is constant.
 The external cost of pollution is borne by others.

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 b. Private bargaining between the affected parties.

 This solution was proposed by Coase in 1960 on the basis of the following
assumptions:
 zero and minimum transaction cost.
 small number parties affected.
 well defined initial property rights.

 The optimum outcome depends on the bargaining power of the parties this
is known as the Coase theorem.
 The optimum pollution does not mean zero pollution as the
latter implies zero production.

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 c. Defining and enforcing property rights for those who would like to pollute the
environment.
 This means the sale of property rights.
 Since producers incur some additional costs due to the
property rights, they will take this consideration into their
production decisions and hence, produce relatively smaller
quantities, as a result of which less pollution occurs.

 However, there is one limitation of assigning/selling property rights.

 That is, the market in which we exchange these property rights
may not be a perfectly competitive market.

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 2. Solutions for positive externality

 a. Provide per unit subsidy which is equivalent to the difference between SMB
and PMB corresponding to the socially optimal output.
 Thus, if private firms are subsidized, they will supply optimal output.

 b. The government itself can supply the product at a price of Ps and hence, bear
the loss.

By: Muhdin Z Secret Training Institute

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 In general, all solutions to externality (positive and negative) problems recognize

that the need for internalizing externalities.

<<Internalizing externalities means making the person or entity

responsible for the externality bear the full cost or benefit of their
actions.>>

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Summary- Externalities

 An externality occurs when the consumption or the production of goods has positive
or negative effects on other people’s utility where these effects are not reflected in the
price.

 The characteristics of externalities

 Externalities can be either positive or negative
 Externalities can be generated by consumers or producers.
 Externalities are reciprocal in nature.

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 In the presence of externality, the free market economy will not allocate resources
efficiently.
 inefficiency is created due to over production and under production

 In general, all solutions to externality (positive and negative) problems recognize that
the need for internalizing externalities.

By: Muhdin Z Secret Training Institute

Exercise Question (Page-69/70)

 Suppose that a producer of commodity Y is located on the upstream of river Z. The
MC of producing Y is given by the function MC = 10 + 0.5Y . In addition to this, MC
however, an external cost is incurred. Each unit of product Y produces a pollutant
that flows to the river, which causes damage valued at Birr 10. Suppose that this
external cost is borne by the wider community rather than by the polluting firm. The
MR obtained from each unit of Y is given by MR = 30 - 0.5Y
a) Derive the profit maximizing level of output for Y and Price
b) Derive the socially optimum level of output for Y and Price
c) Graphically illustrate the optimal points
d) Explain why the socially efficient level of output is lower than the profit
maximizing level output of Y.
e) Per Unit Tax to Internalize Externality
f) Find the Deadweight Loss

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GRADE 12 ECONOMICS UNIT 3

Part-3
• Asymmetric Information
• Definition of Asymmetric Information
• Implications of Asymmetric Information
• Consumer Protection
• Concept of consumer protection
• The need for consumer protection
• Consumer protection experience in Ethiopia

By: Muhdin Z Secret Training Institute

Asymmetric Information
Definition
 Asymmetric information is a situation in which different agents have a different
amount of information about a good.

 In other words, asymmetric information is when one party in a

transaction is in possession of more information than the other.

By: Muhdin Z Secret Training Institute

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 In general, information asymmetry deals with the study of decisions in transactions

where one party has more information than another.

 This creates an imbalance in power in transactions which can

sometimes cause the transaction to go away.

 In certain transactions,
 Sellers can take advantage of buyers because asymmetric
information exists whereby the seller has more knowledge of
the good being sold than the buyer.

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 Two types of problems associated with asymmetric information: adverse selection

and moral hazard.

 Adverse Selection Problem

 This refers to situations where one side of the market cannot observe the
“type” or quality of the goods on the other side of the market.

 It is sometimes known as
 “hidden information problem” or
 “anti-selection problem” or ‘
 “negative selection problem”.

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 Adverse selection problem is a term that is used in economics, insurance,

statistics and risk management.

 Examples:
 Used car market: Sellers know more about the quality of their
used cars than buyers.
 Health Insurance Market: Health insurance is more likely to be
purchased by people who are more likely to get sick.
 Job Market: Workers may have hidden characteristics that make
them less desirable to employers

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 Moral Hazards Problem

 This refers to situation where one side of the market cannot observe the
actions of the others.

 It is sometimes known as “hidden action problem”.

 In simple words, it is the inability to observe and/or verify the agents’ action.

By: Muhdin Z Secret Training Institute

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 A moral hazard problem arises when an individual or situation does not bear
the full consequences of its actions.
 Therefore, there is a tendency to act less carefully than it
otherwise would.

 Examples:
 Employment: An employee who knows they are unlikely to be fired
may be less productive or motivated.
 Car Insurance: A person with comprehensive car insurance might be
less careful, knowing that the insurance will cover any damages.
 Government Programs: Welfare recipients may reduce their work
effort if they believe that their benefits will not be affected.
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Solutions for Moral Hazard and Adverse Selection

 A- Signaling
 It is the idea that one party (agent) conveys some meaningful
information about itself to another party (principal).
 By “action, symbol, or gesture”
 Examples:
 Education: Employees signal the levels of their skills to
employers by acquiring a certain degree of education.

 Warranties: In a market for used goods, those who own a good

used car can offer warranty.

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 Employment: Dressing professionally for a job interview can

signal competence and seriousness.

 Job search: A well-crafted resume can signal qualifications and

experience.

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 Limitations:
 Signals requires significant cost

 Signals can be misinterpreted, leading to incorrect assumptions.

 Overuse of common signals reduces their effectiveness.

 Individuals may create false signals or exaggerate qualifications.

 Signals can become outdated quickly in fast-changing markets.

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 Screening
 Refers to a strategy of combating adverse selection.
 Assume there are two individuals Hana and Hikma. Hana knows more about
herself than Hikma knows about Hana.
 If they are going to engage in some sort of transaction, they
need to develop a long term relationship.

 Banks often screen people who are interested in borrowing money in order to
weed out those who will not be able to repay the debt.
 They might also ask potential borrowers for their financial
history, job security, reason for borrowing assets, education,
experience, etc.
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Summary-Asymmetric Information
 Asymmetric information is when one party in a transaction is in possession of more
information than the other.
 Symmetric information means that all parties have complete information
about the economic variables that are relevant for their decisions.

 The two types of problems associated with asymmetric information.

 Adverse Selection Problem: refers to a situation where one side of the
market cannot observe the quality of the goods on the other side of the
market.
 Moral Hazards Problem: refers to situation where one side of the market
cannot observe the actions of the others.

 Solutions: Signaling and Screening

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Consumer Protection
Concept of Consumer Protection
 Consumer protection means safeguarding the interest and rights of consumers.
 In other words, it refers to the measures adopted for the protection
of consumers from corrupted and unethical malpractices.

 The most common business malpractices leading to consumer exploitation are

given below.
 a) Sale of adulterated goods
 i.e., adding something inferior to the product being sold.

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 b) Sale of spurious goods

 i.e., selling something of little value instead of the real product.

 c) Sale of sub-standard goods

 i.e., sale of goods which do not conform to prescribed quality
standards.

 d) Sale of duplicate goods

 e) Use of false weights and measures leading to underweight.

By: Muhdin Z Secret Training Institute

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 f) Hoarding and black-marketing leading to scarcity and rise in price.

 g) Charging more than the maximum retail price fixed for the product.

 h) Supply of defective goods.

 i) Misleading advertisements
 i.e., advertisements that falsely claim a product or service is of
superior quality, grade or standard.

 j) Supply of inferior services

 i.e., quality of service is inferior to the quality agreed upon etc

MUHDIN M. 11/21/2024 73

Need for Consumer Protection

 The necessity of adopting measures to protect the interest of consumers arises
mainly due to the helpless position of the consumers.

 The consumers have the basic right to be protected from the loss or
injury which is caused by defective goods and deficiency of services.

 But many consumers do not exercise their rights due to lack of awareness,
ignorance, or laziness.

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 In view of the prevailing malpractices and their vulnerability to them, it is

necessary to:
 provide them physical safety,
 protection of economic interests,
 access to information,
 satisfactory product standard, and
 statutory measures for redressal of their grievances.

By: Muhdin Z Secret Training Institute

MUHDIN M. 11/21/2024 75

 The other main arguments in favor of consumer protection are outlined below:

 Social Responsibility
 The business must be guided by certain social and ethical norms.
 It is the moral responsibility of the business to serve the
interest of consumers.
 It is the duty of producers and traders to provide the right quality and
quantity of goods at fair prices to consumers.

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 Increasing Awareness
 Consumers are becoming more mature and conscious of their rights
against the malpractices by business.
 They take up their cases at various levels and helping them to
enforce their rights.

 Consumer Satisfaction
 Consumers’ satisfaction is the key to the success of a business.
 Business should take every step to serve the interests of
consumers by providing them the quality goods and services at
reasonable prices.

MUHDIN M. 11/21/2024 77

 Principle of Trusteeship
 Manufactures and producers are not the real owners of business.
 This is because resources are supplied by the society.

 Businesses are merely the trustees of the resources

 Therefore, they should use such resources effectively for the
benefit of the society, which includes the consumers.

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 Principle of Social Justice

 It is expected from business to refrain from malpractices and take care
of consumers’ interest.

 Survival and Growth of Business

 Businesses have to serve consumer interests for their own survival and
growth.
 Hence, in their own long run interest, they should become consumer
oriented.

By: Muhdin Z Secret Training Institute

MUHDIN M. 11/21/2024 79

Consumer Protection Experience in Ethiopia

 In Ethiopia, the Trade Competition and Consumer Proclamation No. 813/2013 has
provided the rights to consumers. Here is a brief outline of about these rights of
consumers.
 1. Consumers should receive sufficient and accurate information or
explanation as to the quality and type of goods or services they
purchase.

 2. Consumers should buy goods and services on the basis of their own
choice.

 3. Consumers should not to be obliged to buy because they looked into

quality or options of goods and services or they made price bargains.
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 4. Consumers should be received humbly and respectfully by any

business person and be protected from insult, threat, frustration and
defamation by the business person.

 5. Consumers should be able to claim compensation either jointly or

severally from persons who have participated in the supply of goods or
services such as the manufacturer, importer, and wholesaler retailer or
in any other way for damages suffered as a result of purchase or use of
the goods or services.

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 The main objectives of the Consumer Protection Act in Ethiopia are to:
1. Protect the
 business community from anti-competitive and unfair market
practices,
 consumers from misleading market conducts, and
 to establish a system that is conducive to the promotion of a
competitive free market.

2. Ensure that consumers get goods and services safe and suitable to their
health and equivalent to the price they pay.

3. Accelerate economic development

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Summary- Consumer Protection

 Consumer protection means safeguarding the interest and rights of consumers.

 The necessity of adopting measures to protect the interest of consumers arises mainly
due to the helpless position of the consumers.

 In Ethiopia, the Trade competition and Consumer Proclamation No. 813/2013 has
provided the rights to consumers.

By: Muhdin Z Secret Training Institute

THANK YOU!

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