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AS Market Failure

Positive Externalities

There are many occasions when the production and/or consumption of a good or a service creates external benefits which boost social welfare. In this note we consider the idea of positive externalities and the market failure that can result if the market under-consumes or under-provides these sorts of products.

Examples of positive externalities

• Social benefits from providing milk to young schoolchildren
• External benefits from vaccination / immunisation programmes
• Social benefits from restoration and use of historic buildings
• External benefits from improved training and education
• External benefits from development of renewable energy sources
• External benefits from other new production technologies

Positive externalities and market failure

Where positive externalities exist, the good or service may be under consumed or under provided since the free market may fail to value them correctly or take them into account when pricing the product. In the diagram above, the normal market equilibrium is at P1 and Q1 – but if there are external benefits, the Q1 is an output below the level that maximises social welfare.

There is a case for some form of government intervention in the market designed to increase consumption towards output level Q2 so as to increase economic welfare.

Bird flu vaccine being prepared

Vocational training – externalities and market failure

There is growing evidence that skilled workforces have positive impacts on high-level economic aims, such as raising productivity and enhancing a country's GDP growth.

At the same time, there is evidence of a major skills deficiency in the UK, which is reflected in the low numbers of people holding intermediate level vocational qualifications, compared to Germany and other European Union countries. There is further evidence that there are three forms of market failure that continue to cause this skills gap:

1. Externalities leading to under-investment in training by employers. Firms are concerned that once trained, an employee will leave the firm before the firm has recouped its investment. Unless training pays off very quickly, firms are therefore reluctant to provide training to their workers. This is an example of the free-rider problem - where one firm can take advantage of the money invested in training by another firm. Fewer than four in ten employers in the UK provide some off-the-job training each year.

2. Imperfect information leading to employees (workers) being unable to judge the quality of their training or appreciate the benefits to themselves. This reduces their willingness for example to accept lower wages during the training period or to receive any training at all.

3. Credit market imperfections. Training is a costly business, but individuals expect to obtain higher wages from training in the long-term (i.e. their wages are likely to be higher in jobs that require a greater degree of training and specific skills). Some individuals may wish to borrow money to fund training in the expectation that they will be able to pay back the loan through higher future wages. However, low-paid employees in particular are likely to be "credit constrained" and unable to obtain loans to pay for training.

These market failures mean that the level of training provided by the market is likely to be inefficiently low from society’s point of view. Well-designed government intervention may help to bridge the gap

How can government intervention help to resolve the “training gap?”

The aims of government intervention might be to

• Move towards a socially optimal level of training
• Achieve higher productivity among those who take training programmes
• Build the economy’s human capital
• Increase the proportion of the employed workforce that has a recognised vocational training qualification

Options for government intervention

• Increased funding for education and training programmes within the public sector
• State funded and operated vocational training e.g. modern apprenticeships and expansion of vocational exams
• Tax credits for businesses that invest in vocational training programmes
• Regulation
• The Industrial Training Levy (2002)