Do icecream makers actions mean market failure theory is wrong?

Both Unilever, who are the worlds major icecream brand, and Mars, one of the major chocolate makers are shrinking the size of their products to help consumers make 'healthier choices'.

This seems to contradict the standard economic theory which says in the presence of externalities a free market will fail to allocate resources efficiently.

First let's recap what a free market is. There is no government intervention and so firms produce an amount that maximises profit and consumers maximise the benefit (utility) they can derive from their income. Competition is the only force restraining the behaviour of firms and households.

Economic theory tells us that when there are externalities present the market will not allocate resources in an optimal way. With ice-cream and chocolate we find there are negative externalities of consumption. Consumers over-estimate the benefits of consuming the good because they do not consider all of the costs of consumption, such as the dangers of high sugar and fat consumption (I'm going to assume you know the details of this danger).

The standard market outcome is shown below, in this case for cigarettes.

The market provides no incentive for firms to reduce production (and so consumption) to 0Q*. The market fails when left to itself.

So why has Mars and Unilever decided to take action to effectively reduce their output from 0Q1?

There are a number of explanations. In no particular order:
1. Competition. Doing this first gains the firms market share. Those who feel they should act to improve their health are attracted to the new smaller products. Mars and Unilever increase profit.
Note that competition will make other firms follow if successful.

2. Higher profits. Smaller portions will not be matched with proportional price cuts.

These first two reasons means the free market is alive and well. It has just adjusted to the new market conditions.

3. Better information has changed household preferences. The problem of negative externalities in consumption is a 'lack of information'. Many years of better education has led to a better informed public and pressure for firms to behave ethically. Consumers want to make a better choice.

There are a number of ways to correct market failure, such as tax and legislation. However here we have an example of the market reacting to better information which is closing the gap between Marginal Social Benefit and Marginal Private Benefit (MPB has moved to the right).

For some the conclusion will be a victory of the free market. For others it will be seen as the victory of many years of publicly funded research and education.

The Guardian covers the story here.

This post is more suited to IB Economics, but Market Failure is part of VCE Unit 3 where the MSC/MSB analysis is not required, but the principle is.

If used for an IB Internal Assessment the theory can be closely applied and explanations of motive explored.