Market Failure

Market Failure

• Occurs when free market forces, using the price mechanism, fail to produce the products that people want, in the quantities they desire at prices that reflect consumers’ satisfaction.

• Where resources are inefficiently allocated due to imperfections in the working of the market mechanism

Market Failure

• When markets do not provide us with the best outcome in terms of efficiency and fairness

• Types of market failure?...

Sources of Market Failure• Externalities• Merit and demerit Goods• Common access resources (‘tragedy

of the commons’)• Public Goods• Asymmetric Information• Monopoly Power

Efficiency

• In Economics, efficiency is a situation where all possible scarce resources are being used in the most effective way possible to meet the greatest possible level of consumer wants

• To be sure that we can state that economic resources are being used in the best possible way and thus that Economic Efficiency exists, 2 things must be true…

1. Everything that is produced must be done so using the least possible amount of scarce resources=

Productive Efficiency (producing on the PPC/ producing at the lowest possible average cost)

2. Products produced are what consumers want and in the right quantities i.e. resources are allocated in a way which maximises consumers’ satisfaction=

Allocative Efficiency (where S=D when social costs and benefits are taken into account)

Allocative efficiency• Occurs when the benefit (utility) to

consumers is maximised and producers maximise profit.

• Scarce resources are allocated to meet consumer demand and therefore supply must equate with demand i.e. at equilibrium.

• At any other price demand and supply do not equate, and resources will not be allocated efficiently

S1

D1

Q*

P*

Price

Quantity

S1

D1

Q*

P*

Price

Quantity

P1

Qd1 Qs1

S1

D1

Q*

P*

Price

Quantity

P2

Qs2 Qd2

Costs and Benefits

• Social Costs= Private Costs + External Costs• Social Benefit= Private Benefit + External

Benefit

• List the private costs, private benefits, external costs and external benefits of car ownership

Showing Efficiency on a Diagram

• The socially efficient output is the point where the market is in equilibrium when all social costs and benefits are taken into account

• At this equilibrium the welfare of society is maximised

(social welfare= producer and consumer surplus)

• So far when looking at supply and demand we have only considered the private costs of production when thinking about the S curve and the marginal utility (marginal private benefit) when considering the D curve.

• Now we consider the private and external costs and benefits when looking at supply and demand.

• The supply curve is determined by the marginal costs of production (MC= change in total cost when output is changed by one unit) in this case the S curve equals the marginal cost to the whole of society thus S=MSC

• The demand curve is determined by the marginal benefit (marginal utility). In this case the D curve = marginal benefit to the whole of society thus D=MSB

• MSC=MPC+MEC• MSB=MPB+MEB

Socially Efficient (Optimum) Output/ Allocatively Efficient Output

Price/ Costs and Benefits

S= MSC

D= MSB

Q*

P*

QuantityThe value consumers place on the last unit produced is equal to the full cost of producing that last unit

Market Failure

• When markets do not provide us with the best outcome in terms of efficiency and fairness

• Types of market failure?...

Externalities

Externalities are defined as ‘third-party’ or ‘spillover’ effects from the consumption or production of a good or service for which no appropriate compensation is paidAn externality occurs when there is a cost or benefit arising from an activity or transaction that is not reflected in the market price

Output is not at a socially optimum level

Negative Externalities• External costs of an economic activity• Negative Consumption Externalities-

external costs arising from a consumption activity eg. Driving a car

• Negative Production Externalities- external costs arising from a production activity eg. A chemical factory discharges it’s waste into a local river

Positive Externalities

• External benefits of an economic activity• Positive Consumption Externality-

external benefits arising from a consumption activity eg. Healthcare has benefits for the whole of society- not passing on illnesses etc

• Positive Production Externality- external benefits arising from a production activity eg. Training an employee who leaves to work for another firm

Negative Production Externalities

S (based on private costs to the firm (MPC))

D (based on private benefits to the consumer and assuming no external benefits (MPB+MEB= MSB))

Q1

P1

Price (costs/ benefits)

Quantity

S (based on private and external costs (MPC+MEC= MSC))

Q*

P*a

b

c

Therefore…

• When negative production externalities exist, the marginal social costs exceed marginal private cost

• This leads to the private optimum level of output being greater than the social optimum level of production hence loss of welfare to society

Positive Production Externalities

Positive Production Externality

• Output is lower than socially optimum

• Society has gained from the actions of the firm (recall training) thus the marginal private cost of the firm is greater than the marginal social cost

S (= MSC)

D (= MSB)

Price (cost/ benefit)

Q1

P1

Quantity

S (= MPC)

Q*

P*

Consumption Externalities

Negative Consumption Externalities

• Negative consumption externalities lead to a situation where the social benefit of consumption is less than the private benefit

• Consumption is ‘too high’

Negative Consumption Externality

D (MSB)D (MPB)

P1

Price ( Costs/ Benefits)

S (MSC)

Q*

P*

Q1 Quantity

Positive Consumption Externalities

• Consumers maximise their private utility (benefit) and consume where MSC=MPB (here we are presuming there are no external costs thus MPC=MSC=S)

• The MSB of consumption is greater than the MPB, thus consumption is ‘too low’

Positive Consumption Externality

D (MPB)

D (MSB)

P1

Price ( Costs/ Benefits)

S (MSC = MPC i.e. there are no external costs)

Q*

P*

Q1