Market Failure DAYO

Market Failure
Objectives:
At the end of this class the student should be able to:
Explain:
• Market failure
• Marginal social cost,
• Marginal external cost,
• Marginal private cost,
• Marginal social benefit,
• Marginal external benefit and marginal private benefit
Explain, with the aid of a diagram:
• Positive and negative externalities (external benefits and external
costs); consumption and production
What is market failure?
Market failure, in economics, is a
situation defined by an inefficient
distribution of goods and services in the
free market. In an ideally functioning
market, the forces of supply and demand
balance each other out, with a change in
one side of the equation leading to a
change in price that maintains the
market's equilibrium. In a market failure,
however, something interferes with this
balance.
TYPES OF MARKET FAILURE
Externalities: An externality is the cost or benefit a
third party receives from an economic transaction
outside of the market mechanism. In other words, it
is the spillover effect of the production or
consumption of a good or service. This leads to the
over or under-production of goods, meaning
resources aren’t allocated efficiently. For example,
cars and cigarettes have negative externalities whilst
education and healthcare have positive externalities.
● Public goods are another example of market failure
because they defy the tenets of supply and demand that
drive the free markets. Public goods and services are
nonexcludable—once something like a street light is
produced, it is accessible to everyone, and the producer
cannot limit consumption only to paying customers.
Public goods are also nonrival, as use by one individual
does not limit consumption by others. Given these
characteristics, the private sector has little incentive to
produce public goods, which leads to market failure, and
the government usually has to provide these goods or
subsidize their production
● Information gaps: When there is insufficient information available
to certain participants in the market, this can also be the source of
market failure. If the buyer or seller in a transaction lacks access to
the information on which the price is based, they may be willing to
overpay or undercharge for a good or service, disrupting the
market's equilibrium. Homo economicus is assumed to have perfect
information, allowing them to make rational decisions. Similarly,
firms are assumed to have perfect information on their cost and
revenue curves and governments are assumed to know the full cost
and benefits of each decision. Therefore, economic agents do not
always make rational decisions and so resources are not allocated
to maximise welfare. For example, consumers do not know the
quality of second hand products, such as cars, and pension
schemes are complex so it is difficult to know which one is best.
Private, external and social costs and benefits:
Private costs/benefits are

the costs/benefits to the
individual participating in
the economic activity.
The demand curve
represents private
benefits and the supply
curve represents private
costs.
Social costs/benefits are the costs/benefits of the activity to society
as a whole.
External costs/benefits are the costs/benefits to a third party not
involved in the economic activity.
They are the difference between private costs/benefits and social
costs/benefits. A merit good is a good with external benefits, where
the benefit to society is greater than the benefit to the individual.
These goods tend to be underprovided by the free market. A
demerit good is a good with external costs, where the cost to society
is greater than the cost to the individual. They tend to be over-
provided by the free market.
A marginal cost/benefit is the extra cost/benefit of
producing/consuming one extra unit of the good.
For example, the marginal private benefit (MPB) is the
extra satisfaction gained by the individual from
consuming one more of a good
The marginal social benefit (MSB) is the extra gain to
society from the consumption of one more good.
The marginal private
cost (MPC) is the
extra cost to the
individual from
producing one more
of the good and the
marginal social cost
(MSC) is the extra
cost to society from
the production of one
more good.
Positive externalities of production
A positive production externality

occurs when the production of a
good or service itself results in
benefits to third parties—for
example, when a company tears
down an abandoned building and
constructs a new office or
apartment building that enhances
the surrounding community
NEGATIVE EXTERNALITIES OF PRODUCTION
Negative externalities of production occur when social
costs are greater than private costs. The market left to
operate freely will ignore the external costs involved in
producing a good. It will produce where MPB=MPC,
the market equilibrium, at Q1P1. . At Q1, the costs to
the society are higher than the benefits to society
resulting in the loss of welfare equal to the shaded
area. The external cost at Q1 is equal to the line AB.
The economy should produce where MSB=MSC, the
social optimum position, at Q2P2. The difference
between marginal social cost and the marginal private
cost increases as output grows, because external costs
grow the more that people do something.
If one person drove their car, then the external costs of
pollution would be very small. The more people that drive
cars, the larger the external cost of pollution. The noise
pollution from airplanes and industrial waste are two
examples of negative production externalities.
Positive externalities of consumption
Positive externalities of consumption occur when
social benefits are greater than social costs. In the
diagram, the market left to its own devices will
produce where MPB=MPC, it will not consider the
benefits to society so will produce Q1P1. If the
market considers all the benefits, it would
produce where MSB=MSC at Q2P2. The failure of
the market to consider the external benefits has
led to the misallocation of resources and so there
is an underproduction of Q1-Q2. This leads to a
welfare loss of the shaded area. The line AB
represents the external benefit.
Again, the difference between marginal private benefit and
marginal social benefit grows since external benefits grow the
more people that undertake the activity, for example the
external benefits of vaccinations are larger the more people
that have the vaccination. Healthcare and education are two
examples of positive consumption externalities. It is difficult It
is difficult to work out the size of the externality as it tends to
be placed on value judgements, since it is difficult to monetise
external costs. Many externalities are involved with information
gaps, as people are unaware of the full implications of their
decisions.
Negative externalities of consumption
Another type of negative

externality is the negative
consumption externality, in
which the consumption of a good
reduces the well-being of others
who are not compensated for this
harm. Cigarette smoking is a
common example, in which one's
consumption affects others as a
result of the health hazards of
secondhand smoke
Government intervention:
There are a number of ways that the government can
intervene to ensure the market considers the external costs
and benefits:
● Indirect taxes and subsidies: Taxes can be put on goods
with negative externalities and subsidies on goods with
positive externalities. These help to internalise the
externalities, moving production closer to the social
optimum position.
● Tradable pollution permits: These allow firms to produce up to a
certain amount of pollution, and can be traded amongst firms so
give them choice whilst reducing the total level of pollution.
● Provision of the good: When social benefits are very high, the
government may decide to provide the good through taxation. They
do this with healthcare and education.
● Provision of information: Since some externalities are associated
with information gaps, the government can provide information to
help people make informed decisions and acknowledge external
costs.
● Regulation: This could limit consumption of goods with negative
externalities, for example banning advertising of smoking etc.
evaluation
explain, with the aid of a diagram, what is meant by positive and negative externalities
(external benefits and external costs) of consumption
• explain, with the aid of a diagram, what is meant by positive and negative externalities
(external benefits and external costs) of production
• explain what is meant by marginal social cost, marginal external cost
, marginal private cost, marginal social benefit, marginal external benefit and marginal private
benefit
• explain, with the aid of a diagram, why the following cause market failure: - negative
externalities of consumption - negative externalities of production - positive externalities of
consumption - positive externalities of production
• evaluate how the existence of externalities affects markets, such as education, health,
transport and the environment

Market Failure DAYO

Uploaded by

Copyright:

Available Formats

Market Failure DAYO

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Market Failure DAYO

Uploaded by

Copyright:

Available Formats

Market Failure

At the end of this class the student should be able to:

Private costs/benefits are

A positive production externality

Another type of negative

You might also like