Market Failure

AS Economics

Market Failure – a definition

• Market failure occurs when the free market, left alone, fails to deliver an efficient allocation of resources. The result is a loss of economic and social welfare.

Causes of market failure• Negative externalities e.g. pollution causing the social cost

to exceed the private costs• Positive externalities e.g. education causing the social

benefit to exceed the private benefits• Imperfect information meaning merit goods are under-

produced and demerit goods are over-produced• The private sector being unable to supply important public

and quasi-public goods• Market dominance by monopolies• Immobility of factors of production causes unemployment

and productive inefficiency• Equity (fairness) issues resulting in an unacceptable

distribution of income and social exclusion

Activity 1

Which of the following would provide evidence of market failure?

a)shortagesb)unemploymentc) unfilled job vacanciesd)output occurring inside the PPF

Market failure and economic efficiency

• MF results in productive inefficiency • Firms are not maximising output from given

factor inputs• This is problematic as lost output could have

been used to satisfy more needs and wants; resources are misallocated and producing goods and services not wanted by consumers – resources could have been put to better use

Externalities

• Externalities are costs OR benefits that spill over to third parties external to a market transaction

Externalities

Private Costs

orBenefits

Private Costs

orBenefits

Social costs or benefits

Externality – positive or negative depending on costs or benefits

Activity 3

A public house is permitted to stay open all weekend over the May bank holiday. Identify one group of people not directly involved in running or visiting the pub who may:

a)benefit from this decisionb)suffer as a result of this decision

Negative externalities• Private costs of any action are those suffered by the

individual decision maker• Social costs of any action are all the conceivable costs

associated with that action• If social costs exceed private costs then a negative

externality exists; the private optimum level of output is greater than the social optimum level of output – the individual or consumer does not take into account the effects of externalities into their calculations

• PC/SC are usually referred to in the ‘margin’ – the costs or benefits of one extra unit of output

• So, MSC = MPC + MEC

Positive externalities

• These arise when third parties benefit from the ‘spillover’ effects of production and consumption

• Education – improves skills and productivity – PB of better for employers – earn more – SB – you increase living standards of the nation

• So, MSB = MPB + MEB

Activity 4

Identify:a)three private costs a bus company may incur

when operating a bus routb)two private benefits a newspaper company

can gain from selling its newspapers

Activity 5

• Identify a benefit the other residents of a street could gain from one household holding a firework party to which they were not invited

Activity 6

• Identify three negative externalities which villagers may experience as a result of a bypass being built through their village

Negative externality

Quantity

pric

e

0 Q

D

S (MPC)

S1 (MSC = MPC + MEC)

Q1

P

P1

•At price P and demand/supply Q, only the private costs are taken into account•If the external costs are taken into account then the supply curve would shift to the left to S1

•Price would rise from P to P1

•Equilibrium quantity would fall from Q to Q1

•The negative externality is causing over-production of Q-Q1 and the price paid is lower than it should be

Positive externality

Quantity

pric

e

0 Q

D (MPB)

•At price P and demand/supply Q, only the private benefits are taken into account•If the external benefits are taken into account then the demand curve would shift to the right to D1

•The market equilibrium would be at Price P1 and Quantity Q1

• When the market fails to operate in this way there is under-production and this is shown by the difference between Q1 and Q•Too few scarce resources are being used hence the market failure

Q1

P

P1

D1 (MSB = MPB + MEB)

S (MPB)

Recap

• Negative externalities lead to over-production• Positive externalities lead to under-production• MSC = MPC + MEC• MSB = MPB + MEB

Cheap food – at a huge price & questions

P91 - 92

Merit and Demerit goods• Merit goods are more beneficial for consumers

than they realise – usually have positive externalities. Governments usually subsidise these so consumption does not depend on ability to pay

• Left to market forces merit goods would be under-consumed and so under-produced (underprovided)

• Demerit goods are more harmful for consumers than they realise – usually have negative externalities, and are over-provided

Activity 9Decide whether the following are merit or demerit goods:a) heroinb) catalytic convertorsc) insuranced) MOT testse) public librariesf) educationg) legal drugsh) healthcarei) tobaccoj) vaccinationsk) alcohol

Under-provision of a merit good

Quantity

pric

e

0 Q

D (MPB)

S (MSC) •Demand (D) is based on an underestimate of the private benefits of a merit good.•The full benefit to consumers and third parties is represented by the curve D1

•Society would gain from increasing output from Q to Q1

D1 (MSB = MPB + MEB)

Q1

P

P1

Over-provision of a demerit good

Quantity

pric

e

0 Q

D

S (MSC)•Demand (D) is based on an overestimate of the private benefits of a demerit good.•The full benefit to consumers and third parties is represented by the curve D1

•A reduction in output from Q to Q1 would be a move towards a more efficient allocation of resources

D1

Q1

P

P1