MARKET FAILURE

Negative / Positive Externalities

Social Benefit and Cost

MARKET FAILURE

What is Allocative Efficiency and Maximization of Welfare?

1 3

$1

$9

$5

Burgers

Consumers willing to buy 1st burger for $9 but pays market rate of $5 (market equilibrium price). Thus the consumers enjoy $9-$5 =$4 of consumer surplus, while producer enjoy $$5-$1=$4 of producer surplus.

1st Burger

Consumer Surplus

Producer Surplus

MARKET FAILURE

What is Allocative Efficiency and Maximization of Welfare?

1 4

$1

$9

$5

Burgers

$7

$3

2

Sellers willing to buy 2st burger for $7 but pays market rate of $5 (market equilibrium price). Thus the consumer enjoys $7-$3 =$4 of consumer surplus, while producer enjoy $$5-$3=$4 of producer surplus.

2nd Burger

Consumer Surplus

Producer Surplus

MARKET FAILURE

What is Allocative Efficiency and Maximization of Welfare?

1 4

$1

$9

$5

Burgers

$7

$3

2

$6

$4

3

Ultimately, when consumers pay the equilibrium price, we say that consumers and producer’s surplus is maximized. Another way to put is that allocative efficiency has been reached whereby welfare has been maximized. In this state resources are fully and efficiently used.

MARKET FAILURE

What is Allocative Efficiency and Maximization of Welfare?

1 4

$1

$9

$5

Burgers

$7

$3

2

$6

$4

3

If society does not produce at ( up to the market clearing equilibrium of 4 units of at $5, then we say that the market is not allocative efficient. When this happens market failure occurs

Welfare lost giving rise to inefficient use of resources

When a market has failed to achieve economic efficiency it has failed to achieve allocative efficiency. This means that the market has failed to allocate the usage of resource in an efficient manner resulting in a society not achieving maximum welfare.

MARKET FAILURE

MARKET FAILURE

In a failed market, at market equilibrium, something is causing the market to not be able to allocate efficiently so that welfare is not maximized. The welfare of all in society (consumers, producer and all 3rd parties) has not been considered.

MARKET FAILURE

There are 4 causes of Market Failure

1. Externalities

2. Public Goods

3. Merit Good

4. Existence of Monopolies

O level focus

MARKET FAILURE

1. A. Negative Externalities

They are defined as third party (or spill-over) effects arising from the production and/or consumption of goods and services for which there exist an external cost to society and no appropriate compensation is paid to society.

- Negative externalities – smoking

MARKET FAILURE

1. B. Positive Externalities

They are defined as third party (or spill-over) effects arising from the production and/or consumption of goods and services the external benefit of which society has not paid for. 

- Positive externalities - education

MARKET FAILURE

2. Public Goods

Null

MARKET FAILURE

3. a. Merit Good

b. Demerit Good

MARKET FAILURE

4. Existence of Monopolies

Null

MARKET FAILURE

Social Cost

When one consumes a cigarette, others around him (the 3rd party) will also end up inhaling 2nd hand smokes. For these 3rd parties, long term exposure to these smokes will result in respiratory diesease and they will need to pay for medication. As such, the smoking of cigarettes (a demerit good) will give rise to social cost.

MARKET FAILURE

Social Benefit

When one is injected with anti-flu vaccination, others around him (the 3rd parties) will not be infected and the person will also be healthier having less MCs. 3rd parties benefit by the person’s continued contribution to society as a productive unit of labour. As such, vaccination (a merit good) will give rise to social benefit.

MARKET FAILURE1. Positive or Negative Externalities?

2. Social Benefit or Social Cost?

Activity Identified Externality

Positive/Negative Externality

Social Cost or Benefit

Solution

Drinking Coke

Obesity/MC -ve Cost Tax or Min Price

Driving a Car

Carbon Emission

-ve Cost Gas tax/ERP

University Education

Volunteerism +ve Benefit Subsidy

Using Solar Energy

Clean Environment

+ve Benefit Subsidy Edcucation

MARKET FAILURE

4. Existence of Negative Externalities

How Will A Tax (GST) Affect Producers and Consumers

1. Taxes will increase the cost of production of the firm.

2. Owing to the tax, producers will cut back on production so as they now have less resources and they need to maintain a level of profit.

3. This will cause the prices of the cigarettes to increase causing consumers to decrease the quantity demanded for cigarettes.

4. The tax, therefore has succeeded in reducing the consumption of a demerit good that gives off negative externalities.

Advantage and Disadvantages of the Tax Reduce Consumption of a Demerit Good

Advantage1.The consumption tax increases the price of the demerit good causing consumers to consume less of the good.2.The tax is easy to implement and government does not have to spend a lot of money to implement it.

Disadvantage1.The tax may not be severe enough to deter consumer to reduce their consumption.2.The tax maybe too severe and may reduce employment in the firms significantly as firms reduce their production due to the tax.3.It the demerit good (cigarette in this case) is price inelastic in demand, then the consumers will in the long run get use to the high prices and will not significantly reduce the quantity demand of the good by much.