IB Economics
Unit 2: Microeconomics
IB Chapter 13: Market Failure
Measuring Economic Welfare
Price (BHD)
• Consumer surplus
• Producer surplus
• Total surplus (or
welfare) = CS+PS
• Why does market
failure lead to a
reduction in TS?
Quantity (000’s)
What is Market Failure?
Definition:
• Where the market mechanism fails to allocate
resources efficiently, when left to the market we
get an inefficient allocation of resources
• TS is not maximised
• Types of efficiency
–
–
–
–
Social efficiency
Allocative Efficiency
Productive Efficiency
(Dynamically efficient)
Market Failure: Types of Efficiency
• Social Efficiency: where external costs and benefits are
accounted for when decisions are made in both consumption and
production.
• Allocative Efficiency: A market will be allocatively efficient if it
is producing the right goods for the right people at the right price
(where MC = AR known as marginal cost pricing).
– Also referred to as; Pareto Efficient Allocation where resources
cannot be readjusted to make one consumer better off without making
another worse off – zero opportunity cost! Vilfredo Pareto (1848 –
1923)
• Productive Efficiency: production of goods and services at
lowest factor cost (lowest point of AC curve).
• Static Efficiency: efficiency at a point of time (e.g. using current
technology)
• Dynamic Efficiency: an economy that appropriately balances
short run concerns (static efficiency) with concerns in the long run
(focusing on encouraging research and development)
Market Failure: When?
• Market Failure occurs where:
–
–
–
–
–
Knowledge is not perfect – ignorance or deception
Goods are differentiated
Resource immobility e.g. Labour or Capital
Market power e.g. Monopolies
Services/goods would or could not be provided in
sufficient quantity by the market e.g. street lighting
– Existence of external costs and benefits
– Inequality exists e.g. wealth, income
Market Failure: Imperfect Competition
• Market Power:
–
–
–
–
–
–
Existence of monopolies and oligopolies
Collusion
Price fixing
Abnormal profits
Rigging of markets
Barriers to entry
Welfare loss under IMPERFECT COMPETITION
Why?
Costs, Benefits & Price
Quantity
How do CARTELS operate?
Why?
Costs, Benefits & Price
Quantity
What can be done to limit the failures
caused by imperfect competition?
• Legal measures to increase competition
– 25%
– Concentration ratio
• Regulatory bodies
– Monitor behaviour of firms e.g. OFWAT
– Monopoly regulators e.g. UK Competition
Commission
We must ensure that all intervention
results in an improvement in economic
welfare and does not make the situation
worse (Government Failure)
The Existence of Public Goods
• Public Goods: Markets would
not provide such goods and
services at all!
– Non-excludability:
Person paying for the
benefit cannot prevent
anyone else from also
benefiting - the ‘free rider’
problem
– Non-rivalry: Large
external benefits relative
to cost – socially desirable
but not profitable to
supply!
• Possible Solutions:
– The government collects
tax (in most countries)
and supplies public goods
themselves, but how does
it know how much to
supply?
– Subsidisation of private
firms to produce
A non- excludable good?
Would you pay for this?
Under provision of a Public Good: MSB Vs MSC
Why?
Merit Goods
• Merit Goods: goods and
services which are better
for us that we realise:
• Under provision
• Under consumption
•
•
•
•
•
Education
Healthcare
Organic food
Seat belts
Sports facilities
• Possible Solutions
• Government provision
• Subsidised production
• Positive advertising to
encourage consumption
and/or production
Would we all pay if the state did not provide it?
Under provision of a Merit Good: MSB Vs MSC
Why?
Under consumption of a Merit Good: MSB Vs MSC
Why?
Demerit goods and services
De-Merit Goods
• Over Production:
• Over Consumption:
• Examples:
– Tobacco
– Alcohol
– Drugs
– Gambling
– Sheesha
• Possible Solutions
– Regulation of use
– Negative advertising to
discourage production
and/or consumption
– Taxation to reduce QD via
increased P
A Russian drug addict injects heroin
Over Consumption of a De-Merit Good: MSB Vs MSC
Why?
Over Supply of a De-Merit Good: MSB Vs MSC
Why?
Market Failure: Knowledge
• Imperfect Knowledge:
–
–
–
–
–
Consumers do not have adequate technical knowledge
Advertising can mislead or mis-inform
Producers unaware of all opportunities
Producers cannot accurately measure productivity
Decisions often based on past experience rather than
future knowledge
How does imperfect knowledge affect the market?
Why?
Market Failure
• Goods/Services are
differentiated
– Branding
– Designer labels - they cost
three times as much but
are they three times the
quality?
– Technology – lack of
understanding of the
impact
– Labelling and product
information
Which one is the ‘quality’ item and why?
How does product differentiation affect the market?
Why?
Market Failure: Immobility
• Resource Immobility
– Factors are not fully mobile
– Labour immobility – geographical and
occupational
– Capital immobility – what else can we use the
Channel Tunnel for?
– Land – cannot be moved to where it might be
needed – e.g. London and South East!
World Income Distribution
Market Failure: Externalities
External Costs and Benefits
• External or social costs
– The cost of an economic decision to a third
party
• External benefits
– The benefits to a third party as a result of a
decision by another party
Market Failure
External Costs
• Decision makers do not take
into account the cost imposed
on society and others as a
result of their decision
– e.g. Pollution, traffic
congestion, environmental
degradation, depletion of the
ozone layer, misuse of
alcohol, tobacco, anti-social
behaviour, drug abuse, poor
housing
External Costs: MSB Vs MSC
Why?
Market Failure: Benefits
External benefits –
– by products of production
and decision making that
raise the welfare of a third
party
– e.g. Education and training,
public transport, health
education and preventative
medicine, refuse collection,
investment in housing
maintenance, law and order.
External Benefits: MSB Vs MSC
Why?
Market Failure
• Inequality:
–
–
–
–
–
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Poverty – Absolute and Relative
Distribution of factor ownership
Distribution of Income
Wealth Distribution
Discrimination
Housing
Inequality
FIG: 1.1
Diagram Title: The LORENZ curve
%age of Income (Y)
RECORD NOTES HERE
%age of Population
GINI Co-Efficient
Source: ECONandBIZ.com
Gini co-efficient
formula
A
A+B
A
B
Market Failure
Measures to Correct Market Failure
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–
–
–
–
–
–
–
–
–
State Provision
Extension of property rights
Taxation
Subsidies
Regulation
Prohibition
Positive Discrimination
Redistribution of Income
Price Controls
Buffer Stocks
Correcting Market Failure: Taxes e.g. de-merit
Why?
Correcting Market Failure: Education e.g. de-merit
Why?
Correcting Market Failure: Subsidy e.g. Merit
Why?
Correcting Market Failure: Regulation e.g. Merit
Why?
Correcting Market Failure: Inequality e.g. Min wage
Why?
Correcting Market Failure: Redistribution of Income
Why?
Correcting Market Failure: Max/Min Prices
Why?
Correcting Market Failure: Buffer Stocks
Why?
Government Failure
Government failure is when intervention by the government in a market
results in a worsening of welfare for society.
P1
Take this example of a tax
aimed at reducing
consumption. While the
policy has been successful in
reducing quantity demanded
from Q1 to Q2 what about
the price increase and how
will this affect people on poor
incomes?
Price in $US
What we are saying here is that the GOVERNMENT SOMETIMES
MAKES IT WORSE THAN IT WAS ALREADY.
Q: How effective will this
policy become as PED
falls?
S2 (S1+Tax)
S1
Tax
P2
D
Q2
Q1
QD & QS per yr
How does PED affect our analysis?
S2 (S1+Tax)
S1
Tax
A
P2
B
P1
Price in $US
A
+
B
Tax burden that
falls on the
consumer
Tax burden that
falls on the
producer
Total Tax
Revenue
D
Q2 Q1
QD & QS per yr
Has this tax been successful?
Record
Student
views here
YES: it has raised revenue for the government
NO: the low level of PED means that there has been limited results
YES: it has discouraged some people from consuming the good or service
NO: what about the poor people or those who cannot change their
consumption patterns?
Sources of Government Failure
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Political self-interest
Policy myopia
Regulatory capture
Government intervention and disincentive effects
Government intervention and evasion
Policy decisions based on imperfect information
The Law of Unintended Consequences!
Costs of administration and enforcement
TASK: Take 5-10 minutes to read the handout ‘Does the government
always get it right?’ and then right a paragraph to explain what you
understand by the term GOVERNMENT FAILURE
Examples of Government Failure
Government intervention to reduce
the power of monopolies which
hinders international
competitiveness and/or is against
the public interest
The Government uses increases in
minimum wages to win votes during the
election campaign
Incorrect or inefficient tax/benefit
systems to correct for the existence of
externalities
Regulations which result
in harmful unregulated
black markets
The existence of unintended
consequences as a result of
government action
Task: Take each of the scenarios and write a brief example to
illustrate the issues raised. Make sure that you explain a
likely instance of government failure.
Case Study: Smoking Bans
A UK businessman
has begun
marketing an
'electronic cigarette'
which he says
allows smokers to
get around the
smoking ban.
http://news.bbc.co.uk/2/hi/uk_news/england/7660141.stm
Case Study: Tax on cigarettes
http://news.bbc.co.uk/2/hi/uk_news/4096911.stm
Ideas Board