Market Failure
Market Failure
...is the presence of inefficiency in a market
Type of Efficiency
Efficient when...
Failure when...
Productive efficiency
when ATC is at a
minimum
When costs are higher
than the minimum
Allocative efficiency
when MC = AR
[or when S = D]
What is produced is
what is demanded
When more or less than
the true equilibrium is
produced
Pareto efficiency
When it is not possible
to make anyone better
off, without making
someone worse off
When either productive
or allocative efficiency is
missing
Externalities
- Consumers not
paying the true cost
Information
Failure
-lack of understanding
Inequality
- Waste of resources
So what causes
Market Failure?
Free-riders
– consumers who
don’t pay at all
Market Structure
– lack of competition
Discrimination
- Inefficient choices
Positive and Negative
Externalities
Positive and Negative Externalities
• The effects of a decision by
consumers and producers that has
an impact on a third party
– Negative Externalities – costs
incurred by third parties
– Positive Externalities – beneficial
effects on third parties
Negative Externalities
Cost to third parties
Social Cost
(externality) £9
(to the whole of
society) £12
Private Cost
(to the consumer) £3
Negative Externalities
Costs in production and consumption:
• External costs in production –
where MSC > MPC (there are external costs)
– e.g. air and water pollution, congestion, housing development
on green belt areas, destruction of hedgerows and wildlife,
noise, pollution…
• External costs in consumption –
where MPB > MSB (there are external costs)
– e.g. passive smoking, litter, noise,
anti-social behaviour, binge drinking...
If there are externalities
present...
...the market is inefficient
Why are externalities inefficient?
• Negative Externalities– socially efficient
output should be less than current output.
So true allocative equilibrium in not
achieved..too much is produced.
• Allocative Efficiency is only achieved where
MSC = MSB [true supply = true demand]
True Equilibrium – allocative efficiency
Price
MSC=S
The Marginal Social Benefit
curve (MSB) represents the
sum of the benefits to
everyone in society as a
whole – the private and
external benefits together.
This is the true Demand.
The Marginal Social Cost
(MSC) curve represents the
sum of the costs to everyone
in society as a whole – the
private and external costs
together.
£5
This is the true Supply curve.
MSB=D
100
Quantity Bought and Sold
Negative External Costs of Production
Price
MSC=S
MPC
The MPC does not take into
account the cost to society
of production.
The producer reaches
equilibrium at 130 units of
output.
But what is the cost to
society of this over
production?
£5
Welfare loss
caused by
externality
MSB=D
100
130
Quantity Bought and Sold
Negative External Costs of Consumption
Price
MSC=S
Welfare loss
caused by
externality
£5
MSB=D
100
140
The MPB does not take into
account the cost to society
of consumption.
The consumer reaches
equilibrium at 140 units of
output.
But what is the cost to
society of this over
consumption?
MPB
Quantity Bought and Sold
Positive Externalities
Social Benefit
(to the whole of society) £15
Benefit to third parties
(externality) £10
Private Benefit
(to the consumer) £5
Positive Externalities
Benefits in production and consumption:
• External benefit in production
– where MPC > MSC (there are external benefits)
– e.g. human resource development, research
and development in industry, pleasant
looking buildings, clean water…
• External benefits in consumption
– where MSB > MPB (there are external benefits)
e.g. preventative health care – vaccinations,
public transport, attractive private gardens,
bathing regularly, pretty balloons in the sky...
If there are externalities
present...
...the market is inefficient
Why are externalities inefficient?
• Positive Externalities– socially efficient
output would be greater than current output.
So true allocative equilibrium is not
achieved...too little is produced.
• Allocative Efficiency is only achieved where
MSC = MSB [true supply = true demand]
True Equilibrium – allocative efficiency
Price
MSC=S
The Marginal Social Benefit
curve (MSB) represents the
sum of the benefits to
everyone in society as a
whole – the private and
external benefits together.
This is the true Demand.
The Marginal Social Cost
(MSC) curve represents the
sum of the costs to everyone
in society as a whole – the
private and external costs
together.
£5
This is the true Supply curve.
MSB=D
100
Quantity Bought and Sold
Positive External Benefits of Production
MPC
Price
MSC=S
The MPC does not take into
account the benefits to
society of production.
The producer reaches
equilibrium at only 80 units
of output.
But what is the cost to
society of this under
production?
£5
Welfare loss
caused by
externality
MSB=D
80
100
Quantity Bought and Sold
Positive External Benefits of Consumption
Price
MSC=S
Welfare loss
caused by
externality
£5
MPB
90 100
The MPB does not take into
account the benefit to
society of consumption.
The consumer reaches
equilibrium at 90 units of
output.
But what is the cost to
society of this under
consumption?
MSB=D
Quantity Bought and Sold
Quick Diagram Test
MSC=S
MPC
MPC
MSC=S
Negative
Production
Externality
Positive
Production
Externality
MSB=D
MSB = D
“Deforestation”
“Water purification during production”
MSC=S
Negative
Consumption
Externality
MPB
MSB=D
“Litter”
MSC=S
Positive
Consumption
Externality
MSB=D
MPB
“Christmas house lights”
Quick Diagram Test
Where’s the
Welfare
Loss?
MSC=S
MPC
MPC
MSC=S
MSB=D
MSB = D
Negative Production
Externality
Positive
Production Externality
MSC=S
MPB
MSB=D
Negative Consumption
Externality
MSC=S
MSB=D
MPB
Positive Consumption
Externality