Market Failure Diagrams
Market Failure and Merit Goods
Price
S
P2
P1
D2
D1
Q1
Q2
Quantity
Under-provision of a merit good
Market Failure & Demerit Goods
Price
S
P1
P2
D1
D2
Q2
Q1
Quantity
Over-provision of a demerit good
Negative Externalities
S1 = social costs (private
costs + external costs)
P
S = private costs
P1
QePe = free market equilibrium
Pe
Q1P1 = social optimum
D
Q1
Qe
Q
Positive Externalities
P
S
QePe = free market equilibrium
P1
Q1P1 = social optimum
Pe
D1 = social benefits (private
benefits + external benefits)
D = private benefits
Qe
Q1
Q
Using Taxation to Internalise
Negative Externalities
S1 = new private costs
(initial private costs + tax)
P
S = private costs
P1
Pe
QePe = free market equilibrium
t
Q1P1 = social optimum
D
Q1
Qe
Q
Using Subsidy to Internalise
Positive Externalities
P
S
S1 = new private costs (initial
private costs - subsidy)
P1
QePe = free market equilibrium
s
Pe
Q1P1 = social optimum
P2 = consumer price
P2
D1 = social benefits (private
benefits + external benefits)
D = private benefits
Qe
Q1
Q
Limitations of taxation & subsidy as
a solution to market failure
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Difficult to determine the correct level of
taxation/subsidy (How do we measure the externality?)
Effectiveness depends upon elasticity (see next slide)
Subsidies require government funding (and higher taxes
elsewhere?)
Taxation is unpopular (especially in inelastic markets?)
Difficult to target on those creating the externality
(positive and negative)
Costs of collection and enforcement
Tax evasion
The effects of PED
S1
P
S1
P
S
S
P1
Pe
t
P1
Pe
t
Delastic
Dinelastic
Q1Qe
Price inelastic demand – small
change in Q, large change in P
Q
Q1
Qe
Price elastic demand – large
change in Q, small change in P
Q
Imposition of a Minimum Price
P
S
PM
PM
Pe
D
QD
Qe
Excess Supply
QS
Q
Imposition of a Maximum Price
P
S
Pe
PM
PM
D
QS
Qe
Excess Demand
QD
Q
Imposition of a Minimum Wage
W
S
WM
WM
We
D
QD
Qe
QS
Excess Supply = Unemployment
Q
Maximum Prices – Rent Controls
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Designed to deal with equity and abuse of market power
by some landlords
Maximum price imposed to make housing more
affordable
Likely to create excess demand – supply of housing may
fall as landlords remove it from the market (selling or
leaving them empty)
Depends upon elasticity of supply
Scarce supply of properties allocated by waiting lists or
‘chance’
Black markets may develop
Government may be forced to intervene by providing
‘social’ housing
Maximum prices are likely to benefit some but harm
others
Minimum Prices - Food
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Designed to provide stable incomes for farmers (equity)
and protect strategic supply of food
Likely to generate excess supply
Government must intervene and buy unsold stocks of
food
Food ‘mountains’ created – may be ‘dumped’ on third
world markets later – undermining local supply (EU
solution)
Alternative is to destroy the food (US solution)
Both methods are expensive for taxpayers
Another alternative is to restrict output by paying
farmers not to grow crops – ‘set aside’
Less of an issue as we move from food surplus to food
shortage?
Minimum Wage
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Designed to:
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Effect depends upon level at which it is set & the state of the
economy
If it is set at or below the equilibrium during a period of growth, it
will have little or no effect – this is effectively the case in the UK
If it is set above the equilibrium it could cause:
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guarantee a minimum income for low-paid workers (equity)
Reduce exploitation by employers (monopsony power)
increase supply of workers (labour market failure due to the poverty
trap)
incentivise employers to increase the quality of labour through training
(increase productivity & competitiveness)
Unemployment
Inflation
Reduction in international competitiveness
Growth of the black economy
May have little effect on the poorest (who are not likely to be in
employment) or on relative poverty (as it has no effect on wage
differentials)