Market Failure - Economics @ Tallis

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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 underproduced 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)shortages b)unemployment c) unfilled job vacancies d)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

Social costs or benefits

Externalities

Externality

– positive or negative depending on costs or benefits

Private

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 decision b)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 rout b)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

0

P

1

P

Negative externality

Q

1

Q

S

1

(MSC = MPC + MEC)

D

S (MPC)

Quantity

•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 S

1

•Price would rise from P to

P

1

•Equilibrium quantity would fall from Q to Q

1

•The negative externality is

causing over-production of

Q-Q

1 and the price paid is lower than it should be

P

1

P

0

Positive externality

S (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 D

1

•The market equilibrium would be at

Price P

1 and Quantity Q

1

• When the market fails to operate in this way there is under-production and this is shown by the difference between Q

1

Q and

•Too few scarce resources are being used hence the market failure

Q Q

1

D

1

(MSB = MPB + MEB)

D (MPB)

Quantity

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 9

Decide whether the following are merit or demerit goods: a) heroin b) catalytic convertors c) insurance d) MOT tests e) public libraries f) education g) legal drugs h) healthcare i) tobacco j) vaccinations k) alcohol

Under-provision of a merit good

P

1

P

0

Q Q

1

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 D

1

•Society would gain from increasing output from Q to Q1

D

1

(MSB = MPB + MEB)

D (MPB)

Quantity

Over-provision of a demerit good

S (MSC)

P

P

1

•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 D

1

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

0

Q

1

Q

D

1

D

Quantity

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