Market Failure
Market Failure
• Occurs when free market forces, using
the price mechanism, fail to produce the
products that people want, in the
quantities they desire at prices that
reflect consumers’ satisfaction.
• Where resources are inefficiently
allocated due to imperfections in the
working of the market mechanism
Market Failure
• When markets do not provide us with
the best outcome in terms of efficiency
and fairness
• Types of market failure?...
Sources of Market Failure
• Externalities
• Merit and demerit Goods
• Common access resources (‘tradgedy of
the commons’)
• Public Goods
• Asymmetric Information
• Monopoly Power
Efficiency
• In Economics, efficiency is a situation
where all possible scarce resources are
being used in the most effective way
possible to meet the greatest possible
level of consumer wants
• To be sure that we can state that
economic resources are being used in
the best possible way and thus that
Economic Efficiency exists, 2 things
must be true…
1. Everything that is produced must be
done so using the least possible amount
of scarce resources=
Productive Efficiency (producing on the PPC/
producing at the lowest possible average cost)
2. Products produced are what consumers
want and in the right quantities i.e.
resources are allocated in a way which
maximises consumers’ satisfaction=
Allocative Efficiency (where S=D when social
costs and benefits are taken into account)
Allocative efficiency
• Occurs when the benefit (utility) to
consumers is maximised and producers
maximise profit.
• Scarce resources are allocated to meet
consumer demand and therefore supply must
equate with demand i.e. at equilibrium.
• At any other price demand and supply do
not equate, and resources will not be
allocated efficiently
S1
Price
Pe
D1
Qe
Quantity
S1
Price
P1
Pe
D1
Qd1
Qe
Qs1
Quantity
S1
Price
Pe
P2
D1
Qs2
Qe
Qd2
Quantity
Costs and Benefits
• Social Costs= Private Costs + External Costs
• Social Benefits= Private Benefits + External Benefits
• List the social costs and benefits of driving a
car.
Showing Efficiency on a Diagram
• The socially efficient output is the point
where the market is in equilibrium when all
social costs and benefits are taken into
account
• At this equilibrium the welfare of society
is maximised (social welfare=producer and
consumer surplus)
• So far when looking at supply and demand we have only
considered the private costs of production when thinking
about the S curve and the marginal utility (marginal
private benefit) when considering the D curve.
• Now we consider the private and external costs and
benefits when looking at supply and demand.
• The supply curve is determined by the marginal costs of
production (MC= change in total cost when output is
changed by one unit) in this case the S curve equals the
marginal cost to the whole of society thus S=MSC
• The demand curve is determined by the marginal benefit
(marginal utility). In this case the D curve = marginal
benefit to the whole of society thus D=MSB
• MSC=MPC+MEC
• MSB=MPB+MEB
Socially Efficient (Optimum) Output/
Allocatively Efficient Output
Price/
Costs
and
Benefits
S= MSC
P*
D= MSB
Q*
The value consumers place on the last unit produced is
equal to the full cost of producing that last unit
Quantity
Costs
and
Benefits
Welfare Loss
MSC
At every level of
output between
Q1 and Q* the
MSB>MSC.
Consumers value the
product more than
the MSC of
producing the
product at Q2.
Output is too low
By increasing
output beyond Q1
up to Q* welfare
could be gained
MSB
Q1
Q*
Quantity
Costs
and
Benefits
Welfare Loss
MSC
At every level of
output between
Q1 and Q* the
MSB>MSC.
The value consumers place on
the extra unit of output at
Q1 is less than the MSC.
Output is too high
By increasing
output beyond Q1
up to Q* welfare
could be gained
MSB
Q*
Q1
Quantity
Market Failure
• When markets do not provide us with
the best outcome in terms of efficiency
and fairness
• Types of market failure?...
Externalities
Externalities are defined as ‘third-party’
or ‘spillover’ effects from the consumption
or production of a good or service for
which no appropriate compensation is paid
An externality occurs when there is a cost
or benefit arising from an activity or
transaction that is not reflected in the
market price
Output is not at a socially optimum level
Negative Externalities
• External costs of an economic activity
• Negative Consumption Externalitiesexternal costs arising from a
consumption activity eg. Driving a car
• Negative Production Externalitiesexternal costs arising from a production
activity eg. A chemical factory
discharges it’s waste into a local river
Costs
and
Benefits
Negative Externalities
When the costs to society are greater than the
benefits output is above the socially optimum
Always start with this diagram when illustrating a
negative externality
S= MSC
Welfare Loss
D= MSB
Q*
Q1
Quantity
Negative Production
Externalities
Negative externalities caused
by production activities (caused
by firms)
Price/
Costs/
Benefits
Start with this diagram.
Output is at Q1 instead of Q*
With negative production externalities this is
because firms do not consider the external costs, so
S=
supply is higher than the socially optimum…
MSC
Welfare Loss
D= MSB
Q*
Q1
Quantity
S (based on private and external
costs (MPC+MEC= MSC))
Price
(costs/
benefits)
P*
S (based on private
b
costs to the firm (MPC))
a
P1
c
D (based on private benefits to
the consumer and assuming no
external benefits (MPB+MEB=
MSB))
Q*
Q1
Quantity
Therefore…
• When negative production externalities
exist, the marginal social costs exceed
marginal private cost
• This leads to the private optimum
level of output being greater than the
social optimum level of production
hence loss of welfare to society
Negative Consumption
Externalities
Negative externalities caused
by consumption activities
(caused by consumers)
Negative Consumption
Externalities
• Negative consumption externalities lead
to a situation where the social benefit
of consumption is less than the private
benefit
• Consumption is ‘too high’
Price/
Costs/
Benefits
Again, start with this diagram.
Output is at Q1 instead of Q*
With negative consumption externalities this is
because consumers do not consider the external costs,
S=
so demand is higher than the socially optimum…
MSC
Welfare Loss
D= MSB
Q*
Q1
Quantity
Price/
Costs/
Benefits
Negative Consumption
Externality
S (MSC)
P1
P*
D (MSB)
Q*
Q1
D (MPB)
Quantity
Positive Externalities
Costs
and
Benefits
Welfare Loss
MSC
At every level of
output between
Q1 and Q* the
MSB>MSC.
Consumers value the
product more than
the MSC of
producing the
product at Q2.
Output is too low
By increasing
output beyond Q1
up to Q* welfare
could be gained
MSB
Q1
Q*
Quantity
Positive Externalities
• External benefits of an economic activity
• Positive Consumption Externality- external
benefits arising from a consumption
activity eg. Healthcare has benefits for
the whole of society- not passing on
illnesses etc
• Positive Production Externality- external
benefits arising from a production activity
eg. Training an employee who leaves to
work for another firm
Positive Production
Externalities
Positive Production Externality
• Output is lower than socially optimum
• Society has gained from the actions of
the firm (recall training) thus the
marginal private cost of the firm is
greater than the marginal social cost
Costs
and
Benefits
Welfare Loss
MSC
At every level of
output between
Q1 and Q* the
MSB>MSC.
Consumers value the
product more than
the MSC of
producing the
product at Q2.
Output is too low
By increasing
output beyond Q1
up to Q* welfare
could be gained
MSB
Q1
Q*
Quantity
Price
(cost/
benefit)
S (= MPC)
S (= MSC)
P1
P*
D (= MSB)
Q1
Q*
Quantity
Positive Consumption
Externalities
Positive Consumption
Externalities
• Consumers maximise their private utility
(benefit) and consume where MSC=MPB
(here we are presuming there are no
external costs thus MPC=MSC=S)
• The MSB of consumption is greater
than the MPB, thus consumption is ‘too
low’
Positive Consumption Externality
Price (
Costs/
Benefits)
S (MSC = MPC
i.e. there are no
external costs)
P*
P1
D (MPB)
Q1
Q*
D (MSB)
Activity
• Data Response p141 Grant
• Economic Review April 2003