Explanation of the reasons for and consequences of market failures.
Reflect on cost-benefit analysis.
• The causes of market failures
• Consequences of market failures
• Cost-benefit analysis
Market failure: when firms do not produce the quantity of output that
would have been produced under the conditions of perfect
competition.
In LR under perfect competition…
• Firms productively efficient & make normal profits.
• Consumers pay lowest possible price
• Produced at lowest average cost of production.
• Society maximises output from scarce FOP’s
• Changes in demand encourage firms to change industries allocatively
efficient.
Market failure occurs when the quantity of output produced is either
too little or too great - allocative inefficiency.
Quantity produced too little…
• product under-produced & under-consumed
• Society better off if more resources were used to produce the
product.
Quantity produced too great…
• product is over-produced and over-consumed.
• Society better off if less output produced & excess resources
transferred to making other products in greater demand.
The following are causes of market failure:
1. externalities
2. public goods
3. merit and demerit goods
4. imperfect competition
5. imperfect information
6. immobility of factors of production
7. unequal distribution of income and wealth
1.Externalities
Externalities: costs/benefits of a transaction that affect economic agents who are
not directly involved in the transaction or activity.
When producing goods/services, private sector only take into account private costs
and private benefits.
Producers don’t take into account costs/benefits of production on society.
These costs/benefits are called externalities.
If externality results in a cost to society - negative externality.
If externality results in a benefit to society - positive externality.
AKA: third-party effects, side effects, spill-over effects or neighbourhood effects.
Basic cost and benefit concepts :
Private costs (internal costs): costs that the producer/consumer incurs
voluntarily when they produce/purchase goods/services.
Basic cost and benefit concepts :
External costs (negative externalities): costs of production/
consumption decision that accrue to people other than the
producer/consumer.
Basic cost and benefit concepts :
Social costs: total costs borne by society.
Social costs = Private costs + External costs
Basic cost and benefit concepts :
Private benefits (internal benefits): accrue to consumers who purchase
goods & producers that produce them.
Basic cost and benefit concepts :
External benefits (positive externalities): additional benefits to the
community, caused by consumption or production of goods/services.
Basic cost and benefit concepts :
Social benefits: combined benefits to producers and society.
Social benefits = Private benefits + External benefits
The market for chemicals – negative externalities in production present
Social costs
Socially optimal equilibrium:
social benefits = social costs
Private costs
External costs
Free market equilibrium:
private benefits = private costs
Private benefit + external benefit
= Social benefit
The market for flu vaccinations – positive externalities in consumption present
External benefits
Private costs + External Costs
= Social costs
Socially optimal equilibrium:
social benefits = social costs
Social benefits
Free market equilibrium:
private benefits = private costs
Private benefits
Public goods: goods provided by the government, which exhibit characteristics of
non-excludability and non-rivalry in consumption.
Non-excludability: even if the good is produced for the use of one consumer, no
other consumer can be prevented from consuming it.
Non-rivalry: if one person consumes the good, it does not prevent someone else
from also consuming the good.
Problem - no-one else will pay as they will be able to consume the
above goods free of charge – FREE RIDERS
Public goods are under produced by market system -too few consumers
prepared to pay
Under allocation of resources to production of public goods - market
fails.
Merit goods: goods that society feels should be consumed by its
citizens because it increases the welfare of the individual person and of
society as a whole.
Merit goods under-produced and under-consumed in free market people underestimate value.
Demerit goods: goods that may be harmful to society as a whole
(creates negative externalities).
Social costs
Private costs
Social benefit
Over-produced and over-consumed
In summary…
• under-allocation of resources to production of merit goods
• over-allocation of resources to production of demerit goods
Monopoly, oligopoly and monopolistically competitive firms restrict
supply to maximise their profits.
Therefore resources under-allocated
Productively inefficient - output not produced at lowest AC
Perfect competition - consumers & producers have perfect information
to make informed production/consumption decisions.
Real world of imperfect competition = asymmetric/imperfect
information.
https://www.youtube.com/watch?v=cYcsFyim_Cs
Principal–agent problem: principal has more information than the agent),
may use this information to benefit from the transaction.
Under these conditions…
• Demerit goods over-produced and over-consumed
• Merit goods under-produced and under-consumed
Perfect competition – FOP assumed perfectly flexible.
Real world FOP NOT perfectly mobile…
• Capital usually fixed
• Governments impose controls on movement of labour between
countries.
• Within countries, labour sometimes inflexible.
• SA: shortage of 500 000 skilled workers; surplus of 4 million unskilled workers.
Economy’s capacity to produce less than under conditions of
perfect competition - allocative inefficiency, or market failure.
How do consumers indicate their preferences to producers???
Bearing this in mind, when income/wealth unevenly distributed…
• Too many resources used to produce output for rich
• Too few resources used to produce output for poor.
Now complete…
Activity 1 – page 188
Activity 2 – page 193