market failure - different types of goods + taxation + minimum pricing

market failure

Market failure occurs when the free market leads to an inefficient allocation of resources, meaning welfare is not maximised.

In other words → markets fail to deliver allocative and/or productive efficiency.

free market

consumers + producers only deal to benefit themselves

third parties are not considered

individuals aim to maximise their utility

firms aim to maximise their profits

-however too many goods with negative externalities are produced and consumed in a free market

complete market failure

is when the market does not supply products = missing market

e.g provisions of public goods

national defense market for AI + regulations

partial market failure

market functions but supplies at either wrong quantity of product or at wrong price

e.g public goods

Types of market failure

P- public goods underprovision

I - information gaps

E - externalities

Externalities

cost or benefit a third party receives from an economic transaction outside of the market mechanism

leads to the over or overproduction of goods/ resources that aren't allocated efficiently

causes partial market failure, goods are provided but not in optimal quantities.

what does negative externalities mean?

MSC > MPC → overproduction.

what does positive externalities mean?

MSB > MPB → underproduction.

MPC, MSC, MPB, MSB

MPC- marginal private cost

MSC- marginal social cost

MPB- marginal private benefit

MSB- marginal social benefit

draw an externalities diagram

1. label axis

2. draw steady state ( D & S equilibrium)

3. consumption = demand

production = supply

4. label D,S,P,Q,E

5. MPB>MSB label the curve not shifting

6. straight line down starting from old demand curve

7. does old price effect the new quantity , price changes

Main causes of market failure

1. Imperfect Information

Definition: When buyers or sellers do not have full knowledge about a product or service, leading to inefficient decisions.

Examples:

-Selling unsafe products without consumers knowing the risks.

Misleading advertising that distorts demand.

2.Monopoly and Market Power

Definition: When a single firm or a small group controls a large portion of the market, it can restrict output or raise prices.

-Problem: Consumers face higher prices, and resources may not be allocated efficiently.

Example: A utility company that is the sole electricity provider in a region.

3. Factor Immobility

Definition: When labor or capital cannot move freely to where it is most needed.

Problem: Some regions or industries may experience unemployment or underutilized resources.

Example: Skilled workers cannot easily move to a different city due to housing or social constraints.

4. Inequality and Distribution Issues

Definition: Free markets may not provide a fair distribution of goods and income.

Problem: Some essential goods may be inaccessible to low-income individuals, leading to social welfare loss.

Example: High costs of healthcare or education in purely market-driven systems.

public goods

Goods that are non-excludable (can't stop others using them) and non-rivalrous (use by one doesn't reduce availability for others).

-Examples: streetlights, defence.

Causes free rider problem → private firms unwilling to provide → under provision.

Quasi-Public (Quasi) Goods

Definition: Goods that are not purely public or private; they can be partially excludable or partially rivalrous.

Characteristics:

They may be provided by the government but can sometimes be restricted for certain users.

Consumption by one person may slightly reduce availability for others, but not completely.

Merit and Demerit Goods

Merit goods: under-consumed in free market (education, healthcare).

Demerit goods: over-consumed in free market (alcohol, junk food).

Reason: consumers suffer from information failure → don't perceive true benefits/costs.

Information Failure

Market failure occurs when buyers/sellers don't have perfect information.

-Examples: second-hand cars (asymmetric info), pensions, financial products.

Can lead to overconsumption or underconsumption.

private goods

Definition: Goods that are both rivalrous and excludable.

Examples: Food, clothing, cars.

Key Feature: If one person consumes it, others cannot; access can be restricted.

Merit goods

Definition: Goods that are non-rivalrous but excludable.

Examples: Subscription services, private parks, Netflix.

Key Feature: People can be excluded, but one person's consumption doesn't reduce availability for others.

Consumer Goods

Goods bought for personal use.

Examples: Food, clothing, electronics.

capital goods

Goods used to produce other goods and services.

Examples: Machinery, tools, factories.

free rider problem

The free rider problem occurs when people benefit from a good or service without paying for it, which can lead to underproduction or depletion of that good.

Key Characteristics:

Non-excludable: People cannot be prevented from using the good.

Non-rivalrous: One person's use does not reduce availability for others.

taxation

Tax: A compulsory payment made by individuals or firms to the government to fund public services and influence the economy.

Purpose: Raise revenue, redistribute income, correct market failure, influence consumption or production, and stabilize the economy.

types of taxes

direct

indirect

direct taxes

Definition: Levied directly on income or wealth. Paid directly to the government.

Examples:

Income Tax

Corporation Tax

Inheritance Tax

Characteristics: Progressive or proportional depending on the system.

indirect taxes

Definition: Levied on goods and services. Paid by firms but often passed on to consumers in prices.

Examples:

VAT (Value Added Tax)

Excise Duties (e.g., alcohol, tobacco)

Customs Duties

Characteristics: Usually regressive, may affect consumption patterns

progressive taxes

Progressive: Tax rate rises as income rises (e.g., higher-rate income tax).

regressive tax

Regressive: Tax rate falls as income rises (e.g., VAT, excise duties)

proportional tax

Proportional/Flat: Tax rate is the same for all income levels (e.g., some corporation taxes).

Economic Effects of Taxation on consumers

Price effects: Indirect taxes raise prices → lower quantity demanded (depends on PED).

Income effect: Reduces disposable income → lower consumption.

Economic Effects of Taxation on producers

Cost of production rises (for indirect taxes) → supply curve shifts left.

Can reduce profits or be passed on to consumers.

Economic Effects of Taxation on government

Revenue generation → fund public goods and services.

Redistribution of income → reduce inequality (progressive taxes).

Deadweight Loss (DWL) effect on efficiency

Taxes can create inefficiency if they reduce mutually beneficial transactions.

Diagram: Supply and demand with tax → shows price paid by consumers, price received by producers, and government revenue.

taxation effect on Price Elasticity of Demand (PED)

If demand is inelastic, tax has little effect on quantity, mostly paid by consumers.

If demand is elastic, quantity falls a lot → higher DWL, less government revenue.

taxation effect on Incidence of Tax

Who actually bears the tax depends on relative elasticity of demand and supply.

More inelastic demand → consumers bear more.

More inelastic supply → producers bear more.

Evaluation Points

Equity vs Efficiency: High taxes can reduce inequality but may discourage work or investment.

Administrative costs: Some taxes are harder to collect (e.g., wealth taxes).

Behavioural effects: Sin taxes reduce negative externalities but may create black markets.

Globalisation: High taxes may encourage tax avoidance or relocation of firms.

key diagrams

Indirect tax (ad valorem or specific) → shifts supply curve up → shows price, quantity, government revenue, DWL.

Direct tax (income tax) → effect on labor supply (backward-bending labor supply curve).

Tax incidence → shows distribution between consumers and producers.

Minimum pricing

A minimum price is a government-imposed legal floor price set above the equilibrium price.

It aims to ensure producers receive a fair price or to reduce harmful consumption.

Objectives of Minimum Pricing

Protect producer incomes (e.g., agriculture, wages via minimum wage).

Reduce consumption of harmful goods (e.g., alcohol minimum unit pricing in Scotland).

Prevent market failure where equilibrium price is too low.

what does it mean if the minimum price is set above equilibrium

Price cannot fall below this level.

Creates a surplus (excess supply) because higher prices encourage supply but reduce demand.

If set below equilibrium, it has no effect.

Key features to draw on diagram:

1.Standard demand and supply graph.

2.Minimum price line above equilibrium.

3.Show new higher price.

4.Highlight excess supply (surplus).

5.(Optional) Government intervention like buying surplus.

advantages of minimum pricing

-Protects producer incomes - especially in volatile markets like farming.

-Reduces harmful consumption - of demerit goods like alcohol.

-Prevents exploitation - e.g., minimum wage ensures fair pay.

-Encourages sustainable production - by supporting smaller producers.

Disadvantages of minimum pricing

-Excess supply (surplus) - leads to government spending (buying stock) or waste.

-Higher prices for consumers - regressive effect (hurts low-income households more).

-Black markets - if minimum prices are too high.

-Inefficiency - producers may overproduce low-value goods knowing prices are guaranteed.

-International effects - dumping of surplus in global markets → trade distortions.

evaluation points

Effectiveness depends on PED:

--If demand is inelastic (e.g., alcohol), consumption reduction may be small.

--If demand is elastic, consumption falls significantly.

Government budget - buying surplus may be costly.

Equity - benefits producers but can worsen inequality for consumers.

Alternatives - could taxation achieve similar goals more efficiently?

Long-run impacts - may encourage inefficiency in protected industries.