Market Failure (1.3)

market failure

When the market fails to allocate scarce resources efficiently, causing a loss in social welfare

Three main types of market failure

Externalities

Under-provision of public goods

Information gaps

Externalities

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

Public goods

non-rivalry and non-excludable, meaning that they are under-provided by the private sector due to the free-rider problem. This means the market is unable to ensure that enough of these goods are provided

Examples of public goods

Examples: Streetlights, roads, parks, beaches

Non-rivalry

One person consuming the good does not reduce the amount available to others

Non-excludable

People cannot be prevented from using the good, even if they do not pay

Free-rider problem

When consumers consume a good without paying for it due to the good being non-rivalry and non-excludable

Information gaps

Homo economics is assumed to have perfect information, allowing the making of rational decisions

Firms are assumed to have perfect information on their cost and revenue curves

Governments are assumed to know full costs and benefits of every decision

This is not always the case as economic agents do not always make rational decisions leading to resources not being allocated to maximise welfare

Examples of information gap in consumers

Examples: Consumers do not know the quality of second hand products such as cars, and pension schemes are complex so it is difficult to know which is best.

Private Costs (PC)

Producer’s costs of production

Social Costs (SC)

Private Costs + External Costs

Private Benefits (PB)

Individual consumer benefits upon consumption

External Costs/Benefits

The costs/benefits to a third party not involved in the economic activity.

They are the difference between private costs/benefits and social costs/benefits.

Society surplus

Consumer surplus + Producer surplus

Maximisation of Social benefit

When Marginal Social Benefit (MSB) = Marginal Social costs

When resources perfectly follow consumer demand

Demand = Supply

Externalities diagram

When market equilibrium occurs

When MPC = MPB

When MSC = MSB

Marginal cost/benefit

The extra cost/benefit of producing/consuming one extra unit of the good

Marginal private benefit (MPB)

the extra satisfaction gained by the individual from consuming one more of the good

Marginal social benefit (MSB)

The extra gain to society from the consumption of one more good

Marginal private cost (MPC)

The extra cost to the individual from producing one more of the good

Marginal social cost (MSC)

The extra cost to society from the production of one more good

Assumptions made when discussing externalities

There are many buyers and sellers

Perfect information

No barriers to entry or exit

Firms are profit maximisers and consumers are utility maximisers

Negative production externalities

Costs to third parties as a result of actions of production

MSC > MPC

Why negative externalities of production occur

Firms ignoring social costs due to self interest - only considering their private cost

Overproduction/consumption

Price too low

Misallocation of resources

Examples of negative externalities of production

Air pollution

Resource depletion

Resource degradation

Deforestation

Positive consumption externalities

Benefits to third parties as a result of the actions of consumers

MSB > MPB

Why positive externalities of consumpi

Consumers ignoring full social benefit due to self interest - only considering private benefits

Underproduction/consumption

Misallocation of resources

Examples of private consumption externalities

Healthcare, education, exercise, healthy eating

Gov. Intervention - Indirect taxes and subsidies

Placed on goods with negative externalities. This internalises the externalities , moving production closer to the social optimum

Gov. Intervention - Tradable pollution permits (TPPs)

Allow for firms to produce up to a certain amount of pollution

Can be traded amongst firms so gives them choice while reducing the total level of pollution

Negative production externality diagram

Positive externality of consumption diagram

Government interventions to tackle externalities

Indirect taxes and subsidies

Tradable pollution permits (TPPs)

Provision of the good

Provision of information

Regulation

Gov. Intervention - Provision of the good

When SB are very high the government may decide to provide the good through taxation. e.g education and healthcare

Gov. Intervention - provision of information

Some externalities are associated with information gaps, thus, the government can provide information to help people make informed decisions and acknowledge external costs

Gov. Intervention - regulation

Could limit the consumption of goods with negative externalities. e.g. banning advertising of smoking

Quasi-public goods

Are not properly non-rivalry and non-excludable but aren’t perfectly rivalry or excludable

Example of quasi-public goods

Roads as they are semi-excludable due to tolls. They are also semi-rivalry as people don’t ‘use up’ the roads.

Symmetric information

Occurs where buyers and sellers have potential access to the same information (perfect information)

Asymmetric information

When one party has superior knowledge compared to another

The seller may have more information that the buyer meaning that they can take advantage of the other party’s lack of knowledge

How information gaps lead to market failures

There is a misallocation of resources as people do not buy things that maximise welfare