2.8 Market failure, Negative and positive externalities

market failure

in the free market when resources are missallocated or inefficiently allocated in the best way for society.

• MSC /= MSB

Main causes of market failure

1. externalities

2. public goods

3. common pool or resources

4. merit and demrit goods

externalities deinfiton

external impact on a thrid party not involved in the economic transaction between the buyer and seller

→ third party effect from production or consumption

2 types of externalities and how do they cause market failure

• negative externalities - over production/consume of goods with negative externalities

• positive externalities - underproduction/ consumption of goods with positive externalities

how do common pool resources cause market failure

• they are non-excludable

• rivalrous

• people overuse cause if they dont someone else will as there is no ownership of the goods

→ over - allocation of resources meaning that too many is used now and not enough left for future

→ overuse of finite resources

how are merit and demerit good market failure

→ from consumer perspective/behaviour

• demerit goods are over consumed

• merit goods are underconsumed

→ people dont realise full benefits and full harm

MPC

• The extra cost to YOU (individual/firm) of producing or consuming one more unit

MPB

The extra satisfaction YOU get from consuming one more unit

MSB

Total benefit to society of one more unit

• private benefit + external benefit

MSC

Total cost to society of one more unit

• private cost + external cost

When talking about market failure and analysing it what you should mention and why?

• the level of output (quantity)

• how resources are allocated

→ because market failure is about producing the wrong quantity

steps to explain tax on cigarettes

• smoking causes negative externalities

• the market over produces → market failure

• tax on cigarettes → cost of production → reduces production and consumption → corrects overconsumption

what are negative externalities of production

are negative external costs created during the production of a g/s

why and how do these negative extrenalities of production cause market failure

1. over-provision - too much is produced because external costs are ignored

2. costs are higher than benefit

3. misallocation of resources for harmful production

4. not at MSB=MPC which is the social optimal output

Diagram analysis negative externalities explain

• MSC>MPC causing welfare loss, negative externalities

• gap between MSC and MPC causes negative externalities

• market produces at (Pe and Qe) - MPB = MPC

Analysis points for negative externalities - chain of events

1. self - interest

2. price too low

3. too much produced and cosnsumed

4. missallocation of resources

explaining self-interest point

• firms want to maximise profit and consumers want to maximize satisfaction

• both ignore harm to others

• only MPC and MPB are considered

explaining prices are too low points

• because external costs are ignored firms costs seem lower than they are

• supply is higher

• price falls

→ doesnt reflect true cost to society

explaining over-production and over-consumption

• overproduction because costs look too low so they overproduce leading to output Qe>Qopt

• overconsumption because price is low they buy more → they dont see the negative externalities

explaining missallocation of resources

• too many resources go into harmful production

• not enough resources go into beneficial goods

→ resources are wasted

negative externalities of consumption

occur when the consumption of a g/s impose negative externalities on third parties not involved in a transaction

why is there market failure due to negative externalities of consumption

• overconsumption of g/s as only private costs are considered and not external costs

• if external costs were considered demand would decrease and they would be sold at lower prices

analysis of negative externalities of consumption

• self-interest

• over-consumptiona and production

• misallocation of resources

Why do positive externalities of production cause market failure?

• undersprovision of g/s with positive extrnal benefits

• producers consider private benefit and bot the external benefit

• if external benefit were considered the supply would increase as they would be sold at a lower price

Positive externalities of consumption definition

Positive externalities of consumption occur when consumption results in benefits to third parties.

EX: Healthcare/vaccines, Education (productivity, spending, more tax revenue), Exercise and healthy eating (limits healthcare costs, producity)

Why is MSB greater than MPB in positive externalities of consumption?

Because society receives external benefits in addition to the consumer’s private benefits.

• MSB > MPB

• SB = PB + EB

DIAGRAM POSITIVE EXTERANLITIES OF CONSUMPTION

Diagram description for positive externalities of consumption

• In the free market, scarce resources are allocated where:

  • MPC = MPB

• Society would prefer allocation at:

  • MSC = MSB

  • this is the social optimum

• There is:

  • under-consumption

  • under-production

  • a gap in quantity (Q)

• This causes:

  • misallocation of resources

  • allocative inefficiency

  • welfare loss

Welfare loss due to positive externalities of consumption

Welfare loss occurs because:

• benefits are greater than costs

• extra units are not produced/consumed

• society loses the extra benefits that could have been gained

Analysis - positive externalities of consumption

• Consumers act in self-interest

• They only consider private benefits

• External/social benefits are ignored

• Scarce resources are allocated at the private optimum instead of the social optimum.

Positive externalities of production definition

Positive externalities of production occur when production creates benefits for third parties.

ex:

Worker training (other firms can poach trained workers, those firms benefit without paying training costs themselves)

Research and development (R&D) (firms create new technologies, other firms are able to copy/use these technologies)

DIAGRAM - POSITIVE EXTERNALITIES OF PRODUCTION

Diagram description for positive externalities of production

• MSC < MPC

• Social costs are lower because there are external benefits

• SC = PC + EC

• External costs are negative, reducing social costs

The market allocates scarce resources at the private optimum where:

• MPC = MPB

• Society would prefer allocation at:

  • MSC = MSB

  • this is the social optimum

• There is:

  • under-production

  • misallocation of resources

  • welfare loss

• The gap between Q1 → Q2:

  • could have been produced where benefits are greater than costs

  • society loses extra welfare/benefits

Analysis of positive externalities of production

• Producers act in self-interest

• They only consider private costs and private benefits

• External benefits are ignored

• Due to self-interest:

  • resources are allocated at the private optimum instead of the social optimum

  • leading to under-production

  • causing allocative inefficiency and welfare loss