Theme 3A - Market failure ugh

AE + Externalities

State when AE is achieved

1. Marginal Social Benefits (MSB) = Marginal Social Costs (MSC)

2. Sum of consumer and producer surplus is maximised

Define price mechanism

Interaction of market demand (reflecting consumers’ decisions) and market supply (reflecting producers’ decisions) which determines the price to be charged and output to be produced for different goods and services.

Describe the incentive + signalling role of prices

• Consumer sovereignty: consumers determine which goods and services are produced by firms by signalling to producers the goods they are willing and able to pay for

• Consumers ‘vote’ for what they want firms to produce through purchases. 

• Through the use of ‘dollar votes’, consumers decide ‘what to produce’

• Firms respond by producing only those goods using scarce resources 

• Consumers also determine ‘how much to produce’ by signalling to producers their preference for a particular good through the price they are willing and able to pay for it 

• High preference, higher price 

• For example: 

  • When income increase, demand for car increase -> upward pressure on price and price increase -> higher price signaled to producers there is shortage and incentive profit-motivated producers to increase Qs 

  • The higher price is a signal and incentive for consumers as it signals cars are now more expensive, reduce Qd 

• Profit-maximising producers are incentivised to produce using the least-cost factor combination in their production process (Eg. When supply of labour increases, wages for workers decrease and signal and incentivise firms to hire more workers)

Describe the incentive role of prices

Incentive

Change in price incentives / disincentives firms to change production level because it signals that total profits that can be earned from producing that good has changed Change in price incentivises consumers to change consumption level because it signals that net total benefit from consumption of that good has changed Profit-maximising producers are incentivised to produce using the least-cost factor combination in their production process

How to produce?  *Firms want to maximise profits, NOT TR

Describe the rationing role of prices

• Solve problem of ‘for whom to produce’ 

• As price of cars increase, some consumers realise they are unwilling or unable to pay the price

• Consumers with fewer dollar votes will decrease consumption -> Qd falls 

• This continues until shortage is eliminated 

• Function ensures that limited cars produced using limited resources are rationed out only to those who are most willing and able to pay for it

Society’s welfare is maximised under what assumptions

1. Private good market

2. Absence of externalities

3. Perfectly competitive markets (perfect information, perfect factor mobility, no market power)

4. NO market failure -> shortage or surplus is temporary and can be cleared overtime 

Explain how consumers allocate resources in a free market

• Demand curve = maximum price that consumers are willing and able to pay for various quantities of the good

1. In the pursuit of self-interest, a rational consumer will seek to maximise the net total private benefit from buying and consuming a good/service given his limited income. 

2. He will buy an additional unit of a good as long as the marginal private benefit (MPB) of consuming it exceeds its marginal private cost (MPC). 

• The MPB is the additional utility/satisfaction derived from consuming an additional unit of the good 

• The MPC is the additional cost of consuming one more unit of the good, which is equivalent to the price consumers pay for the good

3. Maximum price that a consumer would be willing to pay for one more unit of a good = marginal utility that he derives from consuming that additional unit

4. Demand curve = MPB curve for consumers

Explain how producers allocate resources in a free market

• Supply curve = minimum price that producers are willing and able to accept for various quantities of the good

1. In the pursuit of self-interest, a rational producer seeks to maximise the total profits from producing and selling a good/service

2. He will be willing to sell an additional unit of a good as long as the marginal private benefit (MPB) of producing it exceeds its marginal private cost (MPC)

• The MPB is the additional revenue derived from selling an additional unit of the good (marginal revenue) = price consumers pay for the good in a perfectly competitive market

• The MPC is the additional cost of producing one more unit of the good (MCOP)

3. Minimum price that a producer would be willing to accept to produce one more unit of a good = marginal cost that he incurs from producing that additional unit

4. Supply curve = MPC curve for producers

What happens if market output is less than Qe

• For units Q1 to Qe, MSB is greater than the MSC

• For every additional unit of output from Q1 to Qe, the additional benefit to society is greater than the additional cost incurred. 

• TSB = area beQeQ1, TSC = area ceQeQ1

• There will be a net increase in society’s welfare of area bec that could be gained if society is to produce and consume Q1 to Qe units. 

• Any market output less than Qe, society’s welfare is not maximised due to under-production/consumption -> not allocatively efficient

Explain what happens when market output is more than Qe

• For units Qe to Q2, the MSC is greater than MSB. 

• TSB = area eyQ2Qe, TSC =  area exQ2 Qe

• There is a net loss in society’s welfare of area exy that is incurred 

• Any markey output more than Qe, society’s welfare is not maximised due to over-production/consumption -> not allocatively efficient

Explain AE using CS and PS

At Qe, the sum of consumer surplus and producer surplus is maximised -> society’s welfare is maximized and allocative efficiency is achieved

State when market failure occurs

• Occurs when free markets, operating without any government intervention, fail to allocate scarce resources efficiently and hence society’s welfare is not maximised

State the causes of market failure

NOTE: 

• There is underconsumption due to individual consumers disregarding the external benefits generated by education, not because of the lack of awareness of these external benefits

Define externalities

Refers to a positive or negative impact on a third party not directly involved in the consumption or production of a good or service, may be generated from the consumption or production of a good or service

Describe positive externality

Positive externality

Beneficial impact on a third party not directly involved in the economic transaction

Total social benefit = Total private benefit + Total external benefit Marginal social benefit (MSB) = Marginal private benefit (MPB) + Marginal external benefit (MEB) MEB: Additional benefit enjoyed, from the production or consumption of the additional unit of a good, by third parties who are not directly involved in the production or consumption of the good

Describe negative externality

Negative externality

Adverse impact on a third party not directly involved in the economic transaction

Total social cost = Total private cost + Total external cost Marginal social cost (MSC) = Marginal private cost (MPC) + Marginal external cost (MEC) MEC: Additional cost imposed, by the production or consumption of the additional unit of a good, on third parties who are not directly involved in the production or consumption of that good

Describe the effects of positive externalities

• Marginal social benefits greater than marginal private benefits, by the amount of the marginal external benefits

• Underproduction / underconsumption of goods in the market result in the under-allocation of resources -> leads to welfare loss to society -> free market has failed to achieve allocative efficiency

State some examples of positive externalities from consumption and production

From consumption	From production
Vaccinations Private benefit: Those who get immunisation injections against communicable diseases have higher resistance to such diseases and better health status External benefits: Third parties like their family members and those around them have lower risk of contracting such diseases	Research and development  Private benefit: New products or new methods of production  External benefit: No patents -> third parties use or build on what was discovered -> higher revenue

Explain how positive externality leads to market failure (Eg. Immunisation)

Describe problem	Third parties enjoy a positive externality from the individual's consumption of immunisation, which is an external benefit to third parties not directly involved in the consumption (or production) of the good.
Explain market outcome	The positive externality causes the marginal social benefit (MSB) to be greater than the marginal private benefit (MPB) of consuming immunisation This is because additional benefits to society (MSB) includes both the additional private benefits to individuals consuming the immunisation (MPB) and additional benefits to third parties not directly involved in the consumption (MEB).  Hence, MSB curve is higher than the MPB curve and MEB is the vertical distance between the MSB and MPB curves Impt part:  In the free market, self-interested consumers will base their consumption decisions on their MPB, and disregard the external benefits Assuming there are no negative externalities, MPC = MSC Left to market forces, the market equilibrium output will be at Q where demand equals supply and the market equilibrium price will be at P
Explain socially optimal outcome	However, the socially optimal output and price is at Q* and P*, where MSB = MSC and society’s welfare is maximised Hence, the positive externalities generated from the consumption of the good has resulted in the underconsumption of immunisation by Q* - Q units, resulting in welfare loss to society (deadweight loss) MSB is greater than the MSC if Q* - Q more units of immunisation are consumed The deadweight loss of consuming at the market equilibrium output Q is area A given that the TSB of consuming Q to Q* units (areas A+B) is greater than the TSC (area B)
Explain welfare loss and allocative inefficiency	Therefore, the free market has failed to achieve allocative efficiency as society’s welfare is not maximised

Draw graph of how positive externality leads to market failure (Eg. Immunisation)

Describe the effects of negative externalities

• Social costs being greater than private costs, by the amount of the external costs.

• Overproduction and overconsumption of goods in the market result in the over-allocation of resources -> welfare loss to society -> free market has failed to achieve allocative efficiency

State some examples of negative externalities from consumption and production

From consumption	From production
Cigarettes  Private cost: health problems to yourself and cost of cigarettes  External cost: second-hand smoking -> higher healthcare costs for third parties (passive smokers)	Waste from industrial production  Private cost: cost of factor inputs  External cost: healthcare cost incurred by residents living near industrial areas when they inhale polluted air/ drink polluted water

Explain how negative externality leads to market failure (Eg. Coal-fired electricity generation) 

Describe problem	Households suffer a negative externality from the firm’s electricity generation, which is an external cost to third parties not involved in the production (or consumption) of the good
Explain market outcome	MSC is greater than MPC of producing electricity using coal  This is because MSC includes both the MPC and the marginal external cost (MEC) to third parties in society MSC curve to be higher than the MPC curve, where MEC is the vertical distance between the MSC and MPC curves Impt part:  In the free market, self-interested producers will base their production decisions on their MPC and disregard the external costs Assuming there are no positive externalities, MPB = MSB. Left to market forces, the market equilibrium output will be at Q where demand equals supply and the market equilibrium price will be at P
Explain socially optimal outcome	However, the socially optimal output and price is at Q* and P*, where MSB = MSC and society’s welfare is maximised
Explain welfare loss and allocative inefficiency	Hence, the negative externalities generated from the production of the good resulted in the under-pricing of the good as market price P is lower than socially optimal price P* as well as the overproduction of electricity of Q – Q* units, resulting in welfare loss to society The deadweight loss of consuming at the market equilibrium output of Q is area D given that the total social costs incurred by producing Q* to Q units (areas D+E) is greater than the total social benefits (area E) Therefore, the free market has failed to achieve allocative efficiency as society’s welfare is not maximised.

Draw graph to explain how negative externality leads to market failure (Eg. Coal-fired electricity generation)