1.3 market failure

market failure

exists whenever a free market left to its own devices, fails to deliver economics efficiency.

what does normal interaction of supply and demand lead to:

• producing or consuming too much of some goods

• producing or consuming too few of some goods

• or even failing to produce some goods that are needed by society

3 cause of market failure

• public goods

• externailities

• information failure - merit and demerit goods

public goods

goods that are non-excludable and non-rivalrous

left to its own devices market may not supply these goods at all

non-excludable

once the good is provided for one consumer its impossible to stop other consumers benefiting from it

non-rivalrous

as more and more people consume the product, the benefit to those already consuming the product are not diminished

examples of public goods

streetlights, lighthouses, park benches

free rider principle

market may fail to produce public goods because of this

if one consumer pays for the public good others benefit therefore firms are unable to make a profit and so they must be provided from the government

private costs

costs to individual

private benefits

benefit to individual

external costs

costs imposed on a 3rd party

external benefits

benefits imposed on 3rd party

full social benefits

private benefits + external benefits

full social costs

private costs + external costs

economic efficiency / pareto optimiality

social costs = social benefits

externalities

imposed on 3rd parties outside of the economic transaction

negative externalities

costs imposed on 3rd parties

positive externalities

benefits imposed on 3rd parties

what does a negative externality mean in a free market

too much of the good will be produced

i.e we need to reduce the amount

not economically efficient

what does a positive externality mean in a free market

too little of the good is produced

i.e we need to increase the amount

not economically efficient

PMB

Private marginal benefit

SMB

Social marginal benefit

SMC

Social marginal costs

PMC

Private marginal costs

negative production externality graph

assumed there is no external benefits therefore PMB=SMB

product has many negative externalities, but if we see if left to its own devices (Q1) there is under-pricing and over-production

therefore if we include external costs we go to SMC which is at a higher price and a lower production equilibrium.

and the triangle represents deadweight welfare loss

gradients aren’t same because as more products there is an even bigger increase in external costs

positive consumption externalities

assumed there is no external costs therefore PMC=SMC

product has many positive externalities, but if we see if left to its own devices (Q) there is under-production

therefore if we include external benefits we go to SMB which is at a higher price and a higher production equilibrium.

and the triangle represents welfare gain

gradients aren’t same because as more products there is an even bigger increase in external benefits

symmetric information

when buyers and sellers have potential access to the same information

assymetric information

when 1 party has superior knowledge compared to another in which they have the advantage

what leads to information gaps

most advertising

why do information gaps lead to market failure in a free market

misallocation of resources because people do not buy things that maximise welfare

e.g. drugs - young people dont see long term effects

merit goods

goods which are underconsumed because of either lack of awarness of positive externalities or information gaps.

demerit goods

Demerit goods are goods which are overconsumed because of either lack of awarness of positive externalities negative externalities or information gaps.