2.8 Market Failure + Externalities (Merit & Demerit Goods + Common Pool Resources)

Unit 2, Microeconomics

Market failure

The inability of a market to achieve allocative efficiency. Markets fail to produce the

output at which marginal social benefits are equal to marginal social costs; social or

community surplus (consumer surplus + producer surplus) is not maximised.

Externalities

External costs or benefits to third parties when a good or service is produced or

consumed. An externality arises when an economic activity imposes costs or creates

benefits on third parties for which they are not compensated or do not pay for

respectively.

Marginal benefit

The extra or additional benefit enjoyed by consumers that arises from consuming one

more unit of output.

Marginal costs

The extra or additional costs of producing one more unit of output.

Marginal social benefit (MSB)

The extra or additional benefit/utility to society of consuming an additional unit of output,

including both the private benefit and the external benefit.

Marginal social cost (MSC)

The extra or additional cost to society of producing an additional unit of output, including

both the private cost and the external costs.

Negative externalities of consumption

Negative effects / costs suffered by a third party whose interests are not considered when

a good or service is consumed, so the third party is therefore not compensated.

Negative externalities of production

Negative effects / costs suffered by a third party whose interests are not considered when

a good or service is produced, so the third party is therefore not compensated.

Positive externalities of consumption

The beneficial effects / benefits that are enjoyed by third parties whose interests are not

accounted for when a good or service is consumed, therefore they do not pay for the

benefits they receive.

Positive externalities of production

The beneficial effects that are enjoyed by third parties whose interests are not accounted

for when a good or service is produced, therefore they do not pay for the benefits they

receive.

Welfare loss

A loss of a part of social surplus (consumer plus producer surplus) that occurs when

there is market failure so that marginal social benefits are not equal to marginal private

benefits.

Socially optimum output

This occurs where there is allocative efficiency, or where the marginal social cost of

producing a good is equal to the marginal social benefit of the good to society.

Alternatively, it occurs where the marginal cost of producing a good (including any

external costs) is equal to the price that is charged to consumers

(P = MC for the last unit produced).

Allocative efficiency

Achieved when just the right amount of goods and services are produced from society’s

point of view so that scarce resources are allocated in the best possible way. It is

achieved when, for the last unit produced, price (P) is equal to marginal cost (MC), or

more generally, if marginal social benefit (MSB) is equal to marginal social cost (MSC).

Merit good

Cause of market failure

External benefit: MSB > MPB

Positive externality of consumption

Underconsumption

Government intervention needed to correct

Demerit good

Cause of market failure

External cost: MPB > MSB

Negative externality of consumption

Overconsumption

Government intervention needed to correct

Common pool resources

A diverse group of natural resources that are non-excludable, but their use is rivalrous, for

example, fisheries.

Non-excludable

A characteristic of a good, service or resource where it is impossible to prevent a person,

or persons, from using it.

Excludable

A characteristic that most goods have is the ability of producers to charge a price and

thus exclude whoever is not willing or able to pay for it from enjoying it.

Rivalrous

Goods and services are considered to be rivalrous when the consumption by one person,

or group of people, reduces the amount available for others.

Non-rivalrous

A characteristic of some goods such that their consumption by one individual does not

reduce the ability of others to consume them. It is a characteristic of public goods.

Tragedy of commons

A situation with common pool resources, where individual users acting independently,

according to their own self-interest, go against the common good of all users by

depleting or spoiling that resource through their collective action.

Carbon (emissions) tax

Payment to the government levied on the carbon content of fuel. They are a type of

Pigouvian tax.

Tradable permits

Permits to pollute, issued by a governing body, that sets a maximum amount of pollution

allowable. These permits may be traded (bought or sold) in a market for such permits.

Collective self-governance

In the case of a common pool resource, such as a fishery, users solve the problem of

overuse by devising rules concerning the obligations of the users, the monitoring of the

use of the resource, penalties of abuse, and conflict resolution.

Property rights

The exclusive, legal, authority to own property and determine how that property is used,

whether it is owned by the government or by private individuals.

Land rights

Property (ownership) legal rights over land holdings that include rights to

possess, occupy and use the land.