IB micro economics: market failure 2.8-9 SL

Market failure

The failure of markets 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 maximized.

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).

Allocative inefficiency

When either more or less than the socially optimal amount is produced and consumed so that misallocation of resources results (MSB ≠ MSC).

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.

Negative externalities of production

Negative effects suffered by a third party whose interests are not considered when a good or service is produced, so the third party are therefore not compensated. Example: pollution from a factory.

Negative externalities of consumption

Negative effects suffered by a third party whose interests are not considered when a good or service is consumed, so the third party are therefore not compensated. Example: second-hand smoke from cigarettes.

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. Example: a beekeeper’s bees pollinating nearby crops.

Positive externalities of consumption

The beneficial effects 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. Example: education or vaccinations.

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.

Marginal social benefit (MSB)

The extra or additional benefit or utility to society of consuming an additional unit of output, including both the private benefit and the external benefit.

Marginal private cost (MPC)

The extra or additional cost to producers of producing one more unit of output.

Marginal private benefit (MPB)

The extra or additional benefit to consumers from consuming one more unit of a good or service.

Merit goods

Goods or services considered to be beneficial for people that are under-provided by the market and so under-consumed, mainly due to positive consumption externalities.

Demerit goods

Goods or services that not only harm the individuals who consume these but also society at large, and that tend to be overconsumed. Usually they are due to negative consumption externalities.

Public goods

Goods or services that have the characteristics of non-rivalry and non-excludability, for example, flood barriers.

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.

Non-excludable

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

Free rider problem

Arises when individuals consume a good or service without paying for it because they cannot be excluded from enjoying it.

Common pool resources

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

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.

Tragedy of the 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.

Sustainability

Refers to preserving the environment so that it can continue to satisfy needs and wants into the future. Relates to the concept of “sustainable development”.

Sustainable development

Refers to the degree to which the current generation is able to meet its needs today but still conserve resources for the sake of future generations.

Asymmetric information - hl

A type of market failure where one party in an economic transaction has access to more or better information than the other party.

Adverse selection - hl

A type of market failure involving asymmetric information, where the party with the incomplete information is induced to withdraw from the market. Example: buyers of used cars hesitate to buy without knowing the vehicle’s quality.

Moral hazard - hl

A type of market failure involving asymmetric information where a party takes risks but does not face their full costs by changing behaviour after a transaction has taken place. It is very common in insurance markets.

Signalling - hl

In asymmetric information, the participant with more information sending a signal revealing relevant information about a transaction to the participant with less information, to reduce adverse selection.

Screening - hl

In asymmetric information, the use of a screening process by the participant with less information to gain more information regarding a transaction, and so reduce adverse selection.

Government intervention in market failure

The use of policies such as taxes, subsidies, regulations, provision of public goods, and property rights to correct market failure.

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.

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.

Carbon (emissions) taxes

Taxes levied on the carbon content of fuel. They are a type of Pigouvian tax.

Pigouvian taxes

An indirect tax that is imposed to eliminate the external costs of production or consumption.