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what is market failure
when the free market fails to allocate resources efficiently or equitably
what are the 3 main causes of market failure
externalities
under-provision of public goods
information gaps
how do externalities lead to market failure
externalities are the spill over costs onto third parties when a good is consumed of produced
this means that goods with negative c or p externalities have costs (eg. smoke when burning coal) that are unaccounted for in the price of the good, which means they are underpriced and overconsumed —> partial market failure
what are the 2 features of pure public goods and what problem does it lead to
non-excludable and non-rival
leads to the free rider problem, where people consume the good or service without paying
how do public goods lead to market failure
public goods are non-excludable and non-rival which means they are not profitable, as a result firms who act rationally will not provide them. this means that they are underprovided by the private sector which leads to a missing market and complete market failure.
how do information gaps lead to market failure
it can lead to goods being sold at wrong prices, eg. second hand cars being sold for too much, they are overpriced —> overpriced and under consumed —> partial market failure
Moral Hazard: After a transaction, one party may act in a riskier way because they are shielded from the consequences. For instance, a person with insurance might take fewer precautions, increasing the cost for the insurer.
what are social costs
the costs to society as a whole
private costs + external costs
for negative consumption externalities, what are the labels on the graph
for positive consumption externalities, what are the labels on the graph
how do indirect taxes help negative production externalities
increases the cost of production, external costs are internalised
supply shifts right
new equilibrium price is higher
external costs are now accounted for
why might implementing an indirect tax not help a negative production externality
due to imperfect information the government don’t know the size of the external costs and therefore don’t know how much to tax
external costs are often intangible and hard to give a monetary value to (eg. air pollution), so government may tax the wrong amount which can lead to government failure
evaluate tradeable pollution permits
they provide an incentive for cleaner energy, the green firms can sell the unused permits, not needing the permits also lowers costs
it also can give the government revenue which can be reinvested
internalises the externality
however
the “right amount” of emissions is hard to calculate, and firms may not agree with this which can lead to lobbying
it can be hard to calculate how much has been emitted, rational firms will underestimate and can lead to regulatory capture
leads to higher administration costs for the government
firms may relocate which leads to lower tax revenue
how do information gaps lead to market failure
people usually don’t buy things that maximise their welfare (eg. pensions) as they aren’t aware of the future benefit
whereas goods like fast food are consumed a lot
this means that the quantity demanded may be too high or too low, which means that the market is not at the social optimum —> partial market failure
