market failure

Market failure

A situation where free market is unable to achieve an efficient allocation of resources from society’s point of view

causes of market failure

1. Externalities

2. Public goods

3. Merit and de merit goods

4. Monopoly power

Externalities

Spillover effects arising from production or consumption of goods on third parties

Third parties

Not directly involved in production or consumption of the good

Positive externalities

spillover benefits to third parties , leads to external benefits and hence high social benefit

External benefits def

Benefits enjoyed by the third party

Social benefits def

The total benefits to society of an activity

Negative externalities

Harmful spillover effects on third parties caused by actions or decision of an individual or firm, leads to external cost and high social cost

External cost def

Cost incurred by third party

Social cost def

The total costs to society of an activity

Eg of negative externalities due to consumption

Smoking causes second hand smoke or health problems to passers by who inhale the smoke

Negative externalities of production example

Unused clothing or dye not used by shein (for eg) gets dumped into the river , killing the fish . Hence, fishermen are affected

Positive externalities consumption example

Flu vaccines reduce the risk of infections to other and lead to higher productivity in firms

Positive externality of production example

Workers training can benefit other firms when workers leave and join them

Merit goods

Socially desirable goods with high external benefits but are under consumed/produced. Eg , healthcare and education

De merit goods

Socially undesirable goods with high external cost but are overly consumed/produced . Eg , cigarettes and alcohol

How does merit goods cause market failure

1. Consumers do not take into account the high external benefits when consuming it

2. Prices tend to be high due to high cost of production which leads to underconsumption (expensive for ppl to buy)

3. Many people do not realise the full extent of the private benefit to themselves. ( people skip health care check ups because they don’t understand how valuable these are long term hence underconsumption)

How does de merit goods cause market failure

1. Consumers do not take into account the high external cost ( eg, drinking which leads to disruption of sleep)

2. Many people do not realise the private cost to themselves ( eg . Smoking in the long run lung cancer may develop but they’re not aware hence they continue over consuming that good )

Public good

Goods that have 2 main characteristics, non rivalrous and non excludable . Eg , policing and street lamps

Non rivalrous

One persons consumption of the good does not reduce the availability for others . Eg street lamp. When 1 person walks by vs when 20 people walk by amount of light produced is the same

Non excludable

Once the good is provided , it is impossible to stop non-payers from benefitting from it. Eg flood defence , once the dam is provided , it is impossible to stop people living in the same area from benefitting from the protection)

Why does public goods cause market failure

Firms cannot profit from selling public goods due to free riders and since it’s impossible to charge goods based on someone’s usage . Hence, private firms find it unprofitable to supply these goods which causes a higher social cost and welfare loss to the public if the public good is not produced

Free rider problem

When free riders (enjoying advantages without paying the share)can enjoy the good without paying

Consumers want to

Maximise satisfaction

Producers want to

Maximise profits

Private benefit

Benefits enjoyed by the firm or person when consuming or producing the product

Private cost

the Cost incurred by the firm or person when consuming or producing the product

social cost = to

Both private and external cost

Social benefit = to

Both external benefit and private benefit

How does negative externalities cause market failure

1. Social cost is more than social benefits

2. Overallaoction of resources

3. Good is either over consumed or over produced

4. Reduces economic welfare to society

5. Thus, market failure (resources not used efficiently )

How does positive externalities cause market failure

1. Social benefits > social cost

2. There is an underallocation of resources

3. G/s is underconsumed / under produced

4. Market failure occurs (resources not used efficiently )

5. Allocating more resources In this activity increases the economic welfare of society.

How does monopoly power affect market failure

1. Some firms may have few or no competitors in the market or they may produce goods with few substitutes ( eg. Water /electronic supplies )

2. Hence, they have monopoly power to control the market supply and price of the product

3. Consumers have little choice but to buy from them, demand is price inelastic

4. These firms may try to exploit customers by restricting the supply of the product and increasing its price to earn excessive profits , the good is thus under produced from society’s pov cause market failure

Factor immobility

difficult to move factors of production (especially labour & capital) to different productive uses & locations.

Firms are unable to respond efficiently when patterns of consumer demand or production methods change. Market economic system is thus unable to allocate resources efficiently.

How does factor immobility lead to market failure

Firms are unable to respond efficiently when patterns of consumer demand or production methods change. Market economic system is thus unable to allocate resources efficiently.

2 types of factor immobility

Occupational, geographical