Market Failures, part 1
Market Failures: Definition and Concepts
Market Failure: Occurs when the market equilibrium results in a less than optimal outcome for society.
Markets usually reach an equilibrium that maximizes economic surplus, defined as the sum of consumer and producer surplus.
Economic Surplus: The net benefit from transactions.
Deadweight Loss: The reduction in economic surplus caused by market interventions like price ceilings and price floors.
Recap of Previous Module: Market Efficiency
Reached the conclusion that a market in equilibrium results in optimal economic surplus.
Economic surplus is maximized when both consumer surplus and producer surplus are maximized.
Markets inherently lead to an outcome where marginal cost matches marginal benefit.
Introduction to Externalities
Externalities: Impacts on third parties who are not directly involved in a transaction.
Can be Positive Externalities: Benefits to those not involved in the transaction (e.g., vaccinations).
Can be Negative Externalities: Costs imposed on those not involved in the transaction (e.g., pollution).
Externalities result in market transactions affecting people outside the immediate buyer-seller relationship.
Marginal Costs and Benefits in Transactions
Private Marginal Cost: Cost borne by producers.
External Marginal Cost: Cost imposed on third parties due to production.
Social Marginal Cost: Sum of private and external marginal costs.
Private Marginal Benefit: Benefit received by consumers.
External Marginal Benefit: Benefit received by third parties.
Social Marginal Benefit: Sum of private and external marginal benefits.
Example of Negative Externality: Pollution from a Power Plant
Scenario: A power plant produces electricity but also releases pollutants.
San Diego residents and businesses benefit from the electricity (private marginal benefit).
Orange County residents experience air quality degradation from pollution (negative external marginal cost).
Conclusion: Market equilibrium leads to inadequate consideration of social costs, resulting in inefficiency.
Example of Positive Externality: COVID Vaccinations
Scenario: Vaccinations offer direct benefits to individuals who receive them (private marginal benefit) and also protect those who do not (external marginal benefit).
Total societal benefit includes both the direct benefits to vaccine recipients and indirect benefits to the broader community.
This results in an underproduction of vaccinations; thus, societal optimal production is not reached at market equilibrium.
Optimal Social Level of Production
The socially optimal level of production occurs where Social Marginal Benefit (SMB) equals Social Marginal Cost (SMC).
If we fail to account for externalities, the equilibrium will not reflect the true costs and benefits to society.
Implications of Externalities on Market Efficiency
Positive externalities often lead to underproduction:
Market equilibrium is below the economically efficient production level.
Resulting in deadweight loss.
Negative externalities lead to overproduction:
Market equilibrium is above the socially optimal production level.
Again, resulting in deadweight loss.
Conclusion and Solutions
Markets alone do not naturally adjust for externalities.
Societal impacts outside the market participants need correction via policy intervention or external regulation to reach efficient equilibrium.