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.