BUS171 Topic 7

Market Failure

Overview

• Competitive markets generally promote economic efficiency.

• Market failure occurs when the market does not achieve economic efficiency, leading to allocative inefficiency.

• When the market fails, the level of output is either too high or too low, resulting in the overproduction or underproduction of goods and services.

Causes of Market Failure

Externalities

• Definition: A benefit or cost affecting someone not directly involved in a good's production or consumption, with no payment for benefit or compensation for costs.

  • Positive externalities: Supply benefits exceeding those enjoyed by the producer.

  • Negative externalities: Production or consumption imposing costs on others not associated with the activity.

Public Goods

• Goods that are non-excludable and non-rivalrous; consumption by one individual does not reduce availability for others.

Common Resources

• Resources that are shared and may be overused due to lack of ownership and regulation.

Lack of Competition

• Issues like monopoly or oligopoly market power that distort market efficiency.

Understanding Externalities

Types of Externalities

1. Positive Externalities

   • Examples:

     • Consumption: Education, public transport.

     • Production: Research and development, publicly accessible infrastructure.

   • Result: Social benefit exceeds private benefit.

2. Negative Externalities

   • Examples:

     • Consumption: Second-hand smoke, vehicle emissions.

     • Production: Pollution (air, water), land degradation.

   • Result: Social cost exceeds private cost.

Definitions

• Private Cost: Cost incurred by the producer for the production of a good.

• Social Cost: Total cost arising from production, including both private and external costs.

• Private Benefit: Benefit received by consumers of a good.

• Social Benefit: Total benefit including both private and external benefits.

Addressing Externalities

Positive Externalities

• Encourage consumption/production through:

  • Subsidies to consumers or private suppliers.

  • Government initiatives to increase publicly-available resources.

Negative Externalities

• Management approaches include:

  • Command and Control:

    • Regulations on pollution limits.

    • Required pollution control technology or practices.

    • Penalties for non-compliance.

  • Market-Based Policies:

    • Implementing taxes (e.g., Pigovian tax) to internalize externalities.

    • Tradeable emissions permits to limit pollution through market mechanisms.

Efficiency and Taxation

• Imposing taxes on negative externalities increases marginal costs, thereby reducing output and increasing prices to achieve efficiency.

• The efficient level of pollution reduction occurs when the marginal benefit of reduction equals the marginal cost (MB = MC).

Policy Evaluation

• Evaluate policies based on:

  • Effectiveness in addressing market failure.

  • Ease of implementation.

  • Cost of implementing policies.

Government Failure

• Definition: Occurs when government fails to provide goods/services society wants, or fails to correct economic inefficiencies.

• Factors contributing to government failure:

  • Imperfect information about societal demands for externalities.

  • Budget constraints and enforcement costs.

  • Influence by interest groups, leading to unrepresentative policies.

  • Lack of a price mechanism.

  • Reliance on voting mechanisms for determining public good levels.