IB EconomicsUnit 2: Microeconomics

IB Chapter 13: Market Failure

Measuring Economic Welfare

• Consumer surplus• Producer surplus• Total surplus (or

welfare) = CS+PS• Why does market

failure lead to a reduction in TS?

Price

(BH

D)

Quantity (000’s)

Class Task: Complete the diagram to show CS & PS

What is Market Failure?

Definition:• Where the market mechanism fails to allocate

resources efficiently, when left to the market we get an inefficient allocation of resources

• TS is not maximised• Types of efficiency

– Social efficiency– Allocative Efficiency– Productive Efficiency– (Dynamically efficient)

Market Failure: Types of Efficiency

• Social Efficiency: where external costs and benefits are accounted for when decisions are made in both consumption and production.

• Allocative Efficiency: A market will be allocatively efficient if it is producing the right goods for the right people at the right price (where MC = AR known as marginal cost pricing).– Also referred to as; Pareto Efficient Allocation where resources

cannot be readjusted to make one consumer better off without making another worse off – zero opportunity cost! Vilfredo Pareto (1848 – 1923)

• Productive Efficiency: production of goods and services at lowest factor cost (lowest point of AC curve).

• Static Efficiency: efficiency at a point of time (e.g. using current technology)

• Dynamic Efficiency: an economy that appropriately balances short run concerns (static efficiency) with concerns in the long run (focusing on encouraging research and development)

Market Failure: When?

• Market Failure occurs where:– Knowledge is not perfect – ignorance or deception– Goods are differentiated– Resource immobility e.g. Labour or Capital– Market power e.g. Monopolies– Services/goods would or could not be provided in

sufficient quantity by the market e.g. street lighting– Existence of external costs and benefits– Inequality exists e.g. wealth, income

Market Failure: Imperfect Competition

• Market Power:– Existence of monopolies and oligopolies– Collusion– Price fixing– Abnormal profits– Rigging of markets– Barriers to entry

Welfare loss under IMPERFECT COMPETITION

Why?

Costs, B

enefits &

Price

Quantity

How do CARTELS operate?

Why?

Costs, B

enefits &

Price

Quantity

What can be done to limit the failures caused by imperfect competition?

• Legal measures to increase competition– 25%– Concentration ratio

• Regulatory bodies– Monitor behaviour of firms e.g. OFWAT– Monopoly regulators e.g. UK Competition

Commission We must ensure that all intervention

results in an improvement in economic welfare and does not make the situation worse (Government Failure)

The Existence of Public Goods

• Public Goods: Markets would not provide such goods and services at all!– Non-excludability:

Person paying for the benefit cannot prevent anyone else from also benefiting - the ‘free rider’ problem

– Non-rivalry: Large external benefits relative to cost – socially desirable but not profitable to supply!

• Possible Solutions: – The government collects

tax (in most countries) and supplies public goods themselves, but how does it know how much to supply?

– Subsidisation of private firms to produce

A non- excludable good?

Would you pay for this?

Under provision of a Public Good: MSB Vs MSC

Why?

Merit Goods• Merit Goods: goods and

services which are better for us that we realise:

• Under provision• Under consumption

• Education • Healthcare• Organic food• Seat belts• Sports facilities

• Possible Solutions• Government provision• Subsidised production• Positive advertising to

encourage consumption and/or production

Would we all pay if the state did not provide it?

Under provision of a Merit Good: MSB Vs MSC

Why?

Under consumption of a Merit Good: MSB Vs MSC

Why?

Demerit goods and services

De-Merit Goods• Over Production: • Over Consumption: • Examples:

– Tobacco– Alcohol– Drugs– Gambling– Sheesha

• Possible Solutions– Regulation of use– Negative advertising to

discourage production and/or consumption

– Taxation to reduce QD via increased P

A Russian drug addict injects heroin

Over Consumption of a De-Merit Good: MSB Vs MSC

Why?

Over Supply of a De-Merit Good: MSB Vs MSC

Why?

Market Failure: Knowledge

• Imperfect Knowledge:– Consumers do not have adequate technical knowledge– Advertising can mislead or mis-inform– Producers unaware of all opportunities– Producers cannot accurately measure productivity– Decisions often based on past experience rather than

future knowledge

How does imperfect knowledge affect the market?

Why?

Market Failure

• Goods/Services are differentiated– Branding– Designer labels - they cost

three times as much but are they three times the quality?

– Technology – lack of understanding of the impact

– Labelling and product information

Which one is the ‘quality’ item and why?

How does product differentiation affect the market?

Why?

Market Failure: Immobility

• Resource Immobility– Factors are not fully mobile– Labour immobility – geographical and

occupational– Capital immobility – what else can we use the

Channel Tunnel for?– Land – cannot be moved to where it might be

needed – e.g. London and South East!

World Income Distribution

Market Failure: Externalities

External Costs and Benefits• External or social costs

– The cost of an economic decision to a third party

• External benefits – The benefits to a third party as a result of a

decision by another party

Market Failure

External Costs• Decision makers do not take

into account the cost imposed on society and others as a result of their decision– e.g. Pollution, traffic

congestion, environmental degradation, depletion of the ozone layer, misuse of alcohol, tobacco, anti-social behaviour, drug abuse, poor housing

External Costs: MSB Vs MSC

Why?

Market Failure: Benefits

External benefits – – by products of production

and decision making that raise the welfare of a third party

– e.g. Education and training, public transport, health education and preventative medicine, refuse collection, investment in housing maintenance, law and order.

External Benefits: MSB Vs MSC

Why?

Market Failure

• Inequality:– Poverty – Absolute and Relative– Distribution of factor ownership– Distribution of Income– Wealth Distribution– Discrimination– Housing

Inequality

RECORD NOTES HERE

FIG: 1.1

Diagram Title: The LORENZ curve

Line of equality

45º

e.g.

Bah

rain

e.g.

UK

%age of Population

%ag

e o

f In

com

e (

Y)

GINI Co-EfficientSource: ECONandBIZ.com

A

B

Gini co-efficient formula

A

A + B

Market Failure

Measures to Correct Market Failure– State Provision– Extension of property rights– Taxation– Subsidies– Regulation– Prohibition– Positive Discrimination– Redistribution of Income– Price Controls– Buffer Stocks

Correcting Market Failure: Taxes e.g. de-merit

Why?

Correcting Market Failure: Education e.g. de-merit

Why?

Correcting Market Failure: Subsidy e.g. Merit

Why?

Correcting Market Failure: Regulation e.g. Merit

Why?

Correcting Market Failure: Inequality e.g. Min wage

Why?

Correcting Market Failure: Redistribution of Income

Why?

Correcting Market Failure: Max/Min Prices

Why?

Correcting Market Failure: Buffer Stocks

Why?

Government Failure

TaxS1

S2 (S1+Tax)

D

QD & QS per yr

Pric

e in

$U

S

Q1Q2

P2

P1

Government failure is when intervention by the government in a market results in a worsening of welfare for society.

What we are saying here is that the GOVERNMENT SOMETIMES MAKES IT WORSE THAN IT WAS ALREADY.

Take this example of a tax aimed at reducing

consumption. While the policy has been successful in reducing quantity demanded from Q1 to Q2 what about the price increase and how

will this affect people on poor incomes?

Q: How effective will this policy become as PED

falls?

How does PED affect our analysis?

A

B

Tax burden that falls on the consumer

Tax burden that falls on the producer

A B+ Total Tax Revenue

TaxS1

S2 (S1+Tax)

D

QD & QS per yr

Pric

e in

$U

S

Q1Q2

P2

P1

Has this tax been successful?

YES: it has raised revenue for the government

YES: it has discouraged some people from consuming the good or service

NO: the low level of PED means that there has been limited results

NO: what about the poor people or those who cannot change their consumption patterns?

Record Student

views here

Sources of Government Failure

Political self-interest Policy myopia Regulatory capture Government intervention and disincentive effects Government intervention and evasion Policy decisions based on imperfect information The Law of Unintended Consequences! Costs of administration and enforcement

TASK: Take 5-10 minutes to read the handout ‘Does the government always get it right?’ and then right a paragraph to

explain what you understand by the term GOVERNMENT FAILUREGOVERNMENT FAILURE

Examples of Government Failure

Government intervention to reduce the power of monopolies which hinders international competitiveness and/or is against the public interest

Incorrect or inefficient tax/benefit systems to correct for the existence of externalities

The existence of unintended consequences as a result of government action

The Government uses increases in minimum wages to win votes during the election campaign

Regulations which result in harmful unregulated black markets

Task: Take each of the scenarios and write a brief example to illustrate the issues raised. Make sure that you explain a

likely instance of government failure.

Case Study: Smoking Bans

http://news.bbc.co.uk/2/hi/uk_news/england/7660141.stm

A UK businessman has begun marketing an 'electronic cigarette' which he says allows smokers to get around the smoking ban.

Case Study: Tax on cigarettes

http://news.bbc.co.uk/2/hi/uk_news/4096911.stm

Ideas Board