Market Efficiency and Market Failure

Autumn 2011

Definition• Market failure occurs when the free market forces

of demand and supply, fail to produce the quantities of goods/services that people want at prices which reflect their marginal utilities AND/OR the failure of market forces to achieve an efficient allocation of resources.

• Efficiency occurs when the quantity in the market is optimal in the sense that the amount of community surplus (= consumer surplus + producer surplus) is maximised, i.e. no deadweight loss exists.

Marginal Benefit and Consumer Surplus

• Marginal benefit (utility) The additional benefit to a consumer from consuming one more unit of a good or service.

• Consumer surplus The difference between the highest price a consumer is willing to pay and the price the consumer actually pays.

The Demand Curve is Also the Marginal Benefit Curve

Consumer Surplus

Marginal Cost and Producer Surplus

Marginal cost

The additional cost to a firm of producing one more unit of a good or service.

Producer surplus The difference between the lowest price a firm would have been willing to accept and the price it actually receives.

Economic Surplus and Economic Efficiency

• Economic efficiency o A market outcome in which the marginal benefit to consumers of

the last unit produced is equal to its marginal cost of production.o It is where the sum of consumer surplus and producer surplus is at

a maximum.

Community Surplus of Competitive Markets

Community Surplus Equals the Sum of Consumer Surplus and Producer Surplus

The Efficiency of Competitive Markets

Marginal Benefit Equals Marginal Cost Only at Competitive Equilibrium

Externalities and Market failure• Externality

o A benefit or cost that affects someone (a third party) who is not directly involved in the production or consumption of a good or service.

• The Effect of Externalitieso Private cost (PC)

• The cost borne by the producer of a good or service.o Social cost (SC=PC+EC)

• The total cost of producing a good, including both the private cost and any external cost (EC).

o Private benefit (PB)• The benefit received by the consumer of a good or service.

o Social benefit (SB=PB+EB)• The total benefit from consuming a good, including both the

private benefit and any external benefit (EB).

Negative Externalities• External or social costs

o The costs of an economic decision to a third party (someone other than the producer or consumer)

• Decision makers do not take into account the cost imposed on society and others as a result of their decision,o e.g. pollution, traffic congestion, environmental degradation,

depletion of the ozone layer, misuse of alcohol, tobacco, anti-social behaviour, drug abuse and gun crime

Negative Externalities and Efficiency

A NEGATIVE EXTERNALITY IN PRODUCTION REDUCES ECONOMIC EFFICIENCY

The Effect of Pollution on Economic Efficiency

Positive Externalities• External benefits

o The benefits of production or consumption of a good/service that is good for third parties.

o e.g. education and training, public transport, health education and preventative medicine, refuse collection, mosquito nets, public libraries & law and order

Positive Externalities and Efficiency

A POSITIVE EXTERNALITY IN CONSUMPTION REDUCES ECONOMIC EFFICIENCY

The Effect of a Positive Externality on Efficiency