Market Failure

1.3.1 syllabus

Candidates should be able to:•Define market failure•Assess different types of market failure - externalities, under-provision of public goods and information gaps.

1.3.1 What is “Market Failure”?

For an optimum allocation of resources, prices must reflect the full costs and benefits and they must not be open to the undue influence of firms.

Market failure occurs when the free market (the price mechanism) causes an inefficient allocation of resources.

The result is a loss of economic and social welfare.

1.3.1 Why does market failure lead to inefficiency?

There are two key reasons: Firms are not maximising output. Why does this matter?

Resources are misallocated and goods are produced that are not wanted. Why does this matter?

1.3.1 Why might markets fail?

1. externalities - negative or positive externalities are the costs or benefits that affect third parties (1.3.2).

2. Under provision of public goods such as education or healthcare (1.3.3)

3. information gaps - imperfect market information (1.3.4)

1.3.2 syllabus

Candidates should be able to:•Distinguish between private, external and social costs and benefits•Illustrate: the external costs of production using marginal analysis; the distinction between market equilibrium & social optimum position; welfare loss•Illustrate: the external benefits of consumption using marginal analysis; the distinction between market equilibrium & social optimum position; welfare gain•Understand the impact of externalities on economic agents and government intervention

1.3.2 Externalities

What are externalities?

Externalities are the costs or benefits that affect third parties (society).

Why might externalities cause market failure?

They cause market failure if the price mechanism does not take account of the wider costs and benefits to society of production and consumption.

1.3.2 Costs

When a firm builds a factory to produce steel, what costs does it incur?

These are known as the private costsWhat costs might local people incur?

These are known as the external costs The actual total cost is private + externalThis is called the social cost

1.3.2 Negative externalities

Negative externalities occur when the total cost to society (the social cost) exceeds the cost to the firm (the private cost).This leads to the private optimum level of output being greater than the social optimum level of production.Externalities lead to the wrong amount of a product being produced.

1.3.2 Benefits

When a firm builds a factory to produce steel, what benefits does it gain?

These are known as the private benefitsWhat benefits might local people incur?

These are known as the external benefits So total benefit is private + externalThis is called the social benefit

1.3.2 Marginal costs

The marginal cost is the additional cost derived from producing one more unit of something.

The marginal social cost considers both marginal private costs and marginal external costs.

Remember the actual total cost = private + external and this is called the social cost

Marginal social cost = marginal private cost + marginal external cost

1.3.2 Marginal benefits

The marginal benefit is the additional benefit derived from consuming one more unit of something.

The marginal social benefit considers both marginal private benefits and marginal external benefits.

Remember the actual total benefit = private + external and this is called the social benefit

Marginal social benefit = marginal private benefit + marginal external benefit

Negative externalities for a coal-fired power station

What are the private costs for a coal-fired power station?

Who pays for them?

What are the external costs?

Does the firm take these into account when making decisions about pricing?

1.3.2 More negative externalities

Firms will only consider the private costs of production.This means that the price will be lower than if the full costs to society were accounted for. Thus the level of production and the quantity demanded will be higher than if the full social costs had been considered.

1.3.2 Diagram showing negative externalities

Draw supply and demand curves.Label:•D = MSB = MPB•S1 = MPCAssume that the supply curve takes into account all of the costs to society. Add this to your diagram and label appropriately.HINT: remember the formula you wrote on your slide on page 3.

1.3.2 Explain your negative externalities diagram

On the previous diagram: if there are negative externalities, we must add the external costs to the firm’s supply curve to find the social cost curve. Hence supply curves shifts left.

If the market fails to include these external costs, then the equilibrium output will be Q1 and the price P1 this is the market optimum position.

1.3.2 Diagram showing welfare loss

Draw the same diagram and label curves MSB, MPC and MSCLabel the socially optimum output and the free market output. Highlight the welfare loss triangle.

1.3.2 Pollution

Edexcel state: “It is useful to point out that the efficient level of pollution is not zero”

Why is this the case?

1.3.2 Positive externalities

Positive externalities occur when the social benefit of consumption exceeds the private benefit

e.g. ______________________ both benefit society as well as individuals

Marginal social benefit = marginal private benefit + marginal external benefit

The problem with positive externalities is that too little of a good or service is produced.If only the private benefits (and not the full benefits to society) are considered, then there will be under-production.

1.3.2 Diagram showing positive externalities

Draw two curves.Label:•MPB•MPCAssume that we take into account the full benefit to society. Add this to your diagram and label appropriately.HINT: remember the formula you wrote on your slide on page 3.

1.3.2 Explanation of diagram

1.3.2 Education

What are the benefits of education to you?

To your parents?

To society?

Which of these are private benefits and which are external benefits?

1.3.2 Other examples of external benefits

Why might the following have external benefits as well as private benefits?•Healthcare•Public libraries•Local sports facilities

1.3.2 Draw a diagram showing positive externalities and welfare gain

1.3.3 syllabus

Candidates should be able to:•Distinguish between public and private goods using the concepts of non-rivalry and non-excludability• Explain why the market may not provide public goods (the free-rider problem)

Public goods

Public goods are a type of good that can lead to market failure.

Public goods are defined as having two key characteristics:

1. non-excludability

2. non-rivalry

1.3.3 Definition of public goods

o non-excludability: the benefits derived from the provision of public goods cannot be confined to only those who have actually paid for it. This is the free-rider problem. E.g. defence

o i.e. anyone can benefit – they don’t need to payo non-rivalry: consumption of a public good by one

person does not reduce the availability of a good to other. E.g. defence

o i.e. one person using it doesn't affect the quantity

1.3.3 Private goods

o Private goods are excludable: the benefit derived is confined to those who have actually paid for it.

o Private goods are rivalry: consumption of a good by one person reduces the availability for others

E.g.

1.3.3 Provision of public goods

Why are public goods not provided by the private sector?

1.3.3 Free-rider problem

The government must decide what output of public goods is needed.To do this it must estimate the social benefit. This is difficult to do!The free-rider problem is that consumers behaving rationally will try to gain a ‘free ride’ but once a public good has been provided, other consumers can’t be excluded. Examples:

1.3.3 More public goods questions

Are the following private goods or public goods? Are they non-rivalrous or non-excludable or do they contain elements of both?•A playground•Broadcasting•A firework display•Police protection

1.3.4 Syllabus

Candidates should be able to:•Distinguish between symmetric and asymmetric information•Analyse how imperfect information may lead to a misallocation of resources.

1.3.4 Imperfect information – merit goods

Merit goods are goods that would be under-consumed in a free market, as people do not fully understand the benefitsThe public and private sector both provide merit goods. e.g. Consumption of merit goods is believed to generate positive externalities.

1.3.4 Imperfect information continued

A merit good is a product that society values and judges that everyone should have regardless of whether an individual wants them.

The government believes that individuals may not act in their own best interest because of imperfect information about the long-term benefits that can be derived.

1.3.4 Imperfect information and demerit goods

Demerit goods are goods considered ‘bad’

e.g.

The consumption of demerit goods can lead to negative externalities, which consumers may be unaware of, since they have imperfect information about long-term damage to their own health.

Demerit goods are linked to a failure of information. So the government tries to reduce consumption of demerit goods.

1.3.4 Draw a diagram showing the welfare loss for alcohol

1.3.4 Link between imperfect information and merit goods

Merit goods are linked to a failure of information.

E.g.

Merit goods are an example of market failure - the free market will lead to the provision of a product, but in the wrong quantity, leading to a misallocation of resources.

1.3.4 Symmetric information

Symmetric information is when both buyers and sellers have perfect information i.e. they all have a good knowledge about the product.

E.g. you may know a great deal about ?

1.3.4 Asymmetric information

Asymmetric information is when one party knows more than the other.

Some products are only bought occasionally so consumers may have limited information e.g. washing machines.

For other products e.g. dentistry, consumers have very limited information whilst the producer knows a great deal – you can’t tell if you are getting appropriate treatment!

1.3.4 Examples of asymmetric information

1.3.4 Summary of imperfect information

In summary, imperfect information means that merit goods are under-produced while demerit goods are over-produced or over-consumed.

Merit and demerit goods are considered failures of the market since their existence will cause the wrong amount of the goods and services concerned to be produced.

Imperfect information may lead to a misallocation of resources.

1.3.4 What type of information?

• A private dentist tells you that you need a filling

• A second-hand car sales person tells me the car is a good runner

• The seller of a pension scheme who says the future will be well provided for

• The cigarette manufacturer who does not inform potential consumers of the true health risk from smoking