Unformatted text preview: Market Failure
What is market failure?
What is economic efficiency? Economic efficiency is making best use of scarce resources
List the main types of efficiency used in economics. Productive efficiency: firms deliver the highest possible output using the least amount of
scarce resources. This means firms produce output at lowest possible unit cost
Allocative efficiency: scarce resources are used in a way that maximises consumer
satisfaction ie resources are used to make items most valued by society, given their costs How is economic efficiency achieved? Economic efficiency occurs in a market when both
allocative and productive efficiency are achieved.
What is market failure? Market failure occurs when free markets make an inefficient use of
scarce resources by failing to deliver allocative or productive efficiency.
Why is market failure a problem? Productive inefficiency means firms are not maximising
output from given inputs. There is lost potential output. Allocative inefficiency means scarce
resources are not being used in a way that maximises consumer satisfaction
List the main causes of market failure. Free markets can fail because of: the impact of externalities on others is usually ignored by producers and consumers
Information failure leads to choices that do not maximise satisfaction. Eg markets can
fail to provide appropriate amounts of merit goods and demerit goods
There is no financial incentive for private sector firms to supply pure public goods. The
high cost of excluding free riders deters firms from supplying quasi-public goods
The immobility of labour can cause unemployment hence productivity inefficiency
Price volatility can result in unstable commodity markets Externalities
What is an externality? Externalities are the spill over effects of economic activity on others
not directly involved in production or consumption of the product.
Why do externalities cause market failure? Economic activity often affects third parties
(others). Generally producers and consumers only take into account their own private interest
when making economic decisions - the potential impact of any spillover effects is ignored. This
means the private and social costs and benefits diverge. To identify the true cost to society of an
economic decision, both private and external costs and benefits must be considered
Define negative externalities. Negative externalities occur when production or consumption
imposes costs on third parties who receive no compensation
Give examples of negative externalities. a car journey generates spillover effects such as
increased noise and pollution; Smokers ignore the harmful impact of ‘passive smoking’ on nonsmokers.; acid rain created by UK power stations can damage the forests of Norway
Define positive externalities. Positive externalities exist when third parties receive benefits
from the spill over effects of production or consumption for which they do not pay
Give examples of positive externalities. Firms benefit when workers are educated or trained
at the taxpayers’ expense; Preventative health provision such inoculations reduce absenteeism;
The Arts and museums help create a sense of national identity and shared culture; Sports
participation leads to improved health and team working skills | What is market failure? 27 Costs and benefits
What are private costs and benefits? Private costs and benefits are experienced by those
individuals or firms directly involved in economic activity ie consumption or production.
Define private costs. Private costs are the costs to individuals or firms of consuming or
producing a good or a service. Eg the cost of a car journey is, say 50p per mile travelled.
How are private costs measured? Supply curves reveal the private cost of the resources used
up in production eg wages and rent
Define private benefits. Private benefits are the gain to individuals or firms of consumption or
production. Consumers gain satisfaction from using items while firms earn revenue from sales.
Define external costs. An external cost is the cost a consumer or producer’s economic decision
imposes on others and for which no compensation is made.
Define external benefits. An external benefit is the gain a consumer or producer’s economic
activity creates for others, and for which no payment is made.
Give an example of external benefits. A new leisure facility creates benefits to third parties
for which no payment is made by generating local employment, and extra trade for local shops
How is the impact of externalities valued? Money can be used as a unit of account to measure
costs and benefits. Money can be used to value the impact of spillover effects.
What are the issues in estimating externalities? Using money to place a value on external
costs and benefits is difficult and controversial. Can the cost of noise from planes, or lost life or
limbs from an accident, be expressed in £s?
State the methods used to estimate external costs and benefits. There are two methods: Exante (before the fact): estimate the amount of money consumers are prepared to pay to avoid an
externality. Ex-post (after the fact): estimate the cost of putting right the externality
What is a missing market? A non-existent market eg there is no markets for externalities
generated by economic activity.
Explain shadow prices Money is used to measure the impact of externalities. However, some
externalities have a missing market and so no market price. Instead economists estimate the
value of externalities and create a shadow price.
What are social costs? Social costs are the total cost to society of a given economic activity ie
the cost to both the consumers and firms involved (first parties) and any costs imposed on
others (third parties). Social costs are found by adding together both private and external costs.
Private Costs + External cost = Social Costs Cost to individual consumers or
firms of their economic activity Cost to others of individual consumers or
firms economic activity Total cost to society of a given
economic activity Cost to first parties: individuals Cost to third parties: others Total cost to society: everyone What are social benefits? Social benefits are the total gain to society from a given economic
activity ie the benefit to both first parties and any beneficial spillover effects on third parties.
Social benefits are found by adding together both private and external benefits..
Private Benefits + External benefits = Social Benefits Benefits to individual consumers
or firms of their economic activity Benefits to others of individual consumers
or firms economic activity Total benefits to society of a
given economic activity Benefits to first parties:
individuals Benefits to third parties: others Total benefits to society:
everyone 28 Externalities | How is the concept of the margin use in assessing efficiency? Economists are interested in
decisions taken by consumers and firms, ‘at the margin’. Marginal means the extra unit. Does
society gain if an extra unit of a good is produced and consumed? Allocative efficiency in a given
market involves comparing the full social cost of producing an extra unit (marginal social cost
MSC) with the full benefit gained from its consumption (marginal social benefit MSB)
Define socially optimum output. The socially optimum level of output occurs when scarce
resources are used in a way that maximises consumer satisfaction.
How are social costs and benefits used to define the socially optimum level of output?
Allocative efficiency means providing consumers with the products they most value, given their
cost of production, and is achieved if price equals marginal cost. However price and marginal
cost only reveal private benefits and costs. Account must be taken of spillover effects on third
parties ie externalities. The socially optimum allocation of resources requires output to be
increased to the point where marginal social benefit equals marginal social cost ie MSB = MSC
Why do externalities cause market failure? In free unregulated markets, externalities cause
private and social costs or benefits to diverge so that the equilibrium and allocatively efficient
level of output are different. Markets fail from over or under production.
Use a graph to show negative externalities
The supply curve S1 reveals the marginal private
cost (MPC) of economic activity to the decision
maker eg a firm. S1 = MPC.
The marginal external cost curve (MEC) shows the
estimated negative impact of this economic
activity imposed on third parties without
Adding MEC to MPC gives marginal social cost
curve (MSC). S2 shows the full cost to society
Use a graph to show positive externalities
The demand curve D1 reveals the marginal private
benefit (MPB) of economic activity to the
consumer. D1 = MPB
The marginal external benefit curve (MEB) shows
the estimated positive impact of an economic
activity enjoyed by third parties without payment
Adding MEB to MPB gives marginal social benefit
curve (MSB). D2 shows the full benefit to society | Externalities 29 Use a graph to show market failure from
negative externalities: over production
The supply curve S shows the firm’s marginal
private cost of production (MPC) S= MPC.
Given negative externalities such as pollution,
marginal external costs (MEC) are added to the
MPC curve to give the marginal social cost (MSC)
curve. MSC = MPC + MEC.
The demand curve is a measure of private
marginal benefit. If no positive externalities D
shows social marginal benefit D = PMB = MSB.
The equilibrium level of output delivered by a free market, Q1, is allocatively inefficient. SMB =
SMC at Q2. The market has overproduced by (Q2–Q2). The welfare loss triangle JKL gives the
amount of welfare loss from over production
Define deadweight loss. The welfare loss to society that occurs when firms produce where
market price does not equal marginal cost
Use a graph to show market failure through positive externalities: under production
The demand curve D1 reveals marginal private
benefit but ignores potential positive spill over
effects on third parties
Assume the monetary impact of positive
externalities are estimated to = MEB. The full gain
to society is shown by the marginal social benefit
curve (MSB). MSB = MPB+ MEB.
Assume no negative externalities. The supply
curve S1 also shows MSC. S1 = MSC.
The equilibrium level of output delivered by a free
market, Q1, is allocatively inefficient. SMB = SMC
at Q2. The market has under produced by (Q2 –
Q1). The welfare loss triangle JKL gives the amount of welfare loss from under production Property Rights and externalities
What are property rights? Property rights state the legally enforceable rules for owning, using
and selling a resource eg land. Eg a landlord can ask the police to prosecute fly tippers.
How can lack of clear property rights cause externalities? Owners protect their assets. If
assets such as sea and air have no owners, then anyone can use that resource regardless of any
externalities imposed. Eg decades of over fishing in the North Sea threaten the survival of the
cod. For markets to work, property rights must be clearly defined and enforced.
Explain tragedy of the commons. The tragedy of the commons describes how an unowned
asset can be over used by agents with no regard to spillover effects on others eg over fishing
leads to long term permanent damage to the stock of natural resources. Fish stocks dwindle.
What is Coase’s theory? Creating property rights for ownerless assets reduces externalities.
Owners use the law to protect their land from polluters – if they can afford legal fees
Are property rights restricted? UK laws restrict the use of some assets eg planning
permission is required before new houses in rural areas. 30 Externalities | ...
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This note was uploaded on 02/08/2012 for the course ECO 51844 taught by Professor Sabet during the Spring '11 term at FIU.
- Spring '11