1.3 Market Failure Flashcards
Market Failure
Occurs when the market fails to allocate scarce resources efficiently, causing a loss in social welfare
Types of Market Failure
Externalities
Under Provision of Public Goods
Information Gaps
Externalities
An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism
Spillover effect of the production/consumption of a good/service
Leads to the over/under production of goods meaning resources are not allocated efficiently
Types of Externalities
Private Cost/Benefits
Social Costs/Benefits
External Costs/Benefits
Private Costs/Benefits
Costs/Benefits to the individual participating in the economic activity
Demand curve represents private benefits and the supply curve represents private costs
Social Costs/Benefits
Costs/Benefits of the activity to society as a whole
External Costs/Benefits
Costs/Benefits to a third party not involved in the economic activity
Merit Good
Good with external benefits, where the benefit to society is greater than the benefit to the individual
Tend to be underprovided by the free market
Demerit Good
Good with external costs, where the cost to society is greater than the cost to the individual
Tend to be over-provided by the free market
Externalities Diagram
Look at marginal costs and benefits
Marginal Costs/Benefits
MPX (Marginal Private X)
MSX (Marginal Social X)
Extra cost/benefit of producing/consuming one extra unit of the good
MPB is the extra satisfaction gained by the individual from consiming one more of a good
MSB is the extra gain to society from the consumption of one more good
MPC is the extra cost to the individual from producing one more of the good
MSC is the extra cost to society from the production of one more good
Negative Production Externalities
Positive Consumption Externalities Diagram
Government Intervention
Indirect Taxes and Subsidies Tradable Pollution Permits Provision of the Good Provision of Information Regulation
Government Intervention
Indirect Taxes and Subsidies
Taxes can be put on goods with negative externalities and subsidies on goods with positive externalities
These help to internalise the externalities, moving production closer to the social optimum position
Government Intervention
Tradable Pollution Permits
Allow firms to produce up to a certain amount of pollution, and can be traded amonsts firms to give them the choice whilst reducing total level of pollution
Government Intervention
Provision of the Good
When social benefits are high, the government may decide to provide the good through taxation
They do this with healthcare and education
Government Intervention
Provision of Information
Since some externalities are associated with information gaps, the government can provide information to help people make informed decisions and acknowledge external costs
Government Intervention
Regulation
This could limit consumption of goods with negative externalities
E.g. banning advertising of smoking etc.
Public Goods
Public goods are missing from the free market, but offer many benefits to society
They are non-rivalrous and non-excludable
Non-rivalrous - one person’s use of the good does not stop someone else from using it
Non-excludable - you cannot stop someone from accessing the good and someone cannot choose not to access the good
Free Rider Problem
You cannot charge an individual a price for the provision of a non-excludable good because someone else will gain benefit from it without paying anything
A free rider is someone who receives benefits without paying for it
Public Goods
Private Sector
Private sector producers will not provide public goods to people because they cannot be sure of making a profit, due to the non-excludability of public goods. Therefore, if the provision of public goods was left to the market mechanism, the market would fail and so they are provided by the government and financed through taxation
Information Gaps
Symmetric Information
Asymmetric Information
Advertising
Misallocation of resources
Symmetric Information
Where buyers and sellers have potential access to the same information
Perfect information
Many decisions are based on imperfect information and so economic agents are unable to make an informed decision; they suffer from information gaps
Asymmetric Information
When one party has superior knowledge compared to another
Usually, the seller has more information than the buyer and this means they can take advantage of the other party’s lack of knowledge, by charging them a higher price
Advertising
Leads to information gaps as it is designed to change attitudes of the consumers to encourage them to buy the good
Could cause them to think the benefits are greater than they actually are
Increases in technology means information gaps are on the decline as people can get more information
Misallocation of resources
Information gaps lead to market failue as there is a misallocation of resources because people do not buy things that maximise their welfare
It means that consumer demand for a good or producer supply of a good may be too high or too low thus price and quantity are not at the social optimum position
Economic agents are unable to make rational decisions due to the information gaps
Principal Agent Problem
When the goals of the principle (the person who gains/loses from the decision) are different from the agents (those making decisions on behalf of the principle)
E.g. education where the child is the principle and the agents are parents/governments. The child has imperfect information as they do not see the benefits of education and so therefore will devote too few resources to education, if allowed.
