1.3 Market Failure Flashcards
What is market failure ?
- an inefficient allocation of resources in a market that occurs when individuals acting in rational self-interest produce a less-than-optimal outcome
- ie. resources are not allocated as efficiently as they could be
- main role of prices in a market economy is to allocate scarce resources efficiently
What is complete market failure ?
- occurs when the market does not supply products at all ➡️ there is a missing market (main reason is under-provision of public goods)
What is partial market failure ?
- occurs when the market exists, but supplies either the wrong quantity of a product or the wrong price
- incl. negative externalities from production, positive externalities from consumption & info gaps
What are externalities ?
- spill over effects from production/consumption for which no appropriate compensation is paid to the third parties affected
Why are externalities not reflected in market price ?
- as they lie outside the initial market transactions
Why do externalities cause market failure ?
- if the price mechanism does not take into account the full social costs and benefits of production and consumption
- product/service’s price equilibrium does not accurately reflect the true costs and benefits of that product/service
What are private costs ?
- the costs faced by the producer or consumer directly involved in a transaction
What are external costs ?
🔔 the costs imposed on third parties as a result of a transaction that they are not directly involved in
- occurs when the activity of one group has a negative effect on the wellbeing of a third party ➡️ BUT the consumer and producer don’t have to pay, meaning that output will be too high and therefore the market price is too low (over provision)
- also knows as negative externalities ➡️ social costs exceed private costs
What are social costs ?
- private costs + external costs
- 🔔 when negative externalities exist, social costs > private costs
What meant when its said economists work ‘at the margin’ ?
- when drawing diagrams, economists consider the impact of one more unit of consumption/production
What is meant by marginal private cost (MPC) ?
- cost to the firm of producing an additional unit of output
What is meant by marginal external cost (MEC) ?
- cost to third parties from the production of an additional unit of output
What is meant by marginal social cost (MSC) ?
- total cost to society of producing an extra unit of output
- MSC = MPC + MEC
Examples of negative externalities from production ?
- noise & atmospheric pollution from factories
- air pollution from factories
- pollution from fertilisers
- industrial waste
- noise pollution
- collapsing fish stocks
- methane emissions from farming cows
What are positive externalities ?
- exist when third parties benefit from the spill over effects of production/ consumption
- eg. the social returns from investment in training or the positive benefits from health care/medical research
What are private benefits ?
- the benefits faced by the producer or consumer directly involved in a transaction
What are external benefits ?
🔔 the benefits enjoyed by third parties as a result of a transaction that they are not directly involved in
- occurs when the activity of one group has a positive effect on the wellbeing of a third party ➡️ they are good for third parties but the consumer and producer don’t take this into account meaning that output is TOO LOW and therefore market price will be TOO HIGH (under provision)
- also known as positive externalities
What are social benefits ?
- private benefits + external benefits
- 🔔 therefore when positive externalities exist, social benefits > private benefits
What is meant by marginal private benefit (MPB) ?
- the benefit to the consumer of consuming an additional unit of output
What is meant by marginal external benefit (MEB) ?
- the benefit to third parties from the consumption of an additional unit of output
What is meant by marginal social benefit (MSB) ?
- the total benefit to society of consuming an extra unit of output
- MSB = MPB + MEB
Examples of positive consumption externalities ?
- health programmes eg. NHS
- early years education eg. nursery provision
- subsidised bikes schemes in urban areas
- public libraries/community spaces
- museums and gallaries
- free school meals/nutritional advise
What are public goods and why do they cause market failure ?
- goods that are both non-rival & non-excludable
- they cause market failure due to the problem of missing markets ➡️ private firms will not provide the good as unable to profit from it
🔔 public goods is not one provided by the public sector but instead public sector provision is usually the solution to market failure
What are the characteristics of a public good ?
- Non-excludable: the benefits derived from pure public goods cannot be confined solely to those who have paid for it ➡️ non-payers can enjoy the benefits of consumption at no financial costs 🔔 known as the ‘free-rider’ problem
- Non-rival: consumption by one consumer does not restrict consumption by other consumer (if it is supplied to one person, it is available to all)
- Non-rejectable: the collective supply of a public good for all means that people cannot reject it eg. nuclear defence system or major flood defence projects affecting the entire community