1.3. Market Failure and Externalities Flashcards
Market Failure
when the market fails to achieve an efficient resource allocation.
- Market equilibrium does not lead to economic efficiency (productive and allocative efficiency).
Reasons for Market Failure
1) Negative externalities in production / consumption.
2) Positive externalities in production / consumption.
3) Merit goods underprovided (information failure).
4) Demerit goods over provided (to information failure).
5) Public goods unprovided (free-rider problem).
6) Monopoly abuse of market power (restrict output / raise prices).
7) Adverse selection
8) Moral hazard
9) Factor immobility due to occupational or geographical reasons.
Geographical Immobility
workers are unable / unwilling to get to where the jobs are located.
Occupational immobility
when workers lack the required skills to be put to more efficient use.
Adverse Selection
a difference in information between buyers and sellers
Moral Hazard
changing behaviour / taking risks when protected from the consequences e.g. flood, health, car insurance
Lack of Property
where private property rights cannot be established, common resources will be over-exploited.
- Known as “The Tragedy of the Commons”
Externalities
external costs / benefits imposed on third parties (not directly involved).
- Externalities can be negative (external costs) or positive (external benefits).
- Externalities can be from production or consumption.
Negative Externality
external costs imposed on third parties of a transaction.
Positive Externality
external benefits imposed on third parties of a transaction.
Negative production externality explanation (draw the diagram)
e.g. air pollution from factories
1) Producers only consider their MPC (S1) and MPB (D1) during production.
2) Free market quantity (Qfm) occurs where MPC = MPB (S1 = D1).
3) However, at Qfm an external cost (MEC) occurs because MSC > MPC.
4) This is the negative production externality.
Socially optimal quantity (Qso) occurs where MSC = MSB.
5) Since Qfm > Qso, there is overproduction in the market, resulting in a deadweight loss (DWL) to society (i.e. inefficiency), which is market failure.
Positive production externality explanation (draw the diagram)
e.g. beekeeper and flower grower
1) Producers only consider their MPC (S1) and MPB (D1) during production.
2) Free market quantity (Qfm) occurs where MPC = MPB (S1 = D1).
3) However, at Qfm an external benefit (MEB) occurs because MPC > MSC.
4) This is the positive production externality.
Socially optimal quantity (Qso) occurs where MSC = MSB.
5) Since Qso > Qfm, there is underproduction in the market, resulting in a deadweight loss (DWL) to society (i.e. inefficiency), which is market failure.
Negative consumption externality explanation (draw the diagram)
e.g. passive smoking
1) Consumers only consider their MPC (S1) and MPB (D1) during consumption.
2) Free market quantity (Qfm) occurs where MPC = MPB (S1 = D1).
3) However, at Qfm an external cost (MEC) occurs because MPB > MSB.
4) This is the negative consumption externality.
Socially optimal quantity (Qso) occurs where MSC = MSB.
5) Since Qfm > Qso, there is overconsumption in the market, resulting in a deadweight loss (DWL) to society (i.e. inefficiency), which is market failure.
Positive consumption externality explanation (draw the diagram)
e.g. education
1) Consumers only consider their MPC (S1) and MPB (D1) during consumption.
2) Free market quantity (Qfm) occurs where MPC = MPB (S1 = D1).
3) However, at Qfm an external benefit (MEB) occurs because MSB > MPB.
4) This is the positive consumption externality.
Socially optimal quantity (Qso) occurs where MSC = MSB.
5) Since Qso > Qfm, there is underconsumption in the market, resulting in a deadweight loss (DWL) to society (i.e. inefficiency), which is market failure.
Deadweight Loss
the loss of economic welfare due to the fact that potentially desirable production and consumption does not take place.
- Caused by: market failure and government intervention.
- Results in: a loss of consumer and producer surplus.
