Market Failure

Question 1

What is market failure?

Answer 1

Market failure occurs when the price and quantity supplied of a product do not reflect the true production costs and consumption benefits

Question 2

What are the three main sources of market failure?

Answer 2

Externalities: additional/unaccounted for effects resulting from activities

Public Goods: goods that are neither excludable nor rivalrous in their use

Common Resources: rival but not excludable

Question 3

What are externalities?

Answer 3

When an individual or firm engages in an activity that impacts on the well-being of a bystander

The bystander neither pays nor receives compensation for the effect

They can occur from either the production or consumption of a good/service

Question 4

What are some examples of negative externalities?

Answer 4

Pollution

Bad Drivers (accidents)

Cigarettes (second-hand smoke)

Traffic Congestion

Question 5

What are some examples of positive externalities?

Answer 5

Education

Immunisation

Research & Development

Question 6

What are production externalities?

Answer 6

An additional cost or benefit generated during the production process that the firm does not take into account

Affects the Marginal Cost of production – there is a difference between the MC as the firm sees it and the MC as society sees it

For example, the extraction of gold released a chemical that caused acid rain, which decreased the productivity of local farmers

Question 7

What is the difference between private marginal cost and social marginal cost?

Answer 7

Private Marginal Cost
The supply curve depicts a producer’s willingness to sell per unit
It encompasses their costs of production (both explicit and implicit)

Social Marginal Cost
The true cost of production
Encompasses positive and negative externalities of production

Question 8

What is the difference between private marginal benefit and social marginal benefit?

Answer 8

Private Marginal Benefit
The demand curve depicts a consumer’s willingness to pay per unit
It encompasses how much benefit they think they will derive from each unit

Social Marginal Benefit
The true cost of consumption
Encompasses positive and negative externalities of consumption

Question 9

Explore the impacts of a negative production externality

Answer 9

If no consumption externality, PMB stays the same

If the market is operating beyond the socially efficient equilibrium, it is operating inefficiently, producing too much creating a DWL

Question 10

What happens to negative production externalities over time?

Answer 10

They increase in impact

Question 11

Explore the impacts of a positive production externality

Answer 11

In this case, the market is creating inefficiency by not producing enough

Question 12

What is a consumption externality?

Answer 12

An additional cost of benefit generated during the consumption of a good that the consumer does not take into account

Affects the Marginal Benefit of consumption, meaning that the private marginal benefit is going to be greater than the social marginal benefit

Question 13

Explore the impacts of a negative consumption externality?

Answer 13

If there is no production externality, PMC stays the same

One of the most common examples is cigarettes

In this case, the market is operating inefficiently, producing too much and creating a DWL

Question 14

Explore the impacts of a positive consumption externality

Answer 14

In this case, the market is operating inefficiently by not producing enough

Question 15

What are some private solutions to externalities?

Answer 15

Moral Sanctions – not necessarily a rule, but a social judgement that encourages people to act
Consider littering or mask-wearing

Charities – help to assist with the negative externalities of issues such as poverty and ecosystem degradation

Vertical Integration – you may see some companies subsume parts of the production process to minimise negative externalities

Question 16

What is the Coase Theorem, and how does it attempt to solve the problem of market failure?

Answer 16

Suggests that private markets can be effective in dealing with externalities (in some circumstances)

Coase showed that if private parties can bargain, costlessly, over the allocation of resources, then an efficient outcome will be achieved without the need for government intervention

We want to encourage people to create positive externalities

For example, a cherry farmer would benefit from the pollination of having a been farmer next door

The Coase Theorem states that when there’s a social benefit (cost) parties can negotiate a price (compensation)

Question 17

What are some general rules surrounding the Coase Theorem?

Answer 17

Whatever has the highest value for the parties is the outcome that will be attained

The money flows to the person who has the right to the property

For the Coase Theorem to work, there needs to be clear property rights on who owns what, and on what its value is

Question 18

What are some of the problems with the Coase Theorem?

Answer 18

The Coase Theorem doesn’t work for problems like pollution, because no one owns the air or the ocean, and you cannot place a monetary value on its effects

Another issue with the Coase Theorem is the implication of costless bargaining

It is relatively easy for individuals to get together and bargain
It is much harder when this involves cross country negotiations or when there are multiple parties involved in the dispute

These are known as ‘transaction costs’ - the cost of doing business

Question 19

How does the government attempt to correct market failure through laws and regulations?

Answer 19

The government can enforce laws that control the production or consumption of goods with associated externalities

For example, gun laws or the ACT banning fireworks

The downside of this is a regulatory burden – the government has to pay people to deter and enforce people who buy fireworks

There are also ways that individuals/firms can find loopholes, this is known as ‘effort creep’

Benefit = socially efficient outcomes

Question 20

What is a Pigovian Tax, and how does it attempt to rectify market failure?

Answer 20

In the case of cigarettes, social marginal benefit is less than private marginal benefit – these need to be corrected

This is done via the tax, which must be the exact size of the externality

In this sense, some tax is better than no tax – it might not totally reach the SMB, but it is the second best solution

Question 21

What is a Pigovian subsidy, and how does it attempt to rectify market failure?

Answer 21

In the case of electric cars, there is positive externalities in terms of the Social Marginal Benefit (consider reduction in fuel costs in the future)

The difference between PMB and SMB leads to an underproduction of the good, this can be corrected by subsidising

As long as the size of the subsidy equals the size of the externality, we can remove the deadweight loss due to underconsumption

There is a trade-off; it does cost the government now, but consider future costs of air pollution and medical bills

Question 22

What are tradable permits, and how doe they attempt to rectify market failure?

Answer 22

Creating a market of tradable pollution permits allows the workings of the invisible hand to determine an efficient price for pollution

The Government sets the total allowable quantity of permits and the market sets the price for these scare permits

We need to find out the amount of permits – at the moment we have virtually no idea

The government does need to decide on the correct level of the pollutant allowed