Market Failure Flashcards
What are the two microeconomic problems that require government intervention?
- Inefficiency in resource allocation: due to allocative and productive inefficiency, governments need to get markets to produce at the social optimum level.
- Inequitable distribution of income: distribution of output may not be equitable or fair.
What is market failure?
The failure of the free market to achieve an efficient allocation of resources that maximises the society’s welfare.
Allocative efficiency:
- Society producing and consuming a combination of goods and services that maximises its welfare, when goods and services are produced in the right quantities.
- 1 point on PPC curve
- Consumer and producer surplus is maximised
- Price = Marginal benefit
- Marginal social benefit = Marginal social cost
Productive efficiency:
- All resources fully and efficiently utilised and the cost of producing any given level of output is minimised.
- Any point on the PPC
- Any point on LRAC (firm’s POV)
- Produce at MES (society’s POV)
What are the reasons for market failure?
- Externalities
- Information failure
- Zero provision of public goods
- Market dominance
- Immobility of factors of production
What are externalities?
Some costs or benefits associated with the production or consumption of a good spills over to third parties (parties other than the immediate seller and buyer).
Terminologies for externalities:
MPC: costs to producers of producing one more unit of a good
MEC: costs on third parties when one more unit of good is produced
MSC: costs to society of producing one more unit of a good (MPC+MEC)
MPB: benefits to consumers of producing one more unit of a good
MEB: benefits on third parties when one more unit of a good is produced
MSB: benefits to society when one more unit of a good is produced (MPB+MEB)
What are the types of externalities?
- Negative externalities from production
- Negative externalities from consumption
- Positive externalities from production
- Positive externalities from consumption
What are negative externalities from production?
External costs imposed on third parties from the production of a good or service.
Explain negative externalities from production:
Sellers, in pursuit of self interest, will only consider their own private costs of production, ignoring the external costs. When MEC>0, there is a divergence between MPC and MSC, as MSC>MPC. Free market equilibrium output is where MPC=MPB, however, at this output level, MSC>MSB since MSB=MPB. Welfare would increase if fewer goods are produced, meaning free market equilibrium output is allocatively inefficient and results in overproduction, resulting in deadweight loss.
What are negative externalities from consumption?
External costs imposed on third parties from the consumption of a good or service.
Explain negative externalities from consumption:
Buyers, in pursuit of self interest, will only consider their own private costs of consumption, ignoring the external costs. When MEB<0, there is a divergence between MPB and MSB, as MPB>MSB. Free market equilibrium output is where MPC=MPB, however, at this output level, MSC>MSB since MSB=MPB. Welfare would increase if fewer goods are produced, meaning free market equilibrium output is allocatively inefficient and results in overproduction, resulting in deadweight loss.
What are positive externalities from production?
External benefits enjoyed by third parties from the production of a good or service
Explain positive externalities of production:
Sellers, in pursuit of self interest, will only consider their own private costs of production, ignoring the external benefits. When MEC<0, there is a divergence between MPC and MSC, as MPC>MSC. Free market equilibrium output is where MPC=MPB, however, at this output level, MSB>MSC since MSB=MPB. Welfare would increase if more goods are produced, meaning free market equilibrium output is allocatively inefficient and results in underproduction, resulting in deadweight loss.
What are positive externalities of consumption?
External benefits enjoyed by third parties from the consumption of a good or service.
Explain positive externalities of consumption:
Buyers, in pursuit of self interest, will only consider their own private costs of consumption, ignoring the external benefits. When MEB>0, there is a divergence between MPB and MSB, as MSB>MPB. Free market equilibrium output is where MPC=MPB, however, at this output level, MSB>MSC since MSB=MPB. Welfare would increase if more goods are produced, meaning free market equilibrium output is allocatively inefficient and results in underproduction, resulting in deadweight loss.
What is information failure?
People having inaccurate, incomplete, uncertain or misunderstood data and hence make potentially suboptimal choices about their behaviour, resulting in over or underconsumption of a good or service.
What are the types of information failure?
- Imperfect information
2. Asymmetric information
What is imperfect information?
Individuals not knowing the full private costs or benefits of consuming a good.
How does imperfect information result in over-allocation of resources?
Imperfect information results in people being unaware if the true private costs arising from consuming a good, thus overestimating their own private benefits and over-value the good. Demand for the good under imperfect information is higher than that under perfect information. Good will be over-consumed and the market fails to achieve allocative efficiency as too many resources are diverted to the production and consumption, which will result in a welfare loss.
Supplier induced demand through advertisements can increase demand through influencing tastes and preferences.
How does imperfect information result in under-allocation of resources?
Imperfect information results in people being unaware of the true private benefits arising from consuming a good, thus undervaluing their own private benefits and under-value the good. Demand for the good under imperfect information is lower than that under perfect information. Good will be under-consumed and the market fails to achieve allocative efficiency as too few resources are diverted to the production and consumption, which will result in a welfare loss.
What is asymmetric information?
One party involved in a trade having more or better information compared to another when making decisions and transactions.
What are the consequences of asymmetric information?
- Adverse selection
2. Moral hazard
How does asymmetric information result in adverse selection?
When seller knows more about the good than consumer, they will try to conceal information in pursuit of profits. Buyer’s will hence offer a lower price as they cannot tell good quality goods from bad quality ones. This low price discourages sellers of peaches to offer their goods for sale, giving rise to a market for lemons. The market ends up adversely selecting against the peaches.
When buyers’ know more about themselves than sellers, they conceal information in pursuit of utility. Sellers hence charge higher prices, discouraging individuals who don’t need the good as much from buying the good. The sellers are left with an adverse pool of buyers.
Good products and consumers are under-represented while bad products and consumers are over-represented and could even lead to a missing market.