Market failure Flashcards
Market Failure
Market Failure
Market failure occurs when the price mechanism fails to allocate scarce resources to achieve efficient and equitable outcomes, leading to welfare loss in society. Thus, the government has to intervene to prevent market failure.
What are externalities?
The external costs or benefits to a third part who is not involved in the production or consumption of the good or service
Negative externalities
Arise in the production or consumption of a good or service which negatively impacts a third party who is not directly involved in the the production or consumption
Explain Market Failure caused by Negative Externalities
- MPB=MPC ==> aim to maximise consumer/self satisfaction, Qm
MPBe.g: Additional benefit/satisfaction of consuming an additional unit of good
MPCe.g: Additional cost of consuming an additional unit of good - MECe.g ==> divergence of MPC and MSC (STATE WHO IS THIRD PARTY), MEC>0
Since MEC is positive, at Qm, MSC is greater than MPC since MSC=MPC + MEC
3.GRAPH //
4.MSB=MSC==>aim to maximise society’s welfare, Qs - Overconsumption==>However, since Qm>Qs: For every additional unit consumed between Qm and Qs, the marginal social cost is greater than the marginal social benefit. Hence, there is overconsumption of the good. This results in DWL, which is the potential gained if society consumes at Qs instead of Qm, the area between MSC and MSB (AEm)
- Conclusion: Thus society’s welfare is not maximised since too many resources are being allocated to the ___ market. Resources are not allocated efficiently, leading to market failure.
Draw the Negative Externalities diagram// (MP is always lower than MS)
Examples of Negative Externalities
- ext in consumption: Smoking, traffic congestion, noise (night life)
- ext in production: noise pollution, water pollution, farm animal production, oil production
Positive externalities
Arise in the production or consumption of a good or service which positively impacts a third party who are not directly involved inn the production or consumption
Explain Market Failure by Positive externality
- MPB=MPC ==> aim to maximise consumer/self satisfaction, Qm
MPBe.g: Additional benefit/satisfaction of consuming an additional unit of good
MPCe.g: Additional cost of consuming an additional unit of good - MEBe.g ==> divergence of MPB and MSB (STATE WHO IS THIRD PARTY), MEB>0
Since MEB is positive, at Qm, MSB is greater than MPB since MSV=MPB + MECB
3.GRAPH
4.MSB=MSC==>aim to maximise society’s welfare, Qs - Underconsumption==>However, since Qm is less than Qs: For every potential additional unit consumed between Qm and Qs, the marginal social benefit is greater than the marginal social cost. Hence, there is underconsumption of the good. This results in DWL, which is the potential gained if society consumes at Qs instead of Qm, the area between MSC and MSB (AEm)
- Conclusion: society’s welfare is not maximised due to resources not allocated efficiently, leading to market failure due to presence of negative externalities.
Draw the Positive Externality diagram \
Examples of Positive Externalities
+ ext in consumption: education, vaccines, electric cars, recycling
+ ext in production: farming (mangoes and bee), increased quality of airports, advertising, increased workplace safety, improved technology
What are Merit Goods
- Goods that the government deems to be good and desirable for consumers and the rest of society
- Tend to be under-consumed
- Examples: healthcare, education
Why do merit goods tend to be under-consumed?
- Postive externalities in consumption:
In the free market the positive externalities that merit goods provide are ignored, and production and consumption will be below the socially optimal level. E.g. producers and consumers won’t consider the wider benefits to society of a good education, such as having a more productive workforce. - Due to imperfect information:
Consumers don’t always realise the full benefits that merit goods provide. E.g. people might not have enough information on how serious their health problems might be, so their demand for health care isn’t as high as it should be and health care is under-provided. - Excessive income inequality - equity concerns:
Free market allocates goods and services based on dollar votes and hence, income level. Effective demand under income inequality, DD0, is lower than DD under perfect income equality, DD1⇒ Free market allocates scarce resources based on dollar vote ⇒ Produce at output where DD0=SS. Low income workers are willing to consume some essential goods & services but are unable to afford them leading to lower demand.
What are demerit Goods?
- Goods that the government deems to be harmful and undesirable for consumers and the rest of society
- Tend to be over-consumed
- Examples: cigarettes, drugs
Why do demerit goods tend to be over-consumed?
- Negative externalities in consumption:
In the free market the negative externalities that demerit goods cause are ignored, and production and consumption will be above the socially optimal level. E.g. producers and consumers won’t consider the wider disadvantages to society of cigarettes, such as smoking-related health issues putting a strain on health care services.
2.Due to imperfect information:
Consumers don’t always realise the harm that demerit goods cause. E.g. people might not have enough info on how a harmful drug might affect their health, so their demand is higher than it should be and the drug is over-provided.
Demerit and merit goods - evaluative statements
Not all goods with positive externalities are merit goods, e.g. planting flowers may have positive externalities such as providing pollen for bees or an attractive sight for passers-by, but flower seeds are unlikely to be seen as a merit good whose consumption should be encouraged for the benefit of society.
>Not all goods with negative externalities are demerit goods, e.g. driving a car can cause negative externalities (like pollution), but driving a car isn’t seen as being harmful to an individual in the way that taking a drug might be.
What are Public goods?
Goods that are non-excludable and non-rivalrous
E.g lamp posts, fireworks
Non-excludable: Impossible or very costly to exclude non-payers from consuming the good once it is provided. E.g street lights shine for all. It is impractical to allocate for lamp posts only to people who pay for it.
Non-rivalrous: Consumption of the good by an additional person does not reduce the amount available to others. E.g Additional users of street lighting do not diminish the benefit to other users. Thus, marginal cost (MC) to society of an additional user is zero.
Explain Public goods in the market
Non-excludability ⇒ Free-rider problem ⇒Everyone waits for someone to pay for lamp posts. Consumers send the wrong price signal of zero market demand ⇒ No effective demand ⇒ TR=0 ⇒ No profit-maximising firm will produce the good when TR=0 ⇒ Missing market problem
Non-rivalry ⇒ MC (of allowing an additional user to consume the good)=0⇒ Allocatively efficient at P=MC=0 ⇒ However, no firm will produce at P=0 ⇒ Allocatively inefficient for the government to allow a private firm to produce the good. Need for the government to intervene in the market for public goods to solve the missing market problem and make it available at the price of zero for the consumers. [free provision]
Information failure
caused by:
1. Imperfect information : Merit/Demerit goods
2.Different types of asymmetric information: adverse selection and moral hazard.
Define: Imperfect information
Individuals/firms lack information required to make economic decisions. In a perfectly competitive market, consumers/firms have perfect information/knowledge about prices, costs and benefits of goods and services. However, in the real world, there is ignorance and uncertainty. Thus, economic agents are unable to equate marginal benefit with marginal cost. Hence, they are unable to produce and consume at the allocative efficient price and output level. Consumers may be unaware of the TRUE COSTS AND BENEFITS of consuming a good, leading to an overconsumption or underconsumption of the good
Imperfect Information - Demerit good
Context: Cigarettes
1. Overconsumption: <– Lack of knowledge of the true costs of cigarettes. Consumers only make rational decisions based on information available. E.g their PERCEIVED cost of smoking cigarettes could be the cost of the cigarette and the opportunity cost incurred
2. ACTUAL COST: They lack information on further costs of a cigarette such as developing lung diseases and cancer in the future
3. ACTUAL COST higher than PERCEIVED COST: over-consumption of cigarettes due to UNDERESTIMATION of cost associated with consuming cigarettes
Draw Imperfect information-demerit good diagram // (no divergence)
- Explain contents of graph:
Perceived marginal private cost: MPC perceived
Actual marginal private cost: MPC actual
MPC actual > MPC perceived - MPC perceived=MPB ==> perceived consumer welfare is maximised, consume at current market output Q1.
- MPC actual=MPB ==> actual consumer welfare is maximised, consume at actual level of output Q2, which is the socially optimal level
- Overconsumption==> However, since Q1>Q2: For every additional unit consumed between Q2 and Q1, the marginal social cost is greater than the marginal social benefit. Hence, there is overconsumption of the good. This results in DWL, which is the potential gained if society consumes at Q2 instead of Q1, the area A.
- Conclusion: MF occurs since too many resources are being allocated to the market, leading to consumer welfare not being maximised. Since society’s welfare is not maximised, allocative efficiency is not achieved, this also leads to MF. Thus, government must intervene to ensure lower levels of consumptions of good.
Imperfect information - merit good
Context: Regular health check-ups
1. Underconsumption: <– Lack of knowledge of the true benefits of regular health check-ups. Consumers only make rational decisions based on information available.
2. ACTUAL Benefit: They lack information on further benefits of regular health check-ups such as earlier detection of certain illnesses could increase the chance of recovery
and extend their life expectancy in the long term.
3. ACTUAL BENEFIT higher than PERCEIVED BENEFIT: under-consumption of regular health check-ups due to UNDERESTIMATION of benefit.
Draw imperfect information - merit good diagram \ (no divergence)
- Explain contents of graph:
Perceived marginal private benefit: MPB perceived
Actual marginal private benefit: MPB actual
MPB actual > MPC perceived - MPB perceived=MPC ==> perceived consumer welfare is maximised, consume at current market output Q1.
- MPB actual=MPC ==> actual consumer welfare is maximised, consume at actual level of output Q2, which is the socially optimal level
- Underconsumption==> However, since Q1 is less than Q2: For every additional unit consumed between Q2 and Q1, the marginal social benefit is greater than the marginal socia lcost. Hence, there is underconsumption of the good. This results in DWL, which is the potential gained if society consumes at Q2 instead of Q1, the area A.
- Conclusion: MF occurs since few resources are being allocated to the market, leading to consumer welfare not being maximised. Since society’s welfare is not maximised, allocative efficiency is not achieved, this also leads to MF. Thus, government must intervene to ensure higher levels of consumptions of good.
Define: Asymmetric Information - adverse selection
Definition of Asymmetric information: A situation where economic agents involved in economic transactions do not have the same amount of knowledge. This information gaps between economic agents can result in the distortion of incentives and markets to not function efficiently.
Definition of Adverse selection: When one party knows more about a goods characteristics. When this happens, they will try to take advantage of this, and causes more undesirable parties to be attracted to the market.
Explain Adverse selection
Context: 2nd hand car market
1. Dealers have more information regarding the condition of the used cars being sold as compared to the potential buyers
2. Information such as the true mileage of the car, if the car has been met with any accidents, any defects unnoticeable by the naked eye.
3. To profit from sale of used, car dealers might have the incentives of hiding some of the information that they have about the condition of the used car from potential buyers.
4. If buyers have the information to distinguish between lemon (low quality car) and gem (high quality car) , they could strike fair trades with the respective sellers: gem owner receive high prices for good quality car while lemon-owner receives a low price for lower quality car. However, irl, there is asymmetric information
5. since buyers cannot spot the quality difference, there will only be one market for all used cars, and buyers will only be willing to pay the average of the prices of lemons and gems
6. since the average price is below the minimum that the gem-owner is willing to sell it for, gem-owners exit the market as they are unwilling to offer their goof quality cares for sale, resulting in only lower quality cars being sold (lemons).
7. Asymmetric information thus results in used cars being adversely selecting against higher quality cars and in favour of lower quality used cars. This distortion of incentives results in the inefficient market outcome, where there is a ‘missing market’, leading to market failure. Gems are pushed out of the market, leaving only lemons
LINK: Hence, consumers who would have purchased the gem cars will not enjoy consumer welfare they would have gained if they did purchase gem cars, leading to welfare not being maximised, resulting in allocative inefficiency, leading to market failure.
Define: Asymmetric information - Moral Hazard
Moral hazard is a situation in which economic agents take greater risks than they normally would because the costs that result would not be borne by the economic agents themselves.
Explain Moral Hazard
Context: Health insurance
1. Asymmetric information is due to the fact that the buyer knows more about his/her intended action than the seller, with the buyer having the tendency to engage in riskier behaviour which he otherwise would not have engaged in, which is detrimental to society
2. if an individual is not insured, then he/she is more likely to take care of his/her own health. for instance, by exercising, taking health supplements or even going for annual health check ups.
3. However, an insured individual with health insurance at full value by adding on rider payment, he would be fully covered and will not lose out in the event of hospitalisation, as he would not be required to pay both deductible and the co-payment.
4. As a result, individual has less incentive of taking care of his health and might visit hospital over minor ailments. They ay even have the incentive to seek more expensive and even riskier services that they would otherwise not require, leading to an overconsumption of resources.
5. Lessens the burden on the individual in the case of an admission to the hospital or treatment being required.
LINK: The overconsumption of healthcare services leads to an inefficient allocation of resources that could have brought greater welfare to society if enjoyed by other consumers, resulting in market failure
Define: Immobility of Factors of Production
Labour immobility: when workers are unable or unwilling to move from one job to another. This could be due to occupational immobility as a worker may lack education or skills required for the new job. It could also be due to geographical immobility where the worker is unable or unwilling to travel to the location of the new job
2 types of Labour immobility:
2. Geographical immobility
3. Occupational immobility
Reasons for occupational immobility
- Technological improvements: (occupational immobility)
Some labour-intensive jobs will become obsolete due to automation. (structural unemployment)
E.g production workers are retrenched as their assembly work jobs are replaced by machines. These workers maybe be occupationally immobile:
a. lack the skills to take up jobs available in expanding sectors like banking or may be unwilling to take up jobs like cleaning due to lower pay and poorer working conditions.
Reasons for geographical immobility
Retrenched workers living in economically depressed regions may be unable or unwilling to relocate to take up jobs in other areas which are booming.
This could be due to:
1. Poor transport and communication links which make it costly, time consuming and inconvenient for them to travel between regions, and to communicate with loved ones back home.
2. High housing prices in the boom areas may also make relocation too costly to bear.
3. Imperfect information about the jobs available at the area
Consequences of immobile FOP
==> high unemployment, decreased productive capacity. The economy is productive inefficient as it is producing inside the production possibility curve due to idle resources.
==>Underutilisation of resources: if the economy were to move from a point inside the PPC to a point on the PPC, more of both goods will be produced [DRAW PPC DIAGRAM 2 GOODS]. Society’s welfare rises as there will be higher overall output, income, consumption and hence increase material SOL. Hence, underutilisation of resources due to labour immobility results in market failure because society’s welfare is not maximised.
Market dominance
Market dominance:
1. Large market shares due to strong barriers to entry or imperfect information
2. Large market power and become price setters.
3. It exists in monopolies, oligopolies, and monopolistic competition
Explain Market Dominance
- MC=MR: (profit-maximising)
-Monopolist pursue self-interest by maximising their profit at where MC=MR
-restrict at the output (Qm) and charge a higher price at (Pm)
-inefficient allocation of resources (P>MC) at profit-maximising level, instead of the socially optimal level at P=MC - DRAW GRAPH \ )
- At the socially optimal level, P=MC, the equilibrium price and output occurs at Pe and Qe respectively, whereby DD(AR)=SS(MC). Consumer surplus is shown by areas 1+2+3 and producer surplus by areas 4+5. Total surplus is maximised at this output Qe.
- At the new level of output Qm, producer surplus is areas 2+4. Consumer surplus falls drastically to area 1. Total surplus under monopoly is areas 1+2+4. Monopolisation of the industry has resulted in a loss of surplus of areas 3+5. This is known as the deadweight welfare loss to society from the underconsumption of the good. Society’s welfare is not maximised.
5.The stronger the market dominance, the steeper and less price elastic the demand curve is, as consumers will have fewer substitute producers to purchase from. therefore the stronger the market dominance the larger the difference between the actual price charged and the marginal costs. - Productive inefficiency==as firms rarely produce at the level where AC is the lowest, where resources are utilised fully and efficiently. ==> more X-inefficient since large market power means limited competition therefore complacency in minimising costs may set in.
Effects of market dominance
- allocative inefficient
2.Possibly high productive inefficiency
3.↓ Consumer surplus - Exacerbates income disparity due to exorbitant profits of monopolist
Income inequality
In economies with high levels of inequality of income and wealth distribution (e.g. Sierra Leone) there can be people who are starving whilst others have very high levels of income and wealth.
Causes of income inequality
- Globalisation
Developed countries:Inflow of cheap foreign labour depresses wages for domestic unskilled labour to a greater extent than for skilled labour ⇒↑ income inequality
Developing countriesSome industries grow faster than others due to specialisation and international trade ⇒↑DD for workers in industries which the country specialises in ⇒ Faster ↑ in wages of workers in industries which the country specialises in compared to other workers - Different DD-SS conditions in the market for different jobs
-Could be due to strong trade unions/discrimination in which case is undesirable
-However, usually desirable as it is allocatively efficient - Monopoly power
- Unequal factor endowments for non-wage incomes (e.g. rent, interest, profits)Inequalities in access to education e.g. Private schools that have higher quality education, e.g. Tuition centres
Effects of income inequality
- Free market allocates goods and services based on dollar votes and hence, income level
- Income determines effective demand (i.e. willingness + ability to consume) which is what matters in a market based system
- High income ⇒ Higher dollar votes ⇒ Able to determine what should be produced ⇒ Profit maximising firms divert scarce resources into production of luxury goods for the rich, away from necessities for the poor⇒ Over-allocation of resources into production of luxury goods and under allocation of resources into necessities ⇒ Society’s welfare not maximised⇒ Allocative inefficiency
In the case of merit goods, the problem of allocative inefficiency becomes more acute: Ideally, all citizens should have a minimum level of healthcare/education services. However, low income workers are willing to consume some essential goods & services but are unable to afford them.
4.Effective DD under income inequality, DD0, is lower than DD under perfect income equality, DD1⇒ Free market allocates scarce resources based on dollar vote ⇒ Produce at output where DD0=SS
5.However, socially optimal output level is where DD1=SS ⇒ Under-consumption of education ⇒ Misallocation of resources as free market does not respond to the needs and wants of those that do not have the ability to pay ⇒ Allocative inefficiency ⇒ DWL
