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.
