Market failure Flashcards
What is a negative/positive externality?
costs/benefits to a third party that are not included in the price of the economic activity (consumption or production of a good or service)
Define private and social costs
Private costs
- any cost that a consumer or firm pays in order to buy or produce goods and services
- for producers, this includes wages, rent, raw material, capital
- the private cost to the consumer is simply the price paid by the consumer
Social costs
- the total cost to society of producing or consumer a good/service
- social cost = private cost + external cost
define private and social benefits
Private benefits
- the benefits of consuming or producing goods or services received by the economic actor (individual or firm)
Social benefits
- the benefit received by society of producing or consuming a good
Marginal benefit definition
the extra benefit to a consumer of consuming one additional unit of output
Marginal cost definition
the extra cost to the producer of producing one additional unit of output
WHY do externalities lead to market failure
- because economic actors (individuals or firms) only consider the marginal private costs or the marginal private benefits of its activities
- therefore, the good is being produced/consumed at the free market equilibrium, where MPB = MPC
- consequently, the good is being under/over -consumed, or under/over - produced
- this is because the economic actors fail to take into account the wider social costs and benefits, which may be harmful or positive for society
- therefore there is a welfare loss to society shown by the shaded area, which represents the welfare to be gained if the good were produced/consumed at the socially optimum level of output
- market failure arises due to the failure of the private decision maker to consider external costs/benefits, leading to the under/over-allocation of resources
why will the production of steel, which has negative production externalities, cause market failure?
- the cost to society is greater than the cost to the firm, because the production of steel has negatibve externalities, including emitting greenhouse gases into the atmosphere, which can then impact biodiverisity + the health impact on humans.
- MPC = cost to the producer of producing steel - private cost
- MSC = the full cost to society of producing a certain good
- therefore, the MPC needs to be shifted inwards in order to reflet the socially optimum level of output
- the good is being overproduced by Q1-Q2
- this means that there is a welfare loss, illustrated in the diagram - the cost to society of producing at the free market equilibrium
Define a public good
Public good
- a good which is both non-excludable, non-rivalrous, and non-rejectable
- non-excludable - once provided, it is impossible to stop other individuals from benefitting from this good
- non-rivalrous - the consumption of this good does not reduce the amount available for consumption for others. The marginal cost of supplying this good to an extra person is zero
- the collective supply of a pure public good for all means that it cannot be rejected by the people - e.g., national defence
- public goods would other wise be underprovided by the free makret without govt intervention.
explain the free-rider problem associated with public goods - why do public goods cause market failure
Free rider problem
- the free rider problem is where people benefit from a good without paying for it.
- there is little incentive for firms to supply public goods, because it would ultimately be unprofitable for firms, when not enough individuals would buy the good, considering that it can be consumed by others for free. Public goods are non-excludable, therefore, firms wouldn’t be able to stop other individuals who hadn’t paid from using the good. Firms would therefore make little-to-no profit
- therefore, public goods cause a market failure in that they create a missing market - the govt is forced to intervene otherwise this good will be underprovided
what are a few examples of public goods
Public good examples:
lighthouses, street lamps, national defence, policing
What is a quasi-public good?
- take some of the characteristics of public goods
- semi-non-excludable - there might be the opportunity to stop some people from enjoying this good without paying for it
- semi non-rivalrous - up to a certain point, the use of a beach by one person won’t affect its use by another - but at a certain point the beach, road will become overcrowded, and this will affect how the good can be used
Examples:
- beaches, parks, roads
Explain why public goods are an example of market failure. (10)
AO1
- define market failure - when an unregulated free market leads to a level of output that does not maximise the welfare to society, meaning that there has been a misallocation of resources
- market failures lead to a welfare loss
- define the characteristics of a public good - non-excludable and non-rivalrous +give a few examples
AO3
- non-excludable, therefore it’s not possible to prevent those who don’t pay from benefitting and consuming a good
- consequently, this good will not be supplied by the private sector, as firms that provide this good will make very little if no profit at all, people know that they don’t have to pay in order to enjoy the good
- therefore, leads to a missing market
- fail to produce goods for which the MSB would have been greater than the MSC
- or resources are not being used here where they would have been most valuable - will have been used in other less desirable sectors
Define non - excludability and non-diminishability
Non-excludability
- It is impossible to confine the consumption of this good to a certain number of people
- therefore, it is not only those who have paid for the good that get to enjoy it, but also those who haven’t paid, creating a free-rider problem
non-diminishability
- the consumption of the good by an individual will not diminish other individuals’ ability to consume the good. The marginal cost of supplying this good to an extra person is zero
Why is healthcare a merit good and not a public good
- the consumption of this good by one person decreases the consumption available for others, therefore it is diminshable/rival
- the consumption can be excludable - those who don’t pay for healthcare won’t receive it to some extent
To what extent should the government provide public goods?
(links to privatisation and public private partnerships)
see doc
