Market Failure

Question 1

Define the concept of market failure.

Answer 1

Market failure occurs when their is an inefficient allocation of resources in a market, displayed through either an underproduction or overproduction DWL.

Question 2

Identify the characteristics of an imperfectly competitive market.

Answer 2

1. Small number of firms - oligopoly or monopoly
2. Firms have market power
3. Product differentiation
4. Barriers to entry and exit

Question 3

Further elaborate on the idea of market power.

Answer 3

Market power is the ability for a business to set the market price, due to the nature of an imperfect market - small number of firms means minimal competition.

For a business to exert market power, there must be inelastic demand for its products.

Simply said, when a business has market power, it enables them to set prices above competitive levels (can be achieved by reducing quantity) because they know consumer’s have nowhere else to go.

Question 4

How does market power inflict market failure?

Answer 4

The increase in price and reduced economic output causes an underproduction DWL.

Reducing the total surplus because of the DWL, the economic welfare for society reduces.

Question 5

Explain the idea of externalities.

Answer 5

When people consume or purchase a product, they often neglect the external costs or benefits it has. The impact of these costs and benefits are felt by a by-stander.

Question 6

What are the 2 types of externalities?

Answer 6

1. Positive externality - impact on by-stander is beneficial (e.g. education).
2. Negative externality - impact on by-stander is adverse (e.g. smoking).

Question 7

How do externalities inflict market failure?

Answer 7

Externalities inflict market failure because a product’s market equilibrium does not reflect the true costs or benefits of the product in reality.

*supply curve represents cost.
*demand curve represents benefit

1. Positive externality - when consuming or producing a product, there is more than just the private benefit, there is a social benefit.

If product was sold at intersection of private benefit supply line, an underproduction DWL would form because in reality, there is a social benefit that is not being paid for.

2. Negative externality - when consuming or producing a product, there is more than just the private cost, there is a social cost.

If product was sold at intersection of private cost supply line, an overproduction DWL would form because in reality, there is a social cost that is not being paid for.

Question 8

How can the market failure of externalities be prevented?

Answer 8

To internalise (take consideration of social costs or benefits into pricing structure - market equilibrium price and quantity) externalities, government intervention is imperative, in the form of:

1. Subsidising positive externalities - government compensates for the unaccounted social benefit by reducing the amount a consumer has to pay, and paying the remainder so the producer receives the same amount.

On the graph, this shifts the private benefit demand curve to the social benefit demand curve. This increases price (which is paid for by the government), and quantity.

2. Taxing negative externalities - government compensates for the unaccounted social cost by increasing the price of the product to the price of the external cost (which the government receives as government revenue).

On the graph, this shifts the private cost supply curve to the social cost supply curve. This increases price (which margin goes to the government), and reduces quantity.