Market Failure Flashcards
What is market failure?
When the price mechanism fails to allocate resources to the socially optimum amount. It is the non-Pareto effect - ineffective distribution in the free market.
There is allocative inefficiency where too much or too little of a good/service is provided/consumed from what is socially desirable.
What does market failure lead to?
Over production and consumption, or, under production and consumption of a good or service.
When is allocative efficiency achieved?
Allocative efficiency is a state of the economy where resources are distributed in a way that maximizes social welfare. This occurs when marginal benefit (MB), the additional satisfaction or utility gained from consuming one more unit of a good or service, is equal to marginal cost (MC), the additional cost of producing one more unit of that good or service.
Why is allocative efficiency rarely achieved?
- Market power - In monopolies or oligopolies, firms may set prices above marginal cost, leading to underproduction and allocative inefficiency because fewer consumers can afford the good at higher prices.
- Externalities: The presence of positive or negative externalities disrupts the equality of marginal benefit and marginal cost. For instance:
- Negative externalities (like pollution) mean the true social cost is higher than the private cost, leading to overproduction.
- Positive externalities (like education) mean the true social benefit is higher than the private benefit, leading to underproduction.
- Public goods: Non-excludable and non-rival goods (e.g., streetlights, national defense) are underprovided in free markets because individuals cannot be charged for their use, resulting in market failure.
- Imperfect information: Consumers or producers may lack the information needed to make decisions that align marginal benefit and marginal cost, causing inefficiency. For example, consumers may overconsumer harmful goods (like tobacco) or underconsumer beneficial ones (like vaccines).
- Strict assumptions in theory: Allocative efficiency assumes:
- Perfect competition.
- Complete information.
- No externalities.
- Rational decision-making by all participants.
These conditions are rarely met in real-world markets, leading to deviations from allocative efficiency.
What is marginal private costs (MPC)?
It refers to the costs to producers of producing one more unit of a good.
What is marginal social costs (MSC)?
It refers to the costs to society of producing one more units of a good.
What is marginal private benefits (MPC)?
It refers to the benefits to consumers from consuming one more unit of a good.
What is marginal social benefit (MSB)?
It refers to the benefits to society from consuming 1 more unit of a good.
What happens when there is an externality?
1) An externality creates a divergence between private and social costs or benefits, disrupting allocative efficiency
2) Additional benefits or additional costs affecting third parties arise, and the full benefits or full costs to society differ from the private ones. These involve marginal social benefits (MSB) that differ from marginal private benefits; or marginal social costs (MSC) that differ from the marginal private costs.
3) When this occurs, the equilibrium price and quantity determined by the intersection of the demand (MPB) curve and supply (MPC) curve is no longer a social optimum, because allocative inefficiency is introduced by social benefits or costs that differ from private ones.
4) In a diagram, social benefits appear as a marginal social benefit curve, MSB, representing the full benefits to society from the consumption of a good, and social costs as a marginal social cost curve, MSC, representing the full costs to society of producing the good. When MSB and MSC are equal to each other, there is a social optimum in which allocative efficiency is realized.
What happens if there is no externality?
1) D = MPB = MSB, and S = MPC = MSC –> Since there are no external costs or benefits, the marginal cost of production reflects the true cost to society, and the marginal benefit reflects the true benefit to society.
Allocative efficiency is achieved when the marginal benefit equals the marginal cost, maximizing social welfare.
2) No market failure - The market operates without distortions, as no third-party effects are influencing the allocation of resources.
3) Competitive markets - They can naturally achieve an efficient allocation of resources, assuming other conditions (like perfect competition and complete information) are met.
4) Social Surplus is Maximized - The total welfare, measured by the sum of consumer surplus and producer surplus, reaches its maximum.
No additional intervention (like taxes, subsidies, or regulations) is needed because the market is already functioning optimally.
5) Since the private costs and benefits align with the social costs and benefits, the market naturally achieves allocative efficiency where MPC = MSC = MPB = MSB.
Why is supply equal to marginal private costs?
What is an externality?
An externality is a benefit or loss resulting from the production or consumption of a good or service that affects a third party who is not directly involved in the economic activity, without compensation.
What is negative externality of production?
1) Negative externalities of production refer to external costs created by producers due to overproduction of a good or service. The free market over-allocates resources to the production of the good and too much of
2) It is produced relative to the social optimum. The supply curve S = MPC refers to the firm’s private cost. MSC refers to the marginal social cost curve. The vertical difference between the two represents the external cost, and since this externality only takes into account supply, the demand curve can represent both private and marginal social benefits.
3) When there exists a negative production externality, the free market overallocates resources to the production of the good and too much of it is produced relative to the social optimum.
4) This negative production externality can also lead to a welfare loss, which occurs due to the misallocation of resources. It is a loss of social benefits due to the overproduction of the good caused by the externality. The tip of the “welfare loss triangle” always lies at the optimum (faces socially optimum) quantity of the product.
5) Comparing total social benefits at the market equilibrium and at the social optimum, we find that they are smaller at the market equilibrium by the area e. This is the welfare loss.
All negative externalities of production create external costs, when MSC > MSB at the
point of production by the market.
