Market failure Flashcards
Define market failure
When the price mechanism causes an inefficient allocation of resources leading to a net welfare loss
Consequence of market failure
Resources are not allocated to their best or optimum use
What are the main types of market failure
- Externalities
- Under-provision of public goods
- Information gaps
Define externalities
•Costs or benefits which are external to an exchange
What are externalities also known as
- Indirect costs and benefits
* Spillovers from production or consumption from a good/service
Define external costs(negative externalities)
- Negative third-party effects that represent costs outside of the market transaction
- E.g pollution from coal extraction
Example of external costs in production
- External costs may occur in production and the consumption of a good/service
- E.g a chemical firm polluting a river with waste
- This causes an external cost to the fishing and water supply industries
- Fish catches may be reduced
- Purification of water may be very expensive to meet the European Commission’s safety standards
Example of external costs in consumption
- Smoking tobacco would pollute the air for others
* The negative third-party effect is passive smoking which may cause non-smokers to suffer the same illnesses
Define private costs
Costs internal to a market transaction which are taken into account by the price mechanism
What are private costs of production
•Costs internal to the firm which it pays for directly within a free market
Examples of private costs for firms
- Wages for workers •Payment for raw materials
- Rent of buildings •Machinery costs
- Electricity/gas costs •Insurance
- Transport costs
Private costs for consumers
•The market price that a consumer pays for a good service
Define social costs
- The sum of external costs and private costs from a market transaction
- Private costs + external costs = social costs
- (PC+EC=SC)
What does it mean if the marginal private cost and marginal social cost curves diverge
- External costs increase disproportionately with output
- (evaluation) However it is possible that external costs per unit of output remain constant
- In which case the marginal private cost and marginal social cost curves are drawn parallel to each other
Relationship between private cost, external cost and social cost in production of a good diagram
(real card 33)
Define external benefits
•Positive third-party effects and represent benefits outside of the market transaction
Examples of external benefits in production
- Recycling of waste materials(glass)
- This reduces the amount of waste disposal for landfill sites and re-using of materials for production
- This can help to promote sustainable economic growth
Examples of external benefits in consumption
- The vaccination of an individual against various diseases
* Reduces possibility of other people catching a disease who come into contact with the vaccinated individual
Define private benefits
Benefits internal to a market transaction which are taken into account by the price mechanism
Consumers and private benefits
•In a free market, consumers are only concerned with the private benefits/utility from consuming a good/service
Producers and private benefits
The revenue a firm obtains from selling a good or service
Define social benefits
•The sum of external benefits and private benefits from a market transaction
•External benefits+Private benefits=Social benefits
(EB+PB=SB)
What does it mean if the marginal private benefit(MPB) and the marginal social benefit(MSB) curves diverge
- The external benefits increase disproportionately with output consumed
- (evaluation) however it is possible that external benefit per unit consumed will remain constant
- In this case, MPB and MSB curves would be drawn parallel to each other
Relationship between private benefits, external benefits and social benefits from consuming a good diagram
(real card 33)
Production external cost examples
- Burning coal in power stations adding to global warm
* Increased production of biofuels which destroy rain forests + increase food prices
Consumption external cost examples
- Excess alcohol intake could lead to vandalism
- Expansion of Heathrow airport could lead to road congestion
- Tobacco smoking which affects passive smokers
Production external benefit examples
- Paper recycling plant reduces waste for landfill sites
- Construction of the London Crossrail project could increase inward investment and raising local property prices
- The use of renewable forms of energy to create electricity to emit less carbon emissions than fossil fuels (e.g wind turbines)
Consumption external benefit examples
- Education and training programmes could increase human capital levels
- Higher labour productivity increases profits for firms
- Consumption of vaccinations help reduce spread of disease which increase life expectancy for millions
Define market equilibrium
Where marginal private benefit equals marginal private cost
What is the supply curve for a firm
The marginal private cost curve (MPC)
What forms the market supply curve
The addition of all the MPC curves of firms in a market for a particular good or service
What is the demand curve for consumers
The marginal private benefit curve (MPB)
What do economists assume about consumer benefits
It is possible to measure the benefit obtained from consuming a good by seeing the price which people are prepared to pay for it
Why does the demand curve slope downwards from left to right
As an individual consumes more units of a good the marginal benefit falls(marginal utility)
What forms the market demand curve
The addition of all the consumers’ MPB curves for a particular good or service
Define social optimum equilibrium level of output
Where marginal social benefit equals marginal social cost
•MSB=MSC
What is the social cost of producing the last unit of output equal to
The social benefit from consuming it
When is welfare maximised
When the social optimum is reached in a market
What market ignores negative externalities
The free market
What causes the supply curve of a firm to become the marginal social cost curve
Adding external costs on to the production of a good/service, causing the supply curve of the firm shift to the left
External costs and the triangle of welfare loss diagram
(real card 35)
When is the social optimum equilibrium at price OP1 and quantity OQ1
When we assume there are no external benefits in the production of a good or service
What happens when external costs are ignored
- Underpricing
- Overproduction
- Excess of social costs over social benefits for the marginal output between Qe and Q1
What is the marginal social cost of the output slice QeQ1
QeWYQ1
•This exceeds the marginal social benefit of this output, QeXYQ1
What does the triangle XWY show
The excess of social costs over social benefits
What is the triangle of welfare loss
The area of welfare loss to society-the market has failed since negative externalities are ignored
What market ignores positive externalities
The free market
What causes the demand curve to become the marginal social benefit curve
Adding external benefits on to the consumption of a good or service causing the demand curve to shift the right
When is the social optimum equilibrium at price OP2 and quantity OQ2
When we assume there are no external costs in the consumption of the good/service in a free market
What happens when external benefits are ignored
- Underpricing
- Underproduction
- Excess of social benefits over social costs for the marginal output between Qe and Q2
- By raising output from OQe to OQ2 welfare could be increased
External benefits and triangle of welfare gain diagram
(real card 36)
What is the marginal social benefit of the output slice QeQ2
QeMTQ2 which exceeds the marginal social cost of this output, QeZTQ2
What does the triangle MTZ show
The excess of social benefits over social costs
What is the triangle of welfare gain
The area of welfare gain to society-the market has failed since positive externalities are ignored
What happens when external costs and benefits are ignored
Market failure can be caused
Impact of external costs to consumers/producers
1.Overproduction
The free market level of output exceeds the social optimum level of output causing overproduction
Impact of external costs to consumers/producers
1.Underpricing
The free market price is below the social optimum price causing underpricing
Impact of external costs to consumers/producers
1.Welfare loss
Marginal social costs exceed marginal social benefits causing welfare loss
Impact of external costs to consumers/producers
1.Concern over resource availability
E.g:
•Overfishing could lead to a collapse in fish stocks which may become unsustainable
•This would create concern over availability of resources
Impact of external costs to consumers/producers
1.Concern over pollution levels
E.g:
•burning fossil fuels to produce energy could lead to global warming or climate change
•Air pollution could reduce life expectancy
•This would create concerns over pollution levels
Impact of external costs to consumers/producers
1.Calls for government intervention
- Government intervention may be needed to internalise external costs
- This would aid in correcting market failure
- This may take the form of indirect taxes and trade pollution permits
Impact of external benefits to consumers/producers
1.Underproduction (fuugl(y)
The free market level of output is less than the social optimum level of output causing underproduction
Impact of external benefits to consumers/producers
1.Underpricing
The free market price is below the social optimum price causing underpricing
Impact of external benefits to consumers/producers
1.Potential welfare gain
Marginal social benefits exceed marginal social costs which could lead to potential welfare gain
Impact of external benefits to consumers/producers
1.Concerns over long-term implications of underproduction
E.g:
•Underprovision of education and healthcare could lead to lower economic growth
•Therefore the economy may lose competitiveness
•Living standards may rise more slowly
•This creates concerns over long-term implications of underproduction
Impact of external benefits to consumers/producers
1.Calls for government intervention
- Government intervention may be needed to internalise the external benefits to correct market failure
- This could be done through regulation, government provision and subsidies
What is a missing market
When goods are not produced at all through the markets despite offering benefits to society
Define public goods
Goods that have non-rivalry and non-excludability in their consumption
What is collective consumpton
Public goods involve a large element of collective consumption
•E.g national defence, flood defence systems
What do public goods demonstrate characteristics of
Non-excludability and Non-rivalry
Define non-excludability
Once a good has been produced for the benefit of one person it is impossible to stop others from benefitting
Define non-rivalry
- As more people consume a good and enjoy its benefits, it does not reduce the amount available for others
- So it is non-diminishable
What is the cost of supplying a public good to an extra consumer once it has been provided
Zero
Examples of public goods
- Firework displays
- Lighthouses
- Street lighting
Define private goods
Goods that have rivalry and excludability in their consumption
Define excludability
Once a good has been produced for the benefit of one person it is possible to stop others from benefitting
Define rivalry
- As more people consume a good and enjoy its benefits, it reduces the amount available for others
- So it is diminishable
Example of private goods
- A chocolate bar
* The consumption of the good directly excludes other people from consuming that particular good
How can owners of private goods prevent other people from consuming them
By using private property rights
What does it mean if private goods can be rejected
One has a choice over whether to consume them or not
Why are public goods underprovided in a free market
Due to the free rider problem
Why does the market fail due to the free-rider problem
- Once a public good has been provided for one individual it is automatically provided for all
- It is not possible for firms to withhold the good from consumers who refuse to pay for i
- This causes market failure
Examples of public goods that contribute to the free-rider problem
National defence and street pavement
What would a rational consumer do in terms of the free-rider problem
They would wait for someone else to provide the good and then obtain the rewards by consuming it for free
Disadvantages of the free-rider problem
- If everyone waits for others to supply a public good then it may never be provided
- The non-excludability part means that the price mechanism can’t develop as free-riders won’t pay
- Firms are reluctant to supply this type of good in a free market as it would be difficult to gain profits
Government solutions to the free-rider problem
The government would provide public goods and fund them from general taxation
Define information gaps
Where consumers, producers or the government have insufficient knowledge to make rational decisions
How do information gaps lead to market failure
1.Unequal balance of information
- Consumers or producers may have more market knowledge than the other about a good or service
- So there is an unequal balance of information when carrying out economic transactions between them
- This causes market failure
How do information gaps lead to market failure
2.Non-rational decisions
- Consumers or producers may lack perfect knowledge about a good or service
- This causes them to make non-rational decisions
Define symmetric information
Where consumers and producers have access to the same information about a good or service in a market
What is assumed about symmetric information
- It is assumed that consumers and producers have symmetric information when making decisions
- So they have access to the same information about a good or service in a market
How does symmetric information lead to an efficient allocation of resources
- Consumers and producers would be assumed to act rationally
- This would lead to an efficient allocation of resources
- Consumers would buy a good/service from a producer offering the best deal
Define asymmetric information
Where consumers and producers have unequal access to information about a good/service in a market
How does asymmetric information lead to an inefficient allocation of resources
- Consumers and producers would have unequal market knowledge
- This would lead to irrational economic decisions
- This would cause a misallocation of resources
Define lemon market
When the market price for all goods are reduced and the losers are both buyers and sellers
Solutions to imperfect knowledge and a misallocation of resources (when producers have more knowledge)
- Inspection schemes by motor organisations for cars
- Watchdog bodies to investigate offending practitioners who over-treat patients for higher profits
- Producer knowledge may exceed consumer knowledge
- E.g a car salesman may have more knowledge of the goods than consumers
How can imperfect knowledge lead to a misallocation of resources (when consumers have more knowledge)
- Consumer knowledge may exceed producer knowledge
- E.g a consumer may purchase an insurance company that hides important details (e.g risky lifestyle)
- The insurance company may insure someone who is too risky to insure causing a loss
What does imperfect knowledge mean
- Many people fail to make sufficient contributions to pension schemes (schemes providing income to people when they retire from work)
- This reflects the uncertainty surrounding their long-term future circumstances(quality of health)
- There is also the risk with the type of pension scheme as returns are linked to performance of the stock market
- This may lead to little provision for retirement and people ending up in poverty in old age
Solutions to imperfect knowledge and a misallocation of resources (when consumers have more knowledge)
- Watchdog bodies with powers to investigate and prosecute fraudulent insurance claims (for insurance)
- Government intervention to make it compulsory for owners to contribute to a National Insurance scheme
- This allows payments for state pensions(for pensions)
