Market Failure Flashcards
When does market failure occur
Market failure occurs when the price mechanism causes an inefficient allocation of resources and so leads to a net welfare loss. Consequently, resources are not allocated to their best or optimum use.
What are the theme 1 market failures we focus on
Externalities
Under provision of public goods
Information gaps
Define market failure
When the price mechanism causes an inefficient allocation of resources, leading to a net welfare loss.
What are externalities
Externalities are those costs or benefits which are external to an exchange. They are third party effects ignored by the price mechanism.
Externalities are also known as indirect costs and benefits, or as spillovers from production or consumption of a good or service. In effect, external costs are negative externalities and external benefits are positive externalities.
External costs are…
Negative externalities
External benefits are..
Positive externalities
Define external costs
Negative third party effects outside of a market transaction
What are external costs, when do they occur
External costs may occur in the production and the consumption of a good or service.
An example of an external cost in production is a chemical firm polluting a river with its waste. This causes an external cost to the fishing and water supply industries. Fish catches may be reduced and it may become very expensive to purify water to meet safety standards.
Be prepared to give an example in exam questions
Eg. External cost in consumption is a person smoking tobacco, polluting the air for others. The effect is to cause passive smoking, where non smokers may suffer the same illnesses as smokers.
In a free market, what costs are producers concerned with
Producers are only concerned with the private costs of production.
What are private costs of production
These are costs internal to the firm, which it pays for directly. These costs include wages for workers, rent of buildings, payment for raw materials, machinery costs, electricity, insurance, packaging and transport costs.
Private costs may also refer to the market price that a consumer pays for a good or service
Define private costs
Costs internal to a market transaction, which are therefore taken into account by the price mechanism.
How do we get social costs
By adding private costs to external costs, we obtain social costs.
This means that external costs are the difference between private costs and social costs.
The marginal private cost and marginal social cost curves often diverge, what does this indicate
indicating that external costs increase disproportionately with output. 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.
Define social costs
The sum of external costs and private costs from a market transaction.
What does the edexcel spec focus on to do with external costs
It focuses on diagrammatic analysis of external costs in production.
What does the relationship between private cost, external cost and social cost in the production of a good look like on a diagram
2 straight lines in same direction as supply curve, on graph of costs (y axis) and quantity (x axis) are drawn from a single point.
One line has a lower gradient and so falls below the other line. The lower line is the MPC (marginal private costs), the higher line are MSC (marginal social costs) and the difference between the two lines is external cost.
What are external benefits and give me an example of one in production
External benefits may occur in the production and consumption of a good or service. An example of an external benefit in production is the recycling of waste materials such as newspapers,glass and tins. It has the benefit of reducing the amount of waste disposal for landfill sites as well as re using materials for production. It helps to promote sustainable economic growth.
Give me an example of an external benefit in consumption
An external benefit in consumption is the vaccination of an individual against various diseases. It reduces the possibility of other people catching a disease who come into contact with the vaccinated individual.
Define external benefits
Positive third party effects outside of a market transaction.
Be prepared to give an example in exam
When are we only concerned with private benefits
In a free market
What are private benefits
In a free market, consumers are only concerned with the private benefits or utility from consuming a good or service.
How can we measure private benefits
Economists assume this can be measured by the price that consumers are prepared to pay for a good or service.
What may private benefits also refer to
Aside from the utility from consuming a good or service, private benefits may also refer to the revenue that a firm obtains from selling a good or service.
Define private benefits
Benefits internal to a market transaction, which are therefore taken into account by the price mechanism.
How do we obtain social benefits
By adding private benefits to external benefits, we obtain social benefits.
What are external benefits in terms of private and social benefits
External benefits are the difference between private benefits and social benefits.
The marginal private benefit and marginal social benefits curves often…
Diverge, MPB below MSB
Indicating, that external benefits increase disproportionately with output consumed.
On diagram, y axis is benefits
However, it is possible that external benefit per unit consumed will remain constant, in which case the marginal private benefit and marginal social benefit curves are drawn parallel to each other.
Note that the spec focuses on diagrammatic analysis of external benefits in consumption of goods and services.
Define social benefits
The sum of external benefits and private benefits from a market transaction
Give me some examples of external costs in production
A waste disposal firm dumping toxic waste at sea, which destroys fish life
Burning coal in power stations to create electricity, adding to global warming
Increased production of biofuels, which destroy rain forests and increase food prices
Give me some examples of external costs in consumption
Excess alcohol intake, which leads to vandalism
Increased road congestion around the expansion of Heathrow airport
Tobacco smoking, which affects passive smokers
Tell me some examples of external benefits in production
A paper and glass recycling plant, which reduces the waste for landfill sites
Construction of the London cross rail project, increasing inward investment and raising local property prices.
The use of wind turbines and tidal power to create electricity. These are renewable forms of energy, which emit less carbon emissions than fossil fuels.
Tell me some examples of external benefits in consumption
Education and training programmes, which increase human capital levels. Higher labour productivity increase profits for firms.
Improving the quality of ones garden, which increases the value of neighbouring houses
The consumption of vaccinations, which help reduce the spread of disease and so increase life expectancy for millions.
What is the supply curve for a firm equal to
The supply curve for a firm is the marginal private cost curve (MPC)
What is the market supply curve
The addition of all the MPC curves of firms in a market for a particular good or service will form the market supply curve.
What’s the demand curve for consumers equal to
The demand curve for consumers is the marginal private benefit curve (MPB)
Economists assume that it is possible to measure the benefit obtained from consuming a good by the price people are prepared to pay for it. As an individual consumes more units of a good, the marginal benefit (marginal utility) will fall.
This is why the demand curve slopes downwards from left to right.
What’s the market demand curve a sum of
The addition of all the consumers MPB curves for a particular good or service will form the market demand curve.
Define market equilibrium
Where marginal private benefit equals marginal private cost
What’s market equilibrium
Occurs at the price and output position where marginal private benefit equals marginal private cost.
What’s the social optimum equilibrium
The social optimum equilibrium level of output or price for a good or service occurs where marginal social cost, MSC, equals marginal social benefit, MSB. The social cost of producing the last unit of output equals the social benefit from consuming it.
When the social optimum is reached in a market, welfare is maximised
When social optimum is reached in a market, what is maximised
Welfare
Define social optimum
Where marginal social benefit equals marginal social cost
The free market ignores ….
Externalities
Tell me about external costs and the triangle of welfare loss
Adding external costs on to the production of a good or service, causes the supply curve of the firm to shift to the left and become the marginal social cost.
For simplicity we assumed there are no external benefits so MPB=MSB
We go to the social optimum and then to market equilibrium and draw up to the MSC curve. This triangle pointing towards the y axis is the triangle of welfare loss.
There is an excess of social costs over social benefits for the marginal output in this area.
This area of welfare loss to society shows the market has failed, since negative externalities are ignored
Tell me about external benefits and the triangle of welfare gain
The free market ignores positive externalities.
Adding external benefits on to the consumption of a good or service, causes the demand curve to shift to the right and become the marginal social benefit curve.
Assuming there are no external costs in the consumption of the good, (MPC = MSC), we find the triangle by…
Finding the market equilibrium and drawing up to toe MSB and then go to the social optimum and the triangle area facing away from the y axis is the welfare gain.
There is a welfare gain to society, the market has failed, since positive externalities are ignored
What’s an exam tip to do with finding welfare gain and loss areas on an externality diagram
Always start from the free market equilibrium position and draw a line vertically up to the MSC or MSB curve. Then find the social optimum and this makes the triangle
For a welfare loss which way will area lost point
Triangle point towards y axis
For a welfare gain, which way will triangle point
Area point away from y axis
External costs can be taken into account or ignored?
External costs can be ignored by consumers and producers when they make their economic decisions, so causing market failure.
List the consequences of ignoring external costs
Overproduction
Underpricing
Welfare loss
Concerns over the availability of resources
Concerns over pollution levels
Calls for government intervention to internalise the external costs and so correct market failure
How does ignoring external costs lead to overproduction
Since the free market level of output exceeds the social optimum level of output, overproduction occurs
How does ignoring external costs lead to underpricing
Since the free market price is below the social optimum price.
How does ignoring external costs lead to welfare loss
Since marginal social costs exceed marginal social benefits
How does ignoring external costs lead to concerns over the availability of resources for future generations
Eg. Overfishing will lead to a collapse in fish stocks, which may become unsustainable
How does ignoring external costs lead to concerns over pollution levels
Eg. Burning fossil fuels to produce energy could lead to global warming and consequent problems of climate change. Air pollution could also increase respiratory diseases and reduce life expectancy
How does ignoring external costs lead to calls for government intervention to internalise external costs and so correct market failure
This may take the form of indirect taxes and trade pollution permits
External benefits can be….
Ignored by consumers and producers making their economic decisions and so cause market failure.
What can ignoring external benefits lead to
Underproduction
Underpricing
Potential welfare gain
Concerns over the long term implications of underproduction
Calls for government intervention.
How does ignoring external benefits lead to underproduction
Underproduction since the free market level of output is less than the social optimum level of output
How does ignoring external benefits lead to underpricing
Underpricing since the free market price is below the social optimum place. (Note that society should be prepared to pay more for the goods or services to take account for external benefits)
How does ignoring external benefits lead to potential welfare gain
Since marginal social benefits exceed marginal social costs
How does ignoring external benefits lead to concerns over the long term implications of underproduction
For example, under provision of education and healthcare could lead to lower economic growth and a less competitive economy. Living standards may rise more slowly
How does ignoring external benefits lead to calls for government intervention to internalise the external benefits and so correct market failure
This may take the form of regulation, government provision and subsidies.
What are public goods
Some goods may not be produced at all through the markets, despite offering significant benefits to society. Where this occurs it is known as a MISSING MARKET and the goods are called public goods. These goods involve a large element of collective consumption: eg. National defence, flood defence systems, the criminal justice system and refuse collection
Define public goods
Those goods that have non-rivalry and non-excludability in their consumption
Public goods demonstrate characteristics of….
Non-excludability and non-rivalry
What is non excludability
Means that once a good has been produced for the benefit of one person, it is impossible to stop others from benefitting.
What is non rivalry
Means that as more people consume a good and enjoy its benefits, it does not reduce the amount available for others, in effect, it is non diminishable.
Once a public good has been provided, the cost of supplying it to an extra consumer is…
Zero.
Further examples include public firework displays, lighthouses, public beaches, public parks, drains and street lighting.
What are private goods
Private goods are the opposite of public goods. They display characteristics of rivalry and excludability in consumption. The owners of private goods are able to use private property rights which prevent other people from consuming them. Private goods can also be rejected, which means one has a choice over whether to consume them or not.
Define private goods
Those goods that have rivalry and excludability in their consumption.
What shouldn’t we mistake public goods for
The NHS and state educations are not public goods. Theirs is rivalry in consumption.
It is more appropriate to describe them as goods which yield external benefits, or merit goods.
What is meant by the free-rider problem
In a free market economy, public goods are under provided due to the free rider problem. Once a public good has been provided for one individual, it is automatically provided for all. The market fails because it is not possible for firms to withhold the good from those consumers who refuse to pay for it. Examples are national defence and street pavements.
The rational consumer would wait for someone else to provide the good and then reap the rewards by consuming it for free. However, if everyone waits for others to supply a public good then it may never be provided. The non excludability characteristic means that the price mechanism cannot develop as free riders will not pay. Firms are reluctant to supply such a good in a free market as it is difficult to gain profits from it. The solution is for government to provide public goods and fund them from general taxation.
What are information gaps
Information gaps can lead to market failure due to either consumers or producers having more market knowledge than the other about a particular good or service. It means there is an unequal balance upon which to conduct economic transactions between them. A good example is the second hand car market.
Define information gaps
Where consumers, producers or the government have insufficient knowledge to make rational decisions.
How can information gaps lead to market failure
Information gaps can also lead to market failure when consumers or producers simply lack perfect knowledge about a particular good or service and so end up making non rational economic decisions. A good example is the pension market, where people tend to make too few contributions for their retirement.
When is it assumed there is symmetric information
In competitive markets, it is often assumed that consumers and producers have symmetric information when making their economic decisions - that they have access to the same information about a good or service in a market.
What will symmetric information lead to
Assuming that consumers and producers act in a rational way, symmetric information will lead to an efficient allocation of resources. This means consumers will buy a good or service from a producer offering the best deal, taking into account things like price, quality, reliability and after sales service.
Define symmetric information
Where consumers and producers have access to the same information about a good or service in the market.
What is asymmetric information
In reality, consumers and producers have asymmetric information - that is, unequal market knowledge upon which to make their economic decisions, and this could lead to a misallocation of resources.
Asymmetric information
Where consumers and producers have unequal access to information about a good or service in the market.
What is a lemon market
Producer knowledge may exceed consumer knowledge. A second hand car salesman for example, may have greater knowledge of the history of vehicles for sale as well as more technical knowledge than consumers. This could lead to a consumer paying too much for a poor quality car. The fear of buying a defective car tends to reduce the market price for all second hand cars, even the good quality ones. Consequently, the losers could be both buyers and sellers, depending on the car sold. This is known as a lemon market.
What’s the solution to a lemon market / imperfect knowledge
The solution is to have inspection schemes offered by motoring organisations such as the Automobile Association for 2nd hand car dealers. Eg inspecting cars on behalf of consumers.
What happens when consumer knowledge may exceed producer knowledge
A consumer may purchase an insurance policy, concealing information about himself or simply knowing more than the insurance company about his intended future actions. This might include having a risky lifestyle. The insurance company may then provide insurance at too low a price or insure someone who might be too risky to insure, and therefore may make a loss. This could lead to insurers exiting the market or refusing to make the payouts due. The solution is to have a watchdog body with powers to investigate and prosecute fraudulent insurance claims.
What’s an example of the government solving imperfect knowledge
Government intervention with pensions which makes it compulsory for workers to contribute to a National Insurance scheme that pays for state pensions
What are the types of market failure
There are various types, for example
Externalities
Under provision of a public good
Information gaps
Why do external costs and benefits arise
Due to third party effects in market transactions that the price mechanism ignores
External costs in production lead to…
A welfare loss triangle as the free market output equilibrium exceeds the social optimum position
External benefits in consumption lead to…
A potential welfare gain as the free market output equilibrium is less than the social optimum
What characteristics do public goods display
Non rivalry
Non excludability
In a free market public goods are…
Under-provided or not provided at all in a free market economy due to the free rider problem
Information gaps mean…
Consumers and producers may make economic decision on buying and selling goods which reduce their welfare. This can be seen in the underconsumption of healthcare, education, pensions, or the overconsumption of Tabasco, alcohol or gambling
What is symmetric information
Is where consumers and producers have equal access to market knowledge.
Asymmetric information is where consumers and producers have unequal access to market knowledge
What are social costs
Social costs are the total of private costs and external costs
What are social benefits
Social benefits are the total of private benefits and external benefits
Distinguish between the market equilibrium and social optimum positions in a market
Market equilibrium is the output position where MPB equal MPC. externalities are ignored. However, the social optimum is where MSB equal MSC.
What is the triangle of welfare loss
The welfare loss triangle is the area on an externality diagram that depicts the excess of social costs over social benefits for a given level of output.
What is the triangle of welfare gain
The welfare gain triangle is the area on an externality diagram that depicts the excess of social benefits over social costs for a given output level.
Why do external costs cause market failure
External costs cause market failure since they are ignored by the price mechanism and lead to a welfare loss. For example, a person smoking leads to passive smoking for others, who suffer but are not compensated.
Why do external benefits cause market failure
External benefits cause market failure since they are ignored by the price mechanism and lead to a loss of potential welfare. For example, a person paying for a vaccination will reduce the risk of disease for others but this benefit is not accounted for by the price mechanism and so under provision occurs.
When might a public beach cease to be a public good
On a hot day a public beach might become so overcrowded that people compete for space on the beach - there may be rivalry in consumption. A public beach might also be sold off to a property developer who restricts access to members of the public.
What is meant by the free rider problem
The free rider problem is where an individual is able to consume a good without paying for it. Consequently, there is no incentive for firms to supply the good in a free market.
Why do public goods represent a type of market failure
Public goods are a type of market failure since there would be no provision or very little provision of them in a free market. This is due to the free rider problem - where it is possible to consume the goods without paying for them. Consequently, there is no profit incentive for firms to provide them.
Why does imperfect market information lead to market failure
Imperfect market information leads to market failure because consumers and producers may make decisions on buying or selling a good which reduce their overall welfare.
