Market Failure and Market Analysis Flashcards
Market Failure Definition A
Occurs when competitive outcome of free markets is not efficient for the whole economy
Causes of Market Failure [A]
- Externalities causing private and social costs and/or benefits to diverge
- Lack of pure public goods/merit goods
- Common Access Resources & threat to sustainability
Causes of Market Failure [B]
- Factor immobility
- Government policy failure
- Inequity – income distribution (fairness) issues.
Externalities
Incidental costs or benefits to a third party not involved in an economic activity
Determination of Externalities
Determined when a transaction occurring in a market doesn’t yield socially optimal (or allocatively efficient) outcomes
Total Social Cost
Marginal cost (supply) of providing the last unit sold
Total Social Benefit
Marginal benefit (demand) of purchasing the last unit brought
Marginal Social Benefit Calculation
Marginal Social Benefit = Marginal Private Benefit (MPC) + Marginal External Benefit (MEC)
Marginal Social Cost Calculation
Marginal Social Cost = Marginal Private Cost + Marginal External Cost (MEC)
Allocative Efficiency
Occurs when firms produce goods and services most valued by society
Efficient Allocation of Resources
Scarce resources are allocated so that consumer and producer wants and needs are met effectively
Free Market Equilibrium
A free market produces at Qprv, where MPC = MPB
Determining Allocative Effeciency
Involves comparing the cost of producing an extra unit (marginal cost) with the benefit gained from its consumption (marginal benefit).
Optimal Equilibrium
The market equilibrium where MSC = MSB at Q(Opt) and P(Opt)
MSC > MPC
Negative externality in production
MPB > MSB
Negative externality in consumption
MSB > MPB
Positive externality in consumption
MPC > MSC
Positive externality in production
Chart Type: MSC > MPC
- MSC is upleft of MPC
- Welfare loss triangle facing right between MSC and MPC
- Marginal external cost between MSC and MPC
Chart Type: MPB > MSB
- MPB is upright of MSB
- Welfare loss triangle facing right between MSB and MPB
- Marginal external cost between MSB and MPB
Chart Type: MPC > MSC
- MSC is downright of MPC
- Welfare gain triangle facing left between MPC and MSC
- Marginal external benefit between MPC and MSC
Chart Type: MSB > MPB
- MPB is down left of MSB
- Welfare gain triangle facing left between MPB and MSB
- Marginal external benefit between MPB and MSB
Supply/Demand Label: Component of Market Failure
Assume S = MPC or D = MPB at the start of your market failure analysis (if they make up the component of market failure)
Supply/Demand Label: Not a Component of Market Failure
Assume S = MSC or D = MSB if they’re not part of the market failure being discussed
MC of an extra unit < MB of consumption
Optimal to increase production from underproduction (and use additional resources for the better use)
MC of an extra unit > MB of consumption
Optimal to decrease production from overproduction (and release resources for better uses)
Positive Externalities and Optimal Production
- Private optimal amount to produce < socially optimal amount
- Loss in net benefit from underproduction
Solution to externality: internalizing the externality
Make the private cost/benefit equal the social cost/benefit of an economic activity
Issue with internalizing the externality
Can be difficult to calculate & prioritize costs vs. benefits of an activity, particularly externalities
Job Security and Externalities
Must weigh job security when reducing an externality means reducing the revenue of a firm
Subsidies
- Subsidize firm’s costs of producing good
- Will shift MPC curve to the right towards the MSC curve
Issues with Subsidies
Create taxpayer burden & appeals from non-subsidized firms
Indirect Tax
- Shifting MPC leftwards to correct for a negative production-based externality
- Useful when government knows how much to shift MPC
Issues of Indirect Tax
Optimal degree to shift MPC can be difficult to determine
Legislation
- Governments can ban/limit consumption/use of certain goods
- Creates enforcement costs and potential black market activities
Advertising & Persuasion Goal
Bring equilibrium price & quantity closer to social optimum, where MSB = MSC
Advertising & Persuasion (discouraging)
- Government dissuades consumers from product via PSAs
- Ex: cigarette ads, drinking and driving
- Opportunity costs of producing, distributing PSAs
Advertising & Persuasion (encouraging)
- Government advertises benefits of using product/service
- Ex: Advertising to promote flu vaccinations
Example: Dissuading Consumption
- Anti-cigarette PSA’s decrease Marginal Private Benefit, or demand.
- The welfare loss shrinks as the equilibrium price and quantity move closer to the social optimum
Property Rights (Coase Theorem)
- Assigning property rights can correct for an externality
- Economic externalities that previously affected a third party must be considered by parties in a transaction involving the externality
Coase Theorem is Possible If
- Property rights exist
- Small no. of parties involved
- Low transaction costs
Public Goods
- Goods available for all to consume, regardless of who pays and who doesn’t
- Exhibit non-rivalry and non-excludability
Non-rivalry (non-diminishability)
No limitations on someone’s ability to consume a good from another party consuming that good
Non-excludability
The inability to prevent others from consuming a good
Lack of Public Goods
- Market fails to provide public goods due to unwillingness to fund them
- Individual buyers for a collective product
Free Rider Problem
Parties are naturally tempted to let others pay for a good and receive the benefit of said good without paying
Solutions to Free Rider Problem
- Government provides public goods, forcing people to pay via taxes
- Finding ways to exclude non-paying parties (ex: private roads)
Public-private partnerships
Government finances establishment of a public good before allowing a private producer to operate it (and exclude non-paying parties)
Merit Goods
- Goods where social benefits exceed private benefits
- May be provided by private or public sector
- Ex: Healthcare, education, roads
Encouraging Consumption of Merit Good
- Subsidizing consumption to increase quantity demanded
- Advertising benefits of good/service to increase marginal private benefit
Demerit Goods
- Goods where private benefits exceed social benefit, leading to market failure
- Ex: Cigarettes, alcohol, gambling
Solutions to Demerit Good
Taxing, regulating or prohibiting consumption of good
Tragedy of the Commons
Absence of incentives to prevent overuse and depletion of a commonly owned resource
Common Access Resource Attributes
- Rivalrous and non-excludable
- Unable to exclude other users
- Use of a good depletes availability of good for others
Collective Self-Governance
- Communities who use resource have greatest incentive to develop roles to manage shared resources.
- No “one size fits all” approach works.
International Cooperation
Nations agree on goals to manage commonly owned resources sustainably
Problem of International Cooperation
- Assessing size of external costs (size of welfare loss triangle) difficult due to global nature of problem
- Difficult to enforce and monitor progress of other countries
Sustainable development of developing countries
- Developing countries rely on natural resources for export earnings
- Excessive natural resource use can lead to environmentally unsustainable development
Extension of Property Rights
Extension of property rights to encourage protection & management of scarce resources (Coase theorem)
Issue with Extension of Property Rights
Difficult to implement for policy makers on large scale
Carbon Taxes
- Charge levied by government on firms burning fossil fuels
- Forces firms to internalize externality by paying external cost
Problems with Carbon Taxes
Estimating amount of tax to levy for allocative efficiency can be difficult
Tradable Permits/Cap & Trade [A]
- Government licenses permitted amount of pollution in shares/permits
- Market is created for permits
Tradable Permits/Cap & Trade [B]
- Greater demand for permits makes polluting more expensive
- Forces firms to reduce pollution
- Relies on enforcement & heavy fines to gain compliance
Factor Immobility
- Resources supposed to move to places where needed most (ex: labor to highest wages)
- Immobility of factors limit socially optimum outcomes
Inequality
- Free markets can lead to significant inequality
- Ex: lack of opportunities limit education and potential income
Policy Failure
Governments placing political interests ahead of socially optimal economic outcomes
