Market Failure Pt1 Flashcards
Market failure
Failure of free market to achieve an efficient allocation of resources that maximises society’s welfare
Static effiency
Efficiency at a given point in time, how much output can be produced from a given stock of resources at a given point in time, assuming constant technology
Implies that both allocative and productive efficiency are achieved
Productive efficiency, how it is achieved and how free market leads to productive efficiency
All resources are fully and efficiently utilised and the cost of producing any given level of output is minimised
Achieved when:
- Society produces at any point on the PPC
- Firms produce at any point on their LRAC curve (Firm’s POV)
- Firms produce at a scale of output levels where LRAC is at minimum (Society’s POV)
In free market:
- Firms will maximise profits by being cost efficient in pursuit of self-interest
- Firms are incentivised by profit motive to be productively efficient, to minimise wastage and keep unit cost of production as low as possible
Allocative efficiency
Society produces and consumes a combination of goods and services that maximises its welfare, achieved when goods are produced in the right quantities
Achieved when:
- Society produces at particular point that maximises its social welfare on the production possibility curve
- Sum of consumer surplus and producer surplus is maximised
- Price equals marginal cost of production, where society’s valuation of last unit of output produced and consumed is equal to opportunity cost of producing
- Marginal social benefit equals marginal social cost, where additional benefits society gets from last unit of good produced and consumed equals additional opportunity costs that society incurs from producing
In free market:
- Demand curve reflects consumers’ valuation of corns and the max prices they willing and able to pay at any quantity
- Supply curve shows additional opportunity cost to producers in terms of resources used in producing that last unit of corn and the min. price accepted by producers for selling it
- Net benefits of society refer to area under demand curve - area under supply curve
- Sum of consumer surplus and producer surplus is maximised for allocative efficiency to be achieved
Steps for explaining externalities
- Market is ___, positive/ negative production/ consumption externality occur when external benefits/ costs are enjoyed/ imposed by/ on third parties from the production/ consumption of a good or service by private firms/ individuals
- When a product is produced/ consumed, the firm/ individual’s private benefits/ costs include_____
- However, there are external benefits/ costs to this production/ consumption in _____, but these are generated for the rest of the society and are not compensated/ ignored by private firms/ consumers, causing external costs where MEC </> 0
- This creates a divergence between MPB/ MPC of _____ by private producers/ consumers and the MSC/ MSB by society as a while, where MPB/ MPC is higher/ lower
- The free-market equilibrium output of the market would be at ___ units where MPC=MPB, while socially optimal output level would be higher/ lower at ___ units where MSC=MSB
- There would be an under/over production of ___, resulting in a deadweight loss of ____
- Thus the free market output is thus allocatively inefficient`
Information failure
People have inaccurate, incomplete, uncertain or misunderstood data and hence make potentially suboptimal choices about their behaviour
1. Due to imperfect information, consumers are unaware of true private cost/ benefit arising from consuming such goods
2. Consumers overvalue/ undervalue the full cost/ benefits of goods
3. Consumers’ demand for these goods under imperfect information if left to free market forces would be lower/ higher than their demand under perfect information
4. Socially optimal level of consumption and production is at an output higher/ lower than the level with perfect information
5. Good will be over-/ under- consumed in the free market and too much/ little resources will be diverted to the consumption and production of it
6. This leads to allocative inefficiency, where it will result in a welfare loss to society represented by area ___ as the social benefits gained/ lost from consuming the units of goods is less/ more than costs of the resources that society uses to produce them incurred/ saved
Assymetric information
One party involved in a trade has more/ better information compared to another when making decisions and transactions, leading to market failure if more well-informed party in the trade utilises superior information to benefit themselves at expense of others
Adverse selection
- Incentive of sellers or buyers to conceal information from other party involved in trade
- Results in buyer unable to distinguish between products of different qualities OR seller unable to distinguish between consumers of different qualities
- Low quality products or high risk buyers crowd out high-quality products or low risk buyers, leading to even lower overall quality and lower price, repeating the cycle
- Result in good products/ consumers being under-represented while bad ones are over-represented in free market
- Long run leads to missing market where parties cannot buy or sell good even if it is beneficial for them, exacerbating extent of market failure
Moral hazard
- Economic agents will take greater risks than they normally would if costs resulting in riskier behaviours would be shifted to third parties
- Occurs when party with more superior information in transaction has both incentive and ability to shift costs onto other party
- Supposed to share given risks, but instead is increasing total size of risk as agents would take on more risks than they would, increasing social cost and use of scarce resources, leading to misallocation of resources and market failure.
Zero provision of public goods
Public goods are:
a. non-excludable:
- impossible/ costly to exclude non-payers from consuming and benefitting from the good
- no one has much incentive to pay for such goods, leading to ‘free rider’ problem
- suppliers would find it difficult to collect revenue for goods they provide
b. non rivalrous in consumption
- consumption of good by one person does not reduce amount or benefits available to others
- marginal cost of providing for and allowing additional consumer to share in usage is 0
- to achieve allocatively efficient provision, consumers should pay price equal to marginal cost
- private market with profit-maximising firms will never provide goods at price of zero, any non-zero price charged for goods that are non-rivalrous discourages some users from enjoying public good, resulting in allocative efficiency since one more person’s consumption of good costs society nothing
BOTH Results in market failure
- Goods are desirable
- Production and consumption of goods will contribute to society’s welfare
c. Non-rejectability
- inability of consumers to refuse consumption of good once it has been produced
Immobility of FOP
Occupational immobility
- Barriers to moving FOPs between different sectors of economy
- Occupation-specific skills may not be easily transferrable to other jobs
- Mismatch between what is needed by firms vs what is offered by the goods
- Demand is always changing
Geographical immobility
- Barriers to them moving from one area to another to find work (family/ money/ cost in living)
- Discourages labour from moving into areas with shortages of labour while perpetuating high unemployment rates
- Longer people remain unemployed, less likely to retain skills, reducing potential and actual income
- Waste of resources and hence market failure
Inequity vs inequality
Equity occurs when there is fairness in distribution of essential goods and services
Equality refers to differences in income/ wealth
Causes of inequitable distribution
Excessive income inequality- unequal distribution of income that is not considered to be fair and just
- Free market allocates resources based on effective demand, causes market to channel more scarce resources to providing normal and luxurious goods and services which are good-to-have but non essential due to rich’s higher ability to pay, while producing less quantities of essential goods due to lack of effective demand by lower income households
High prices of essential goods and services in free market
- People who have lower income levels are unable to afford and gain access to these goods
- Demand and supply changes may affect prices of goods and services, pricing out lower income earners who will be unable to gain access to these essential goods, reducing affordability
Representations of inequality: Lorenz curve and gini coefficient
Lorenz curve: horizontal axis indicate ranking of households in society in ascending order of income levels, vertical axis indicate cumulative share of total income going to different groups of households
45-degree line is line of perfect equality and reflects perfectly equal income distribution
Further it deviates from line of perfect equality, greater income inequality
Gini coefficient: numerical representation of income inequality in a given country, measures area in between the 45-degree line and the curve OVER area under the 45-degree line
Greater deviation of Lorenz Curve, larger the Gini coefficient and higher income inequality, ranges from 0 to 1
Causes of inequality
Wage inequality
- High demand as more productive workers can generate higher returns to company
- Low supply as workers who are more educated and skillful are more limited
Income inequality
- Those who have valuable financial assets or physical assets can yield very large non-wage incomes
- Bay be due to luck of having acquired such assets at the right time/ inheritance/ high propensity to save
Wage inequality can aggravate income inequality
- Individuals receiving low wages tend to have lesser ability to save, making it hard for them to accumulate financial and physical assets to earn non-wage incomes
- Greater wealth inequality, greater income inequality
