Micro - Market Failure Flashcards
25 markers
Negative externality in production
Negative externalities in production are costs to third parties as a result of the actions of producers. n a free market, individual producers only consider their private costs of production, they ignore the full social cost of their actions (the negative externality in the form of costs to third parties) due to self interest. As a result resources are allocated at the private equilibrium of P1 and
Q1 in the market instead of the social optimum p* and Q. There is an overproduction and overconsumption
in the market as Q1 si greater than Q. Furthermore the price ni the market si too low at P1 rather than p* not reflecting the full social cost of production, incentivising more consumption and thus more production making the problem worse. The end result is a misallocation of resources, allocative inefficiency where too many resources are allocated to this market than is socially desirable. This generates a welfare loss with society bearing more cost than benefit with units beyond Q* being produced.
Negative externalities in consumption
Negative externalities in consumption are costs to third parties as a result of the actions of consumers. In a free market, individual consumers only consider their private benefits in consumption; they ignore the full social benefit of their actions (the negative externality in the form of negative benefits to third parties) due to self interest. As a result resources are allocated at the private equilibrium of P1 and Q1 in the market instead of the social optimum p* and Q. There is an overconsumption and overproduction in the market as Q1 is greater than Q. The end result is a misallocation of resources, allocative inefficiency where too many resources are allocated to this market than is socially desirable. This generates a welfare loss with society bearing more cost than benefit given the units beyond Q* being produced.
Positive externalities in consumption
Positive externalities in consumption are benefits to third parties as a result of the actions of consumers. In a free market, individual consumers only consider their private benefits ni consumption; they ignore the full social benefit of their actions (the positive externality to third parties) due to self interest. As a result resources are allocated at the private equilibrium of P1 and Q1 in the market instead of the social optimum p* and Q. There is an under consumption and under production in the market as Q1 is less than Q. The end result is a misallocation of resources, allocative inefficiency where too few resources are allocated to this market than is
socially desirable. This generates awelfare loss with society losing out on units that are not produced beyond Q1 up to Q* that would have generated more benefit to society than cost.
Positive externalities in production
Positive externalities in production are benefits to third parties as a result of the actions of producers. In a free market, individual producers only consider their private costs of production. They ignore the full social cost of their actions (the positive externality to third parties) due to self interest. As a result resources are allocated at the private equilibrium of P1 and Qi ni the market instead of the social optimum P* and Q. There
is an under production and under consumption in the market as Q1 is less than Q. The end result is a misallocation of resources, allocative
inefficiency where too few resources are allocated to this market than is socially desirable. This generates a welfare loss with society losing out on units that are not produced beyond Q1 up to Q* that would have generated more benefit to society than cost.
The tragedy of the commons
Common access resources are goods over which no private ownership exists. This characteristic leads to the tragedy of the commons where individual producers exploit the resource that maximises their profit ultimately leading to a depletion of the resource. Examples include the air, sea (seafood and other minerals) and forests (timber and pulp). In a free market, individual producers only consider their private costs of production, they ignore the full social cost of their actions (the negative externality in the form of costs to third parties) due to self
interest. In this case, self interest is profit maximisation where it is in the best interest of producers
to continue to fish or cut down trees for profit and to gain resources before other producers do and deplete the resource. As a result resources are allocated at the private equilibrium of P1 and Q1 in the
market instead of the social optimum P* and Q. There is an overproduction and overconsumption in the market as Q1 is greater than Q. Furthermore the price in the market is too low at P1 rather than p*
not reflecting the full social cost of production, incentivising consumption and thus more production
making the problem worse. Third parties are future generations that lose out from this over-production and eventual resource depletion as the major source of future income has been closed. Furthermore they will not have the same access to goods developed from such resources in the future reducing their material living standards. Current generations can also lose out from lost income and unemployment. The end result is a misallocation of resources, allocative inefficiency where too many resources are allocated to this market than si socially desirable. This generates a welfare loss with society bearing more cost than benefit with units beyond Q* being produced.
Public goods analysis
Pure public goods possess 2 key characteristics; they are non-excludable and non-rival (non-diminishable). Non-excludable means that no price can be charged to exclude consumers from purchasing the good because the benefits of consuming the good cannot be confined solely to individual who has paid for it. Non-excludability is also there not being areasonable and cost effective way to charge consumers and thus exclude others from using the public good. Non-rival means that upon consumption of the public good, the supply available to others remains exactly the same. Examples include, roads, beaches, flood defenses, road signs, street lights and firework displays. Due to the existence of these characteristics, the free rider problem occurs whereby rational consumers will not contribute at all to the provision of the public good waiting instead for others to contribute to free ride off their contribution. The problem is fi every consumer acts this way; there would be no contribution towards the provision of public goods, taking away the incentive for private firms to supply them with no profit that can be made. There would end up being no supply of public goods at all in the free market, a missing market and complete market failure.
Public goods evaluation
Not all public goods are pure public goods. There can be quasi public goods which possess one but not the other characteristic of a pure public good or that sometimes possess the characteristics of a pure public good but sometimes not. Take roads for example; normally roads are both non-excludable and non-rival. There is no reasonable and cost remunerative way to charge drivers for every road they travel on and on a free flowing road, space does not diminish; there is no rivalry in consumption. However toll roads make roads excludable and during peak rush hour times when there is stand still congestion, roads become rival. In this sense roads can be said to be quasi public goods.
Technology is changing the nature of public goods in particular making it easier to exclude consumers from the consumption of public goods for example electronic road pricing, music and video streaming
services and encryption with file sharing.
Information failure
Free markets assume that information is perfect thus
consumers, producers and government
will make rational decisions that maximise their benefit. If there is information failure however, decisions will be made based on ignorance or imperfect information. For example when consumers lack perfect knowledge of just how good or bad consuming a product is for them; when effective advertising persuades consumers to consume too much of a product that isn’t very good for them and when packaging misleads or purposefully promotes incorrect information to convince consumers to buy products that are not in their best interests. The end result is consumers making irrational decisions, either under or over consuming where their total benefit is not being maximised. There are therefore either too few or too many resources being allocated to such markets causing a misallocation of resources, allocative inefficiency and market failure.
Asymmetric information
Asymmetric information occurs when information exists but is not equally
shared between two parties resulting in the consumer or producer lacking the information to make a rational, welfare maximising decision. For example consumers looking to buy second hand will not have full information over that product’s quality, information possessed purely by the seller. An irrational decision to buy might be made as a result. Another example si when going to a mechanic. The mechanic can force extra payments to be made for repairs, which perhaps are not necessary. Consumers make irrational decisions in accepting these repairs because they lack
the information over repairs
that are necessary. The end result is consumers making irrational decisions, either under or over consuming where their total benefit is not being maximised. Therefore there are either too few or too many resources being allocated to such markets causing a misallocation of resources, allocative inefficiency and market failure.
Factor immobility
If demand and supply in the market change whereby a reallocation of resources needs to take place *perhaps to increase production and quantity in the market, factor immobility can prevent this from actually taking place. Perhaps factors of production are not substitutable to move into other areas of production or perhaps unemployed labour resources lack the skills to transfer into an area of higher demand, structural unemployment. As a result production and quantity in the market may not reach the socially optimum level resulting in a misallocation of resources, allocative inefficiency and market failure.
Volatile Commodity Prices
The prices of primary commodities can be highly volatile due to very price inelastic demand and supply. PED is extremely low because there are few substitutes available, the percentage of income a price change takes is low and these goods are necessities for either consumers or producers. PES is also very low due to the large production lag involved and low stocks due to the perishable nature of some commodities.
These commodities are prone to changes in demand and supply quite frequently, especially due to changes in weather. With very price inelastic demand and supply, any shift in demand and/or supply will cause a sharp change in price, making it very difficult for producers to interpret the change in price and whether to increase or decrease production as a result. The signalling function of price becomes confusing and challenging to understand leading to potentially an over allocation of resources or under
allocation of resources in a given market with regular price fluctuations. The result could be a misallocation of resources, allocative inefficiency and market failure. Some would argue that for producers operating in markets with highly volatile prices, regular price
swings are inequitable (unfair) for producers whose livelihoods depend on such prices. For example if commodity prices suddenly fell, the incomes of commodity producers would fall immediately, harming
their own living standards and the living standards of their family. From a development point of view this impact could be substantial and a market failure in this normative way.
Monopoly Power
A monopoly exists when there is one dominant firm producing in a given industry. To have monopoly
power a firm must have a market share of at least 25%. Profit maximising monopolies would use this power to exploit consumers by charging excessively high prices (price beyond marginal cost) resulting in a deadweight loss of both consumer and producer surplus indicated by the triangle in the diagram below. Aprofit maximising monopolist would produce where MC=MR at quantity Qm and reading the price off the AR curve, Pm results. This price is much higher than the competitive price of Pc taken at allocative efficiency where demand (AR) meets supply (MC). Quantity in the market is below the social optimum at Qm rather than Qc indicating a misallocation of resources, allocative inefficiency and a welfare loss to society.
Income inequality
The price mechanism, as a non personal way of allocating resources, does not differentiate at al between needs and wants. An efficient allocation of resources is simply defined by there being no surpluses or shortages in the market, however this allocation can provide ‘too many wasted resources’ to the rich and ‘too few necessary resources’ to the poor. This is because price exclusion prevents the poor accessing staple, necessity items such as education, healthcare, public transport, food, clothing and water whereas the rich are able to buy multiple houses, cars and foreign holidays. This can, result in an over consumption of goods and services by the rich and an under consumption of goods and services by the poor resulting in a misallocation of resources, allocative inefficiency and thus market failure. The level of income inequality deemed too high is based on equity (fairness) and differs from one government to the next. In that sense, income inequality causing market failure can be argued to be a normative consideration.
