Section 5 - Market Failure Flashcards
Market Failure
>A market fails when the price mechanism (i.e. the forces of supply and demand) fails to allocate scarce resources efficiently and society suffers as a result.
>Market failure is a common problem and governments often intervene to try to prevent it.
What are the 2 types of market failure?
- Complete
- Partial
Complete market failure
>When there’s complete market failure, no market exists - this is called a ‘missing market’.
>National defence is an example of a missing market as there is no market which allocates national defence.
>This means that governments need to intervene and provide it.
Partial market failure
>When the market functions, but either the price or quantity supplied of the good/service is wrong, then there’s partial failure.
>The provision of health care, if left completely to market forces, is an example of partial failure.
>If health care was left to market forces, then some people wouldn’t be able to afford the treatment they needed. As a result, governments might intervene and provide free health care.
Externalities
>Externalities are the effects that producing or consuming a good/service has on people who aren’t involved in the making, buying/selling and consumption of the good/service.
>Positive or negative.
>Can occur in production or consumption.
Externalities - definition
>The external costs or benefits to a third party that isn’t involved in the making, buying/selling and consumption of a specific good/service.
Positive externalities - definition
>The external benefits to a third party.
Negative externalities - definition
>The external costs to a third party.
Why does partial market failure occur?
>A private cost is the cost of doing something to either a consumer or a firm.
>External costs are caused by externalities.
>Adding the private cost to the external cost gives the social cost.
>The social cost is the full cost borne by society of a good or service.
>A private benefit is the benefit gained by the consumer or a firm by doing something.
>External benefits are caused by externalities.
>Adding the private benefit to the external benefit gives the social benefit.
>The social benefit is the full benefit received by society from a good or service.
>Market failure occurs because in a free market the price mechanism will only take into account the private costs and benefits, but not the external costs and benefits.
Externalities diagrams
>The difference between the MPC and MSC curves is the external cost of production - the negative externalities.
>If the MPC and MSC curves are parallel then external costs per unit produced are constant.
>If the curves diverge then external costs per unit increase with output.
>The difference between the MPB and MSB curves are the external benefits - the positive externalities.
>If the MPB and MSB curves are parallel then external benefits per unit are constant. If they diverge then external benefits per unit increase with output.
>An example of when the curves might diverge is vaccination - the more people that are vaccinated, the greater the protection for unvaccinated people.
Equilibrium point on externalities diagrams
>When supply = demand in a free market, there’s an equilibrium.
>In a free market consumers and producers only consider their private costs and private benefits - they ignore any social costs or benefits. So demand curve = MPB and supply curve = MPC.
>So equilibrium is when MPB = MPC.
>However the socially optimal level of output is where MSC = MSB, because this includes the external costs and benefits to society.
Negative production externalities
>Ignoring negative externalities in production causes overproduction and underpricing of a good/service - more is produced and sold at a lower price than is desirable for society.
>For each unit of the good produced between Qm and Q*, the marginal social cost is greater than the marginal social benefit.
>The area between the MSC and MSB is the the area of welfare loss - the loss to society caused by ignoring externalities.
Positive externalities in consumption
>In the free market only private benefits are considered so positive externalities in consumption would cause underconsumption and underpricing of the good - less is consumed and sold at a lower price than is desirable for society.
>For each unit of this good consumed between Qm and Q* the MSB is greater than the MSC.
>The area between the MSB and MSC is the area of potential welfare gain - the gain to society lost by ignoring externalities.
Examples of positive consumption externalities
>Education: better educated workforce = more productive = increases country’s output. Furthermore, increasing education levels has other social benefits such as reduced crime levels and a happier population.
>Health care: healthier workforce = more productive as less time off work = increases country’s economic output. Also society as a whole will benefit if people have an improved sense of personal well-being and increased life expectancy.
Negative externalities in consumption
>In a free market only private benefits are considered so when there are negative externalities in consumption, the good is overconsumed and overpriced - more is consumed and sold at a higher price than is desirable for society.
>For each unit consumed between Qm and Q*, the marginal social cost is greater than the marginal social benefit.
>The area between the MSC and MSB is the area of welfare loss - the loss to society caused by ignoring externalities.
Positive externalities in production
>In the free market only private costs are considered so when there’s positive externalities in production, there will be underproduction and overpricing - less is produced and sold at a higher price than is desirable for society.
>For each unit consumed between Qm and Q*, the MSC is lower than the MSB.
>The area between the MSC and MSB is the area of potential welfare gain - the gain to society lost by ignoring externalities.
What else can cause negative externalities>
>A lack of property rights.
>The absence of property rights can result in production and consumption externalities, and market failure.
>E.g. a factory that emits waste water into a nearby river wouldn’t be held accountable for this pollution if no one had property rights over the river and took responsibility for it.
>Extending property rights can result in production and consumption externalities.
>E.g. a water company with propoerty rights over a river can allow, charge for, or refuse permission for others to pollute the river.
>The absence of property rights generally leads to the overuse (or misuse) of scarce resources, and environmental damage.
Merit good - definition
>A good or service which provides greater social benefits when it’s consumed than private benefits.
>Merit goods tend to be underconsumed.
Demerit good - definition
>A good or service which has greater social costs when it’s consumed than private costs.
>Demerit goods tend to be overconsumed.
Merit goods
>Merit goods are goods whose consumption is regarded as being beneficial to society. They provide benefits to both individuals and society as a whole (due to the positive externalities that result from their consumption), but people are usually unaware of the full benefits that merit goods provide.
>Examples = health care, education.
>Not all merit goods will be welcomed by all potential customers, and they can be rejected - e.g. the offer of free vaccinations may be refused.
Why do merit goods tend to be underconsumed?
- In the free market the positive externalities that merit goods provide are ignored, and production and consumption will be below the socially optimal level. E.g. producers and consumers won’t consider the wider benefits to society of a good education, such as having a more productive workforce.
- Due to imperfect information, consumers don’t always realise the full benefits that merit goods provide. E.g. people might not have enough information on how serious their health problems might be, so their demand for health care isn’t as high as it should be and health care is underprovided.
Demerit goods
>Demerit goods are goods whose consumption is regarded as being harmful to the people that consume them, but people are usually unaware (or don’t care) about the harm that demerit goods can cause. Demerit goods also have a harmful effect on society due to the negative externalities that result from their consumption.
>Examples = cigarettes, heroin.
Why do demerit goods tend to be overconsumed?
- In the free market the negative externalities that demerit goods cause are ignored, and production and consumption will be above the socially optimal level. E.g. producers and consumers won’t consider the wider disadvantages to society of cigarettes, such as smoking-related health issues putting a strain on health care services.
- Due to imperfect information, consumers don’t always realise the harm that demerit goods cause. E.g. people might not have enough info on how a harmful drug might affect their health, so their demand is higher than it should be and the drug is overprovided.
Demerit and merit goods - evaluative ideas
>Sometimes it’s hard to say which goods should be classified as merit or demerit goods. Whether a good fits into one of these classifications is usually a value judgement - based on people’s opinion and not on economic theory or facts.
>E.g. some people consider contraception a merit good, but others don’t.
>Not all goods with positive externalities are merit goods, e.g. planting flowers may have positive externalities such as providing pollen for bees or an attractive sight for passers-by, but flower seeds are unlikely to be seen as a merit good whose consumption should be encouraged for the benefit of society.
>Not all goods with negative externalities are demerit goods, e.g. driving a car can cause negative externalities (like pollution), but driving a car isn’t seen as being harmful to an individual in the way that taking a drug might be.
Market diagram - merit goods
>Merit goods generate positive externalities.
>If it’s left to the free market then price and Qd of a merit good will be at Pe and Qe respectively, where the MPB curve crosses the MPC/MSC curve. The market equilibrium is below the socially optimal level of consumption (Q1) - where MSC=MSB.
>The area ABC is the potential welfare gain lost by underconsuming/underproducing the merit good.
>To increase consumption to the socially optimal level of Q1 the gov. could introduce a subsidy to bring the price down to P2.
Market diagram - demerit goods
>Demerit goods generate negative externalities.
>If it’s left to the free market then the price and quantity demanded of a demerit good will be at Pe and Qe respectively, where the MPC/MSC and the MPB curves cross. The market equilibrium is above the socially optimal level of consumption at Q1 - where MSC = MSB.
>The area ABC is the welfare loss caused by overconsuming/overproducing the demerit good.
>To decrease consumption to the socially optimal level of Q1 the gov. could introduce a tax to bring the price up to P2.
Short-term decision making and the consumption of goods
>When individuals take a short-term approach to decision-making, it can lead to the underconsumption of merit gods and the overconsumption of demerit goods.
>People often only consider the short-term benefits or costs. Individuals can fail t see the need to make provision for the future and for potential changes in their circumstances. A good example of this is paying into an old-age pension.
>The long-term private benefits of merit goods are greater than their short-term private benefits and the long-term private costs of demerit goods are greater than their short-term private costs.
>The short-term benefits of paying towards a pension (knowledge that you are saving for your old age) are less than the benefits of receiving that pension when you retire.
>The short-term costs of buying cigarettes are much less than the long-term costs, e.g. serious smoking related illness.
Merit and demerit goods - government intervention
>The failure of the free market to supply the socially optimal levels of merit and demerit goods is the main reason why governments intervene to affect their supply.
>Governments can directly provide certain goods or services or they can use taxes and subsidies to decrease or increase consumption of certain goods or services to the socially optimal level.
>Governments have a lot of information regarding the costs and benefits of goods/services to both individuals and society as a whole, and can use this info to make decision that benefit the whole of society/
Public goods
>Public goods are goods that are consumed collectively.
>An example of a public good could be a flood defence scheme or street lighting.
>Public goods have 2 main characteristics:
1. Non-excludability.
2. Non-rivalry/non-diminishability.
>Some other examples of public goods include firework displays and lighthouses.
>Public goods are also said to be non-rejectable, e.g. you can’t choose to not be protected by the armed forces - they’ll do it anyway.
Public goods - non-excludability
>People can’t be stopped from consuming the good even if they haven’t paid for it.
Public goods - non-rivalry/non-diminishability
>One person benefitting from the good doesn’t stop others also benefiting.
>This means that public goods have zero marginal cost - there’s no additional cost to extending the good to one more person.
Public good - definition
>A good which people can’t be stopped from consuming even if they’ve not paid for it, and the consumption of which doesn’t prevent others from benefiting from it (e.g. national defence).
Quasi-public good - definition
>A good which appears to have the characteristics of a public good, but doesn’t exhibit them fully.
Private goods
>Private goods are excludable and they exhibit rivalry.
>Unlike public goods, people have a choice as to whether to consume private goods.
>Most goods are private goods.
Quasi-public goods - info
>Some goods are pure public goods, e.g. lighthouses. Others can exhibit the characteristics of a public good - but not fully. These are known as non-pure (or quasi) public goods.
>New technology can change a good that once had the characteristics of a public good into a private good.
>E.g. ‘analogue’ TV has some characteristics of a public good. However, the intervention of digital technology has meant that channels can be encrypted to ensure that if people want a certain channel, they have to pay for it.
What does the non-excludability of public goods lead to?
>The non-excludability of public goods leads to what’s called the free rider problem.
>The free rider problem means that once a public good is provided it’s impossible to stop someone from benefitting from it, even if they haven’t paid towards it.
>E.g. a firm providing street cleaning can’t stop a free rider, who has refused to pay from benefiting.
Illustrate the effects of externalities through supply and demand diagrams
The externality cost
The ‘private’ equilibrium price is Pe, Supply with externality includes external coss of generating electricity shown by the vertical distance
‘social’ equilibrium price is P2 with Q2 being the quantity of electricity bought and sold
Supply shifts right when negative external costs are added to the power station’s private costs. Forcing them to pay pollution tax = price could increase to P2
Describe the relationship between positive consumption externalities and merit goods?
Consumption by an individual produces positive externalities that benefit a wider community.
If educational services were to be provided solely by the market, it would be under-consumed and not enough people would benefit from it.
Market supply curve of education is S1 + market demand at D1 (doesn’t reflect the positive externalities enjoyed by society)
At Q1 children are educated
D2 includes the external benefits of education as well as the private benefits enjoyed by children being educated
Q1 is privately optimal level
Q2 is socially optimal level
In free market schools would not reduce price else risk losing profit. = under consumption -> under production
Describe the relationship between negative consumption externalities and demerit goods?
Diagram shows too much tobacco being consumed when bought at market prices
At market price, Q1 = P1 but because smokers generate negative consumption externalities, Q1 is higher than the socially optimal level of consumption which is Q23
Free market provision leads to over consumption
D2 is positioned below D1 because the social benefits to the whole community of smoking are less than the private benefits enjoyed by the smokers themselves
A tax per unit set equal to the vertical distance between S1 and S2 raises the price to P2 and consumption falls to the socially optimal level Q2
What are price ceilings or maximum price laws?
PRICE CEILING: The price above which it is illegal to trade. Price ceilings or maximum legal prices can distort markets by creating excess demand.
What are price floors and minimum legal prices?
PRICE FLOOR: A price below which it is illegal to trade. Price floors or minimum legal prices can distort markets by creating excess supply.
The incentive and rationing function of prices diagram
Negative Consumption Externality diagram
In the production or consumption of a good there can be negative and positive effects on third parties.
Overproduction = partial market failure
Negative Consumption = private benefit > social benefit -> external cost
MPB > MSB is because of negative external cost
e.g. chewing gum -> clearing up pavements
Private Benefit: the benefit by an individual economic unit from an activity
Social Benefit: social benefit + external benefit (positive externality)
Positive Consumption Externality diagram
The social benefits of healthier eating outweigh the private benefits
E.g. less of a burden on the healthcare service, people will stay in work more
Information failure occur
The free market will fail to allocate resources effectively. This means too little of the good or service is demanded by consumers
It is undervalued by the market mechanism
e.g. increased education of individuals -> more skilled labour force; vaccination programmes -> reduces spread of disease
Positive Production Externalities:
Externality associated with the activity of keeping bees to produce honey is pollination of surrounding crops.
Firms train their employees which results in better manpower in the economy
Firms invest in R&D and succeed in developing new technologies which benefits the society
private cost > social cost because external benefit in production process
merit good diagram
Reasons for under consumption/provision
Asymmetric information (imperfect) prevents individuals from making rational decisions and people cannot foresee the long term benefits in comparison to the short-term costs
There are significant positive externalities present
Provision of merit goods reflects a value judgement that certain products are more ‘beneficial’ than others
Paternalistic view that the individual consumer doesn’t know what’s best for them.
demerit good diagram
High caffeine energy drinks -> health implications
Violent films and games -> influence crime, trauma
Tobacco products ->
Hands-free mobile phone devices -> distractions whilst driving
Binge drinking (alcohol)
Creates negative externalities MSB < MPB
Goods which people over-consume because they don’t accurately assess the full private costs associated with consumption
Too many resources are being allocated = over production and consumption
Draw the different types of impact of indirect taxes on CB and PB (1) and explain
Draw the different types of impact of indirect taxes on CB and PB (2) and explain
Draw the different types of impact of indirect taxes on CB and PB (3) and explain
State spending on subsidy diagram
Different types of subsidy
Guaranteed price for farmers
Employment subsidy for taking on new workers
Financial ‘bail-out’ for an industry
Tax relief on investment projects
Subsidies reduce production costs
Increase in market supply and a lower price for consumers
