Market Failure

1. Market Failure AS Economics

2. Market Failure – a definition • Market failure occurs when the free market, left alone, fails to deliver an efficient allocation of resources. The result is a loss of economic and social welfare.

3. Causes of market failure • Negative externalities e.g. pollution causing the social cost to exceed the private costs • Positive externalities e.g. education causing the social benefit to exceed the private benefits • Imperfect information meaning merit goods are under-produced and demerit goods are over-produced • The private sector being unable to supply important public and quasi-public goods • Market dominance by monopolies • Immobility of factors of production causes unemployment and productive inefficiency • Equity (fairness) issues resulting in an unacceptable distribution of income and social exclusion

4. Activity 1 Which of the following would provide evidence of market failure? • shortages • unemployment • unfilled job vacancies • output occurring inside the PPF

5. Market failure and economic efficiency • MF results in productive inefficiency • Firms are not maximising output from given factor inputs • This is problematic as lost output could have been used to satisfy more needs and wants; resources are misallocated and producing goods and services not wanted by consumers – resources could have been put to better use

6. Externalities • Externalities are costs OR benefits that spill over to third parties external to a market transaction

7. Externalities Externality – positive or negative depending on costs or benefits Social costs or benefits Private Costs or Benefits

8. Activity 3 A public house is permitted to stay open all weekend over the May bank holiday. Identify one group of people not directly involved in running or visiting the pub who may: • benefit from this decision • suffer as a result of this decision

9. Negative externalities • Private costs of any action are those suffered by the individual decision maker • Social costs of any action are all the conceivable costs associated with that action • If social costs exceed private costs then a negative externality exists; the private optimum level of output is greater than the social optimum level of output – the individual or consumer does not take into account the effects of externalities into their calculations • PC/SC are usually referred to in the ‘margin’ – the costs or benefits of one extra unit of output • So, MSC = MPC + MEC

10. Positive externalities • These arise when third parties benefit from the ‘spillover’ effects of production and consumption • Education – improves skills and productivity – PB of better for employers – earn more – SB – you increase living standards of the nation • So, MSB = MPB + MEB

11. Activity 4  Identify: • three private costs a bus company may incur when operating a bus rout • two private benefits a newspaper company can gain from selling its newspapers

12. Activity 5 • Identify a benefit the other residents of a street could gain from one household holding a firework party to which they were not invited

13. Activity 6 • Identify three negative externalities which villagers may experience as a result of a bypass being built through their village

14. Negative externality S1 (MSC = MPC + MEC) • At price P and demand/supply Q, only the private costs are taken into account • If the external costs are taken into account then the supply curve would shift to the left to S1 • Price would rise from P to P1 • Equilibrium quantity would fall from Q to Q1 • The negative externality is causing over-production of Q-Q1 and the price paid is lower than it should be S (MPC) P1 price P D 0 Q1 Q Quantity

15. Positive externality • At price P and demand/supply Q, only the private benefits are taken into account • If the external benefits are taken into account then the demand curve would shift to the right to D1 • The market equilibrium would be at Price P1 and Quantity Q1 • When the market fails to operate in this way there is under-production and this is shown by the difference between Q1 and Q • Too few scarce resources are being used hence the market failure S (MPB) P1 price P D1 (MSB = MPB + MEB) D (MPB) 0 Q Q1 Quantity

16. Recap • Negative externalities lead to over-production • Positive externalities lead to under-production • MSC = MPC + MEC • MSB = MPB + MEB

17. Cheap food – at a huge price & questionsP91 - 92

18. Merit and Demerit goods • Merit goods are more beneficial for consumers than they realise – usually have positive externalities. Governments usually subsidise these so consumption does not depend on ability to pay • Left to market forces merit goods would be under-consumed and so under-produced (underprovided) • Demerit goods are more harmful for consumers than they realise – usually have negative externalities, and are over-provided

19. Activity 9 Decide whether the following are merit or demerit goods: • heroin • catalytic convertors • insurance • MOT tests • public libraries • education • legal drugs • healthcare • tobacco • vaccinations • alcohol

20. Under-provision of a merit good S (MSC) • Demand (D) is based on an underestimate of the private benefits of a merit good. • The full benefit to consumers and third parties is represented by the curve D1 • Society would gain from increasing output from Q to Q1 P1 price P D1 (MSB = MPB + MEB) D (MPB) 0 Q Q1 Quantity

21. Over-provision of a demerit good S (MSC) • Demand (D) is based on an overestimate of the private benefits of a demerit good. • The full benefit to consumers and third parties is represented by the curve D1 • A reduction in output from Q to Q1 would be a move towards a more efficient allocation of resources P price P1 D D1 0 Q1 Q Quantity