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MARKET FAILURE (Part 1) ECONOMICS – A COURSE COMPANION Blink & Dorton , 2007. p135-146. MICROECONOMICS. COMMUNITY SURPLUS. When a market is in equilibrium, with no external influences and no external effects, it is said to be in a state of Pareto optimality. Pareto Optimality
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ECONOMICS – A COURSE COMPANION
Blink & Dorton, 2007. p135-146
As we can see from this graph, the market is in equilibrium. At the equilibrium price, P, and quantity, Q, community surplus is maximised. Given this supply and demand situation, there is no other combination of price and quantity on the diagram that could give a greater community surplus. Thus the market is Pareto optimal/socially efficient, and there is an optimum allocation of resources. No one could be made better off without making someone else worse off. As this graph shows the free market (theoretically) leads to an optimum allocation of resources and maximises community surplus.
The supply curve is determined by the marginal costs of production and since this is the marginal cost to the whole community, we refer to it as marginal social cost. The demand curve is determined by marginal utility (marginal benefit) and since this is marginal benefit to the whole community, it is known as marginal social benefit.
There are many reasons why markets fail.
As profits are maximised where MC=MR, Q1 will be produced at a price of P1 and the socially efficient level of output Q*, is not reached. There is therefore a loss of consumer surplus, shown by the shaded dark blue triangle , and a loss of producer surplus, shown by the shaded pale blue triangle. Thus community surplus is not maximised and we have a situation of market failure. When community surplus falls from the maximum , we say that there has been a welfare loss. This is because the units Q1-Q* are not produced, even though the marginal social benefit is greater than the marginal social cost. The welfare loss is shown by the combination of the two triangles.
Governments may try to reduce market failure
by intervening in a number of ways:
What are public goods?
Governments may try to reduce this market
failure in a number of ways:
What are Merit goods?
A merit good has two characteristics:
What are demerit goods?
A demerit good has two characteristics:
High Taxes on Demerit Goods
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