MARKET FAILURES Market Success: 1. is defined by MC = MB. Market Failure means either a)MC < MB (too little is produced) b) MC > MB (too much is produced) 2. occurs under conditions of PComp (S = D) if … b. MC as seen by firms includes ALL costs relevant to society. I.e. there are no negative externalities c. MB as seen by consumers includes ALL benefits relevant to society. I.e. there are no positive externalities a. there actually IS Perfect Competition: No firm has market power. d. everyone is well informed (there is “perfect information.”)

B. IMPERFECT COMPETITION 1. Monopoly: a single unregulated seller. Rare 2. Monopolistic competition: like PComp: -- many sellers -- zero LR profit due to competitive entry like monopoly: -- each firm sells a some what different (“differentiated”) product 3. Oligopoly: -- a few, large sellers MARKET TYPES A. PERFECT COMPETITION -- many price-taker firm. The market sets the price -- identical products -- easy entry/exit leads to zero profit.

THE NON-PERFECT COMPETITION PROBLEM Monopoly as Market Failure* As Algebra. Descriptormeaning …comment 1.MC = MRfirms maximize profit 2.P > MRnot PCompKnow why? 3.P > MCconsumers aren’t getting all they pay for P > MR = MC 4.MB > MCtoo little is being producedshould do the next one Start, by now, by assuming (for now) that Price indicates the MB of a good to society. I.e. a good’s worth is indicated by what someone will pay for it. * We use the term “monopoly” for simplicity. This argument applies to any firm that is not PComp, that is, most firms. We want to prove that MC < MB. That is, we want to demonstrate that monopoly* will produce less than the socially optimal (i.e. PComp) quantity

As a Graph: $/Q Q D = MB S = MC Q* P* P*, Q* are the “perfect” PComp result. MR Qm Pm Pm, Qm are the “monopoly” result. You can see: -- Qm < Q*. Too little is being produced (at too high a price) -- MC < MB MB at Qm MC at Qm

NEGATIVE EXTERNALITIES as Market Failure A negative externality exists if there is a cost to society that is not paid by the producer. That is, MSC > MPC* Descriptormeaning …comment 1.MPC = MBwe are assuming PCompThe firm only pays MPC, its cost. 2.MPC < MSCthere is another cost not being paid by the firm MSC = MPC + externality 3.MSC > MBtoo much is being producedMSC > MPC = MB Examples of negative externalities: resource pollution, noise, highway congestion. Also called: “third party costs” or “spillover costs” * “S” stands for “social”; “P” stands for “private”. MSC > MPC means that there is an external cost to society that is not a cost to the firm. We want to prove that MC > MB. That is, we want to demonstrate that, if negative externalities exist a market will will produce more than the socially optimal.

As a Graph: $/Q Q D = MB MSC Q* P* P*, Q* are the “perfect” result. MC = MB when the market internalizes ALL costs. Pm, Qm are the market result. Firms ignore external costs. You can see: -- Qm > Q*. Too much is being produced (at too low a price) -- MC > MB MB at Qm MC at Qm Qm Pm S = MPC A “solution” to the problem is to tax the firm an amount equal to the value of the externality. That way, the firm will “internalize the externality.”

POSITIVE EXTERNALITIES as Market Failure A positive externality exists if there is a benefit to society that is not received by the consumer. That is, MSB > MPB* Descriptormeaning …comment 1.MPB = MCwe are assuming PCompThe consumer only considers MPB. 2.MPB < MSBthere is a benefit not being received by the consumer MSB = MPB + externality 3.MSB > MCtoo little is being producedMSB > MPB = MC Examples of positive externalities: home improvement, vaccination and education. * “S” stands for “social”; “P” stands for “private”. MSC > MPC means that there is an external cost to society that is not a cost to the firm. We want to prove that MB > MC. That is, we want to demonstrate that, if positive externalities exist a market will will produce less than the socially optimal.

As a Graph: $/Q Q MSB S = MC Q* P* P*, Q* are the “perfect” result. MC = MB when the market internalizes ALL benefits. Pm, Qm are the market result. Consumers ignore external benefits. You can see: -- Qm < Q*. Too little is being produced. -- MC < MB MB at Qm MC at Qm Qm Pm D = MPB A “solution” to the problem is to subsidize the consumer an amount equal to the value of the externality. That way, the consumer will “internalize the externality.”