Market Failure

What is a ‘market failure’? Market failure is any situation where the allocation of resources by a free market is not efficient.

Allocative Efficiency Pareto Optimality – is when a market is in equilibrium, with no external influences and with no external effects It exists when it is impossible to make someone better off without making someone else worse off Socially efficient Social efficiency exists when community surplus is maximized

Community Surplus Is the welfare of society and it is made up of consumer surplus plus producer surplus Free market leads to an optimum allocation of resources and maximizes community surplus Supply curve is determined by the marginal costs of production (marginal social cost) Demand curve is determined by marginal utility (marginal social benefit)

Marginal Benefit (MB) the benefit a person receives from consuming one more unit of a good or service the dollar value of other goods and services that a person is willing to give up to get one more unit of it decreasing marginal benefit implies that as more of a good or service is consumed, its MB decreases

Marginal Cost (MC) the opportunity cost of producing one more unit of a good or service. the dollar value of other goods and services required to produce one more unit of the good. increasing marginal cost implies that as more of a good or service is produced, its marginal cost increases.

Consumer and Producer Surplus 20 S = MC 15 Consumer Surplus 10 Producer Surplus 5 D = MB O 5 10 15 20 Q

Efficiency and Inefficiency If MB>MC, should produce and consume more of the good.

P 20 S = MC 15 MB > MC 10 5 D = MB O 5 10 15 20 Q

Efficiency and Inefficiency If MB>MC, should produce and consume more of the good If MB<MC, should produce and consume less of the good

P 20 S = MC 15 MB < MC 10 5 D = MB O 5 10 15 20 Q

Efficiency and Inefficiency If MB>MC, should produce and consume more of the good If MB<MC, should produce and consume less of the good If MB=MC, allocative efficiency obtained

Consumer and Producer S = MC D = MB P 20 15 10 5 O 5 10 15 20 Q Consumer Surplus 10 Producer Surplus 5 D = MB O 5 10 15 20 Q

Society’s benefit & costs MB becomes MSB (marginal social benefit) MC becomes MSC (marginal social cost) MSC – ‘true’ supply curve because it shows all the costs to society

Consumer and Producer S = MC = MSC D = MB = MSB P 20 15 10 5 O 5 10 15 Consumer Surplus 10 Producer Surplus There’s no other possible combinations of price and quantity that can improve one group’s situation without hurting the other. If P > 10 consumers will be worse off; if P<10 producers will be worse off. If Q > 10 MSC > MSB; if Q < 10, some amount of community surplus will be lost. Thus max is achieved at the equilibrium (MSB = MSC) 5 D = MB = MSB O 5 10 15 20 Q

Deadweight loss from overproduction.

Deadweight loss from underproduction.

Market Failure Exists when community surplus is not maximized When markets fail, governments are often expected to intervene in order to attempt to eliminate the market failure and move towards the optimal allocation of resources

Types of Market Failure The existence of externalities Negative Externality Positive Externality Lack of public goods Common access to resources and threat to sustainability Asymmetric information Abuse of monopoly power Definition of 'Asymmetric Information' A situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Potentially, this could be a harmful situation because one party can take advantage of the other party’s lack of knowledge.

Market Failure External Costs Decision makers do not take into account the cost imposed on society and others as a result of their decision e.g. pollution, traffic congestion, environmental degradation, depletion of the ozone layer, misuse of alcohol, tobacco, anti-social behaviour, drug abuse, poor housing

External Costs Price Value of the negative externality (Welfare Loss) MSC = MPC + External Cost Price The Marginal Social Benefit curve (MSB) represents the sum of the benefits to consumers in society as a whole – the private and social benefits. The Marginal Private Cost (MPC) curve represents the costs to suppliers of producing a given output. The true cost therefore is the MSC (the MPC plus the external cost). Current output levels therefore (100) represent some element of market failure – price does not accurately reflect the true cost of production. The MPC does not take into account the cost to society of production. At an output level of 100, the private cost to the supplier is £5 per unit but the cost to society is higher than this (£12). The difference between the value of the MSB and the MSC represents the welfare loss to society of 100 units being produced. MPC £12 Value of the negative externality (Welfare Loss) Social Cost £7 £5 Socially efficient output is where MSC = MSB The slide has been designed to try to lead students through the distinction between the private costs of production and the social cost. The diagram starts out with a basic supply and demand position with price at £5 and Quantity at 100. The demand curve has been labelled MSB – a brief explanation of the concept here is useful. The supply curve is the marginal private cost – the cost to the producer. To try to link the theory to the practice it is suggested that the item in question is the production of rolls of Clingfilm! The reason is that in producing cellophane products there is an amount of air pollution. If students are told that the cost to the producer of manufacturing 100 rolls of Clingfilm is £5 (don’t forget to remind them that this figure includes the element of profit they make) but, the company do not take into consideration the cost imposed on society of the pollution they cause. This cost is then highlighted by a dashed line moving up from the bottom and is priced at £12 . The supply curve that considers the true cost (the MPC and MSC) is then drawn in and the right brace appears to indicate the extent of the social cost (£7). The welfare loss triangle is then imposed – this may need to be explained and students could be reminded of the work done on consumer surplus to help reinforce the concept of the ‘value’ here. Finally, the socially efficient output is highlighted; students can be told that there would be benefits to society if less were produced but that we would be paying more as a result! MSB 80 100 Quantity Bought and Sold

Market Failure External benefits – By-products of production and decision making that raise the welfare of a third party e.g. education and training, public transport, health education and preventative medicine, investment in housing maintenance, law and order

External Benefits Price MSC Value of the positive There can be a position where output is less than would be socially desirable (education for example?) In this case, the sum of the benefits to society is greater than the private benefit to the individual. MSC Value of the positive externality (Welfare Loss) £10 Social Benefits £6.50 Socially efficient output is where MSC = MSB £5 This slide looks at MSB MPB 100 140 Quantity Bought and Sold

Meaning of Externalities Externality is a transaction where someone other than the buyer or seller (a third party), experiences a benefit or loss as a result of the transaction. Positive externality – good side-effects Negative externality – bad side-effects When externality occurs, there’s a diff. between society’s experience and that of the individual firm or consumer

NEGATIVE EXTERNALITIES OF PRODUCTION

Negative Externality: Costs of Production External costs of production MSC > MPC

External costs in production S = MPC Costs and benefits P D = MSB O Q1 Quantity

External costs in production MSC S = MPC Costs and benefits P Q2 External cost D = MSB O Q1 Social optimum Quantity

Examples of Negative Production Externalities School and office furniture Strong chemical glues and hardeners Coal When produced, creates pollution Oil production Spills and refinery pollution Depletion of reserves

Potential Solution Negative Production Externalities Taxes Will shift the MPC curve to the left This will raise the price and reduce quantity

Advantages: Reduces the size of the externality, Compels producers & consumers to pay the costs of their transaction,Brings output down towards the optimal level Disadvantages: assessing the magnitude of the externality is extremely difficult (govt and firms hire cost-benefit analysis to determine this); determining the appropriate amount is a challenge, taxing the good may not deter pollution, only reduce it

Potential Solution Negative Production Externalities Taxes Advantages: Reduces the size of the externality Compels producers & consumers to pay the costs of their transaction Brings output down towards the optimal level Disadvantages: Assessing the magnitude of the externality is extremely difficult Determining the appropriate tax amt. is a challenge Taxing the good may not deter pollution, only reduce it

Potential Solution Negative Production Externalities Legislation and regulation Gov’t. can enact laws to deter production of products or services that cause harm to others Force cleaner production with improved technology Order firms to reduce the amount of good produced This will shift MPC to the left due to increase in cost of production Extreme course: an outright ban on the good Tradable permits It’s a system for taxing pollution levels where pollution licenses are exchageable bet. firms

Potential Solution Negative Production Externalities Tradable permits It’s a system for taxing pollution levels where pollution licenses are exchangeable between firms

POSITIVE EXTERNALITIES OF PRODUCTION

Positive Externality: Benefits of Production External benefits of production MSC < MPC

External benefits in production MPC = S Costs and benefits P D O Q1 Quantity

External benefits in production MPC = S MSC External benefit Costs and benefits P Q1 Q2 D O Social optimum Quantity

Examples of Positive Production Externalities Tree farms Oxygenate the atmosphere School in the neighborhood Improve property values Trained workers R&D by one firm can benefit others Software companies Inspire others to create new products

Potential Solution Positive Production Externalities Subsidies Lump-sum payment or as per-unit subsidy Paid by tax revenue, therefore incurs opportunity cost Can be very costly State provision of the article Ex. Gov’t could provide training; devote large public land for tree farming

External costs and benefits in production MSC MPC = S MPC = S MSC External benefit Costs and benefits (£) Costs and benefits (£) P D P D External cost O Q Q O Q Q 2 1 1 2 Quantity Quantity (a ) External costs (b) External benefits