How successful are markets? Allocative efficiency and Market Failure Learning objective: - Be able to explain allocative efficiency and the conditions under which it is achieved. - Be able to explain what is meant by ‘market failure’ in terms of the inefficient use of scarce resources. - Be able to define and explain different kinds of market failure (ideally in terms of a misallocation of scarce resources). KEY TERMS Allocative efficiency Market Failure Externalities Merit goods Demerit goods public goods STARTER: Whilst music stores like HMV and Virgin have gone into decline, online music sales have grown … Use supply and demand analysis to explain what is happening to online and high street music sales. How do the changes represent an efficient use of our scarce resources? l

Key terms Markets failure – when markets fail to produce an efficient use of scarce resources, or when they produce outcomes that we believe are undesirable. Allocative efficiency – when consumer welfare is maximised (this occurs at a price where quantity supplied equals quantity demanded) d Rationing – price increases reduce quantity demanded. Signalling – price increases encourage firms/businesses to move their resources into that market. Prices also encourage businesses to produce at minimum cost to maximise profits. when quantity demanded is relatively responsive to changes in other variables.

To what extent do markets allocate resources efficiently? How do markets fail? Merit goods – good which are under consumed because we cannot accurately measure the benefits derived from their consumption (information failure). Demerit goods – goods which are over consumed because we cannot accurately measure the costs of their consumption. http://ampp3d.mirror.co.uk/2014/06/05/the-true-cost-of-smoking-in-the-uk-in-real-time/ Externalities – when there is an effect on a third party (positive or negative) resulting from the production and consumption of a good or service for which no appropriate compensation is paid or given. Factor immobility – factors of production cannot move from one use to another easily, or at all. Monopoly – when there is a sole supplier of a good or service. Public goods – those goods that have the properties of non excludability and non rivalry

To what extent do markets allocate resources efficiently? Market Failure How does obesity illustrate one way that markets fail to allocate resources efficiently? http://www.theguardian.com/lifeandstyle/2014/jun/23/truth-about-obesity-10-shocking-things-need-to-know Can you think of any examples of goods and services like this?

What are externalities and why are they an example of market failure? Outside Factors: Market Failure and Government Reasoning Learning objective: Identify the causes of Market Failure Apply a knowledge of Market failure to different situations Be able to use diagrams to explain market failure STARTER: Make a list of the costs and benefits that people experience because of air travel. http://www.bbc.co.uk/news/uk-england-london-21975462

To what extent do markets allocate resources efficiently? How do markets fail? Externalities Negative externalities: the social cost of production > the private cost Positive externalities;  the social benefit of consumption >the private benefit Imperfect information;  merit goods are under-produced while demerit goods are over-produced The private sector; in a free-markets cannot profitably supply public goods and quasi-public goods, needed to meet people’s needs and wants Market dominance by monopolies = under-production + higher prices Factor immobility  causes unemployment hence productive inefficiency Equity issues. ‘unacceptable’ distribution of income and consequent social exclusion

To what extent do markets allocate resources efficiently? How do markets fail? RESULTS Productive inefficiency: Businesses are not maximising output from given factor inputs. This is a problem because the lost output from inefficient production could have been used to satisfy more wants and needs Allocative inefficiency: Resources are misallocated and producing goods and services not wanted by consumers. This is a problem because resources can be put to a better use making products that consumers value more highly

To what extent do markets allocate resources efficiently? How do markets fail?

Are E-cigarettes an example of market failure? To what extent do markets allocate resources efficiently? Market Failure Are E-cigarettes an example of market failure? http://www.bbc.co.uk/news/health-27184630#

To what extent do markets allocate resources efficiently? Market Failure How are the deaths caused by air pollution an example of market failure? http://news.sky.com/story/1231325/air-pollution-kills-7-million-people-worldwide

To what extent do markets allocate resources efficiently? Market Failure Externalities can be negative – they impose a cost on a third party for which they are not adequately compensated. They can also be positive – they create benefits for a third party for which they do not pay. We want lower production and consumption of goods that create negative externalities. We want to increase the production and consumption of goods that create positive externalities Why is the potential energy lost from not utilising the methane emitted by cows an example of market failure? How is meat farming, in general an example of market failure? http://www.bbc.co.uk/news/science-environment-25264045 Externalities – when there is an effect on a third party resulting from the production and consumption of a good or service for which no appropriate compensation is paid. The externality creates a difference between private and social optimum outcome. Social cost = private costs + external costs. Social benefits = private benefits + external benefits

To what extent do markets allocate resources efficiently? Market Failure

To what extent do markets allocate resources efficiently? EXAMINATIONA STYLE QUESTIONS EXAMINATION STYLE QUESTIONS 1. Market Failure Explain why negative externalities arising from an increase in air transport are an example of market failure (4 marks)   Comment on why there is likely to be a market failure amongst consumers of processed red meat (6 marks) “…the division between the ‘haves’, who own houses, and the ‘have- nots’, who do not, has been one of the most prominent market failures in the UK housing market” (Extract C, lines 10 –12). In the light of this statement, evaluate the case for and the case against government intervention in the housing market in order to correct or to reduce market failures in such a market (18 marks)

To what extent do markets allocate resources efficiently? Public Goods Why is consumption of the barrier non excludable and non rival? Why might the Thames Barrier have free riders if it was left to the market mechanism to provide this good? Why would it be difficult for a firm to build the barrier and make a profit from doing so? The Thames Barrier is an example of a good with public good properties. Public goods – those goods that have non excludable and non rival consumption. Non excludability: it is not possible to stop somebody consuming this good. Non rivallry: one person’s consumption does not affect the consumption of another person. It is difficult to charge people for using public goods (free riders). This creates a disincentive for firms to produce goods with these properties.

To what extent do markets allocate resources efficiently? Public Goods Why does the BBC have public good properties? How does this explain the licence fee paid by everybody who owns a colour tv? http://marginalrevolution.com/marginalrevolution/2014/05/the-free-rider-problem-as-illustrated-by-a-japanese-fencing-video.html?utm_source=twitterfeed&utm_medium=twitter&utm_campaign=Feed%3A+marginalrevolution%2Ffeed+%28Marginal+Revolution%29

What are Externalities? What are externalities and why are they an example of market failure? What are Externalities? Costs to household e.g. Benefits to household e.g Benefits to energy producer e.g Costs to energy producer e.g. What are the external costs of producing energy with fossil fuels ?

Using supply and diagrams to illustrate market failures What are externalities and why are they an example of market failure? What are externalities and why are they an example of market failure? Using supply and diagrams to illustrate market failures Using supply and demand diagrams to illustrate market failures? Price per unit of energy S1 In the diagram, the amount of energy that would be consumed if private costs and benefits, alone, were taken into account is equal to Q with price per unit of energy P. However, if the external costs of energy production were also taken into account then supply would shift from S to S1 . Higher costs would mean that price would increase to P1 per unit and less energy would be consumer (Q1). The diagram also helps to illustrate the market failure created by the existence of external costs. The external costs mean that too much of our scarce resources are allocated to energy production and , energy is over consumed by Q – Q1, if left to market forces alone. S P1 P D Q Q1 Quantity of Energy

Positive Externalities? What are externalities and why are they an example of market failure? Positive Externalities? Besides the entertainment provided for all of us by University Challenge, what positive externalities are created by people studying up to higher education? http://publicecon.wikispaces.com/Positive+Externalities+and+Education

Using supply and diagrams to illustrate market failures What are externalities and why are they an example of market failure? What are externalities and why are they an example of market failure? Using supply and diagrams to illustrate market failures Using supply and demand diagrams to illustrate market failures? Price In the diagram, the amount of that would be consumed if private costs and benefits, alone, were taken into account is equal to Q with price equal to P. However, if the external benefits of were also taken into account then demand would increase from D to D1 . Higher demand would mean that price would increase to P1 but also that more would be consumed (Q1). The diagram also helps to illustrate the market failure created by the existence of external benefits. The external benefits mean that not enough of our scarce resources are allocated to and , is under consumed by Q – Q1, if left to market forces alone. S P1 P D1 D Q Q1 Quantity Energy

CW Merit and Demerit goods Date:…………. What are merit and demerit goods and why are they an example of market failure? CW Merit and Demerit goods Date:…………. Learning objective: Learn about merit and demerit goods. STARTER: Why, if left to our own devices, would we spend less on healthcare than we should? http://www.economicsonline.co.uk/Market_failures/Merit_goods.html

Using supply and diagrams to illustrate market failures What are externalities and why are they an example of market failure? What are merit and demerit goods and why are they an example of market failure? Using supply and diagrams to illustrate market failures Using supply and demand diagrams to illustrate market failures? However, if the full benefits of healthcare were known then demand would increase from D to D1 . Higher demand would mean that price would increase to P1 but also that more would be consumed (Q1). The diagram also helps to illustrate the market failure created by the existence of merit goods. Not enough of our scarce resources are allocated to the production of merits goods ; they are under consumed by Q – Q1, if left to market forces alone. In the diagram, the quantity of healthcare that would be consumed if we were left to our own devices would be equal to Q with price equal to P. Price per unit of healthcare S P1 P D1 D Q Q1 Quantity of healthcare

Using supply and diagrams to illustrate market failures What are externalities and why are they an example of market failure? What are merit and demerit goods and why are they an example of market failure? Using supply and diagrams to illustrate market failures Using supply and demand diagrams to illustrate market failures? Without perfect knowledge of the benefits of alcohol consumption, we consume a quantity equal to Q with price equal to P. Price per unit of alcohol The diagram also helps to illustrate the market failure created by the existence of demerit goods. To many of our scarce resources are allocated to the production of demerits goods ; they are over consumed by Q – Q1, if left to market forces alone. However, if the true benefits of alcohol consumption were known then demand could fall from D to D1 . Lower demand would mean that less would be consumed and price would fall until a new equilibrium is establised with price P1 and quantity Q1. S P P1 D D1 Q1 Q Quantity of alcohol

What is information failure and why can it result in market failure? CW Information Failure Date:…………. Learning objective: Learn about information failure. STARTER: What is a good price for these products? Why is not knowing what a good price is, a problem? What other examples can you think of, of situations where you have a lack of information?

What are merit and demerit goods and why are they an example of market failure? Key Words Market failure - when markets don’t allocate resources efficiently. Perfect information – being in possession of information that completely eliminates uncertainty in a situation. Asymmetric information - when the people on one side of an economic transaction no more than the other. Moral hazard - when people’s behaviour is less careful than it could be, either because they believe that their carelessness will not be found out, or because they are encouraged to behave carelessly.

What is information failure and why can it result in market failure? Information Failure and Market Failure How can this, and the other examples of information failure lead to market failure? What are the chances that, if you smoke, you will be killed by a smoking related illness? http://www.patient.co.uk/health/smoking-the-facts

What is information failure and why can it result in market failure? What don’t we have information about? What don’t we have information about? All of the options available in the present. The true benefits and costs of the options available. The future. There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know.

Using supply and diagrams to illustrate market failures What are externalities and why are they an example of market failure? What is information failure and why can it result in market failure? Using supply and diagrams to illustrate market failures Using supply and demand diagrams to illustrate market failures? Without perfect knowledge of the costs of smoking , we consume a quantity equal to Q with price equal to P. Price per packet Of cigarettes However, if the true costs of smoking were known then demand could fall from D to D1 . Lower demand would mean that less would be consumed and price would fall until a new equilibrium is established with price P1 and quantity Q1. The diagram also helps to illustrate the market failure created by the existence of information failure. To many of our scarce resources are allocated to the production of demerits goods ; they are over consumed by Q – Q1, if left to market forces alone. S P P1 D D1 Q1 Q Quantity of cigarettes