Market Failure AS Economics Unit 1

Aims and Objectives Aim: To understand how externalities cause market failure. Objectives: Examine market failure in the US. Explain how negative and positive externalities lead to market failure. Describe government policies for correcting market failure. Analyse government policies for correcting market failure.

‘Paying for Protection’ How has market failure occurred? Which resources have not been allocated efficiently? What externalities have been generated because of this market failure? How might you correct this market failure?

Recap: Externalities & Market Failure The problem created by externalities is that too much or too little is being produced. The free market fails to produce an efficient allocation of resources.

Negative Externalities Causing Market Failure MSC = marginal social cost MPC = marginal private cost MPB = marginal private benefit MSB = marginal social benefit MEC = Marginal external costs Consider case of coal burning power station. Assume only negative externalities. Therefore MPB = MSB

Negative Externalities Causing Market Failure Because pollution is discharged during production the MSC is higher than the MPC. Power station maximises private benefit by producing Q1, where MPC=MPB. Socially optimal level of output is producing Q2 where MSC=MSB. Market forces over produce electricity by amount Q1 minus Q2. Market fails because the power station has produced too much electricity.

Positive Externalities Causing Market Failure MSC = marginal social cost MPC = marginal private cost MPB = marginal private benefit MSB = marginal social benefit MEB = Marginal external benefits Consider case of trees being planted. Assume only positive externalities. Therefore MPC = MSC

Positive Externalities Causing Market Failure Tree planting produces positive externalities and external benefits. Reduction in CO2 , water retention etc. Positive externalities like these mean the MSB is greater than the MPB. (Shown by curves). Maximise private benefit for forestry, they plant Q1 trees where MPC=MPB. However it is socially optimal at Q2 where MSC=MSB. Market fails as under production and under consumption occurs shown by Q2 minus Q1.

Team Teaching Teams Prepare to teach the diagrams and explanations to the rest of the class Use two new examples to help Every member of group must contribute Peer assessment

Property Rights Free market fails to account for external costs. May be due to not knowing who owns what? Who owns the air we breathe? The Ocean? For markets to operate efficiently there must be clear property rights. Can lead to ‘tragedy of the commons’. Over-use and abuse of common land, fish stocks etc.

Government Policy Brainstorm in your political parties, how yourself as a government may intervene to correct market failure caused by externalities.

Government Policy Use quantity controls, or regulation. Ban the externality Tax the polluter (pollution permits) Encourage positive externalities by subsidising Financially incentivising

Homework Valuing external costs and benefits is difficult and controversial. Explain two methods which are possible to use.

Plenary Define market failure. Define positive externalities. Define negative externalities. Explain how these cause market failure. Give two government policies for correcting this market failure.