Explanation of the reasons for and consequences of market failures. Reflect on cost-benefit analysis. The causes of market failures Consequences of market failures Cost-benefit analysis

when firms do not produce the quantity of output that would have been produced under the conditions of perfect competition. Market failure: when firms do not produce the quantity of output that would have been produced under the conditions of perfect competition. In LR under perfect competition… Firms productively efficient & make normal profits. Consumers pay lowest possible price Produced at lowest average cost of production. Society maximises output from scarce FOP’s Changes in demand encourage firms to change industries allocatively efficient.

Market failure occurs when the quantity of output produced is either too little or too great - allocative inefficiency. too little… Quantity produced too little… under-produced under-consumed product under-produced & under-consumed more resources Society better off if more resources were used to produce the product. too great… Quantity produced too great… over-producedover-consumed product is over-produced and over-consumed. less output transferredgreaterdemand Society better off if less output produced & excess resources transferred to making other products in greater demand.

The following are causes of market failure: 1.externalities 2.public goods 3.merit and demerit goods 4.imperfect competition 5.imperfect information 6.immobility of factors of production 7.unequal distribution of income and wealth

1.Externalities costs/benefits of a transaction that affect economic agents who are not directly involved in the transaction or activity. Externalities: costs/benefits of a transaction that affect economic agents who are not directly involved in the transaction or activity. private costs private benefits. When producing goods/services, private sector only take into account private costs and private benefits. costs/benefitssociety Producers don’t take into account costs/benefits of production on society. externalities These costs/benefits are called externalities. costnegative If externality results in a cost to society - negative externality. benefitpositive If externality results in a benefit to society - positive externality. AKA: third-party effects, side effects, spill-over effects or neighbourhood effects.

Basic cost and benefit concepts : Private costs (internal costs): Private costs (internal costs): costs that the producer/consumer incurs voluntarily when they produce/purchase goods/services.

Basic cost and benefit concepts : External costs (negative externalities): External costs (negative externalities): costs of production/ consumption decision that accrue to people other than the producer/consumer.

Basic cost and benefit concepts : Social costs: Social costs: total costs borne by society. Social costs = Private costs + External costs

Basic cost and benefit concepts : Private benefits (internal benefits): Private benefits (internal benefits): accrue to consumers who purchase goods & producers that produce them.

Basic cost and benefit concepts : External benefits (positive externalities): External benefits (positive externalities): additional benefits to the community, caused by consumption or production of goods/services.

Basic cost and benefit concepts : Social benefits: Social benefits: combined benefits to producers and society. Social benefits = Private benefits + External benefits

The market for chemicals – negative externalities in production present Private costs Social costs Private benefit + external benefit = Social benefit External costs Free market equilibrium: private benefits = private costs Socially optimal equilibrium: social benefits = social costs

The market for flu vaccinations – positive externalities in consumption present Private benefits Social benefits Private costs + External Costs = Social costs External benefits Free market equilibrium: private benefits = private costs Socially optimal equilibrium: social benefits = social costs

goods provided by the government, which exhibit characteristics of non-excludability and non-rivalry in consumption. Public goods: goods provided by the government, which exhibit characteristics of non-excludability and non-rivalry in consumption. even if the good is produced for the use of one consumer, no other consumer can be prevented from consuming it. Non-excludability: even if the good is produced for the use of one consumer, no other consumer can be prevented from consuming it. if one person consumes the good, it does not prevent someone else from also consuming the good. Non-rivalry: if one person consumes the good, it does not prevent someone else from also consuming the good.

Problem - FREE RIDERS Problem - no-one else will pay as they will be able to consume the above goods free of charge – FREE RIDERS Public goods are under produced by market system -too few consumers prepared to pay Under allocation of resources to production of public goods - market fails.

goods that society feels should be consumed by its citizens because it increases the welfare of the individual person and of society as a whole. Merit goods: goods that society feels should be consumed by its citizens because it increases the welfare of the individual person and of society as a whole. Merit goods under-produced and under-consumed in free market - people underestimate value.

goods that may be harmful to society as a whole (creates negative externalities). Demerit goods: goods that may be harmful to society as a whole (creates negative externalities). Over-produced and over-consumed Private costs Social costs Social benefit

In summary… under-allocation merit goods under-allocation of resources to production of merit goods over-allocationdemerit goods over-allocation of resources to production of demerit goods

Monopoly, oligopoly and monopolistically competitive firms restrict supply to maximise their profits. Therefore resources under-allocated Productively inefficient - output not produced at lowest AC

Perfect competition - consumers & producers have perfect information to make informed production/consumption decisions. Real world of imperfect competition = asymmetric/imperfect information.

principal has more information than the agent), may use this information to benefit from the transaction. Principal–agent problem: principal has more information than the agent), may use this information to benefit from the transaction. Under these conditions… Demerit goods over-produced and over-consumed Merit goods under-produced and under-consumed

Perfect competition – FOP assumed perfectly flexible. Real world FOP NOT perfectly mobile… Capital usually fixed Governments impose controls on movement of labour between countries. Within countries, labour sometimes inflexible. SA: shortage of skilled workers; surplus of 4 million unskilled workers. Economy’s capacity to produce less than under conditions of perfect competition - allocative inefficiency, or market failure.

How do consumers indicate their preferences to producers??? Bearing this in mind, when income/wealth unevenly distributed… Too many resources used to produce output for rich Too few resources used to produce output for poor.

Now complete… Activity 1 – page 188 Activity 2 – page 193