2.4 Market Failure

Definition: Where the market mechanism fails to allocate resources efficiently Social Efficiency Allocative Efficiency Technical Efficiency Productive Efficiency

Market Failure Social Efficiency = where external costs and benefits are accounted for Allocative Efficiency = where society produces goods and services at minimum cost that are wanted by consumers Technical Efficiency = production of goods and services using the minimum amount of resources Productive Efficiency = production of goods and services at lowest factor cost

Market Failure Allocative efficiency: Also referred to as Pareto Efficient Allocation – resources cannot be readjusted to make one consumer better off without making another worse off – zero opportunity cost! After Vilfredo Pareto (1848–1923)

Market Failure Market Failure occurs where: Knowledge is not perfect - ignorance Goods are differentiated Resource immobility Market power Services/goods would or could not be provided in sufficient quantity by the market Existence of external costs and benefits Inequality exists

Market Failure Imperfect Knowledge: Consumers do not have adequate technical knowledge Advertising can mislead or mis-inform Producers unaware of all opportunities Producers cannot accurately measure productivity Decisions often based on past experience rather than future knowledge

Market Failure Goods/Services are differentiated Branding Designer labels - they cost three times as much but are they three times the quality? Technology – lack of understanding of the impact Labelling and product information Which one is the ‘quality’ item and why?

Market Failure Resource Immobility Factors are not fully mobile Labour immobility – geographical and occupational Capital immobility – what else can we use the Channel Tunnel for? Land – cannot be moved to where it might be needed, e.g. London and South East!

Market Failure Market Power: Existence of monopolies and oligopolies Collusion Price fixing Abnormal profits Rigging of markets Barriers to entry

Market Failure Inadequate Provision: Merit Goods and Public Goods Merit Goods – Could be provided by the market but consumers may not be able to afford or feel the need to purchase – market would not provide them in the quantities society needs Sports facilities?

Market Failure Merit Goods Education – nurseries, schools, colleges, universities – could all be provided by the market but would everyone be able to afford them? Schools: Would you pay if the state did not provide them?

Market Failure Public Goods Markets would not provide such goods and services at all! Non-excludability – Person paying for the benefit cannot prevent anyone else from also benefiting - the ‘free rider’ problem Non-rivalry – Large external benefits relative to cost – socially desirable but not profitable to supply! A non-excludable good? Would you pay for this?

Market Failure De-Merit Goods Goods which society over-produces Goods and services provided by the market which are not in our best interests! Tobacco and alcohol Drugs Gambling

Market Failure External Costs and Benefits External or social costs The cost of an economic decision to a third party External benefits The benefits to a third party as a result of a decision by another party

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

Externalities Private costs and benefits are costs and benefits that are borne solely by the individuals involved in the transaction. An externality is a cost or benefit that accrues to someone who is not the buyer (demander) or the seller (supplier). If externalities exist, it means that those involved in the demand and supply in the market are not considering all the costs and benefits when making their market decisions. As a result, the market fails to yield optimal results.

Externalities Externalities are the effect of a decision on a third party that is not taken into account by the decision-maker. Externalities can be either positive or negative.

Negative externalities occur when the effects of a decision not taken into account by the decision-maker are detrimental to others.

Positive externalities occur when the effects of a decision not taken into account by the decision-maker is beneficial to others.

A Negative Externality Example When there is a negative externality, marginal social cost is greater than marginal private cost. A steel plant benefits the owner of the plant and the buyers of steel. The plant’s neighbors are made worse off by the pollution caused by the plant.

A Negative Externality Example Marginal social cost includes all the marginal costs borne by society. It is the marginal private costs of production plus the cost of the negative externalities associated with that production.

A Negative Externality Example When there are negative externalities, the competitive price is too low and equilibrium quantity too high to maximize social welfare.

A Negative Externality* D = Marginal social benefit S = Marginal private cost S 1 = Marginal social cost Cost Quantity0 Q0Q0 P0P0 Q1Q1 P1P1 Marginal cost from externality

More on Externalities A positive externality may result when some of the benefits of an activity are received by consumers or firms not directly involved in the activity. A negative externality may result when some of the costs of an activity are not borne by consumers or firms not directly involved in the activity.

Social Cost Social cost: the total social cost of a transaction is the private cost plus the external cost. If all of the costs of a transaction are borne by the participants in the transaction, the private costs and the social costs are the same.

Externalities and Market Failure When there is a divergence between social costs and private costs, the result is either too much or too little production and consumption. In either case, resources are not being used in their highest-valued activity and market failure can occur.

Negative Externalities With a negative externality, the supply curve does not reflect the true cost of the good. As a result, the supply that is provided is greater than it would be if suppliers had to pay all the costs (including the external cost). S P is the supply provided, whereas S S is the supply as it would be if the suppliers had to pay the external cost.

A Positive Externality Example Private trades can benefit third parties not involved in the trade. A person who is working and taking night classes benefits himself directly, and his co-workers indirectly.

A Positive Externality Example Marginal social benefit equals the marginal private benefit of consuming a good plus the positive externalities resulting from consuming that good.

A Positive Externality Cost Quantity0 Marginal benefit of an externality D 0 = Marginal private benefit D 1 = Marginal social benefit Q0Q0 P0P0 Q1Q1 P1P1 S = Marginal private and social cost

With a positive externality, the demand curve does not reflect all the benefits of the good. As a result, the demand that is given in D P is less than it would be if demanders received all the benefits (including the external one). D S is the demand as it would be if the demanders received the external benefit. Positive Externalities

Pollution Tax One class of solutions to the externality problems involve internalizing the costs and benefits, so that the market can work better. Pollution Tax: if a firm is creating a negative externality in the form of pollution, create a tax on the polluting firm equal to the cost of cleaning up the pollution.

Regulation Through Taxation* Marginal social benefit Marginal private cost Marginal social cost Cost Quantity0 Q0Q0 P0P0 Q1Q1 P1P1 Efficient tax

Pollution Tax

Command Another approach is command—rather than imposing a tax or offering a subsidy, the government simply requires or commands the activity. For a negative externality like pollution, the government simply requires the company to stop polluting. For a positive externality, like inoculation, the government requires certain classes of citizens to be inoculated.

Marketable Pollution Permits Another approach to pollution is the introduction of marketable pollution permits. The government sells the permits, which in total allow the amount of pollution that the government believes to be acceptable. Demanders, typically firms, purchase the permits, allowing them to pollute up to the amount specified by the permits they own. If a firm is able to employ a cleaner technology, then it can enjoy additional revenues by selling its pollution rights to someone else.

Subsidy for Inoculations

Market for Pollution Permits

External Costs Price Quantity Bought and Sold MSB MPC £5 100 MSC = MPC + External Cost £12 Social Cost Value of the negative externality (Welfare Loss) £7 80 Socially efficient output is where MSC = MSB 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 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 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 difference between the value of the MSB and the MSC represents the welfare loss to society of 100 units being produced.

External Costs Price Quantity Bought and Sold MSB MPC £5 100 MSC = MPC + External Cost £12 Social Cost Value of the negative externality (Welfare Loss) £7 80 Socially efficient output is where MSC = MSB 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 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 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 difference between the value of the MSB and the MSC represents the welfare loss to society of 100 units being produced.

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, refuse collection, investment in housing maintenance, law and order

External Benefits Price Quantity Bought and Sold MPB MSC £5 100 Value of the positive externality (Welfare Loss) Socially efficient output is where MSC = MSB MSB £10 £ Social Benefits 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.

Market Failure Inequality: Poverty – absolute and relative Distribution of factor ownership Distribution of income Wealth distribution Discrimination Housing

Market Failure Measures to correct market failure State provision Extension of property rights Taxation Subsidies Regulation Prohibition Positive discrimination Redistribution of income