Market Failure Where resources are inefficiently allocated due to imperfections in the working of the market mechanism When markets do not provide us with the best outcome in terms of efficiency and fairness

Sources of Market Failure Externalities Merit and demerit Goods Public Goods Common access resources (‘tragedy of the commons’) Asymmetric Information Monopoly Power

Merit and Demerit Goods

Demerit Goods Goods that are overprovided in the market economy. The price mechanism allocates more resources to their production than is thought socially desirable Eg. Alcohol, drugs and cigarettes

Why are they overprovided? The social costs of consumption exceed the private costs (negative externalities associated with their consumption) Individuals may underestimate the private costs (imperfect information)- risk and future costs

Demerit Goods D1 D2 P1 Price S1 Q* P* Q1 Quantity

Activity Why are cigarettes considered to be demerit goods? Illustrate the negative externalities associated with the consumption of demerit goods. Fully explain your diagram Illustrate how a tax on cigarettes can reduce the market failure created by the consumption of cigarettes. Fully explain your diagram What other policies could be implemented by the government? Explain how the policy could work in theory. Explain the issues associated with the policy.

Activity ET- The Economics of Binge Drinking h/w- q1-3 Q4-6

Answers 1.Private and external costs and benefits of binge drinking 2.Factors which have led to an increase in demand for alcohol in recent year?

Tuesday 22 nd Jan 2013

Merit Goods Goods that are underprovided in a market economy. The price mechanism allocates fewer resources to their production than is thought socially desirable. Underproduced and underconsumed Classic Examples: Education and healthcare

Reasons why there are underprovided The social benefits are greater than the private benefits- the external benefits of healthcare are not considered when people choose to take medicine Individuals may underestimate the private benefits (imperfect information)- for eg. The benefit of being vaccinnated against a disease (they may not know the chances of them catching the disease) Private benefits may be discounted because benefits may be received in the future, rather than when they are paid for

Merit Goods D2 D1 P1 Price S1 Q* P* Q1 Quantity

Handout Healthcare Answer the following questions Explain how healthcare is described as a merit good What other market failures are associated with healthcare? How does the UK government try to overcome market failure associated with healthcare?

Answers 3. The Law of Diminishing Marginal Utility: As the consumption of a good increases, the total utility derived from consumption of that good rises at a diminishing rate Eg. I have 3 watches, consuming a 4 th watch would give me extra utility. If the price of the new watch is RM500, but I only gain RM 400 satisfaction, I would not buy it as it would be irrational to do so. With alcohol consumption, consumers do not conform to this rule governing rational behaviour. A 7 th pint of beer may only yield utility less than the cost of the pint, thus a rational consumer would not consume the 7 th pint (or continue beyond this point) Why? Alcohol distorts ‘rational’ decision making

Homework Due……… 1. (a) Using at least one production possibility curve diagram, explain the concepts of scarcity, choice, opportunity cost and resource allocation. [10 marks] (b) “The process of resource allocation is most efficiently carried out through the free interaction of demand and supply. This means the provision of merit goods, such as health care and education, should always be left to market forces.” Evaluate this statement. [15 marks]

Public Goods

Article and Questions 1.What is meant by the ‘free rider problem’? 2.Explain the difference between a private and a public good 3.What is meant by a quasi- public good? 4.Why are public goods considered to be a type of market failure? 5.Why does the government provide public goods? (known as state provision) 6.Why is it difficult to decide on the quantity to produce?

Public Goods Non-rivalrous- one person’s use of them does not deprive others from using them Non- excludable- if one person consumes them it is impossible to restrict others from consuming them Non- rejectable- individuals cannot abstain from their consumption even if they want to Eg. National defence, street lighting Non-excludability and Non- rejectability means no market can exist and provision must be made by the government

Evaluating State Provision Same as subsidies: May help to improve the efficiency of resource allocation (increasing consumption of merit goods and goods with positive externalities) Effectiveness of increasing consumption depends on PED (more elastic= more effective) May support inefficient firms Opportunity cost

Also… Cost of state provision v. expensive Danger of inefficient production and waste enhanced if gov. run organisations because of the lack of profit motive Governments may attempt to reduce risk of inefficiency by paying private firms to produce the service (PPPs)- controversial, reduced quality? The effectiveness of state provision in increasing consumption is likely to be limited only by the resources available

Monopoly Power

Market Failure Under Monopoly/ Imperfect Competition One firm dominates the market (monopoly) or firms collude (oligopoly) Restricting output and raising price (market power exists) Thus ‘too little’ is being produced and consumed- allocation of resources is inefficient Monopoly prices will normally be above those in competitive markets – Loss of consumer surplus (because price is above marginal cost) – Output of the monopolist is below the competitive level Monopoly may waste scarce resources in maintaining their position – High levels of advertising and marketing designed to increase brand loyalty and build barriers to the entry of new firms (this is known as “rent-seeking behaviour”)

Simple monopoly diagram to show welfare loss The Pure Monopolist MR D= MSB S= MSC QM PM Output P= MC Imperfect markets restrict output and raise price in order to maximise profits (MC=MR) Thus output is below the socially optimum level There is a welfare loss to society- Lost consumer surplus= Lost producer surplus= HL students need to refer back and provide more detail re. monopoly power in the exams/ IA

Features Firms can do this because there are barriers to entering the market (difficult for new firms to enter the market and compete)- little/ no competition Market power shifts the influence over the use and allocation of resources from consumers to producers The government will often intervene to reduce market power through regulation- specifically competition policy But Remember …. monopoly power can also bring economic benefits – Exploitation of economies of scale (lower unit costs) – Profits used to fund research and development – leading to a faster pace of innovation and gains in dynamic efficiency – Many monopolies face international competition and markets have become more contestable

Monopoly Power  Created through growth of the firm (internal) or merger/ takeover (external)  Monopoly power can be maintained through Barriers To Entry (barriers to new firms entering the market). Examples…?  A clearly differentiated product with brand loyalty  Economies of scale which result in low l/r ACs  Legal and Regulatory barriers  Ownership/control of key factors of production  Other barriers include; aggressive trading tactics, the threat of aggressive merger and takeover, ownership/control of retail outlets and intimidation.

Handout Back to basics… Competition Policy ET Sept 2003