MARKET FAILURE In the real world, market fails to achieve social efficiency. SOURCES OF MARKET FAILURE: Existence of Market Power (Imperfect Competition) Existence of Externalities Existence of Public & Merit Goods

Market power => __________ Existence of Market Power Recall: Social efficiency MSB = MSC Market power => __________ (Imperfect Competition) => ___________________

Existence of Market Power Example: Monopoly Eqm: MR = MC PC: MR = AR = MSB MC = MSC => MSB = MSC at o/p = Q2 Monopoly: price = P1, o/p = Q1 => P1 > MC1 => MSB > MSC => social inefficiency $ MC = MSC P1 MSB=MSC MC1 MR AR (P)=MSB Qty Q1 Q2

Welfare Loss under monopoly $ MC MR Deadweight welfare loss Consumer surplus a Pm Qm c Ppc Producer surplus b AR = D O fig Qpc Q

Existence of Externalities _____________________ to society, over & above those experienced by the individual producer & consumer Drive a ____________________ - between MSC & MPC - between MSB & MPB MSC = MPC + _____ MSB = MPB + _____

Existence of Externalities Two types of externalities: The effects of a decision by consumers and producers that has an impact on a third party Positive Externalities – _______________ on third parties Negative Externalities – _____________ by third parties

Existence of Externalities Costs and benefits in production: External costs in production – ____________ e.g. air and water pollution, congestion, noise, pollution External benefits in production – __________ e.g. human resource development, research and development in industry

Existence of Externalities Costs and benefits in consumption: External costs in consumption – ____________ e.g. passive smoking, litter, noise External benefits in consumption – __________ e.g. preventative health care – vaccinations, public transport, attractive gardens, bathing regularly!

Existence of Externalities Our Focus: Case a: Negative Externality: External costs in production – MSC > MPC Case b: Positive Externality External Benefits of Consumption - MSB > MPB

Negative Externality Case a: External Costs of Production Example: Pollution -> MSC > MPC [ MSC = MPC + MEC ] $ MSC SS (MPC) MEC Socially optimum o/p = Q2 where P = MSC However, firm produces at Q1 => _____________ P2 P1 DD (MPB = MSB) Q2 Q1 QUANTITY

Positive Externality Case b: External Benefits of Consumption Eg: Public Transport -> MSB > MPB [ MSB = MPB + MEB ] $ (MSC = MPC) SS Socially optimum o/p = Q1 where P = MSB However, consumption level at Q2 => __________________ P1 MEB P2 MSB DD (MPB) Q2 Q1 QUANTITY

Mindmap of Externalities