Types of Market Failure

define private and social costs1 and benefits Learning Objective: describe the concept of market failure and explain the reasons for its occurrence define private and social costs1 and benefits discuss conflicts of interest in relation to these costs and benefits in the short-term and long-term through studies of the following issues: conserving resources versus using resources public expenditure versus private expenditure.

How could we define the perfect market? A free market that supplies exactly what consumers demand The examples of market failure that we look at are…. When the free market provides too much When the free market provides too little When the free market provides but it has an effect on a third party that is not involved in the production or consumption (that effect can be good or bad) On the next slide I am going to show you some examples of market failure In pairs, I want you to take 10 minutes to Decide what kind of market failure each one is Think about the reasons why the market fails E.g. what would make the market fail to provide?

2 1 3

So which is number 1? It is a vaccination service It is known as a merit good The government thinks that merit goods provide positive benefits for both the people that use them and society as a whole There is the benefit of the vaccine to the person who is getting it (they don’t get the disease There is also a benefit to society because they won’t get diseases too plus a society that is healthy is more productive Government thinks we should consume more Because the market doesn’t provide enough (because there is not enough demand) the government has to step in How can it supply more or increase demand? It can provide them directly It can subsidise them so that there is no direct cost to the consumer Why no direct cost? Because they pay indirectly through taxes If the price is low (or free) there will be an extension of demand Merit goods are products that society judges are good for us and are not consumed enough Private benefits are the benefits to those who are consuming or producing External benefits are the benefits to those who are not involved in the production or consumption

Information failure: merit goods Merit goods are products that society values and judges that society should have regardless of whether an individual wants them The UK government believes that individuals may not act in their own best interest in part because they do not have the full information on the long term benefits (information failure) Merit goods are under-consumed because people don’t realise that they are not only good for them but good for society too Government will seek to encourage more consumption of merit goods

If the government didn’t provide schools would everyone pay for it? Why is this a merit good? If the government didn’t provide schools would everyone pay for it? Maybe you would be too poor to afford it and leave your kids at home The market would not provide enough so government has to step in When there are positive benefits to third parties who are not involved there is said to be market failure – resources are not being allocated to their best effect! When there is a positive effect on the third party we called it a positive externality

Why are these Merit Goods? Some will be more important than others and will gain more funding Would government provide or subsidise these services to the same extent?

Positive externalities Private benefits + External benefits = Social benefits Benefits to individual consumers or firms of their economic activity Benefits to others of individual consumers or firms economic activity Total benefits to society of a given economic activity benefits to first parties - individuals benefits to third parties - others Total benefits to society –everyone

It is known as a demerit good So which is number 2 – over/under provided, 3rd part effects, not provided? It is fast food It is known as a demerit good The government thinks that demerit goods are bad for both the people that use them and society as a whole The market provides too much (there is too much demand) Government can step in and try to reduce demand What can it do? It could ban them It could educate consumers on the harm Anything else? It could put a tax on them How would that work? It would push up the price which would cause a contraction of demand Demerit goods are those products that society deems as bad for you

Why are these Demerit Goods? Cigarettes may be seen as more harmful than others and have higher taxation If government chose tax to reduce alcohol consumption would it tax the same % as cigarettes?

It is a factory creating pollution So which is number 3? Over/under provided, 3rd part effects, not provided? It is a factory creating pollution It is known as a negative externality What is the cost imposed on the third party here? The pollution may cause harm to society – the fumes may cause ill health to those that are not involved in the production When the firm decides how much to provide what will it think about? It is a profit maximiser Costs will be the most important thing – if costs are low profit will be high It only thinks about its private costs; not the cost to society Together all the firms in the market provide too much so the government feels the need to step in What could it do to get the market to supply less (and therefore pollute less)? Negative Externality: costs imposed on a third party not involved with the consumption or production of the good

What can government do to fix externalities? Regulation – government can set restrictions and inspect to see these are being upheld. If not large fines may be levied Pollution permits Government issues or sells permits to firms allowing them to pollute to a certain limit This increases their costs But…they can be traded to reduce the cost creates an incentive to be clean because they can sell on remaining allocation. Firms that pollute will have higher costs than those that are clean Regulation is the stick and the pollution permit is the carrot Downside – Both need teams of inspectors Firms may move to countries that do not penalise e.g. India

Watch this mjmfoodie video http://www.youtube.com/watch?v=yC5R9WPId0s

Negative externalities When production has a negative effect on people that are not involved in the production we say there are external costs When there are external costs we say there is a negative externality e.g. the noise that Wembley residents have to suffer when a rock concert is on They don’t buy the ticket but they suffer from the noise (a cost to them) The person buying the ticket only thinks about the cost to themselves; not to society Another example – when you decide to take the train or drive your car to your destination you may only take into consideration the costs of the petrol and maybe the road tolls or congestion charges you wouldn’t take into consideration the congestion, pollution or other environment damage the cost of which would fall to others. Negative Externality: costs imposed on a third party not involved with the consumption or production of the good

Negative externalities Another example - A chemical factory that is unregulated and pumps waste into local rivers It may decide to produce a certain amount of output that takes into consideration their private costs when profit maximising but does not take into consideration the costs to society of the polluted river. The pollution is an external cost to the people who are not involved in the production

Negative externalities Private Costs + External costs = Social Costs Costs to individual consumers or firms of their economic activity Costs to others of individual consumers or firms economic activity Total costs to society of a given economic activity costs to first parties - individuals costs to third parties - others Total costs to society –everyone

Negative externalities Why is this a negative externality? What is the private cost? What is the external cost (the cost to the third party) The social cost is both of these added together In a perfect market the private costs would be the same as the social costs Because the social cost is larger than the private cost there is market failure

Negative externalities Why is this a negative externality? What is the private cost? What is the external cost (the cost to the third party) The social cost is both of these added together In a perfect market the private costs would equal what? They would equal the social costs Because the social cost is larger than the private cost there is market failure

Negative externalities Why is this a negative externality? What is the private cost? What is the external cost (the cost to the third party) The social cost is both of these added together In a perfect market the private costs would equal what? They would equal the social costs Because the social cost is larger than (?) there is market failure ? = the private cost

Total costs to society – everyone Total benefits to society –everyone Perfect Market Social costs = Social benefits Total costs to society of a given economic activity Total benefits to society of a given economic activity Total costs to society – everyone Total benefits to society –everyone The perfect market is when Social costs = Social benefits Whenever there is more social cost than social benefit there is market failure Whenever there is more social benefits than social costs there is market failure If there is an external cost or an external benefit there is market failure

Read ‘River Life Dead’ on Page 78 Write some bullet points…… What are the private costs to the firm? What are the external costs to people that are not involved in the production? What are the private benefits to the firm? What are the external benefits to those not involved in production? Private benefits = benefits to the firm Private costs = cost to the firm External costs = costs to the people not involved in the production External benefits = benefits to the people not involved in the production

An economic use of resources? If total social benefit > or = total social cost Economic welfare can be improved by encouraging more production and consumption If total social cost > total social benefit Economic welfare can be improved by reducing production and consumption

Environmental Market Failure Resource depletion – the exhaustion of natural resources through the economic activities of production, consumption and exchange Environmental Market Failure To satisfy our growing wants for goods and services we are using up scarce natural resources (resource depletion) with are non-renewable Global population growth and increasing wealth in newly industrialised countries like China and India is helping to increase this demand further Conservationists argue that we need to slow the pace at which we consume resources because Burning fuel releases harmful emissions which contribute to global warming Deforestation to clear land of trees for farming and building has destroyed habitats and changed local climates Over farming has used up the goodness in soil meaning nothing can be grown Using pesticides and fertilisers to increase crop production has polluted rivers and water supplies Battery farming and the use of drugs to increase meat production are cruel and have helped spread disease Overfishing has depleted fish stocks Many animals are close to extinction Growing air pollution

Arguments for and against conservation No The free market uses the price mechanism to allocate resource in the most efficient way If firms don’t allocate resources efficiently their costs will be higher and they will not be able to compete Conserving resources means resources not being used – using fewer resources means fewer jobs and less income. Instead of conserving use resources more efficiently In the free market the prices rise which discourages consumption (it works so why intervene) As resources run out we will find alternatives e.g. biofuel Yes The market price does not include external costs of damaging the environment therefore the price is too low and demand is too high Taxes can be used to reduce that demand Conserving should not result in less food or fewer goods and services just different more efficient methods of production that don’t deplete resources or damage the environment Resources will be reallocated to areas such as organic farming, the production of environmentally friendly products and energy saving devices such as wind machines and solar panels

Monopoly Market Failure Monopoly power – when a firm has a large market share and can use its power to restrict competition and push prices up Monopoly Market Failure A perfect market is when the market mechanism works – supply and demand create the price When a monopoly exists they can create their own price which is higher than the market price This can be seen to be bad for the customer However, as we will see later, the monopoly can also be good because when it makes profit it can invest in making new products giving us more choice

Correcting market failure How can a government in a mixed economy ensure that firms and consumers take account of the external costs and benefits of their decisions and actions? India to enforce new regulations to curb noise pollution Government unveils plan to tax the carbon emissions of the worst polluters The Australian government has banned live cattle exports to Indonesia until safeguards are adopted to end the brutal slaughter of animals Tax on landfill to increase by 20% as the government attempts to reduce the amount of waste that ends up in the ground. The Chinese government announces 18 recycling projects are to receive government subsidies covering up to 50% of total investment costs South Africa bans plastic bags to reduce litter Retailers caught handing out the bags now face a fine of 100,000 rand ($13,800) or a 10-year jail sentence

Correcting market failures To reduce external costs To increase external benefits Raise taxes on firms with activities that create external costs to reduce those firms’ after-tax profits, e.g. taxes on emissions from the use of fossil fuels, on landfill waste and mineral extraction Increase indirect taxes on products that are considered harmful to raise their prices and discourage their consumption, e.g. taxes on cigarettes, petrol, plastic bags Use regulations and fines to discourage the production or consumption of products or activities that are harmful, e.g. smoking bans, planning controls, legal limits on air and water pollutants, anti-litter laws Ensure public sector provision of socially and economically desirable goods and services, e.g. providing free vaccinations and education, public parks, public transport and roads Provide subsidies to private sector firms to reduce the cost of activities and products that have external benefits, e.g. subsidies for recycling, renewable energy, organic farming Use regulations to encourage firms to change their production methods, e.g. rules to phase out traditional light bulbs to encourage a switch to low-energy light bulbs, health and safety regulations, animal welfare laws

Complete assessment exercises P95 Complete Structured Questions P97

Homework Complete Exam Preparation 2.3 P93 Print the answers Mark your questions (answers in CD from text book) Write comments in another colour