MARKET FAILURE Negative / Positive Externalities Social Benefit and Cost

MARKET FAILURE What is Allocative Efficiency and Maximization of Welfare? 1 3 $1 $9 $5 Burgers Consumers willing to buy 1 st burger for $9 but pays market rate of $5 (market equilibrium price). Thus the consumers enjoy $9-$5 =$4 of consumer surplus, while producer enjoy $$5-$1=$4 of producer surplus. 1 st Burger Consumer Surplus Producer Surplus

MARKET FAILURE What is Allocative Efficiency and Maximization of Welfare? 1 4 $1 $9 $5 Burgers $7 $3 2 Sellers willing to buy 2 st burger for $7 but pays market rate of $5 (market equilibrium price). Thus the consumer enjoys $7-$3 =$4 of consumer surplus, while producer enjoy $$5-$3=$4 of producer surplus. 2nd Burger Consumer Surplus Producer Surplus

MARKET FAILURE What is Allocative Efficiency and Maximization of Welfare? 1 4 $1 $9 $5 Burgers $7 $3 2 $6 $4 3 Ultimately, when consumers pay the equilibrium price, we say that consumers and producer’s surplus is maximized. Another way to put is that allocative efficiency has been reached whereby welfare has been maximized. In this state resources are fully and efficiently used.

MARKET FAILURE What is Allocative Efficiency and Maximization of Welfare? 1 4 $1 $9 $5 Burgers $7 $3 2 $6 $4 3 If society does not produce at ( up to the market clearing equilibrium of 4 units of at $5, then we say that the market is not allocative efficient. When this happens market failure occurs Welfare lost giving rise to inefficient use of resources

When a market has failed to achieve economic efficiency it has failed to achieve allocative efficiency. This means that the market has failed to allocate the usage of resource in an efficient manner resulting in a society not achieving maximum welfare. MARKET FAILURE

In a failed market, at market equilibrium, something is causing the market to not be able to allocate efficiently so that welfare is not maximized. The welfare of all in society (consumers, producer and all 3 rd parties) has not been considered.

MARKET FAILURE There are 4 causes of Market Failure 1. Externalities 2. Public Goods 3. Merit Good 4. Existence of Monopolies O level focus

MARKET FAILURE 1.A. Negative Externalities They are defined as third party (or spill-over) effects arising from the production and/or consumption of goods and services for which there exist an external cost to society and no appropriate compensation is paid to society. -Negative externalities – smoking

MARKET FAILURE 1.B. Positive Externalities They are defined as third party (or spill-over) effects arising from the production and/or consumption of goods and services the external benefit of which society has not paid for. -Positive externalities - education

MARKET FAILURE 2. Public Goods Null

MARKET FAILURE 3. a. Merit Good b. Demerit Good

MARKET FAILURE 4. Existence of Monopolies Null

MARKET FAILURE Social Cost When one consumes a cigarette, others around him (the 3 rd party) will also end up inhaling 2 nd hand smokes. For these 3 rd parties, long term exposure to these smokes will result in respiratory diesease and they will need to pay for medication. As such, the smoking of cigarettes (a demerit good) will give rise to social cost.

MARKET FAILURE Social Benefit When one is injected with anti-flu vaccination, others around him (the 3 rd parties) will not be infected and the person will also be healthier having less MCs. 3 rd parties benefit by the person’s continued contribution to society as a productive unit of labour. As such, vaccination (a merit good) will give rise to social benefit.

MARKET FAILURE 1. Positive or Negative Externalities? 2. Social Benefit or Social Cost? ActivityIdentified Externality Positive/ Negative Externality Social Cost or Benefit Solution Drinking Coke Obesity/MC -veCostTax or Min Price Driving a Car Carbon Emission -veCostGas tax/ERP University Education Volunteerism +veBenefitSubsidy Using Solar Energy Clean Environment +veBenefitSubsidy Edcucation

MARKET FAILURE 4. Existence of Negative Externalities

How Will A Tax (GST) Affect Producers and Consumers 1.Taxes will increase the cost of production of the firm. 2.Owing to the tax, producers will cut back on production so as they now have less resources and they need to maintain a level of profit. 3.This will cause the prices of the cigarettes to increase causing consumers to decrease the quantity demanded for cigarettes. 4.The tax, therefore has succeeded in reducing the consumption of a demerit good that gives off negative externalities.

Advantage and Disadvantages of the Tax Reduce Consumption of a Demerit Good Advantage 1.The consumption tax increases the price of the demerit good causing consumers to consume less of the good. 2.The tax is easy to implement and government does not have to spend a lot of money to implement it. Disadvantage 1.The tax may not be severe enough to deter consumer to reduce their consumption. 2.The tax maybe too severe and may reduce employment in the firms significantly as firms reduce their production due to the tax. 3.It the demerit good (cigarette in this case) is price inelastic in demand, then the consumers will in the long run get use to the high prices and will not significantly reduce the quantity demand of the good by much.