Market Efficiency and Market Failure Autumn 2012

Definition Market failure occurs when the free market forces of demand and supply, fail to produce the quantities of goods/services that people want at prices which reflect their marginal utilities (price they are prepared to pay for that additional satisfaction) Market failure leads to the failure of market forces to achieve an efficient allocation of resources. Efficiency occurs when the quantity in the market is optimal in the sense that the amount of community surplus (= consumer surplus + producer surplus) is maximised, i.e. no deadweight loss exists.

Marginal Benefit and Consumer Surplus Marginal benefit (utility) The additional benefit to a consumer from consuming one more unit of a good or service. The Demand Curve is Also the Marginal Benefit Curve

Marginal Cost and Producer Surplus Marginal cost The additional cost to a firm of producing one more unit of a good or service. The Supply curve is also the Marginal cost curve.

The Efficiency of Competitive Markets Marginal Benefit Equals Marginal Cost Only at Competitive Equilibrium Economic efficiency A market outcome in which the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production.

Externalities and Market failure Externality o A benefit or cost that affects someone (a third party) who is not directly involved in the production or consumption of a good or service. The Effect of Externalities o Private cost (PC) The cost borne by the producer of a good or service. o Social cost (SC=PC+EC) The total cost of producing a good, including both the private cost and any external cost (EC). o Private benefit (PB) The benefit received by the consumer of a good or service. o Social benefit (SB=PB+EB) The total benefit from consuming a good, including both the private benefit and any external benefit (EB).

Negative Externalities External or social costs o The costs of an economic decision to a third party ( someone other than the producer or consumer) Decision makers do not take into account the cost imposed on society and others as a result of their decision, o e.g. pollution, traffic congestion, environmental degradation, depletion of the ozone layer, misuse of alcohol, tobacco, anti- social behaviour, drug abuse and gun crime

Negative Externalities and Efficiency A NEGATIVE EXTERNALITY IN PRODUCTION REDUCES ECONOMIC EFFICIENCY The Effect of Pollution on Economic Efficiency

Positive Externalities External benefits o The benefits of production or consumption of a good/service that is good for third parties. o e.g. education and training, public transport, health education and preventative medicine, refuse collection, mosquito nets, public libraries & law and order

Positive Externalities and Efficiency A POSITIVE EXTERNALITY IN CONSUMPTION REDUCES ECONOMIC EFFICIENCY The Effect of a Positive Externality on Efficiency