1. IB Economics Unit 2: Microeconomics
IB Chapter 13: Market Failure

2. Measuring Economic Welfare
Consumer surplus
Producer surplus
Total surplus (or welfare) = CS+PS
Why does market failure lead to a reduction in TS?
Price (BHD)
Quantity (000’s)
Class Task: Complete the diagram to show CS & PS

3. What is Market Failure? Definition:
Where the market mechanism fails to allocate resources efficiently, when left to the market we get an inefficient allocation of resources
TS is not maximised
Types of efficiency
Social efficiency
Allocative Efficiency
Productive Efficiency
(Dynamically efficient)

4. Market Failure: Types of Efficiency
Social Efficiency: where external costs and benefits are accounted for when decisions are made in both consumption and production.
Allocative Efficiency: A market will be allocatively efficient if it is producing the right goods for the right people at the right price (where MC = AR known as marginal cost pricing).
Also referred to as; Pareto Efficient Allocation where resources cannot be readjusted to make one consumer better off without making another worse off – zero opportunity cost! Vilfredo Pareto (1848 – 1923)
Productive Efficiency: production of goods and services at lowest factor cost (lowest point of AC curve).
Static Efficiency: efficiency at a point of time (e.g. using current technology)
Dynamic Efficiency: an economy that appropriately balances short run concerns (static efficiency) with concerns in the long run (focusing on encouraging research and development)

5. Market Failure: When? Market Failure occurs where:
Knowledge is not perfect – ignorance or deception
Goods are differentiated
Resource immobility e.g. Labour or Capital
Market power e.g. Monopolies
Services/goods would or could not be provided in sufficient quantity by the market e.g. street lighting
Existence of external costs and benefits
Inequality exists e.g. wealth, income

6. Market Failure: Imperfect Competition
Market Power:
Existence of monopolies and oligopolies
Collusion
Price fixing
Abnormal profits
Rigging of markets
Barriers to entry

7. Welfare loss under IMPERFECT COMPETITION
Why?
Costs, Benefits & Price
Quantity

8. How do CARTELS operate?
Why?
Costs, Benefits & Price
Quantity

9. What can be done to limit the failures caused by imperfect competition?
Legal measures to increase competition
25%
Concentration ratio
Regulatory bodies
Monitor behaviour of firms e.g. OFWAT
Monopoly regulators e.g. UK Competition Commission
We must ensure that all intervention results in an improvement in economic welfare and does not make the situation worse (Government Failure)

10. The Existence of Public Goods
A non- excludable good?
Public Goods: Markets would not provide such goods and services at all!
Non-excludability: Person paying for the benefit cannot prevent anyone else from also benefiting - the ‘free rider’ problem
Non-rivalry: Large external benefits relative to cost – socially desirable but not profitable to supply!
Possible Solutions:
The government collects tax (in most countries) and supplies public goods themselves, but how does it know how much to supply?
Subsidisation of private firms to produce
Would you pay for this?

11. Under provision of a Public Good: MSB Vs MSC
Why?

12. Would we all pay if the state did not provide it?
Merit Goods
Merit Goods: goods and services which are better for us that we realise:
Under provision
Under consumption
Education
Healthcare
Organic food
Seat belts
Sports facilities
Possible Solutions
Government provision
Subsidised production
Positive advertising to encourage consumption and/or production
Would we all pay if the state did not provide it?

13. Under provision of a Merit Good: MSB Vs MSC
Why?

14. Under consumption of a Merit Good: MSB Vs MSC
Why?

15. Demerit goods and services
Over Production:
Over Consumption:
Examples:
Tobacco
Alcohol
Drugs
Gambling
Sheesha
Possible Solutions
Regulation of use
Negative advertising to discourage production and/or consumption
Taxation to reduce QD via increased P
A Russian drug addict injects heroin

16. Over Consumption of a De-Merit Good: MSB Vs MSC
Why?

17. Over Supply of a De-Merit Good: MSB Vs MSC
Why?

18. Market Failure: Knowledge
Imperfect Knowledge:
Consumers do not have adequate technical knowledge
Advertising can mislead or mis-inform
Producers unaware of all opportunities
Producers cannot accurately measure productivity
Decisions often based on past experience rather than future knowledge

19. How does imperfect knowledge affect the market?
Why?

20. Market Failure Goods/Services are differentiated
Branding
Designer labels - they cost three times as much but are they three times the quality?
Technology – lack of understanding of the impact
Labelling and product information
Which one is the ‘quality’ item and why?

21. How does product differentiation affect the market?
Why?

22. Market Failure: Immobility
Resource Immobility
Factors are not fully mobile
Labour immobility – geographical and occupational
Capital immobility – what else can we use the Channel Tunnel for?
Land – cannot be moved to where it might be needed – e.g. London and South East!

23. World Income Distribution

24. Market Failure: Externalities
External Costs and Benefits
External or social costs
The cost of an economic decision to a third party
External benefits
The benefits to a third party as a result of a decision by another party

25. Market Failure External Costs
Decision makers do not take into account the cost imposed on society and others as a result of their decision
e.g. Pollution, traffic congestion, environmental degradation, depletion of the ozone layer, misuse of alcohol, tobacco, anti-social behaviour, drug abuse, poor housing

26. External Costs: MSB Vs MSC
Why?

27. Market Failure: Benefits
External benefits –
by products of production and decision making that raise the welfare of a third party
e.g. Education and training, public transport, health education and preventative medicine, refuse collection, investment in housing maintenance, law and order.

28. External Benefits: MSB Vs MSC
Why?

29. Market Failure Inequality: Poverty – Absolute and Relative
Distribution of factor ownership
Distribution of Income
Wealth Distribution
Discrimination
Housing

30. Inequality Line of equality 45º RECORD NOTES HERE FIG: 1.1
Diagram Title: The LORENZ curve
Line of equality 45º
e.g. UK
e.g. Bahrain
%age of Income (Y)
%age of Population

31. Gini co-efficient formula
Source: ECONandBIZ.com
Gini co-efficient formula A
A + B A B

32. Market Failure Measures to Correct Market Failure State Provision
Extension of property rights
Taxation
Subsidies
Regulation
Prohibition
Positive Discrimination
Redistribution of Income
Price Controls
Buffer Stocks

33. Correcting Market Failure: Taxes e.g. de-merit
Why?

34. Correcting Market Failure: Education e.g. de-merit
Why?

35. Correcting Market Failure: Subsidy e.g. Merit
Why?

36. Correcting Market Failure: Regulation e.g. Merit
Why?

37. Correcting Market Failure: Inequality e.g. Min wage
Why?

38. Correcting Market Failure: Redistribution of Income
Why?

39. Correcting Market Failure: Max/Min Prices
Why?

40. Correcting Market Failure: Buffer Stocks
Why?

41. Q: How effective will this policy become as PED falls?
Government Failure
Government failure is when intervention by the government in a market results in a worsening of welfare for society.
What we are saying here is that the GOVERNMENT SOMETIMES MAKES IT WORSE THAN IT WAS ALREADY.
Take this example of a tax aimed at reducing consumption. While the policy has been successful in reducing quantity demanded from Q1 to Q2 what about the price increase and how will this affect people on poor incomes?
Q: How effective will this policy become as PED falls?
S2 (S1+Tax) S1
Tax P2 P1
Price in $US D Q2 Q1
QD & QS per yr

42. How does PED affect our analysis?
S2 (S1+Tax) S1 A
Tax burden that falls on the consumer
Tax P2 B
Tax burden that falls on the producer P1 A B
Total Tax Revenue +
Price in $US D Q2 Q1
QD & QS per yr

43. Has this tax been successful?
Record Student views here
YES: it has raised revenue for the government
NO: the low level of PED means that there has been limited results
YES: it has discouraged some people from consuming the good or service
NO: what about the poor people or those who cannot change their consumption patterns?

44. Sources of Government Failure
Political self-interest
Policy myopia
Regulatory capture
Government intervention and disincentive effects
Government intervention and evasion
Policy decisions based on imperfect information
The Law of Unintended Consequences!
Costs of administration and enforcement
TASK: Take 5-10 minutes to read the handout ‘Does the government always get it right?’ and then right a paragraph to explain what you understand by the term GOVERNMENT FAILURE

45. Examples of Government Failure
Government intervention to reduce the power of monopolies which hinders international competitiveness and/or is against the public interest
The Government uses increases in minimum wages to win votes during the election campaign
Incorrect or inefficient tax/benefit systems to correct for the existence of externalities
The existence of unintended consequences as a result of government action
Regulations which result in harmful unregulated black markets
Task: Take each of the scenarios and write a brief example to illustrate the issues raised. Make sure that you explain a likely instance of government failure.

46. Case Study: Smoking Bans
A UK businessman has begun marketing an 'electronic cigarette' which he says allows smokers to get around the smoking ban.

47. Case Study: Tax on cigarettes

48. Ideas Board