1. Types of Market Failure

2. 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.

3. 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?

4. 2 1 3

5. 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

6. 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

7. 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

8. 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?

9. 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

10. 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

11. 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?

12. 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

13. 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

14. Watch this mjmfoodie video

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. Arguments for and against conservationNo
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

26. 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

27. 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

28. 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

29. Complete assessment exercises P95
Complete Structured Questions P97

30. Homework
Complete Exam Preparation 2.3 P93
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