1. Market Failure

2. Occurs when free market forces, using the price mechanism, fail to produce the products that people want, in the quantities they desire at prices that reflect consumers’ satisfaction. Where resources are inefficiently allocated due to imperfections in the working of the market mechanism

3. Market Failure When markets do not provide us with the best outcome in terms of efficiency and fairness Types of market failure?...

4. Sources of Market Failure Externalities Merit and demerit Goods Common access resources (‘tradgedy of the commons’) Public Goods Asymmetric Information Monopoly Power

5. Efficiency

6. In Economics, efficiency is a situation where all possible scarce resources are being used in the most effective way possible to meet the greatest possible level of consumer wants To be sure that we can state that economic resources are being used in the best possible way and thus that Economic Efficiency exists, 2 things must be true…

7. 1.Everything that is produced must be done so using the least possible amount of scarce resources= Productive Efficiency (producing on the PPC/ producing at the lowest possible average cost) 2. Products produced are what consumers want and in the right quantities i.e. resources are allocated in a way which maximises consumers’ satisfaction= Allocative Efficiency (where S=D when social costs and benefits are taken into account)

8. Allocative efficiency Occurs when the benefit (utility) to consumers is maximised and producers maximise profit. Scarce resources are allocated to meet consumer demand and therefore supply must equate with demand i.e. at equilibrium. At any other price demand and supply do not equate, and resources will not be allocated efficiently

9. S1 D1 Qe Pe Price Quantity

10. S1 D1 Qe Pe Price Quantity P1 Qd1Qs1

11. S1 D1 Qe Pe Price Quantity P2 Qs2Qd2

12. Costs and Benefits Social Costs= Private Costs + External Costs Social Benefits= Private Benefits + External Benefits List the social costs and benefits of driving a car.

13. Showing Efficiency on a Diagram The socially efficient output is the point where the market is in equilibrium when all social costs and benefits are taken into account At this equilibrium the welfare of society is maximised (social welfare=producer and consumer surplus)

14. So far when looking at supply and demand we have only considered the private costs of production when thinking about the S curve and the marginal utility (marginal private benefit) when considering the D curve. Now we consider the private and external costs and benefits when looking at supply and demand. The supply curve is determined by the marginal costs of production (MC= change in total cost when output is changed by one unit) in this case the S curve equals the marginal cost to the whole of society thus S=MSC The demand curve is determined by the marginal benefit (marginal utility). In this case the D curve = marginal benefit to the whole of society thus D=MSB MSC=MPC+MEC MSB=MPB+MEB

15. Socially Efficient (Optimum) Output/ Allocatively Efficient Output Price/ Costs and Benefits S= MSC D= MSB Q* P* Quantity The value consumers place on the last unit produced is equal to the full cost of producing that last unit

16. Welfare Loss MSC MSB Q* Costs and Benefits Quantity Q1 Consumers value the product more than the MSC of producing the product at Q2. Output is too low At every level of output between Q1 and Q* the MSB>MSC. By increasing output beyond Q1 up to Q* welfare could be gained

17. Welfare Loss MSC MSB Q* Costs and Benefits Quantity The value consumers place on the extra unit of output at Q1 is less than the MSC. Output is too high Q1 At every level of output between Q1 and Q* the MSB>MSC. By increasing output beyond Q1 up to Q* welfare could be gained

18. Market Failure When markets do not provide us with the best outcome in terms of efficiency and fairness Types of market failure?...

19. Externalities Externalities are defined as ‘third-party’ or ‘spillover’ effects from the consumption or production of a good or service for which no appropriate compensation is paid An externality occurs when there is a cost or benefit arising from an activity or transaction that is not reflected in the market price Output is not at a socially optimum level

20. Negative Externalities External costs of an economic activity Negative Consumption Externalities- external costs arising from a consumption activity eg. Driving a car Negative Production Externalities- external costs arising from a production activity eg. A chemical factory discharges it’s waste into a local river

21. Welfare Loss S= MSC D= MSB Q* Costs and Benefits Quantity Q1 Negative Externalities When the costs to society are greater than the benefits output is above the socially optimum Always start with this diagram when illustrating a negative externality

22. Negative Production Externalities Negative externalities caused by production activities (caused by firms)

23. Welfare Loss S= MSC D= MSB Q* Price/ Costs/ Benefits Quantity Q1 Start with this diagram. Output is at Q1 instead of Q* With negative production externalities this is because firms do not consider the external costs, so supply is higher than the socially optimum…

24. S (based on private costs to the firm (MPC)) D (based on private benefits to the consumer and assuming no external benefits (MPB+MEB= MSB)) Q1 P1 Price (costs/ benefits) Quantity S (based on private and external costs (MPC+MEC= MSC)) Q* P* a b c

25. Therefore… When negative production externalities exist, the marginal social costs exceed marginal private cost This leads to the private optimum level of output being greater than the social optimum level of production hence loss of welfare to society

26. Negative Consumption Externalities Negative externalities caused by consumption activities (caused by consumers)

27. Negative Consumption Externalities Negative consumption externalities lead to a situation where the social benefit of consumption is less than the private benefit Consumption is ‘too high’

28. Welfare Loss S= MSC D= MSB Q* Price/ Costs/ Benefits Quantity Q1 Again, start with this diagram. Output is at Q1 instead of Q* With negative consumption externalities this is because consumers do not consider the external costs, so demand is higher than the socially optimum…

29. Negative Consumption Externality D (MSB) D (MPB) P1 Price/ Costs/ Benefits S (MSC) Q* P* Q1 Quantity

30. Positive Externalities

31. Welfare Loss MSC MSB Q* Costs and Benefits Quantity Q1 Consumers value the product more than the MSC of producing the product at Q2. Output is too low At every level of output between Q1 and Q* the MSB>MSC. By increasing output beyond Q1 up to Q* welfare could be gained

32. Positive Externalities External benefits of an economic activity Positive Consumption Externality- external benefits arising from a consumption activity eg. Healthcare has benefits for the whole of society- not passing on illnesses etc Positive Production Externality- external benefits arising from a production activity eg. Training an employee who leaves to work for another firm

33. Positive Production Externalities

34. Positive Production Externality Output is lower than socially optimum Society has gained from the actions of the firm (recall training) thus the marginal private cost of the firm is greater than the marginal social cost

35. Welfare Loss MSC MSB Q* Costs and Benefits Quantity Q1 Consumers value the product more than the MSC of producing the product at Q2. Output is too low At every level of output between Q1 and Q* the MSB>MSC. By increasing output beyond Q1 up to Q* welfare could be gained

36. S ( = MSC) D (= MSB) Price (cost/ benefit) Q1 P1 Quantity S (= MPC) Q* P*

37. Positive Consumption Externalities

38. Consumers maximise their private utility (benefit) and consume where MSC=MPB (here we are presuming there are no external costs thus MPC=MSC=S) The MSB of consumption is greater than the MPB, thus consumption is ‘too low’

39. Positive Consumption Externality D (MPB) D (MSB) P1 Price ( Costs/ Benefits) S (MSC = MPC i.e. there are no external costs) Q* P* Q1

40. Activity Data Response p141 Grant Economic Review April 2003