Market Failure

Types of Market Failure

Learning Objective:
 describe the concept of market failure and
explain the reasons for its occurrence
 define private and social costs and benefits
1

 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.
 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….
1. When the free market provides too much
2. When the free market provides too little
3. 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?
 2

3
 So which is number 1?
 It is a vaccination service Merit goods are products
 It is known as a merit good that society judges are
 The government thinks that merit goods provide good for us and are not
positive benefits for both the people that use them consumed enough
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
Private benefits are the
 It can subsidise them so that there is no direct cost benefits to those who are
to the consumer consuming or producing
 Why no direct cost?
 Because they pay indirectly through taxes External benefits are the
 If the price is low (or free) there will be an extensionbenefits to those who are
of demand not involved in the
production or
consumption
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
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
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?
Positive externalities
Private + External = Social
benefits benefits benefits
Benefits to Benefits to others Total benefits
individual of individual to society of a
consumers or consumers or given
firms of their firms economic economic
economic activity activity
activity

benefits to benefits to third Total benefits

first parties - parties - others to society –
individuals everyone
 So which is number 2 – over/under Demerit goods are
provided, 3rd part effects, not provided? those products that
 It is fast food society deems as bad
 It is known as a demerit good for you
 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
Why are these Demerit
Goods?

Cigarettes may be seen as

more harmful to others
and have higher taxation

If government
chose tax to
reduce alcohol
consumption
would it tax the
same % as
cigarettes?
 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
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
Negative externalities
When production has a negative effect on Negative
people that are not involved in the Externality: costs
production we say there are external costs imposed on a third
When there are external costs we say there party not involved
is a negative externality with the
example – when you decide to take the
train or drive your car to your destination consumption or
 you may only take into consideration the production of the
costs of the petrol and maybe the road tolls good
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 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
Negative externalities
Private Costs + External costs = Social Costs

Costs to Costs to others of Total costs to

individual individual society of a
consumers or consumers or given
firms of their firms economic economic
economic activity activity
activity

costs to first costs to third Total costs to

parties - parties - others society –
individuals everyone
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
Social cost is larger than
the private cost there is
market failure
Perfect Market
Social costs = Social
The perfect market is benefits
when Social costs =
Social benefits Total costs to Total benefits
Whenever there is society of a given to society of a
more social cost than economic activity given
social benefit there is
market failure
economic
activity
Whenever there is
more social benefits
than social costs there
is market failure Total costs to Total benefits
If there is an external society – to society –
cost or an external everyone everyone
benefit there is market
failure
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
 Resource depletion –
Environmental Market Failure the exhaustion of natural
To satisfy our growing wants for goods and services we resources through the
are using up scarce natural resources (resource economic activities of
depletion) which are non-renewable production, consumption
Global population growth and increasing wealth in and exchange
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
Overfishing has depleted fish stocks
Many animals are close to extinction
Growing air pollution
 Arguments for and against conservation
No Yes
 The free market uses the price
 The market price does not include
mechanism to allocate resource in the
external costs of damaging the
most efficient way
environment therefore the price is too
 If firms don’t allocate resources
low and demand is too high
efficiently their costs will be  Taxes can be used to reduce that
higher and they will not be able to
demand
compete  Conserving should not result in less
 Conserving resources means
food or fewer goods and services just
resources not being used – using
different more efficient methods of
fewer resources means fewer jobs
production that don’t deplete
and less income.
resources or damage the environment
 Instead of conserving use
 Resources will be reallocated to areas
resources more efficiently
such as organic farming, the
 In the free market the prices rise
production of environmentally friendly
which discourages consumption (it
products and energy saving devices
works so why intervene)
such as wind machines and solar
 As resources run out we will find
panels
alternatives e.g. biofuel
 Monopoly power –
Monopoly Market Failure when a firm has a large
A perfect market is when the market market share and can
mechanism works – supply and demand create use its power to restrict
the price competition and push
When a monopoly exists they can create prices up
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
 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 Government unveils plan to tax the

curb noise pollution carbon emissions of the worst
polluters
The Australian government has banned live
cattle exports to Indonesia until safeguards are Tax on landfill to increase by 20% as the government
adopted to end the brutal slaughter of animals attempts to reduce the amount of waste that ends up
in the ground.
The Chinese government announces
South Africa bans plastic bags to
18 recycling projects are to receive reduce litter
government subsidies covering up to
Retailers caught handing out the bags now
50% of total investment costs
face a fine of 100,000 rand ($13,800) or a 10-
year jail sentence
 Correcting market failures
To reduce external costs To increase external benefits
• Raise taxes on firms with activities that • Ensure public sector provision of socially
create external costs to reduce those and economically desirable goods and
firms’ after-tax profits, e.g. taxes on services, e.g. providing free vaccinations and
emissions from the use of fossil fuels, on education, public parks, public transport and
landfill waste and mineral extraction roads
• Increase indirect taxes on products that • Provide subsidies to private sector firms
are considered harmful to raise their to reduce the cost of activities and
prices and discourage their consumption, products that have external benefits, e.g.
e.g. taxes on cigarettes, petrol, plastic bags subsidies for recycling, renewable energy,
organic farming
• Use regulations and fines to discourage
the production or consumption of • Use regulations to encourage firms to
products or activities that are harmful, change their production methods, e.g.
e.g. smoking bans, planning controls, legal rules to phase out traditional light bulbs to
limits on air and water pollutants, anti-litter encourage a switch to low-energy light bulbs,
laws health and safety regulations, animal welfare
laws
Complete assessment
exercises P95
Complete Structured
Questions P97
 Homework
Complete Exam Preparation 2.3 P93
 Print the answers
 Mark your questions (answers in CD
from text book)
 Write comments in another colour