Market Failure

Content• Externalities in Production and Consumption:

– Positive– Negative

• Public goods• Merit goods• Demerit goods• Market imperfections• Inequalities in:

– Wealth distribution– Income distribution

Externalities

• Externalities result from differences between private and social costs or benefits

• Externalities can be positive or negative:– Positive – these have beneficial effects on 3rd parties– Negative – these are costs that incurred by 3rd parties

External Costs / Negative externalities• External costs created by businesses can impact the environment in the following

ways:• Urban blight – excessive development and inappropriate developments mean the

environment is visually less attractive, loss of farmland• Production and disposal of waste – this could include an increase in litter and

rubbish from packaging • Use of energy • Pollution:

– Noise – from cars, lorries, factories etc – Air – emissions from cars and delivery vehicles– Land– Sea– Water

Negative externalities• If you consider private

costs then they would supply along supply curve S

• Negative externalities mean that social costs are higher so the new supply curve should be S1 and equilibrium moved to P1

External Benefits / Positive externalities• As well as external costs businesses can create external

benefits • External benefits are advantages a business brings to the

local community when it locates its business in a particular area. These benefits will be positive for the local community.

• Examples:• Employment• Quality of life• Providing a service• Regeneration of land

External Benefits / Positive Externalities

• If the business was supplying products ignoring social benefits the initial supply curve S1

External Costs and benefits In production

• External costs are where MSC = MSB – MPC e.g. pollution, traffic congestion

• External benefits are where MSC < MPC e.g. research and development in industry, human resource development

External costs and benefits in consumption

• External costs = where MSB < MPB e.g. anti-social behaviour, passive smoking, noise

• External benefits = where MSB > MPB e.g. public transport, vaccinations, attractive surroundings

Externalities

• The presence of negative externalities is likely to cause over production of a product

• The presence of positive externalities is likely to lead to under production of a product

• Externalities can lead to market failure if the pricing mechanism fails to account for the social costs and benefits of production

Value of Externalities

• The value of social costs and benefits can be measured by looking at:– Consumer surplus– Producer surplus– Cost-benefit analysis : what is the balance of costs and

benefits – Willingness to pay

Cost Benefit Analysis

• Identify all costs and benefits• Measure the value of all costs and benefits• Calculate the likelihood of costs and benefits• Analyse the timing of the costs and benefits looking

at present value• Decide whether the project is worth undertaking

Public Goods

• These are services that are provided by the government• Pure public goods have the following characteristics:

– Non excludability – everyone can consume the goods whether they pay or not

– Non rivalry in consumption – consumption by one person doesn’t reduce consumption for others

• Examples – street lighting, national defence

Public goods and Market Failure

• You cant get an individual to pay for public goods as others can get the benefits from consumption without paying

• Private companies will not supply public goods as they don’t make an economic profit on them

• Public goods are only supplied by the government and financed through taxation

Private goods

• Private goods have the following characteristics:– Excludability – if you don’t pay you can be excluded from

consuming the product – Rivalry – the consumption of one person reduces the

amount available for others to consume– Rejectability – you can choose not to consume them and

therefore reject them

Merit goods

• Merit goods are where social benefits exceed social costs – they generate positive externalities

• Governments aim to provide more of these goods due to the benefits to society

• They may subsidise the production of such goods reducing the marginal costs of consumption and therefore increasing demand

• Examples – healthcare, education

Merit goods and Market Failure

• If the government didn’t step in and produce merit goods then they would be under produced

• Attributable to the fact that individuals do not realise the benefits of consuming these goods

Demerit goods

• Demerit goods are where social costs outweigh social benefits – they generate negative externalities

• Governments try and reduce the consumption of these goods through higher taxes

• Examples – cigarettes, alcohol

Market imperfections

• Monopolies – these are often viewed as allocating resources inefficiently as the producer is able to charge higher prices due to being the only producer in the market

• Imperfect knowledge of the market can also cause market failure

Immobility of factors of production

• These can lead to market failure and may be due to:

• Occupational immobility – this occurs when there are barriers of mobility between different jobs and different industries

• Geographical immobility exists when there are barriers to people of moving to different locations

Inequalities

• In market economies an individuals ability to consume goods and services is dependent on their income / wealth

• An uneven distribution of income / wealth within an economy can result in an unsatisfactory allocation of resources and therefore market failure

• In many developing countries income inequality is great therefore resulting in misallocation of resources

Summary• Externalities are caused when social benefits / costs are different to private benefits / costs• Positive externalities occur where social benefits are greater than private benefits• Negative externalities occur where social costs are greater than private costs• Cost benefit analysis looks at the costs and benefits of producing / consuming a product • Public goods are goods that are provided by the government e.g. street lighting • Merit goods are where social benefits exceed social costs e.g. healthcare the government

encourages people to use these • Demerit goods are where social costs exceed social benefits e.g. smoking the government

discourages people to use these through taxation • Market imperfections can be caused by monopolies, imperfect market knowledge and factor

immobility which can result in misallocation of resources • Inequalities in wealth and income distribution may result in a misallocation of resources as

the rich consume more