MARKET FAILURE

In the real world, market fails to achieve social efficiency.

SOURCES OF MARKET FAILURE:

Existence of Market Power (Imperfect Competition)

Existence of Externalities

Existence of Public & Merit Goods

Existence of Market Power

Recall: Social efficiency MSB = MSC

Market power => __________(Imperfect Competition)

=> ___________________

Existence of Market Power

Example: Monopoly

$ MC = MSC

AR (P)=MSB

Q1 Q2

P1MSB=MSC

MC1MR

Eqm: MR = MCPC: MR = AR = MSB MC = MSC=> MSB = MSCat o/p = Q2

Monopoly: price = P1, o/p = Q1=> P1 > MC1=> MSB > MSC=> social inefficiencyQty

fig

MRO

$

Q

Ppc

Qpc

AR = D

a

Qm

Pm

b

Consumersurplus

Producersurplus

Deadweightwelfare loss

MC

Welfare Loss under monopoly

c

Existence of Externalities

Externalities

_____________________ to society, over & above those experienced by the individual producer & consumer

Drive a ____________________- between MSC & MPC- between MSB & MPB

MSC = MPC + _____ MSB = MPB + _____

Existence of Externalities

Two types of externalities:

The effects of a decision by consumers and producers that has an impact on a third party Positive Externalities – _______________ on

third parties

Negative Externalities – _____________ by third parties

Existence of ExternalitiesCosts and benefits in production:

External costs in production – ____________e.g. air and water pollution, congestion, noise,

pollution

External benefits in production – __________e.g. human resource development, research

and development in industry

Existence of Externalities

Costs and benefits in consumption:

External costs in consumption – ____________e.g. passive smoking, litter, noise

External benefits in consumption – __________ e.g. preventative health care – vaccinations,

public transport, attractive gardens, bathing regularly!

Existence of Externalities

Our Focus:

Case a: Negative Externality:External costs in production – MSC > MPC

Case b: Positive ExternalityExternal Benefits of Consumption - MSB > MPB

Negative ExternalityCase a: External Costs of Production

Example: Pollution -> MSC > MPC [ MSC = MPC + MEC ]

Socially optimumo/p = Q2where P = MSCHowever, firm produces at Q1=> _____________

QUANTITY

DD (MPB = MSB)

SS (MPC)

Q1

P1

Q2

P2

MSC

MEC

$

Positive Externality

Case b: External Benefits of Consumption Eg: Public Transport -> MSB > MPB [ MSB = MPB + MEB ]

Socially optimumo/p = Q1where P = MSBHowever, consumption level at Q2=> __________________

QUANTITY

DD (MPB)

(MSC = MPC) SS

Q2

P2

MSB

MEB

Q1

P1

$

Mindmap of Externalities