Market Failure

Types of Market Failure

Learning Objective:describe the concept of market failure and

explain the reasons for its occurrencedefine 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 resourcespublic 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 much2. When the free market provides too little3. 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?

1

2

3

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

Information failure: merit goods Merit goods are products that society values and judges that society should have regardless of whether an individual wants themThe 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 tooGovernment 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 homeThe 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?

Would government provide or subsidise these services to the same extent?

Some will be more important than others and will gain more funding

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

Positive externalities

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

Why are these Demerit Goods?

If government chose tax to reduce alcohol consumption would it tax the same % as cigarettes?

Cigarettes may be seen as more harmful than others and have higher taxation

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 leviedPollution permits

Government issues or sells permits to firms allowing them to pollute to a certain limitThis increases their costsBut…they can be traded to reduce the costcreates 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 carrotDownside –

Both need teams of inspectorsFirms may move to countries that do not penalise e.g. India

• Watch this mjmfoodie video• http://www.youtube.com/watch?v=yC5R9WPI

d0s

Negative externalitiesWhen production has a negative effect on people that are not involved in the production we say there are external costsWhen there are external costs we say there is a negative externalitye.g. the noise that Wembley residents have to suffer when a rock concert is onThey 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 societyAnother 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 chargesyou 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

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

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

Negative externalities

Negative externalitiesWhy 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 togetherIn a perfect market the private costs would be the same as the social costsBecause the social cost is larger than the private cost there is market failure

Negative externalitiesWhy 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 togetherIn a perfect market the private costs would equal what?They would equal the social costsBecause the social cost is larger than the private cost there is market failure

Negative externalitiesWhy 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 togetherIn a perfect market the private costs would equal what?They would equal the social costsBecause the social cost is larger than (?) there is market failure ? = the private cost

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

Perfect Market

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

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 costs = cost to the firm

External costs = costs to the people not involved in the production

Private benefits = benefits to the firm

External benefits = benefits to the people not involved in the production

An economic use of resources?

If total social benefit > or = total social cost

If total social cost > total social benefit

Economic welfare can be improved by reducing production and consumption

Economic welfare can be improved by encouraging more production and consumption

Environmental Market FailureTo satisfy our growing wants for goods and services we are using up scarce natural resources (resource depletion) with are non-renewableGlobal population growth and increasing wealth in newly industrialised countries like China and India is helping to increase this demand furtherConservationists argue that we need to slow the pace at which we consume resources because

Burning fuel releases harmful emissions which contribute to global warmingDeforestation to clear land of trees for farming and building has destroyed habitats and changed local climatesOver farming has used up the goodness in soil meaning nothing can be grownUsing pesticides and fertilisers to increase crop production has polluted rivers and water suppliesBattery farming and the use of drugs to increase meat production are cruel and have helped spread diseaseOverfishing has depleted fish stocksMany animals are close to extinctionGrowing air pollution

Resource depletion – the exhaustion of natural resources through the economic activities of production, consumption and exchange

No 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

Arguments for and against conservation

Monopoly Market FailureA perfect market is when the market mechanism works – supply and demand create the priceWhen a monopoly exists they can create their own price which is higher than the market priceThis can be seen to be bad for the customerHowever, 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

Monopoly power – when a firm has a large market share and can use its power to restrict competition and push prices up

Tax on landfill to increase by 20% as the government attempts to reduce the amount of waste that ends up in the ground.

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

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

The Chinese government announces 18 recycling projects are to receive government subsidies covering up to 50% of total investment costs

The Australian government has banned live cattle exports to Indonesia until safeguards are adopted to end the brutal slaughter of animals

Government unveils plan to tax the carbon emissions of the worst polluters

Correcting market failures

To reduce external costs

• 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

To increase external benefits

• 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

Complete assessment exercises P95

Complete Structured Questions P97

HomeworkComplete Exam Preparation 2.3 P93 Print the answers Mark your questions (answers in CD

from text book) Write comments in another colour