Transcript Market failure and economic efficiency

Market Failure
Market Failure
• 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
Market Failure
• When markets do not provide us with
the best outcome in terms of efficiency
and fairness
• Types of market failure?...
Sources of Market Failure
• Externalities
• Merit and demerit Goods
• Common access resources (‘tragedy of
the commons’)
• Public Goods
• Asymmetric Information
• Monopoly Power
Efficiency
• 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…
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)
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
S1
Price
P*
D1
Q*
Quantity
S1
Price
P1
P*
D1
Qd1
Q*
Qs1
Quantity
S1
Price
P*
P2
D1
Qs2
Q*
Qd2
Quantity
Costs and Benefits
• Social Costs= Private Costs + External Costs
• Social Benefit= Private Benefit + External Benefit
• List the private costs, private benefits, external
costs and external benefits of car ownership
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)
• 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
Socially Efficient (Optimum) Output/
Allocatively Efficient Output
Price/
Costs
and
Benefits
S= MSC
P*
D= MSB
Q*
The value consumers place on the last unit produced is
equal to the full cost of producing that last unit
Quantity
Market Failure
• When markets do not provide us with
the best outcome in terms of efficiency
and fairness
• Types of market failure?...
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
Negative Externalities
• External costs of an economic activity
• Negative Consumption Externalitiesexternal costs arising from a
consumption activity eg. Driving a car
• Negative Production Externalitiesexternal costs arising from a production
activity eg. A chemical factory
discharges it’s waste into a local river
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
Negative Production
Externalities
S (based on private and external
costs (MPC+MEC= MSC))
Price
(costs/
benefits)
P*
S (based on private
b
costs to the firm (MPC))
a
P1
c
D (based on private benefits to
the consumer and assuming no
external benefits (MPB+MEB=
MSB))
Q*
Q1
Quantity
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
Positive Production
Externalities
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
Price
(cost/
benefit)
S (= MPC)
S (= MSC)
P1
P*
D (= MSB)
Q1
Q*
Quantity
Consumption Externalities
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’
Price
( Costs/
Benefits)
Negative Consumption
Externality
S (MSC)
P1
P*
D (MSB)
Q*
Q1
D (MPB)
Quantity
Positive Consumption
Externalities
• 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’
Positive Consumption Externality
Price (
Costs/
Benefits)
S (MSC = MPC
i.e. there are no
external costs)
P*
P1
D (MPB)
Q1
Q*
D (MSB)