Transcript Topic 1.3.1 to 1.3.4 Market Failure student version

Market Failure
1.3.1 syllabus
Candidates should be able to:
• Define market failure
• Assess different types of market failure
- externalities, under-provision of public
goods and information gaps.
1.3.1 What is “Market Failure”?
For an optimum allocation of resources,
prices must reflect the full costs and
benefits and they must not be open to the
undue influence of firms.
Market failure occurs when the free
market (the price mechanism) causes an
inefficient allocation of resources.
The result is a loss of economic and social
welfare.
1.3.1 Why does market failure lead to inefficiency?
There are two key reasons:
 Firms are not maximising output.
Why does this matter?
Resources are misallocated and goods
are produced that are not wanted.
Why does this matter?

1.3.1 Why might markets fail?
1.
2.
3.
externalities - negative or positive
externalities are the costs or benefits that
affect third parties (1.3.2).
Under provision of public goods such as
education or healthcare (1.3.3)
information gaps - imperfect market
information (1.3.4)
1.3.2 syllabus
Candidates should be able to:
• Distinguish between private, external and social
costs and benefits
• Illustrate: the external costs of production using
marginal analysis; the distinction between market
equilibrium & social optimum position; welfare loss
• Illustrate: the external benefits of consumption using
marginal analysis; the distinction between market
equilibrium & social optimum position; welfare gain
• Understand the impact of externalities on economic
agents and government intervention
1.3.2 Externalities
What are externalities?
Externalities are the costs or benefits that
affect third parties (society).
Why might externalities cause market failure?
They cause market failure if the price
mechanism does not take account of the
wider costs and benefits to society of
production and consumption.
1.3.2 Costs
When a firm builds a factory to produce
steel, what costs does it incur?
These are known as the private costs
What costs might local people incur?
These are known as the external costs
The actual total cost is private + external
This is called the social cost
1.3.2 Negative externalities
Negative externalities occur when the total
cost to society (the social cost) exceeds the
cost to the firm (the private cost).
This leads to the private optimum level of
output being greater than the social
optimum level of production.
Externalities lead to the wrong amount of a
product being produced.
1.3.2 Benefits
When a firm builds a factory to produce
steel, what benefits does it gain?
These are known as the private benefits
What benefits might local people incur?
These are known as the external benefits
So total benefit is private + external
This is called the social benefit
1.3.2 Marginal costs
The marginal cost is the additional cost derived from
producing one more unit of something.
The marginal social cost considers both marginal
private costs and marginal external costs.
Remember the actual total cost = private +
external and this is called the social cost
Marginal social cost = marginal private cost + marginal external cost
1.3.2 Marginal benefits
The marginal benefit is the additional benefit derived
from consuming one more unit of something.
The marginal social benefit considers both marginal
private benefits and marginal external benefits.
Remember the actual total benefit = private +
external and this is called the social benefit
Marginal social benefit = marginal private benefit +
marginal external benefit
Negative externalities for a coal-fired power station
What are the private costs for a coal-fired
power station?
Who pays for them?
What are the external costs?
Does the firm take these into account when
making decisions about pricing?
1.3.2 More negative externalities
Firms will only consider the private costs of
production.
This means that the price will be lower than
if the full costs to society were accounted
for.
Thus the level of production and the
quantity demanded will be higher than if the
full social costs had been considered.
1.3.2 Diagram showing negative externalities
Draw supply and demand curves.
Label:
• D = MSB = MPB
• S1 = MPC
Assume that the supply curve takes into
account all of the costs to society. Add this
to your diagram and label appropriately.
HINT: remember the formula you wrote on
your slide on page 3.
1.3.2 Explain your negative externalities diagram
On the previous diagram: if there are
negative externalities, we must add the
external costs to the firm’s supply curve to
find the social cost curve. Hence supply
curves shifts left.
If the market fails to include these external
costs, then the equilibrium output will be Q1
and the price P1 this is the market
optimum position.
1.3.2 Diagram showing welfare loss
Draw the same diagram and label curves
MSB, MPC and MSC
Label the socially optimum output and the
free market output.
Highlight the welfare loss triangle.
1.3.2 Pollution
Edexcel state: “It is useful to point out that
the efficient level of pollution is not zero”
Why is this the case?
1.3.2 Positive externalities
Positive externalities occur when the social
benefit of consumption exceeds the private
benefit
e.g. ______________________ both benefit
society as well as individuals
Marginal social benefit = marginal private benefit +
marginal external benefit
The problem with positive externalities is that too
little of a good or service is produced.
If only the private benefits (and not the full benefits
to society) are considered, then there will be underproduction.
1.3.2 Diagram showing positive externalities
Draw two curves.
Label:
• MPB
• MPC
Assume that we take into account the full
benefit to society. Add this to your diagram
and label appropriately.
HINT: remember the formula you wrote on
your slide on page 3.
1.3.2 Explanation of diagram
1.3.2 Education
What are the benefits of education to you?
To your parents?
To society?
Which of these are private benefits and
which are external benefits?
1.3.2 Other examples of external benefits
Why might the following have external
benefits as well as private benefits?
• Healthcare
• Public libraries
• Local sports facilities
1.3.2 Draw a diagram showing positive
externalities and welfare gain
1.3.3 syllabus
Candidates should be able to:
• Distinguish between public and private
goods using the concepts of non-rivalry and
non-excludability
• Explain why the market may not provide
public goods (the free-rider problem)
Public goods
Public goods are a type of good that can
lead to market failure.
Public goods are defined as having two key
characteristics:
1. non-excludability
2. non-rivalry
1.3.3 Definition of public goods
o
o
o
o
non-excludability: the benefits derived from the
provision of public goods cannot be confined to
only those who have actually paid for it. This is the
free-rider problem. E.g. defence
i.e. anyone can benefit – they don’t need to pay
non-rivalry: consumption of a public good by one
person does not reduce the availability of a good
to other. E.g. defence
i.e. one person using it doesn't affect the quantity
1.3.3 Private goods
Private goods are excludable: the benefit
derived is confined to those who have
actually paid for it.
o Private goods are rivalry: consumption of
a good by one person reduces the
availability for others
E.g.
o
1.3.3 Provision of public goods
Why are public goods not provided by
the private sector?
1.3.3 Free-rider problem
The government must decide what output
of public goods is needed.
To do this it must estimate the social
benefit. This is difficult to do!
The free-rider problem is that consumers
behaving rationally will try to gain a ‘free
ride’ but once a public good has been
provided, other consumers can’t be
excluded.
Examples:
1.3.3 More public goods questions
Are the following private goods or public
goods? Are they non-rivalrous or nonexcludable or do they contain elements of
both?
• A playground
• Broadcasting
• A firework display
• Police protection
1.3.4 Syllabus
Candidates should be able to:
• Distinguish between symmetric and
asymmetric information
• Analyse how imperfect information may
lead to a misallocation of resources.
1.3.4 Imperfect information – merit goods
Merit goods are goods that would be
under-consumed in a free market, as
people do not fully understand the benefits
The public and private sector both provide
merit goods.
e.g.
Consumption of merit goods is believed to
generate positive externalities.
1.3.4 Imperfect information continued
A merit good is a product that society
values and judges that everyone should
have regardless of whether an individual
wants them.
The government believes that individuals
may not act in their own best interest
because of imperfect information about the
long-term benefits that can be derived.
1.3.4 Imperfect information and demerit goods
Demerit goods are goods considered ‘bad’
e.g.
The consumption of demerit goods can lead
to negative externalities, which consumers
may be unaware of, since they have
imperfect information about long-term
damage to their own health.
Demerit goods are linked to a failure of
information. So the government tries to
reduce consumption of demerit goods.
1.3.4 Draw a diagram showing the welfare
loss for alcohol
1.3.4 Link between imperfect information and merit
goods
Merit goods are linked to a failure of
information.
E.g.
Merit goods are an example of market
failure - the free market will lead to the
provision of a product, but in the wrong
quantity, leading to a misallocation of
resources.
1.3.4 Symmetric information
Symmetric information is when both
buyers and sellers have perfect
information i.e. they all have a good
knowledge about the product.
E.g. you may know a great deal about ?
1.3.4 Asymmetric information
Asymmetric information is when one party
knows more than the other.
Some products are only bought
occasionally so consumers may have
limited information e.g. washing machines.
For other products e.g. dentistry,
consumers have very limited information
whilst the producer knows a great deal –
you can’t tell if you are getting appropriate
treatment!
1.3.4 Examples of asymmetric information
1.3.4 Summary of imperfect information
In summary, imperfect information means
that merit goods are under-produced while
demerit goods are over-produced or
over-consumed.
Merit and demerit goods are considered
failures of the market since their existence
will cause the wrong amount of the goods
and services concerned to be produced.
Imperfect information may lead to a
misallocation of resources.
1.3.4 What type of information?
•
•
•
•
A private dentist tells you that you need a
filling
A second-hand car sales person tells me
the car is a good runner
The seller of a pension scheme who says
the future will be well provided for
The cigarette manufacturer who does not
inform potential consumers of the true
health risk from smoking