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Introduction to

Market Failure

Market Failure

Definition:
Where the market mechanism fails to allocate
resources efficiently

Market Failure

Social Efficiency = where external costs and benefits are


accounted for

Allocative Efficiency = where society produces goods and services at minimum cost that
are wanted by consumers WHO GETS THE GOODS

Technical Efficiency = production of goods and services using the minimum amount of
resources WITH WHAT ARE GOODS PRODUCED

Productive Efficiency = production of goods and services at lowest factor cost HOW
ARE THE GOODS PRODUCED

=,

=
,
=
, ,
=
,

Or put simply
Markets can function inequitably
Markets can function inefficiently

Market Failure
Market Failure occurs where:
Imperfect Competition

Externalities

Incomplete Information

Market Failure
Market Power:
Monopolies and oligopolies
Collusion
Price fixing
Supernormal profits
Barriers to entry

Imperfect Knowledge: Asymmetry of


Information
Consumers do not have adequate technical knowledge
Advertising can mislead or mis-inform
Decisions often based on past experience rather than
future knowledge

Market Failure
Goods/Services are Differentiated

Branding

Designer labels - they cost three


times as much but are they three
times the quality?

Labelling and product


information

-
,

?

Which one is the quality item and why?

Private Goods
i.e. goods that can be identified as your possession.
You have Property Rights over that good.
It is therefore excludable i.e. you can prevent other people from
using it.
.. ,
.
" "
.
' ",
.

Tragedy of the Commons



Because it is difficult to establish property
rights there is the likelihood that this resource
will be overused and destroyed.

,

.

Overfishing

Rubbish Island in Pacific


The Great Pacific Garbage Patch

ARAL SEA

1973

1986

2001

2004

Market Failure
Public Goods
Markets would not provide such goods and
services at all!
e.g. police, street lighting,
Non- excludability

Person paying for the benefit cannot prevent


anyone else from also benefiting - the free rider
problem

A non- excludable good?



!
, ,




-
'

Would you pay for this?

Merit Goods & Demerit Goods


Consumption of merit goods gives social benefits or
imposes social costs.

In groups of two, think of examples of each and why.



.

,
....

Merit Goods
nurseries,
schools,
colleges,
universities
could all be provided by the
market but would everyone
be able to afford them?
,
,
,
Schools: Would you pay if the


state

did not provide them?


,
? ,

Demerit Goods
De-Merit Goods
Society suffers from the consumption of these goods.
Goods and services provided by the market which are not
in our best interests! examples
Tobacco and alcohol
Drugs
Gambling
-
.
, ,
!

De-merit goods
Merit goods are good for you. De-merit goods are thought to
be bad for you

"Smoking may become a reason of


long and painful death".

"Smoking causes drug addiction"

"Smoking

during pregnancy causes harm to


your child".

"Smoking causes impotence".

Activity 5 minutes
How can a government limit the consumption of
demerit goods?
How can the consumption of merit goods be
encouraged?
Think of as many ways.

?
?
, .

Market Failure
External Costs and Benefits
External or social costs
The cost of an economic decision to a third
party
External benefits
The benefits to a third party as a result of a
decision by another party

Market Failure
External Costs

e.g. Pollution
traffic congestion,
environmental degradation
depletion of the ozone layer

One ton of industrial wastes per resident in Pavlodar oblast


Tengri News March 2013

Marginal Social Cost

Price

+ Marginal Private Cost


Marginal Private
Cost

P2
Pe

Negative
Externality

P1
Marginal
Benefit = D

Quantity

Marginal Social Cost

Price

+ Marginal Private Cost


Marginal Private
Cost

P2
Pe

Negative
Externality

P1
Marginal
Benefit = D

Quantity

Marginal Cost Curve


Marginal cost curves are U shaped.
The cost of producing the extra item is
considered to fall at first
then it will rise
This is because of economies and then
diseconomies of scale

Marginal Benefit Curve


Downward sloping
I.e. the benefit from consuming the extra unit
of output will decline
I.e. the value the consumer puts on the extra
good will fall and the quantity increases.


Price

MSC + MPC

( )
12

7
5

Socially efficient output is where


MSC = MSB

80

100

Quantity Bought and Sold

Market Failure
External benefits
by products of production and
decision making that raise the
welfare of a third party


,

External Benefits
Price
MSC

Value of the positive


externality (Welfare Loss)

$10

$6.50
$5

Social Benefits

MSB

Socially efficient output


is where
MSC = MSB

MPB
100

140

Quantity Bought and Sold

Market Failure
Measures to Correct Market Failure

State Provision
Extension of property rights
Taxation
Subsidies
Regulation
Prohibition
Positive Discrimination
Redistribution of Income

Homework
Gyms and sports halls are merit goods. With the help of an appropriate
diagram, explain why merit goods are often underprovided.
(8 marks)
or
With the help of an appropriate diagram, explain how taxation can reduce
the negative externalities (pollution) caused by factories.
(8 marks)
....
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.
(8 )

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(8 )