Market Failure

• A market failure occurs when the market fails to produce at socially optimal amounts.
• To correct perceived market failures, there is a government intervention.
• Private benefits are the gains of consumption enjoyed by an individual.
• Private costs are the expenses of production incurred to an individual firm.
• Social benefits are the total benefits of consumption to society, that is, the sum of private benefits and external benefits.
• Social costs are the total costs of production to society, that is, the sum of private costs and external costs.
• Market failure occurs when the signalling, incentive, and rationing functions of the price mechanism fail to operate optimally.
• Allocative efficiency is achieved when social or community surplus is maximized.
• The socially optimum level of output is when the marginal social benefit equals the marginal social cost.
• Public goods are goods that are non-rivalrous and non-excludable and therefore will not be provided by the free market such as roads, light houses, national defense, etc.
• Both positive and negative externalities are a source of market failure because they are both spillover effects of economic activity.
• Externalities (spillover effects) are the external costs or benefits of an economic transaction
• Merit goods are rivalrous and excludable.
• Rivalrous means that the consumption of a good takes away the ability for others to consume that good.
• Excludable means that firms can exlude non-payers from the benefits of consumption.

  E.g. private healthcare clinics and private schools.
• Since merit goods are both rivalrous and excludable, they tend to be under-consumed and under-produced in a free market.
• Non-rivalrous means that the consumption of a good does not take away the ability for others to consume that good.
• Non-excludable means that firms cannot exclude non-payers from the benefits of consumption.
• Abuse of monopoly power


  When a single firm dominates a market, they tend to produce less than the socially optimal level of output with a price higher than what would be charged in a competitive market.
• Income inequality


  Income is unequally distributed in society because of the underprovision of education and lack of opportunities for economic advancement between different levels of society.
• Information asymmetry


  When the buyer and seller have different levels of information during an economic transaction.
• Private goods


  Goods that are rivalrous and exludable
• Public goods


  Goods that are non-rivalrous and non-excludable
• Club goods


  Goods that are non-rivalrous but excludable
• Common access resources


  Goods that are rivalrous but non-excludable
• Common access resources such as ocean fish are rivalrous but non-excludable; Nobody owns the resource but anyone is able to exploit it. This leads to "tragedy of the commons" where people act in their own interest and there is consumption to the point of depletion.
• Marginal social cost (MSC)


  Total costs to society from an extra unit of production
• Marginal social benefit (MSB)


  Total benefits to society from an extra unit of consumption
• Marginal private cost (MPC)


  Cost to a firm from an extra unit of production
• Marginal private benefit (MPB)


  Benefit to an individual from an extra unit of consumption
• Merit goods


  Goods that create positive externalities when consumed
• Demerit goods


  Goods that create negative externalities when consumed
• Free goods


  Products with a natural abundance and do not require deliberate effort to obtain (eg. air, seawater, sand).
• Perfect competition


  no one firm is able to singlehandedly determine the market price
• Social surplus (or community surplus)


  Sum of consumer and producer surplus at a given market price.
• Positive externalities (External benefits)


  Benefits enjoyed by a third party not directly involved in an economic transaction
• Negative externalities (External costs)


  Expenses incurred to a third party in an economic transaction for which no compensation is paid
• Signalling (Price mechanism) provides information to consumers and producers where resources should be allocated.
• Incentive (Price mechanism) refer to the change in market forces based on changes in price.
• Rationing (Price mechanism) refers to preserving resources and limiting consumption when faced with excess demand or shortage.