1.3 Market Failure

• An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism. This leads to the over or under-production of goods, meaning resources aren’t allocated efficiently. For example, cars and cigarettes have negative externalities whilst education and healthcare have positive externalities.
• Public goods are non-rivalry and non-excludable, meaning they are underprovided by the private sector due to the free-rider problem. The market is unable to ensure enough of these goods are provided. One of the best examples of a public good is streetlights.
• firms are assumed to have perfect information on their cost and revenue curves and governments are assumed to know the full cost and benefits of each decision. In reality, this is not the case. Therefore, economic agents do not always make rational decisions and so resources are not allocated to maximise welfare. For example, consumers do not know the quality of second hand products, such as cars, and pension schemes are complex so it is difficult to know which one is best.
• Private costs/benefits are the costs/benefits to the individual participating in the economic activity. The demand curve represents private benefits and the supply curve represents private costs.
• Social costs/benefits are the costs/benefits of the activity to society as a whole.
• External costs/benefits are the costs/benefits to a third party not involved in the economic activity. They are the difference between private costs/benefits and social costs/benefits.
• A merit good is a good with external benefits, where the benefit to society is greater than the benefit to the individual. These goods tend to be underprovided by the free market. A demerit good is a good with external costs, where the cost to society is greater than the cost to the individual. They tend to be over-provided by the free market.
• (MPB) is the extra satisfaction gained by the individual from consuming one more of a good and the marginal social benefit (MSB) is the extra gain to society from the consumption of one more good. The marginal private cost (MPC) is the extra cost to the individual from producing one more of the good and the marginal social cost (MSC) is the extra cost to society from the production of one more good.
• neg extern. of prod occur when SC > PC. market left to operate freely'll ignore EC inv. in prod a good. It'll produce where MPB=MPC, market equilibrium, at Q1P1. At Q1, costs to soc. > benefits to soc. result in loss of welfare=shaded area. EC at Q1 =line AB. economy should produce where MSB=MSC, social optimum position, at Q2P2. difference between MSC and MPC inc. as output grows cuz external costs grow more as pple do something. If one drove car, then EC of pollution'd be small. more people larger EC of pollution. noise pollution from airplanes and industrial waste are two examples of NPE.

  
• Pos. extern. of cons. occur when SB >SC. In diagram, market left to its own devices'll produce where MPB=MPC, it won't consider benefits to soc. so'll produce Q1P1. If market considers all benefits, it would produce where MSB=MSC at Q2P2. failure of market to consider EB led to misallocation of resources & underproduction of Q1-Q2. leads to a welfare loss of the shaded area. line AB represents EB. difference between MPB and MSB grows since EB grow more people undertake activity, for example EB of vaccinations. Healthcare and education two examples of PCE.

  
• GI Indirect taxes and subsidies: Taxes can be put on goods with negative externalities and subsidies on goods with positive externalities. These help to internalise the externalities, moving production closer to the social optimum position.
• GI Tradable pollution permits: These allow firms to produce up to a certain amount of pollution, and can be traded amongst firms so give them choice whilst reducing the total level of pollution.
• GI Provision of the good: When social benefits are very high, the government may decide to provide the good through taxation. They do this with healthcare and education.
• GI Provision of information: Since some externalities are associated with information gaps, the government can provide information to help people make informed decisions and acknowledge external costs.
• GI Regulation: This could limit consumption of goods with negative externalities, for example banning advertising of smoking etc.
• Free rider problem: you cannot charge an individual a price for the provision of a non-excludable good because someone else will gain the benefit from it without paying anything. A free rider is someone who receives the benefits without paying for it. Private sector producers will not provide public goods to people because they cannot be sure of making a profit , due to the non-excludability of public goods. Therefore, if the provision of public goods was left to the market mechanism, the market would fail and so they are provided by the government and financed through taxation.
• Symmetric information occurs where buyers and sellers have potential access to the same information; this is perfect information. However, many decisions are based on imperfect information and so economic agents are unable to make an informed decision; they suffer from an information gap.
• Asymmetric information is when one party has superior knowledge compared to another. Usually, the seller has more information than the buyer and this means they can take advantage of the other party’s lack of knowledge, by charging them a higher price.
• Most advertising leads to information gaps as it is designed to change attitudes of the consumers to encourage them to buy the good. It could cause them to think the benefits are greater than they actually are. Increases in technology mean information gaps are on the decline as people can get more information.
• Information gaps lead to market failure as there is a misallocation of resources because people do not buy things that maximise their welfare. It means that consumer demand for a good or producer supply of a good may be too high or too low, and thus price and quantity are not at the social optimum position. Economic agents are unable to make rational decisions due to the information gap.
• Some examples of information gaps are: drugs, where users do not see the long term problems; pensions, where young people do not see the long term benefits of paying into their pension schemes; financial services, where the suppliers have more information than the consumers so abuse their customers for their own benefit (moral hazard).