3.8 Limitations of Markets

• Market failure refers to those areas where a free market economy fails to achieve an optimum/ efficient allocation of resources

  A key example of this is externalities, which are defined as ''an effect of an economic activity on a third party''
• There are two types of externality:

  • Positive externalities are defined as 'a beneficial effect of an economic activity on a third party, also known as external benefit'
  • Negative externalities is defined as 'a harmful effect of an economic activity on third parties, also known as external cost'
• • Consumption externalities -> An externality which affects the consumption side of the market. It can be positive or negative, but a negative consumption externality indicates that there is a cost arising from the consumption process which negatively impacts upon an innocent third party.
  • Production externalities -> An externality which affects the production side of the market. It can be positive or negative, but a negative consumption externality indicates that there is a cost arising from the production process which negatively impacts upon an innocent third party.
• Negative Externalities -> terms + concepts:

  • Private cost -> The cost to the decision maker
  • External cost -> The cost to the innocent third party
  • Social cost -> The total cost to everyone in society as a result of a decision.
  • Social Cost = Private Cost + External Cost
• Positive Externalities -> terms + concepts:

  • Private benefit -> The benefit to the decision maker
  • External benefit -> The benefit to the innocent third party/ non decision maker
  • Social benefit -> The total benefit to everyone in society from consumption or production
• Negative externalities arise when social costs exceed private costs. Examples of these are:

  • Environmental pollution
  • Congestion
  • Firms dumping waste into local streams/rivers
  • Overall, individual consumers/ producers will pay the private cost of their actions but completely ignore the external costs. As a result, consumers find that the price is lower than what society would like it to be AND in a free market economy there is OVERCONSUMPTION.
• Positive Externalities occur when too few of these goods are produced/ consumed when left entirely to the free market. Examples of these are:

  • Healthcare -> Individuals benefit from healthcare treatment as they are no longer ill, and society will benefit as workers have fewer days off work sick... so overall output rises.
  • Education -> An individual will gain certain benefits from attending university, & wider society benefits from having a more skilled + productive workforce. Too few people will take into account the external benefits when making a decision to go to university or not.
• Solving Negative Externalities -> The govt. intervene to reduced consumption and production of goods + services which generate negative externalities, to prevent too many scarce resources being inefficiently used in production of goods society does not need/want. The policies used are:

  • Indirect Taxes
  • Legislation + Regulation
  • Information provision
• Solving Positive externalities -> The govt. will intervene in the market to solve under consumption, using these policies:

  • Subsidies
  • State provision
  • Regulation
  • Information Provision
• • Regulation is defined as ''a rule from the govt. that firms and/or consumers have to follow.''
  • State provision is defined as ''Govt. intervention in a market to supply a good or service direct to consumers.''
  • Information provision is defined as ''Govt. intervention in a market to give knowledge that might change behaviour''
• Solving negative externalities -> Indirect Taxes

  • An indirect tax increases a firm's costs of production *see diagram*. This, in turn, leads to a reduction in supply as firms will make less profit, so have less incentive to supply the goods. This increases the equilibrium price resulting in a contraction of demand. Overall, the problem of overconsumption is removed. Additionally, the increased tax revenues can be used by the govt. to combat the effects of negative externalities.
• • Examples of behavioural taxes -> Taxes on cigarettes, alcohol, petrol, and plane tickets
  • Examples of green taxes -> taxes on cars, landfill, & air passenger duty
• A problem with using indirect taxes to solve negative externalities is that there are questions in regards to what size the tax should be. In theory, a tax should be introduced which is identical to the monetary valuation of the external cost. However, this is extremely difficult to achieve, and if the tax is too small then there will still be overconsumption.
• A problem with using indirect taxes to solve negative externalities is that if the product has inelastic demand then consumption will not be reduced by much. *See diagram* Here, a rise in price will result in only a small contraction of demand, so the issue of overconsumption is likely to remain.
• Some problems with using indirect taxes to solve negative externalities:

  • They inflationary -> If firms costs of production have risen, they may pass these on to consumers in the form of higher prices, resulting in cost-push inflation. This will reduce the international competitiveness of a nation.
  • Wider macroeconomic effects -> falling demand in certain industries will lead to higher unemployment + the problems which this brings.
  • The regressive nature of taxes -> These taxes have a big impact on low income groups. So, increased use will worsen the income inequality in an economy.
• In judgement, whether or not indirect taxes are successful in solving negative externalities will depend upon:

  • Whether the correct size of tax is introduced
  • Whether the economy is growing or not.
• Solving Negative Externalities -> Legislation + Regulation

  • High polluting firms are threatened with large fines --> They reduce pollution/ change their behaviour --> This reduces negative externalities --> Market failure which previously existed due to scarce resources being wasted is removed *see diagram*
• Problems with using legislation + regulation to solve negative externalities:

  • They must be enforced
  • There is a cost in enforcing regulation -> An opportunity cost arises of the benefit of spending on other things.
  • Effective regulation requires the govt. to know exactly what level of regulation to introduce.
  • Pollution is a global issue, so regulation needs to be introduced internationally.
  • The level of fines must be sig. enough to act as a sufficient deterrent.
• Solving negative externalities -> Information Provision

  • Providing information about how harmful certain goods are ('demerit' goods) will aim to shift demand to the left, reducing overconsumption.
• Problems with using information provision to correct negative externalities:

  • If products are addictive then consumers may not take notice of advice, so overconsumption will remain.
  • Education can take a very long time to have an impact
  • Advertising can be expensive, incurring an opportunity cost for the govt.
  • Some consumers may be IRRATIONAL and choose to ignore the information.
• Solving positive externalities -> Subsidies

  • If too little of the good/ service is being produced, then a subsidy to producers will have the effect of lowering a firms costs of production. The firm will now make a greater profit, so will have more incentive to supply *see diagram*, which will lead to a fall in equilibrium price, causing an extension of demand. Overall, the subsidy has been effective at raising demand and therefore consumption -> hence the problem of underproduction/ underconsumption can be solved.
• Problems with using subsidies to correct positive externalities:

  • Subsidies are much less effective when PED is inelastic -> Here, a fall in price will only lead to a small change in demand. This means underconsumption will not entirely be sold, and market failure remains.
  • The subsidy must be set exactly equal to the external benefits of an action -> It is very difficult and almost impossible to place a monetary value on external benefits. If the subsidy is too small, underconsumption will remain.
  • Subsidies would be expensive to introduce so there is a sig. opportunity cost.
• Solving positive externalities -> State provision

  • See diagram
  • As there is a fixed supply of school/ hospital places the increase in supply is perfectly inelastic.
  • Here, state provision will increase supply. By providing the goods for free, there will be a greater level of consumption. As a result, underconsumption is solved.
• Problems with using state provision to solve positive externalities:

  • As the good/ service is provided at a zero price, there will be high levels of demand. However, will the govt. be able to provide sufficient quantities of it?
  • There is an opportunity cost to the taxpayer to fund this
  • As it is provided at a zero price, demand may exceed supply which could result in shortages or waiting lists.
• Solving positive externalities -> Information Provision

  • Providing information about how beneficial certain products are ('merit goods') will shift the demand curve for a product to the right, raising consumption and reducing the problem of underconsumption.
• Problems with using information provision to solve positive externalities:

  • It is expensive, so a large opportunity cost arises
  • People may still choose to ignore the information and be irrational, so market failure will remain.
  • In judgement, it will depend upon how rational people are and the willingness of people to change behaviours.
• Solving positive externalities -> Regulation

  • They can be quickly implemented
  • They are legally binding
  • Any revenue gained by fines can be used to improve public services OR can be used to compensate these innocent 3rd parties adversely affected by negative externalities.
  • See analysis in notes
• Problems with using regulation to solve positive externalities:

  • It is difficult to decide exactly what level to introduce. If it is too small, it will not act as a deterrent, and underconsumption will remain.
  • Regulations must be enforced, otherwise they are ineffective. This can be expensive, so an opportunity cost can arise.