1.3 Market Failure

• what happens when markets "work" perfectly

  supply and demand allocate resources

  most efficient allocation of resources is achieved

  best available solution to the basic economic problem is achieved
• why don't markets work perfectly

  • irrational behaviour
  • behavioural economics
  • computational weakness and anchoring
  • lack of information
  • lack of competition
  • inequality
  • misallocated resources from the point of view of society as a whole - externalities - partial market failure
  • missing/absent markets - public goods - complete market failure
• externalities are a major cause of market failure and are likely in every market

  • externalities, spill-over effects from production and consumption
  • no appropriate compensation is paid/received
  • lie outside the initial market transaction/price
  • causes market failure if price mechanism doesn't take account of social costs and benefits of production and consumption
• externalities can be positive and/or negative

  • negative production externalities
  • negative consumption externalities
  • positive production externalities
  • positive consumption externalities
• private costs

  costs faced by the producer or consumer directly involved in a transaction
• private benefits

  benefits for producer of consumer directly involved in an economic transaction
• the existence of externalities creates a divergence between private and social costs of production and the private and social benefits of consumption
• social cost = private cost + external cost

  social benefit = private benefit + external benefit
• when negative externalities exist, social costs exceed private cost

  leads to over-production and market failure if producers do not take into account the externalities
• when positive externalities occur, social benefits exceed private benefit - can lead to market failure
• private and external costs and benefits on a graph

  
• marginal social cost and benefit - MSC + MPB

  
• negative externalities

  exist when third parties are harmed by the spill-over effects from production or consumption
• private costs

  costs faced by the producer/consumer who is directly involved in the transaction
• external costs

  costs imposed on third parties who aren't directly involved in the transaction (externalities)
• social costs = private costs + external costs
• external costs damage third parties, but the consumer and producer don't have to pay, meaning that the output will be too high

  in the case of negative production externalities, the market price will be too low
• marginal private cost - MPC


  cost to the firm of producing an additional unit of output
• marginal external cost - MEC


  cost to third parties from the production of an additional unit of output
• marginal social cost - MSC


  total cost to society of producing an extra unit of output
• MSC = MPS + MEC
• negative production externalities are generated and received in supplying a good or service and they often involve noise and atmospheric pollution e.g. pollution from factories, pollution from fertilisers, industrial waste, noise pollution from aircraft, collapsing fish stocks and methane emissions from cows
• negative production externality

  if MSC pivots away from MPC then the MEC of extra output is increasing, the equilibrium output delivered in the free market is allocatively inefficient assuming there's no externalities from consumption so MSB=MPB

  
• social welfare loss

  when drawing welfare triangle, put pencil on free market equilibrium and draw a vertical line in whichever direction you can create a triangle - triangle always creates an 'arrow' that points towards the desired socially optimal equilibrium

  
• positive externalities exist when third parties benefit from the spill-over effects from production or consumption

  e.g. social returns from investment in education, positive benefits from health care/medical research
• private benefits

  benefits enjoyed by the producer and/or consumer who is directly involved in the transaction
• external benefits

  benefits enjoyed by third parties who aren't directly involved in the transaction (externalities)
• social benefits = private benefits + external benefits
• external benefits are good for third parties, but the consumer and producer don't take this into account, meaning that output will be too low, and in the case of positive consumption externalities, the market price will be too high
• marginal private benefit - MPB

  benefit to consumer consuming additional unit of output
• marginal external benefit - MEB

  benefit to third parties from the consumption of an additional unit of output
• marginal social benefit - MSB

  total benefit to society of consuming an extra unit of output
• MSB = MPB + MEB

  with positive consumption externalities, marginal social benefit is higher than marginal private benefit
• positive consumption externality


  in a free market, there is under-consumption of the good/service

  
• mixed externalities


  negative production and positive consumption externalities

  there are net social benefits from consuming and producing the product, the free market mechanism underprovides this product and leads to market failure

  
• negative production + positive consumption externalities

  there are net social costs from consuming and producing the product, the free market mechanism leads to an overproduction of this product, leads to market failure

  
• shadow pricing


  a means of estimating the effect of an externality by calculating a potential price of lost opportunities

  e.g. the external cost of road congestion can be calculated by the number of hours lost by the average wage - 1m working hours lost x £12 average hourly wage = £12m
• compensation


  estimate the cost of 'putting right' an externality

  e.g. include the cost of installing double glazing in houses affected by increased road noise from a new motorway - if 200 houses are affected each with £5,000 double glazing cost, increased road noise is estimated at £1m
• revealed preference


  how much people are willing to pay to avoid an externality

  e.g. if 200 householders are willing to pay £2,000 each to avoid noise, the externality is valued at £0.4m
• Market failure occurs when the market fails to allocate scarce resources efficiently, causing a loss in social welfare