market failure

• Market failure

  Occurs when resources are not allocated efficiently - total surplus is not maximised
• 4 kinds of market failure

  market power, externalities, public goods, common property resources
• When do imperfect markets exist

  relatively small number of firms, firms have market power, firms use product differentiation, barriers to entry are used
• Barrier to entry

  government regulation and patents, start-up costs, technological advantages
• Market power

  A firm can affect market price by varying its output
• How does market power = market failure

  Firms attempt to profit maximise -> higher prices and reduced output -> decreasing total economic surplus

  Producer surplus increases, but consumers pay more and receive less (DWL)
• Regulation of market power

  govt legislation can prevent anti-competitive conduct to improve efficiency of economy, price regulation can increase quantity and decrease price, requiring firms to protect consumer rights
• Externalities

  Production or consumption of a good creates external costs and/or benefits -> side effects of economic activity
• Why externalities = market failure

  When they exist, market outcome is not efficient: fails to set correct price and fails to produce at socially optimal quantity
• Negative externalities

  Economic actions create an external cost -> cause market quantity to be greater than optimal; price will be less than optimal
• Example of negative externality

  Factories that emit pollutants into atmosphere impose external costs by adversely affecting health of people in the area;
• Why does negative externality = market failure

  overproduction -> DWL -> decrease in TS. Social costs are not recognised by Private market
• Positive externalities

  Benefits of an economic transaction that have "spilled over" to a third party
• Example of positive externality

  education: HECS allows students an extra salary for further education. This benefits society because in the long run the student will be skilled in a productive woorkforce.
• Why does positive externality = market failure

  market quantity is less than optimal -> DWL -> decrease in total surplus
• Internalising externalities

  Govt. uses market based policies to force the government to recognise the external cost or benefit in the market price.
• Internalising positive externalities

  Govt. pays a subsidy equal to external benefit to shift consumer's private demand curve to the social demand curve. Producer recieves Pe, consumer pays P2, quantity increases
• Internalising negative externalities

  Reduce output by placing e.g a pollution tax equal to external costs. This increases firm's private costs to shift and coincide with the social supply curve. Price increases - > output decreases - > polluter pays principle -> factories have incentive to decrease tax bill
• Private goods

  rival in consumption - one person's consumption decreases another excludable from non-payers - exclusion principle (consumers who purchase gain exclusive rights of ownership and benefits)
• example of private good

  most household goods e.g A can of soda
• club goods

  non rival in consumption (can be consumed by multiple people at the same time) e.g streaming music and excludable (price can be used to exclude those that don't pay) e.g people must pay a subscription fee to stream music
• public goods

  non-rival in consumption and non-excludable. Many people can breathe air, watch a free-to-air tv broadcast, watch a fireworks display. Impossible to prevent a non-payer from using the product.
• Example of a public good

  Lighthouses are non-rival (ships using the light doesn't prevent other ships from doing so) and non-excludable (lights cannot be turned off for some ships and on for others.)
• Why does public good = market failure

  characteristics of non-excludable makes public goods subject to the free-rider problem. Producer cannot charge everyone who uses good; benefits of the good are consumed without a cost.
• Common resources

  Non excludable and rival in consumption. Ownership of the oceans are universal (no clearly defined property rights). People become encouraged to use as much of the good as possible (becomes rival and suffers from the tragedy of commons)
• What is tragedy of commons

  People acting independently to pursue their own self interest cause the depletion of shared resources
• Example of a common resource

  Fish and wildlife are non-excludable and rival; some free highways become congested and 'rival' at peak hour
• Why do common resources = market failure?

  Suffers from the tragedy of commons -> market fails to preserve stocks of depleted resources e.g fish and wildlife from becoming extinct -> poses a threat to sustainability
• How does govt. intervene in common resources?

  Regulation to manage and control use of goods e.g setting licenses for commercial fishing, setting a restricted fishing season and bag limits for recreational fishing
• Merit goods

  Govt supplied goods because of their large external benefits on society. Society places less value -> underconsumption -> govt. intervenes to supply at a heavily subsidised price -> more consumption

  e.g health and education
• What is a barrier to entry

  anything restricting or blocking a new firm from entry into a market
• how does market power = DWL 


  Producer surplus increases, consumer surplus decreases (pay more and receive less) total economic surplus decreases
• Examples of business practices that reduce competition


  misuse of market power, predatory pricing, merger, cartel