2.8

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• HL IB Economics
• Contents


  • 2.8.1 Market Failure
  • 2.8.2 Negative Externalities
  • 2.8.3 Positive Externalities
  • 2.8.4 Common Pool (Access) Resources
  • 2.8.5 Government Intervention to Address Market Failure
  • 2.8.6 Other Interventions to Address Market Failure

  
• Market Failure


  In a free market, the price mechanism determines the most efficient allocation of scarce resources in response to the competing wants and needs in the marketplace

  
• Scarce resources


  The factors of production (land, labour, capital, enterprise)
• Free markets often work very well
• Sometimes they do not and there is then a less-than-optimum allocation of resources, from the point of view of society. This is called Market Failure

  
• Causes of market failure which lead to a loss of allocative efficiency

  • Externalities
  • Public goods
  • Common pool resources

  
• Externalities


  External impact on a third party not involved in the economic transaction between the buyer and seller
• These impacts can be positive or negative and are often referred to as spillover effects
• These impacts can be on the production side of the market (producer supply) or on the consumption side of the market (consumer demand)
• Public goods


  Beneficial to society but would be under-provided by a free market
• There is little opportunity for sellers to make profits from providing these goods/services as they are non-excludable and non-rivalrous in consumption
• Common pool resources


  Resources with no private ownership, they are collectively shared and are finite (used up) in consumption
• These resources are non-excludable and rivalrous (limited in supply)
• From society's point of view, in each of these cases, there is a lack of efficiency in the allocation of resources
• Sometimes there is an over-provision of goods/services which are harmful (demerit goods) and therefore an over-allocation of the resources (factors of production) used to make these goods/services
• Sometimes there is an under-provision of the goods/services which are beneficial (public goods and merit goods) and therefore an under-allocation of the resources (factors of production) used to make these goods/services
• In the case of common pool resources there is an overuse of a finite resource
• Marginal private benefit (MPB)


  The additional benefit received from the consumption or production (output) of one additional unit of output
• Marginal private cost (MPC)


  The additional cost incurred through the consumption or production (output) of one additional unit of output
• Marginal social benefit (MSB)


  The benefit to society received from the consumption or production (output) of one additional unit of output. It is the sum of the private benefits plus the external benefits
• Marginal social cost (MSC)


  The cost to society incurred through the consumption or production of one additional unit of output. It is the sum of the private costs plus the external costs
• Socially optimum output


  The level of output where the marginal social benefit (MSB) = marginal social cost (MSC)
• This level of output considers where the market should be, if the market failures were accounted for

  
• This level of output is desired as there is no market failure
• Allocative efficiency from society's point of view


  At the point of allocative efficiency, community surplus is maximised
• The Y-axis is labelled costs/benefits (instead of price)

  
• The supply curve is labelled S=MSC as it represents the social cost
• The demand curve is labelled D=MSB as it represents the social benefit
• The socially optimum level of output is at Q_opt - the point at which all external costs or benefits are accounted for
• There is allocative efficiency at Q_opt as this is where the community surplus (consumer + producer surplus) is maximised
• When we consider market failure, our analysis focuses on the level of output and the resources used to generate that level of output. It is less about the price of the product (high or low): although manipulating the price (e.g. taxes, subsidies) is one way of addressing the under-allocation or over-allocation of resources.

  
• Negative Externalities of Production

  Negative externalities of production are often created during the production of a good/service
• The market is failing due to over-provision of these goods/services as only the private costs are considered by the producers and not the external costs
• If the external costs were considered, the supply would decrease and they would be sold at a higher price
• Common examples of negative externalities of production

  • Air pollution
  • Water contamination
  • Health problems in local communities
• External costs of production (negative externality) result in an over-provision shown by the gap between Q_opt and Q_e