market failure and externalities

• Market failure


  When the market fails at delivering economic efficiency and fails to make optimum use of scarce resources
• The interaction of supply and demand in a market does not lead to productive or allocative efficiency
• Too much or too little of the good is being produced
• Reasons for market failure

  • Externalities
  • Merit & demerit good
  • Monopolies
  • Unequal distribution of income
  • Lack of information
• Externalities


  When third parties are affected by the action of others
• Negative externalities


  Occur when the cost on society is greater than the private costs
• Private costs


  The costs that the firm has to pay in undergoing that action
• Social costs


  Private costs + external costs
• External benefits


  The benefits the firm receives due to the actions it undertakes
• Social benefits


  Private benefits + external benefits
• Negative consumption externalities refer to the negative effect that a person's consumption of a good or service has on others
• Negative consumption externalities can create a market failure
• Asymmetric information


  When some parties to a transaction have better information than others
• Adverse selection is a situation in which a person at risk is more likely to take out insurance
• Moral hazard


  The temptation to take risks when a third party is covering the risk
• Cost benefit analysis (CBA)

  A method for assessing the desirability of a project taking into account the costs and benefits
• Market failure occurs when there is a difference between private and social costs and benefits
• Steps in CBA


  1. Identify all relevant costs and benefits

  2. Place a money value on the costs and benefits identified

  3. Forecast future costs and benefits

  4. Make a final decision
• CBA includes all costs and benefits, not just those affecting the firm
• CBA often has to allocate shadow costs and benefits when no actual figures are available
• Drawbacks of CBA


  • Which costs and benefits should you include
  • How do you place a monetary value on the more abstract costs
  • Does not take into account distributional consequences
  • Political reasons may reject a project