Market Failure: A market failure exists whenever the free
market equilibrium quantity of output is greater or less than the socially optimal level of output. The free market will produce either too much of a good or too little. Market Failure will exist if these four mechanisms fail.
Social Efficiency = where external costs and benefits are accounted for Allocative Efficiency = where society produces goods and services at minimum cost that are wanted by consumers Technical Efficiency = production of goods and services using the minimum amount of resources Productive Efficiency = production of goods and services at lowest factor cost
There are six (6) main types of market failures: Missing Markets Asymmetric Knowledge Lack of Competition in Market Factor Immobility Labour Market Failure Externalities
Merit Goods Education nurseries, schools, colleges, universities could all be provided by the market but would everyone be able to afford them? Schools: Would you pay if the Government did not provide them? Public Goods Markets would not provide such goods and services at all! Non-excludability Person paying for the benefit cannot prevent anyone else from also benefiting - the free rider problem Non-rivalry Large external benefits relative to cost socially desirable but not profitable to supply!
A non-excludable good? Would you pay for this? De-Merit Goods Goods which society over-produces Goods and services provided by the market which are not in our best interests! Tobacco and alcohol Drugs Gambling
Sometimes people have different levels of information about a situation You can never be sure about another persons motives and it is expensive to monitor behavior Moral hazard - an insured party may take more risks, or less risk avoidance behavior than is optimal This simple means
one side of the market knows more than the other
Examples
The market for used cars : Sellers know quality of the cars, but buyers might not. Labour market: Workers know their ability or reliability, but firms might not. Insurance markets: Drivers may know more about their driving habits than the insurance companies do. There is now a Monopoly suffocating in the market. There is only one seller Seller restricts production and charges a higher price This is done in an effort to convert consumer surplus to monopoly profits Natural and un-natural monopoly
Factor immobility occurs when it is difficult for factors of production (e.g. labour and capital) to move between different areas of the economy. Factor immobility could involve: Geographical immobility difficult to move from one geographical area to another.
Occupational immobility difficult to move from one type of work to another.
Reasons for Geographical Immobility
Cost of moving / difficulty in finding accommodation. House prices are much higher in London, therefore the cost of buying or even renting may prohibit a worker moving
Lack of Information. It may be difficult for the unemployment to know about available jobs and available accommodation
Personal ties. An unemployed worker may have family and social ties in his place of birth. He may have children in school or partner in employment. All this makes it difficult to move.
Reasons for Occupational immobility
If coal mines or steel factories closed down in South Wales, it may be very difficult for the unemployed coal miners to find work in new industries in the service sector. They may lack relevant skills / confidence or motivation to work in completely new industries.
Policies to Overcome Factor Immobility
Improve provision of information Improve quality and quantity of rented accommodation in employment hotspots. Subsidise firms to move to depressed areas. Education and retraining for workers who dont have relevant skills.
Inequality: Poverty absolute and relative Distribution of factor ownership Distribution of income Wealth distribution Discrimination Housing
Externalities are the effect of a decision on a third party that is not taken into account by the decision-maker. It is divided into 2 sub categories; Negative and Positive Externalities. Negative externalities (e.g. the effects of environmental pollution) causing the social cost of production to exceed the private cost. Positive externalities (e.g. the provision of education and health care) causing the social benefit of consumption to exceed the private benefit
Negative externalities occur when the effects of a decision not taken into account by the decision-maker are detrimental to others.
When there is a negative externality, marginal social cost is greater than marginal private cost. A steel plant benefits the owner of the plant and the buyers of steel. The plants neighbors are made worse off by the pollution caused by the plant.
Marginal social cost includes all the marginal costs borne by society. It is the marginal private costs of production plus the cost of the negative externalities associated with that production.
When there are negative externalities, the competitive price is too low and equilibrium quantity too high to maximize social welfare. D = Marginal social benefit S = Marginal private cost S 1 = Marginal social cost Cost Quantity 0 Q 0 P 0 Q 1 P 1
Marginal cost from externality Positive externalities occur when the effects of a decision not taken into account by the decision-maker is beneficial to others. Private trades can benefit third parties not involved in the trade. A person who is working and taking night classes benefits himself directly, and his co-workers indirectly.
Marginal social benefit equals the marginal private benefit of consuming a good plus the positive externalities resulting from consuming that good. Cost Quantity 0 Marginal benefit of an externality D 0 = Marginal private benefit D 1 = Marginal social benefit Q 0 P 0
Q 1 P 1 S = Marginal private and social cost With a positive externality, the demand curve does not reflect all the benefits of the good. As a result, the demand that is given in D P
is less than it would be if demanders received all the benefits (including the external one). D S is the demand as it would be if the demanders received the external benefit. Pollution Tax One class of solutions to the externality problems involve internalizing the costs and benefits, so that the market can work better.
Pollution Tax: if a firm is creating a negative externality in the form of pollution, create a tax on the polluting firm equal to the cost of cleaning up the pollution. Marketable Pollution Permits Another approach to pollution is the introduction of marketable pollution permits. The government sells the permits, which in total allow the amount of pollution that the government believes to be acceptable. Demanders, typically firms, purchase the permits, allowing them to pollute up to the amount specified by the permits they own. If a firm is able to employ a cleaner technology, then it can enjoy additional revenues by selling its pollution rights to someone else. Command
Another approach is commandrather than imposing a tax or offering a subsidy, the government simply requires or commands the activity. For a negative externality like pollution, the government simply requires the company to stop polluting. For a positive externality, like inoculation, the government requires certain classes of citizens to be inoculated. Price Quantity Bought and Sold D S 10 500 S + Subsidy Amount of subsidy per unit (4) 14 7 700 Total cost of the subsidy First we look at the market before the subsidy The subsidy will encourage suppliers to offer more for sale at every price The amount of the subsidy is the vertical distance between the two supply curves The effect of the subsidy is to reduce prices and increase the amount available but at what cost? Measures to correct market failure State provision Extension of property rights Taxation Subsidies Regulation Prohibition Positive discrimination Redistribution of income