Market Failure Revision Notes

Market Failure results in external costs to third parties and occurs when the market fails to allocate resources efficiently, or to provide the quantity and combination of goods and services mostly wanted by society resulting in allocative
inefficiency.
Allocative efficiency occurs when the economy allocates its resources so that no one can become better off in terms of increasing their benefit from consumption or production without someone else becoming worse off. The condition for
allocative efficiency is where Marginal Social MSB = MSC.
Market Conditions Externality Diagram Corrective measures Evaluation points
Failure
Negative  MSC > MSB at Qm  Government regulation e.g. limits on pollutants or Externality:
Production  Market equilibrium (EM) > Social requirements to install emissions reducing technologies  External costs
Externality equilibrium (ES)  Indirect taxation / Carbon taxes - ↑ costs ↓ Output  Welfare loss (deadweight loss)
 Resources allocated at the private  Cap & trade (tradeable permits on emissions)  Allocative inefficiency
equilibrium
 Demerit goods Taxation Corrective measures:
 Welfare loss between two supply  Difficulties in calculating the external costs
curves points to Es  Difficulties in setting optimal tax equal to emissions
 Overproduction levels.
 Allocatively inefficient  Tax ↑ costs of production for firms
 Internalises externality & maximises welfare
Examples:  Polluter pays principle
Firms that produce emissions e.g. oil  Regulation an administrative burden to enact and
refinery, toxic smoke, chemical waste, enforce
dumping of waste by-products,  Costly to enforce
pollution etc.  ↑ Revenue
 Unintended consequences – Intervention
outweighs benefits
 Pollution a global issues requires global cooperation
 Allocative efficiency
 ↓ Consumer/producer surplus
 Who carries the tax burden?
 Provision of incentives to switch to less polluting
resources
 Difficulties in setting the ‘cap’ in cap & trade
Tradeable Permits schemes.
 Political favouritism & preferential treatment across
industries
Market Conditions Externality Diagram Corrective measures Evaluation points
Failure
Negative  MSC > MSB at Qm  Government measures e.g. restrictions or heavy  Difficulties in determining the size of the
Consumption  Market equilibrium (EM) > Social regulation on the sale/use of certain demerit goods externality.
Externality equilibrium (ES)  Advertising and campaigns  Difficulties in determining the size of the tax.
 Resources allocated at the private  Taxation  Internalises the externality
equilibrium  Regulation leads to higher costs for firms
 Demerit goods  Greater bureaucracy
 Welfare loss between two Taxation:  Indirect taxes are regressive
demand curves, points to Es  Indirect taxes create incentives for consumers to
 Overconsumption change behaviour.
 Allocatively inefficient  Leads to a reduction in purchasing power
 Taxation generates government revenue which can
Examples: fund alternate policies e.g. education, advertising,
Cigarettes, alcohol, driving diesel cars, subsides etc.
consumption of fast-food, sugar  PED – Whether a good is price elastic or inelastic
consumption, drug use, gambling etc. influences effectiveness of tax and therefore price
increases.
 Can lead to black markets
 ↓ Consumer surplus/producer surplus
 Welfare loss
 Allocative efficiency/inefficiency
 Costs of advertising/campaigns to government –
needs to be funded from taxes
 Opportunity costs

Advertising/education:
Market Conditions Externality Diagram Corrective measures Evaluation points
Failure
Positive  MSB > MSC at Qm  Direct government provision  Calculating size of externality
Production  Social equilibrium (Es) > Market  Subsidies  Calculating amount of subsidy
Externality equilibrium (Es)  Legislation  Improve equitable outcomes in society
 Resources allocated at the social  Improved living standards
equilibrium  Costs to the government and taxpayer
 Merit goods Subsidies:  Opportunity costs
 Welfare loss between two supply  Possibility of increasing the national debt
curves, points to Es  Lack of control over how firms use the subsidy
 Underproduction  Promote anti-competitive, inefficient behaviour
 Allocatively inefficient  PED & non-price factors
 Maximisation of welfare – universal access to public
Examples: goods
Healthcare, education, provision of  Direct provision often political
vaccinations, public transport,
museums and galleries etc.

Positive  MSB > MSC at Qm  Advertising/Education/Campaigns  Calculating externality

Consumption  Social equilibrium (Es) > Market  Information provision  Financial costs for government & taxpayer
Externality equilibrium (Es)  Opportunity costs
 Resources allocated at the social  No guarantee advertising works
equilibrium  Effectiveness of information provision in the long &
 Merit goods short-run
 Welfare loss/external costs  May need to be combined with financial incentives
between two demand curves, such as subsidies
points to Es
 Underproduction
 Allocatively inefficient

Examples:
Consumption of healthy food, gym
membership, sunscreen, consumption
of education, driving electric vehicles
Market Conditions Diagram Corrective measures Evaluation points
Failure
Lack of Public Public goods must be:  Positive production externality diagram as public goods  Direct provision → Gvt. directly provides the public goods,  Free rider problem (where people get to use the
Goods 1. Non-rivalrous i.e. supply generally seen as favourable financed by tax revenues and made available free of charge. good without paying)
available remains the same o DP solves two market failures  No incentive for private firms to invest
upon consumption  Missing market problem with public goods  Often left to government provision
2. Non-excludable i.e. cannot be  Under-consumption/Under-provision of  Direct provision generally seen as favourable as
confined solely to individuals merit goods. they improve well-being in the economy
who pay for the good.  Subsidies  Direct provision requires large public budgets
 Contracting out to the private sector  ↑ Taxation
Examples:  Opportunity costs
Beaches, flood defences, road signs,  Not all public goods meet the non-rivalrous, non-
street lighting, non-toll roads etc. excludability conditions i.e. quasi-public goods e.g.
toll roads are excludable, congested roads are
rivalrous.
 Costs of provision can be calculated
 Difficulties in placing a value on benefits
 Contracting to the private sector involves tendering
which can be more competitive, however
outsourcing also involves a loss of control and still
has to be paid for by gvt. leading to opportunity
costs.

Common  No private ownership exists  Negative production externality diagrams  Legislation to protect resources  Negative externalities – deforestation, pollution,
Access  Tragedy of the commons –  Legislation to curb emissions or toxic waste e.g. carbon soil erosion, depleted fish stocks & other
Resources exploitation and depletion taxes or cap and trade schemes (see diagrams under commodities & resources, destruction of natural
/Common negative externality notes above) habitats & biodiversity, climate change etc.
Pool • Rivalrous → consumption by one  Subsidies for cleaner technologies  Conflict between economic growth versus
Resources person/firm reduces its availability  Bans on harmful substances environmental limitations
for other people/firms.  Sustainability
• Non-excludable → not possible to  Global problem
exclude someone from using them  International government intervention required –
i.e. there is no price mechanism or global problem that requires a global response
other means of excluding users  Affect on developing versus developed countries
 Poverty, high birth rates & population growth
Examples:
Clean air, rivers, oceans, forestry,
biodiversity etc.
Market Conditions Diagram Corrective measures Evaluation points
Failure
Asymmetric  Unequal sharing of information  Negative production/consumption externality diagrams Government Responses:  See evaluation points for negative
Information between two parties which results  Regulation to ensure quality standards and safety production/consumption externalities.
(HL) in consumers/producers lacking  Provision of information
information to make a welfare  Advertising standards
maximising decision.  Health warnings
 Asymmetric information leads to  Nutritional information
two forms of opportunistic  Licensing to ensure proof of competence
behaviour where one party has an
unfair advantage where the other
lacks information: Private Responses:
1. Adverse selection → the • Screening → A way for buyers to try get more information
undesired decisions or results about what they are buying in order to screen out biased,
that occur when buyers and inaccurate or misleading information.
sellers have access to • Signalling → A method used by the party with more
asymmetric information. This information to tackle the problem of adverse selection. For
distorts the process by which example, a seller will aim to convince buyers that the
the price and quantity of product or service being sold is of good quality by offering
goods or services are warranties, build brand recognition associated with quality
determined. and reliability or for example offering certificates of
2. Moral Hazard → where there authenticity.
is an incentive for people to
behave differently than if they Industry Responses:
were fully exposed to a risk • Responses to moral hazard → e.g. insurance providers
because the negative often make the buyer pay for part of the cost of
consequences of their damages through deductibles (egenandel) or by
decisions are borne by others. removing what are known as ‘no-claims-bonuses’ in the
event of an accident that results in a claim.

Market Conditions Diagram Corrective measures to the abuse of market power Evaluation points
Failure
Monopoly  Dominant firm(s)  Legislation against abuse of monopoly power → Anti-  Allocatively inefficient
Power /  Barriers to entry competition/Anti-trust legislation  Productively inefficient
Collusive  Supernormal profits  Legislation governing mergers and acquisitions  Community welfare loss
Oligopoly (HL)  Welfare losses  Fines  Legislation may be difficult to enforce
 Allocative efficiency (MC=AR) -  Regulation  Can be difficult to determine whether a firms
inefficient  Nationalisation actions are anti-competitive.
 Productive efficiency (MC=AC) -  Trade liberalisation  Collusion can be difficult to prove
inefficient  Legislation and regulation can be costly and
 Profit maximisation (MC=MR) requires monitoring
 Economies of scale  Government ownership can lead to socially
desirable outcomes as it ensure economic well-
Monopoly is a market failure as not being but involves large financial and economic
operating at allocative efficiency → costs that have to be funded through taxation or
consumers are charged excessively possibly deficit spending.
high prices, while being provided with
lower quantities of the product or
service. This results in a deadweight
loss for society as the quantity of
resources allocated to the production
of the good is below the social
optimum indicating a misallocation of
resources
Tips for drawing externalities diagrams Nudges
1. Draw and label your axes: S = MPC/MSC D = MPB/MSB • Nudge theory influences the choices that people make by using small prompts or tweaks to alter social and economic
2. Always start with a basic equilibrium diagram behaviour to encourage consumers into behaviour that subtly guides choices away from the consumption of demerit
3. Which curve moves to show the externality? goods.
a. Production externality → Producers → Cost/supply curves i.e. MPC/MSC • To count as a nudge, the intervention must be easy and cheap to avoid.
o Graphic pictures of the consequences of smoking
b. Consumption Externality → Consumers → Benefit/demand curves i.e. MPB/MSB o Placing healthy foods at eye-level.
4. Which way is the curve positioned to show the externality? o Removing sweets from the check-out.
a. Negative externality → Social curve to the left o Removing ‘up-selling’ from fast-food outlets.
o Including prominent calorie counts or sugar content on packaging.
b. Positive externality → Social curve to the right
o Placing notifications of upcoming speed-cameras on the road.
5. Identify the private (market) and social optimums o Using small plates to encourage less food waste.
a. Private optimum/equilibrium → MPC = MPB
b. Social optimum / equilibrium → MSC = MPB
6. Identify the misallocation of resources between Qs & Qm
7. Identify the welfare loss → The welfare loss is always the triangle that points towards the social equilibrium and
is position between the two cost curves (production externalities) or the 2 demand curves (consumption
externalities)