Market Failure
Definition - When the free market fails to allocate scarce resources at the soically optimum level of output
Negative externalities in production and consumption
Negative and positive externailities - self-interest
Demerit and merit goods - information failure or asymmetric information
Public goods - free-rider problem and profit motivated firms
Common access resources (tragedy of the commons) - self-interest
Income inequality - inequity
Monopoly power - one dominant seller and high barriers to entry
Factor immobility - misallocation of resources
A public good is often (though not always) under-provided in a free market because its characteristics of non-rivalry and non-excludability mean there is an incentive not to pay.
Externalities occur when producing or consuming a good cause an impact on third parties not directly related to the transaction.
A situation where there is overconsumption of a particular product/service because rational individual decisions lead to an outcome that is damaging to the overall social welfare.
A merit good is a good which when consumed provides external benefits, although these may not be fully recognised – hence the good is under-consumed. A demerit good is a good which can have a negative impact on the consumer – but these damaging effects may be unknown or ignored by the consumer. Demerit goods also usually have negative externalities – where consumption causes a harmful effect on a third party.
Monopoly power occurs when a firm has a dominant position in the market. A pure monopoly is when one firm has 100% of the market share. A firm might be considered to have monopoly power with more than 25% market share.
Factor immobility occurs when it is difficult for factors of production (e.g. labour and capital) to move between different areas of the economy. Geographical immobility is when it is difficult to move from one geographical area to another.
Occupational immobility is when it is difficult to move from one type of work to another.
The degree to which income is distributed unequally in an economy or population.
Negative externalities in production
MSC>MPC (SC=PC+EC)
Firms are ignoring the full social cost due to their self interest. They are only concerned about their private cost. As a result, the market allocated resources at Q1 P1 which is the private optimum instead of the social optimum. The result is an overproduction and overconsumption. The price is too low as full social costs are not taken into account. Misallocate of resources and allocative ineffiency , culminating in a welfare loss.
Negative externalities in consumption
MSB<MPB (SB=PB+EB)
Consumers are ignoring full social benefits, and only considering their private benefit, due to self-interest. The result is that the market is allocating resources at Q1P1 where MPC meets MPB, and that leads to an overconsumption and an overproduction. Hence, there is a misallocation of resources and allocative inefficiency. Therefore, there is a negative welfare loss to society.
negative external benefits
positive external costs
Positive externalities in consumption and production
Positive externalities in consumption
Positive externalities in production
MSB>MPB (SB=PB+EB)
positive external benefits
Consumers act with self-interest, and so ignore the full social benefit and only consider their private benefits. As a result, the market allocates scarce resources at the private optimum which measn there is an underconsumption and an underproduction of resources. Therefore, there is a misallocation of resources and allocative inefficiency, hence a welfare loss.
MSC<MPC (SC=PC+EC)
negative external costs
Firms only consider their private costs. They don't consider their full social costs due to acting out of self-interest. This means that the resources are allocated at the private optimum which is P1Q1 , instead of the social optimum. There is an underproduction and an underconsumption taking place. Hence, there is a misallocation of resources, allocative inefficiency, and a welfare loss.
Merit and demerit goods
Merit goods
Underconsumed and underproduced (MSB>MPB)
Demerit goods
Overconsumed and overproduced (MSB<MPB)
Public goods
Free-rider problem and missing markets
Non-excludable (no price can be charged for the good) and non-rival (quantity of good doesn't diminish upon consumption)
Evaluation - quasi public goods (roads and beaches)
Common access resources
Natural resources over which no private ownership has been established. Private producers will act according to their self-interest and unsustainably keep exploiting common access resources. Eventually leading to a depletion of that resource.
Negative externalities in the form of resource depletion (MPC<MSC)
Monopoly power
A monopoly can be classified as a market failure because the market is meant to be maximising welfare for society. The monopoly prices higher than a competitive market and restricts output, which is not maximising welfare for consumers.