DEFINITION: When markets are prevented from allocating resources in an optimal manner, there is said to be a market failure.
Market failure = not allocatively efficient (P=MC; socially optimal).
Failure generally results in government intervention to restore optimal allocation of resources.
TYPES OF MARKET FAILURES:
1) LACK OF PUBLIC GOODS:
The lack of public goods in a free market is considered to be a market failure.
Examples: National Defense, Flood barrier.
*Quasi public goods*: goods that, in theory, could be provided by the free market (i.e. street lighting or lighthouse).
To be considered a public good, the good must be both:
Non-excludable (free-rider problem) -- ex. If a private individual erects a flood barrier, the entire area benefits, not just the proprietor.
Non-rivalrous (when one person consumes the good, it does prevents others from consuming it) -- ex. When one consumes ice cream, another person cannot consume the ice cream; however, when one person is protected by a flood barrier, it does not stop other people from being protected at the same time.
The government can intervene, by:
Providing the public goods themselves (spread the cost over many people).
Subsidize private firms, to provide the cost.
2) UNDER-SUPPLY OF MERIT GOODS:
Merit goods: goods that will be under-provided by the market, which makes them under-consumed. Also, goods that the government thinks provide positive benefits for both the people that use them and society as a whole.
Ex. health care, education, sports facilities, opera.
All public goods are also merit goods.
Government can attempt to fix, by:
provide them directly
subsidize them (see graph above).
3) OVER-SUPPLY OF DEMERIT GOODS:
Demerit goods: goods that will be over-provided by the market, which makes them over-consumed. Also, goods that the government thinks are bad both for people who consume them and for society as a whole.
Ex. cigarettes, alcohol, hard drugs and child pornography.
Government can attempt to fix, by:
makes them illegal
Creates black markets, because chance to make profits by fulfilling an existing demand.
Tax, which decreases consumption.
EXTERNALITIES:When the production or consumption of a good or service has an effect upon a third party.
*REMEMBER*: If no externalities exist, MSC=MSB and there is social efficiency.
Positive Externality of Production: If the effect on the third party is beneficial. There has been an external cost to add to the private benefits of the producer or consumer.
Ex. A large printing firm provides high quality training, for its employees. This is a cost (MPC) to the firm. When the employees leave the printing firm and go to other firms, there is a benefit to the other firms who do not have to spend money on training their new workers.
Marginal Private Cost (MPC) is greater than Marginal Social Cost (MSC).
Ways government can rectify situation:
Subsidize firm that offer training, which would shift MPC curve downwards (by subsidy) and MPC=MSC (socially efficient point would be reached).
Very difficult for government to estimate the level of subsidy deserved by every individual firm.
Cost of the subsidies would probably imply an opportunity cost; this would mean the government would have to cut back spending in other areas, which may be more worthy than this one.
Provide vocational training through the state, by setting up training centers for workers in certain industries.
Cost would be high
Trainers may lack the expertise found in the firms
May dissuade firms from offering training of their own.
*Remember*: improvement in the quality of labor (a factor of production) can shift out an economy's PPC.
Negative Externality of Production: If the effect on the third party is harmful. There has been an external cost to add to the private benefits of the producer or consumer.
Ex. When a paint factory emits fumes that are harmful to people in the area, the cost to the community is greater than the cost of the production the firm pays.
Marginal Social Cost (MSC) is greater than Marginal Private Cost (MPC); or, MSC=MPC + external cost.
Ways government can fix negative externalities of production:
Tax the firm, which makes the MPC higher and MPC=MSC.
Difficult to measure accurately the pollution created
Difficult to identify which firms are polluting and to what extent each firm is responsible for the pollution.
Argued that taxes do not actually stop the pollution from taking place.
Legislate and ban the polluting firms, or restrict output in some way.
May lead to job losses and non-consumption of whatever was being produced.
Cost of setting and then policing standards may be greater than the cost of the pollution.
Tradable emission permits -- market-based solution, which are issued by the government and give firms the license to create pollution up to a set level. Once they are issued, firms can buy, sell and trade the permits on the market. (Remember Cap and Trade?). Provides incentives for firms to pollute less than allowed to and sell the permit.
Does not lead to reduction of pollution. Firms simply pay the cost of polluting, some polluting heavily and other not.
Government faces difficult decision to set limit of pollution.
Difficult to measure firm's pollution output.
Developing countries have no obligation to reduce greenhouse gas emissions.
Positive Externalities of Consumption: When certain things consumed (or used), they provide external benefits to third parties.
Ex. healthcare; vaccinations; outdoor music shows; the use of deodorant
Marginal Social Benefit (MSB) is greater than Marginal Private Benefit (MPB).
Ways governments can increase the consumption or services that create positive externalities of consumption.
Subsidize the supply
Developing countries are not able to fund such schemes and so do not fully benefit from the positive externalities that are to be gained from the consumption.
Use positive advertising to encourage people consume good or service that create positive externalities.
High cost
Takes a long time to have an effect and so the short-run benefits may be minimal.
Negative Externalities of Consumption: When things consumed by individuals adversely affect third parties.
Ex. Cigarettes and secondary smoking; cars and air pollution; loud music and noise pollution.
Marginal Social Benefit (MSB) is less than Marginal Private Benefit (MPB).
Ways government can fix negative externalities of consumption:
Ban cigarettes or make illegal to smoke
Large effect upon the tobacco industry, in terms of shareholders and employment.
Governments make a lot of revenue, by taxing cigarettes, which have a price inelastic demand, because they are habit forming.
Indirect taxes on cigarettes, in order to reduce consumption
The inelastic demand for cigarettes tends to mean that taxes do not manage to reduce quantity demanded very much and so, while government revenue is raised, quantity demanded does not fall to the socially efficient level.
People look for other sources of supply (black market).
Provide education about the dangers of smoking; fund negative advertising in order to reduce demand for cigarettes.
Very high cost, on the backs of the tax-payers.
Some doubt as to the effectiveness of education and advertising in terms of reducing cigarette consumption. many teenagers seem prepared to accept the dangers of smoking and are little affected by the measures to put them off.
DEFINITION: When markets are prevented from allocating resources in an optimal manner, there is said to be a market failure.
TYPES OF MARKET FAILURES:
1) LACK OF PUBLIC GOODS:
2) UNDER-SUPPLY OF MERIT GOODS:
3) OVER-SUPPLY OF DEMERIT GOODS:
EXTERNALITIES: When the production or consumption of a good or service has an effect upon a third party.