40 terms

12. Market Failure


Terms in this set (...)

Market Failure
- A situation where market forces alone do not result in efficient allocation of resources
- There is an overproduction/overconsumption of a good
- Types of market failure:
1. Imperfect Competition
2. Lack of public goods
3. Under supply of merit goods and over supply of demerit goods
4. Existence of externalities
5. Imperfect information
- Governments expected to intervene if markets result in market failure to help eliminate market failure and move towards optimal allocation of resources
Pareto Optimality
- When the market is in equilibrium with no external influences or effects
- When a market is Pareto Optimal, it is Socially Efficient
Social Efficiency
Exists when the community surplus is maximized at the equilibrium
Community Surplus
Consumer Surplus + Producer Surplus
Consumer Surplus
Extra benefit gained by consumers from paying a price lower than what they were prepared to pay
Producer Surplus
The excess of actual earnings made by the producers from selling a given quantity for a price higher than what they were willing to accept
Optimal Allocation of Resources
Happens then the market is Pareto Optimal/Socially Efficient
Perfect Competition
- Most efficient market structure
- Firms in PC are both allocatively and productively efficient
1. Allocative efficiency is when producers produce only products that are desired by society
2. Productive efficiency is when the producer producesat the least possible cost
Imperfect Competition
- Is a market failure because:
1. Imperfect markets (e.g. monopolies) tend to charge higher prices and produce less than the socially optimal quantity in order to maximize profits
2. Fall of community surplus = welfare loss
- The government regulates monopolies through antimonopoly laws, including for mergers that result in monopolies or oligopolies
Public Goods
- Have the following characteristics:
1. Non-excludable - Once the good is there, you cannot exclude people from consuming it
2. Non-rival - Consumption of one does not reduce what is available for others
3. Indivisible - Not possible to charge people based on how much they consume public goods
- Examples:
1. Police
2. Street lights
3. Public benches
- Market failure because:
1. Private firms do not find them profitable to produce due to their characteristics, and since they are a benefit to society, lack of providing them is a market failure
2. People get the good for free once it has been produced (free-rider problem)
3. Government provides the public goods or subsidizes firms to produce them, using taxpayers' money, so the cost is spread over a large number of people
- Positive Externality
Merit Goods
- Goods that benefit both the consumers and society as a whole
- E.g. healthcare, education, etc.
- They are produced in the market unlike public goods, but in insufficient amounts, therefore making them under consumed, therefore a market failure
- All public goods are merit goods, but not all merit goods are public goods
- Government intervention needed to increase amount of merit goods to the socially optimal levels
- Degree of intervention will depend on the importance of the good in the government's view
- Positive Externality
Demerit Goods
- Goods harmful to consumers and society as a whole
- E.g. cigarettes, drugs, etc.
- Over provided by the market, therefore over consumed (market failure)
- Government will intervene to reduce supply and/or demand depending on how harmful they are
- Extremely harmful demerit goods become illegal/banned, and less harmful ones are taxed
- Occurs when production or consumption of a good/service has an effect upon a third party
- If effect is harmful = negative externality; full cost of society equals the private costs of producers plus external costs
1. MSC = MPC + Negative Externalities
2. MSB = MPB - Negative Externalities
- If effect is beneficial = positive externality; benefit to society equals the private benefits to the consumers plus the external benefit
1. MSC = MPC - Positive Externalities
2. MSB = MPB + Positive Externalities
- Marginal Private Costs (MPC): Costs to producers of producing one more unit of the good
- Marginal Social Costs (MSC): Costs to society of producing one more unit of the good
- Marginal Private Benefits (MPB): Benefits to consumers from consuming one more unit of the good
- Marginal Social Benefits (MSB): Benefits to society from consuming one more unit of the good
Allocative Efficiency
- Achieved when MSC=MPC
- When there are no externalities, markets lead to an outcome called "perfect/ideal situation" (MSC=MPC=MSB=MPB)
- Existence of externalities creates a divergence between MPC and MSC or MPB and MSB. Therefore, market forces lead to situations where MPC=MPB (S=D), but where MSC is not equal to MSB, indicating allocative inefficiency
Negative Externalities of Production
- Pollution is a negative externality or "external cost"
- External costs imposed on non-users by the production of the good or service
- Social Costs = Private Costs + Negative Externalities
- Results in the overproduction of the good as firms do not take into account the effect of the external costs in their output decisions
Negative Externalities of Consumption
- External costs imposed on non-users by the consumption of the good/service
- Social Benefits = Private Benefits - Negative Externalities
- E.g. cigarette smoking
- Results in an overconsumption of the good as consumers do not take into account the effect of the external costs
Positive Externalities of Production
- External benefits gained by users and non-users of a good/service
- Social Costs = Private Costs - Negative Externalities
- E.g. R&D
- Results because the market forces under-allocated resources to R&D and not enough of them are undertaken as firms do not take into account the effect of external benefits in their output decision
Positive Externalities of Consumption
- External benefits gained by users and non-users of a good/service
- Social Benefits = Private Benefits + Positive Externalities
- E.g. vaccination because it yields benefits to parties other than those vaccinated (reducing contamination rate)
- Results in the under consumption of the good because consumers do not take into account the external benefits in their consumption decision
Why are externalities market failures?
- Result in the misallocation of resources:
1. Positive externalities result in under-production/under-consumption
2. Negative externalities result in over-production/over-consumption
- If no externalities exist then MSC=MSB resulting in social efficiency and pareto optimality
- If externalities exist then MSC is not equal to MSB, and there is a market failure and misallocation of resources
Solutions to Market Failures
- Government intervention needed to increase the amount of positive externalities and decrease the amount of negative externalities in order to reach allocative efficiency
1. Done through subsidies/taxes
Internalizing an Externality
- Refers to giving the firm/consumer an incentive to take into account the external costs/benefits of their actions so they produce/consume a socially optimal level of output
- Done through regulations or market-based solutions (taxes/subs)
Internalizing a negative externality through non-market based solutions
- Legislation
1. E.g. passing laws in order to enforce firms to take pollution into consideration, force them to acquire efficient technology, etc.
Advantages of non-market based solutions
- Simple compared to market-based solutions and can be implemented more easily, and sometimes the only way since market-based solutions could be difficult to implement
- Forces polluting producers to reduce pollution levels (taxes may not)
Disadvantages of non-market based solutions
- Suffer from limitations similar to market-based policies (e.g. lack of info on pollutants emitted), so at best can be only partially effective
- Costs to policing, and there may be problems with enforcement. Therefore problem is only partially corrected
- Not applicable to all products (e.g. prohibiting smoking in public places, but cannot prohibit petrol)
Internalizing a negative externality through market based solutions
- Taxation on firms per unit of output or per unit of pollutants emitted (carbon tax)
1. Government can also tax the products that are negative externalities
- Tradable Permits (Cap and Trade Schemes)
1. Certificates issued by the government, which gives a firm a limit to what it can pollute. These certificates could be traded in the market
2. Firms have an incentive to pollute less, as they could resell these rights to other firms and make money
- Raising people's awareness about negative externalities through education and advertisements
Advantages of market based solutions
- Taxes on emissions are better than on output, because on output firms will just reduce their quantity produced with the same technology, while taxes on emissions will force many firms to move to better technologies so they can be more efficient
- Indirect taxes create incentives for consumers to change their consumption pattern
- Tradeable permits create incentives for firms to cut back on pollution
- Advertising is simple
Disadvantage of market based solutions
- Many technical difficulties to assess who and what is affected and determining the value of the external costs in order to tax a product accordingly
- Some polluting firms may not lower pollution levels despite taxes
- Some negative externalities require a very high tax since they are inelastic (e.g. cigarettes and petrol), and imposing a very high tax on these products might be politically unacceptable
- There are opportunity costs involved in advertising since the government funds them out of tax funds
- Tradeable permits require the government to set a maximum acceptable level (cap) of each pollutant, which can be hard to determine. Therefore, sometimes the cap could be set too high, which will not have the desired effect of cutting pollution levels, and sometimes too low, which will make the permits very costly
- Governments may discriminate some firms with the permits, therefore permits would not be distributed in a fair way
Internalizing a positive externality
- Non-market based solutions
1. Through legislation by promoting greater consumption of production of goods with positive externalities. For example, in some countries there is legislation where education is mandatory up to a certain age
- Market based solutions
1. Subsidies
2. Direct government provision of financial aid
3. Property rights - giving a firm monopoly power for a limited time period, allowing the firm to charge a higher price during that time
4. Advertising to encourage the consumption of positive externalities
Threats to sustainability
- Common Access Resources (CAR) are resources that are not owned by anyone and anyone can use them (e.g. air, lakes, fish, wildlife, etc.)
1. CARs are rivalry, but non-excludable, leading to existence of market failure
2. Producers and consumers don't need to pay for using CARs, therefore they are over-consumed and over-produced
3. CARs like fishing in rivers, cutting trees from public forests, burning fossil fuels to meet the growing demand may pose a threat to sustainability because of the degradation and depletion of the resources, so less will be available for future generations to use
- The problem:
1. There are conflicts between environmental and economical goals; economic goals being increasing output and consumption, while environmental goals are preservation of the environment. Focusing on one at a time will cause a threat to sustainability
- The solution:
1. Sustainable development: Society should pursue economic growth that does not deplete or degrade natural resources so that future generations won't be harmed while trying to meet their own demand. Sustainable resource means that resources should be used at the same rate as they are being reproduced, so that they do not become degraded or depleted
Burning fossil fuels and threats to sustainability
- Burning fossil fuels during any form of production and overusing the clean air and the ozone layer depletion causes a negative externality of production and consumption
1. E.g. burning fossil fuels during the production of cement causes the MSC to be greater than MPC, since burning fossil fuels emits pollutants
2. E.g. heating oil to make food will cause the MSB curve to be less than MPB curve, since that emits pollutants as well
Poverty and threats to sustainability
- Arises because of the increasing numbers of poor people participating in environmentally destructive activities in order to survive
- E.g. deforestation, as poor people have to cut down trees to sell them to furniture makers (MSC>MPC in furniture industry) or use the wood to build their own homes (MPB>MSB)
Government responses to threats to sustainability (Legislation)
- E.g. banning fishing in certain areas during certain times of the year to allow fish to reproduce)
- Advantage:
1. Simple to put into effect and oversee and can be quite effective
- Disadvantages:
1. Do not offer an incentive to reduce emissions or to switch to alternative fuels
2. Involve costs of monitoring and supervision to detect violations
Government responses to threats to sustainability (Carbon taxes)
- A method to reduce emissions of CO2 by taxing the use of fossil fuels
- Advantages:
1. Simple to design and use
2. Gives producers an incentive to switch to fuels that emit less carbon, lowering negative externalities and increasing the social optimal quantity
3. Carbon taxes make energy prices more predictable, which is important for businesses that need to predict their future costs
4. Easier to monitor as they involve payment of a tax depending on the type and quantity of the fossil fuels purchased
- Disadvantages:
1. Taxes may be low
2. Uncertain carbon reducing outcomes because it cannot be predicted
3. It is regressive (does not take into consideration the social class), therefore low-income consumers would be affected more than high-income consumers
Government responses to threats to sustainability (Cap and trade schemes)
- Tradable permits which impose a cap (maximum amount) on the total carbon dioxide that can be polluted by producers in a particular period
1. Distributed to producers and can be bought and sold in a market
2. May be set up in a country or group of countries
- Advantage
1. Effective since it aims to fix the total amount of carbon emissions
- Disadvantages
1. Prices of fossil fuels might be affected
2. Difficult to design and implement since for example it is hard to determine the cap at the right level
3. Requires the monitoring of emissions, which brings up costs
Other government responses to threats to sustainability
- Promoting the use of clean technologies
- Eliminating subsidies on environmentally damaging production (e.g. eliminating subsidies on fossil fuels)
Threats to sustainability is a global issue
- E.g. the depletion of the ozone layer doesn't affect one country, but the entire global community
1. Therefore governments have to cooperate in order to fight this issue since it is a global responsibility
Imperfect information
- When economic decisions are made based on incomplete information; buyers and sellers are not fully aware of the products traded, which is a market failure
- When one party is better informed than the other in an economic transaction (asymmetric information) and results in a misallocation of resources
- Government intervention needed to improve the flow of information to prevent one party of taking advantage of the other
1. Legislation
2. Provision of information
Monopoly power
- When one firm has control over the price of the product they sell due to their high market share
- It is a market failure because:
1. There is a lower output and a higher price in the industry than the socially optimum
2. There is a welfare loss because social surplus is less than the maximum
3. Allocative inefficiency (MB>MC), therefore an under=allocation of resources to the good
4. Productive inefficiency because production does not take place at the lowest possible cost
Government responses to monopoly powers
- Legislation in the form of anti-monopoly laws
- Regulation (e.g. natural monopolies vs. normal firms - govt has to fund normal firms to achieve the low prices of the natural monopolies)
- Nationalization of a monopoly so the government can control the price and output
- Trade liberalization
1. Removing barriers of entry by trading with foreign firms in order to create a competition between the monopoly and the foreign firms, which will reduce the monopoly power of the domestic firm
2. Imports will increase