Market Failure & Externalities

Market failure

Market failure occurs when the price mechanism (i.e. the forces of supply and demand [market forces]) fail to allocate resources efficiently, and society suffers as a result.

Market failure is a common problem and governments often intervene to prevent it (which we will look at later).

The 7 types of market failure

POSITIVE/NEGATIVE EXTERNALITIES – the spillover effects of economic activity on the market

PUBLIC GOODS – non-rivalry and non-exclusive thus the private sector is not interested, therefore the government must provide them. How can you charge/compete for lighthouses/park beneches/street lights or zebra crossings!?

LABOUR IMMOBILITY – a lack of flexibility with the labour force. Two types – occupational immobility (lack of flexibility in skills) and geographical immobility (lack of flexibility in workers in moving location)

ASYMMETRIC INFORMATION – where the seller knows more than the buyer, classic example is second-hand cars!

INEQUALITY – where the rich in society earn more than 3 times the average wage. In the UK – it is 581 times! Thus we live in a very inequal society.

MONOPOLIES/LACK OF COMPETITION IN A MARKET – The legal definition of a monopoly is when market share is beyond 25%. This can lead to the exploitation of competitors and customers.

MERIT GOODS – goods that benefit society but are underproduced by the private sector. Classic example is education and health care – thus the government must intervene and provide merit goods.

Cost / benefit analysis

Externalities/spillover effects occur when external costs/benefits (i.e. costs/benefits for society) differ from private costs/benefits (i.e. costs/benefits for the business). There are two types of externalities – positive (external benefits are greater than private benefits) and negative (external costs are greater than private costs).

Private Benefits are the internal benefits of running a business – mainly profit

Private costs; internal costs of running a business – mainly paid to suppliers/employees/utilities etc.

Though when a business produces goods and services it may cause pollution, CO2 emissions, toxic waste. Businesses want to maximize their profit and thus dispose of their waste in the cheapest way possible. Thus there are external (third party) costs as well….and maybe even external benefits! External benefits/costs are together often referred to as externalities (or spillover effects).

Social benefit is the total benefit arising from producing goods and services. SB = PB + EB __ Social cost__ are the total costs of producing goods and services. SC = PC + EC. If the social benefit is greater than the private benefit (e.g. community problems helped by sports stadium), a positive externality is said to exist. If the social cost is greater than the private cost (e.g. pollution), a negative externality exists – an example of market failure.

Overproduction – when the price paid only covers the private costs. To ensure a positive externality – the price should cover the private and external cost. If the price covered all the costs, less would be produced – thus the term overproduction.

__Underproduction OR Underconsumption __– when less is produced than would be optimal for society as a whole, given the external benefits of the product. E.g. Gym memberships!

NOTE: some textbooks/resources will switch the user of external and social!

What if production and consumption are not at the equilibrium point of M__S__C=M__S__B?

  1. If quantity produced/consumed is greater than the social equilibrium, the extra cost of production is greater than the extra benefit of production (MSC > MSB – negative ext). Welfare would be improved via reducing production and consumption back to the social equilibrium – therefore there is an inefficient allocation of resources (market fail) and a welfare loss.
  2. If quantity produced/consumed is less than the equilibrium point, then the MSB > MSC. Welfare could be optimised if production and consumption were increased.

If production and consumption takes places at private equilibrium point (which it will, for, in theory, firms will always want to supply to the market at the quantity when M__P__B cover M__P__C) then there is a welfare loss to society. The loss is the difference between the MSC and the MPB shown below. The total welfare loss is the area of the enclosed yellow triangle. This is called the welfare loss triangle or the deadweight loss triangle.

The same analysis can be applied to a situation where the MSB are greater than the MPB at every level of output. This means that there are positive externalities. In these scenarios, we assume MSC and MPC are the same line as there is no external cost. The free market equilibrium point is where MC=MPB. However the socially optimum level is when MC = MSB. Again the enclosed triangle shows the welfare that could be gained – the welfare loss.

Market Failure & Externalities, figure 1