CHAPTER 8: Dynamics of

markets:Market failure

CAPS Requirements

Explanation of the reasons for and consequences of market failures. Reflect on cost-benefit analysis.• The causes of market failures• Consequences of market failures• Cost-benefit analysis

IntroductionMarket failure: when firms do not produce the quantity of output that would have been produced under the conditions of perfect competition.

In LR under perfect competition…• Firms productively efficient & make normal profits. • Consumers pay lowest possible price • Produced at lowest average cost of production. • Society maximises output from scarce FOP’s• Changes in demand encourage firms to change industries allocatively

efficient.

Market failure occurs when the quantity of output produced is either too little or too great - allocative inefficiency.

Quantity produced too little…• product under-produced & under-consumed• Society better off if more resources were used to produce the

product.

Quantity produced too great…• product is over-produced and over-consumed. • Society better off if less output produced & excess resources

transferred to making other products in greater demand.

Causes of market failure

The following are causes of market failure:1. externalities2. public goods3. merit and demerit goods4. imperfect competition5. imperfect information6. immobility of factors of production7. unequal distribution of income and wealth

1.Externalities

Externalities: costs/benefits of a transaction that affect economic agents who are not directly involved in the transaction or activity.

When producing goods/services, private sector only take into account private costs and private benefits.

Producers don’t take into account costs/benefits of production on society. These costs/benefits are called externalities.

If externality results in a cost to society - negative externality. If externality results in a benefit to society - positive externality.

AKA: third-party effects, side effects, spill-over effects or neighbourhood effects.

1. Externalities

Basic cost and benefit concepts :Private costs (internal costs): costs that the producer/consumer incurs voluntarily when they produce/purchase goods/services.

1. Externalities (cont.)

Basic cost and benefit concepts :External costs (negative externalities): costs of production/ consumption decision that accrue to people other than the producer/consumer.

1. Externalities (cont.)

Basic cost and benefit concepts :Social costs: total costs borne by society.

Social costs = Private costs + External costs

1. Externalities (cont.)

Basic cost and benefit concepts :Private benefits (internal benefits): accrue to consumers who purchase goods & producers that produce them.

1. Externalities (cont.)

Basic cost and benefit concepts :External benefits (positive externalities): additional benefits to the community, caused by consumption or production of goods/services.

1. Externalities (cont.)

Basic cost and benefit concepts :Social benefits: combined benefits to producers and society.

Social benefits = Private benefits + External benefits

1. Externalities (cont.)

The market for chemicals – negative externalities in production present

1. Externalities (cont.)

Private costs

Social costs

Private benefit + external benefit = Social benefit

External costs

Free market equilibrium: private benefits = private costs

Socially optimal equilibrium: social benefits = social costs

The market for flu vaccinations – positive externalities in consumption present

1. Externalities (cont.)

Private benefits

Social benefits

Private costs + External Costs = Social costsExternal benefits

Free market equilibrium: private benefits = private costs

Socially optimal equilibrium: social benefits = social costs

2. Public Goods

Public goods: goods provided by the government, which exhibit characteristics of non-excludability and non-rivalry in consumption.

Non-excludability: even if the good is produced for the use of one consumer, no other consumer can be prevented from consuming it.

Non-rivalry: if one person consumes the good, it does not prevent someone else from also consuming the good.

Problem - no-one else will pay as they will be able to consume the above goods free of charge – FREE RIDERS

Public goods are under produced by market system -too few consumers prepared to pay

Under allocation of resources to production of public goods - market fails.

2. Public Goods (cont.)

3. Merit and demerit goods

Merit goods: goods that society feels should be consumed by its citizens because it increases the welfare of the individual person and of society as a whole.

Merit goods under-produced and under-consumed in free market - people underestimate value.

Demerit goods: goods that may be harmful to society as a whole (creates negative externalities).

Over-produced and over-consumed

3. Merit and demerit goods (cont.)

Private costsSocial costs

Social benefit

In summary…• under-allocation of resources to production of merit goods • over-allocation of resources to production of demerit goods

5. Imperfect Competition

Monopoly, oligopoly and monopolistically competitive firms restrict supply to maximise their profits.

Therefore resources under-allocated Productively inefficient - output not produced at lowest AC

5. Imperfect Information

Perfect competition - consumers & producers have perfect information to make informed production/consumption decisions.

Real world of imperfect competition = asymmetric/imperfect information.

https://www.youtube.com/watch?v=cYcsFyim_Cs

Principal–agent problem: principal has more information than the agent), may use this information to benefit from the transaction.

Under these conditions…• Demerit goods over-produced and over-consumed • Merit goods under-produced and under-consumed

5. Imperfect Information (cont.)

Perfect competition – FOP assumed perfectly flexible.

Real world FOP NOT perfectly mobile…• Capital usually fixed• Governments impose controls on movement of labour between

countries. • Within countries, labour sometimes inflexible.

• SA: shortage of 500 000 skilled workers; surplus of 4 million unskilled workers.

Economy’s capacity to produce less than under conditions ofperfect competition - allocative inefficiency, or market failure.

6. Immobility of factors of production

How do consumers indicate their preferences to producers???

Bearing this in mind, when income/wealth unevenly distributed…• Too many resources used to produce output for rich• Too few resources used to produce output for poor.

7. Unequal distribution of income and wealth

Now complete…Activity 1 – page 188Activity 2 – page 193