Market Failure

Market Failure

Market Failure: is any situation where the allocation of resources by a free market is not efficient (over-allocation or under-allocation).

Where there is market failure there is justification to modify the way the market works to allocate resources differently.

There are several factors that can lead to market failure,

o Existence of externalities

o Inequality in the distribution of income and wealth

o Abuse of monopoly power

o Informational Asymmetry

At a normally functioning competitive equilibrium, there exists a state of

Pareto optimality.

Pareto optimality: refers to a market situation where no one can be

made better off without making someone else worse off.

o There are no possible combinations of price and quantity that can

improve one group’s situation without hurting the other

o Community surplus = Producer surplus + Consumer surplus

o The maximization of community surplus is synonymous with Pareto

optimality and is achieved at PE and QE where MSB = MSC.

Pareto Optimality

When examining market failure we often look at benefits and costs,

Marginal social benefit (MSB): is all the utility or benefit derived from the use of a good, including benefits to the consumer and society.

Marginal private benefit (MPB): is the benefit derived exclusively by the consumer of a good.

Marginal social cost (MSC): is all the cost incurred from the production or use of a good, including costs to the producers and the rest of society

Marginal private cost (MPC): is the cost of a good suffered solely by the producer.

Externalities

Externalities (Spillover): occur when some of the benefits or costs of

a transaction are passed on to or spillover to someone other than the

immediate buyer or seller

They are benefits or costs that are acquired to some third party that is

external to the market transaction.

Example;

o Education creates a positive externality because more highly

educated people are less likely to engage in violent crime.

o This makes everyone in the community better off, regardless of

their level of education.

Even though society experiences benefits (or costs in the case of negative

externalities) to a particular economic activity these benefits (or costs)

are not reflected in the private market place.

Many market activities affect other people, both positively and negatively

but markets only reflect private benefits or costs

If externalities of an economic activity, producing or consuming, are large

there may be a case to alter resource allocation to reflect the externalities

Where there are externalities,

o Social benefits = Private benefit + External benefit

o Social costs = Private cost + External costs

Where no externalities exist,

o Social benefits = Private benefits

o Social costs = Private costs

Positive Externalities

Positive Externalities: appear as uncompensated benefits accruing to a

third party (consumers/producers)

o Externalities can occur in the course of the production or

consumption of a good

Positive externality of consumption: occurs when the use of a

product creates spillover benefits to others (Example; Flu Vaccines)

o When external social benefits are added to internal private benefits,

total demand is greater than that of the private market demand

o The social benefits exceed the private benefits (MSB > MPB)

o Society would be willing to pay a higher price (PS) to receive a

greater quantity of this good

o If uncorrected, a smaller amount of the product (QE) will be

produced than is socially optimal (QS)

o The free market will be lead to under-allocation

Positive externality of production: occur when making a product

creates spillover benefits to others (Example; Subway lines)

o The company, in producing the good, benefits others beyond itself

and the customer.

o The marginal social cost, the true cost to society, is lower at every

point than the private cost experienced by firms (MPC > MSC).

o This suggests that more could be produced, and society would

enjoy the extra benefits of that production.

Production Externalities- Solutions

The government can actively encourage extra production of a

good/service with positive externalities by the payment of subsidies.

o Typically in the form of a per-unit subsidy

o The goal is to push MPC outwards towards the production of the

socially optimal (QS) units of output

Public Goods

Public Good: is a good that is non-rivalrous and non-excludable, and is typically provided by the government

o Example; Policing, Street lighting, Defense

Non-rivalrous: one person’s consumption of a good does not prevent others from enjoying it.

o Example; National defence is provided by a nation’s military, and the security it offers benefits everyone.

Non-excludability: a good is non-excludable if the producer cannot prevent particular individuals from enjoying its benefits.

o Example; Suppliers of goods and services use price as a mechanism to allocate their scarce goods to consumers. People are excluded unless they pay a price for it.

Public goods have large positive externalities compared to small private

benefits, they would be underprovided in a purely market economy

o This is an example of market failure

The government can provide public goods directly and pay for them from

the taxation system to ensure they are adequately provided

Private Good: is a good that is both rivalrous and exclusive, where the

purchaser enjoys the benefits of the good according to ability to pay

Types of Goods

Excludable Non-excludable

Rivalrous Private goods

Clothing, electronics

Common goods

Fish, air, timber

Non-rivalrous Collective goods

Movie theatre, internet

Public goods

Lighthouses, defence

Underprovision of Merit Goods

Merit Good: is a good which has positive externalities and where the marginal social benefit exceeds the marginal private benefit (MSB > MPB)

A market will provide a private optimum level which is less than the social optimum

A government could respond to this under-provision and attempt to increase resource allocation towards the socially optimal level

There are three methods the government can use to resolve the problem:

1) Subsidizing consumers

o This increases the demand for the merit good, shifting the MPB curve right, by making the good more affordable.

o Example; Food stamps, Education grants

2) Subsidizing Producers

o This reduces producer costs and supply increases, shifting the curve

to the right

o This gives a lower price to consumers, making it more affordable,

and increases the use of the product

o Example; The government subsidizes post-secondary education.

3) Positive Advertising

o To encourage consumption, government can advertise the benefits

of a good with positive externalities

o The government attempts to persuade the public to use such goods

through advertising and public campaigns.

o Example; Flu vaccines

Example; Types of Goods

Good/Service Rivalrous? Excludable? Private Good? Public

Good?

Merit

Good?

Demerit

Good?

Automobile

Street Lighting

Landscaping

Policing

Cigarettes

Pizza Delivery

Healthcare

Example; Market Failure- Vaccines

Question: Using at least one diagram, explain why governments may need to intervene to encourage participation in vaccination programs during a threatened influenza epidemic.

Solution- (10 Marks/20 Minutes)

The government may need to intervene during a influenza epidemic to encourage participation in vaccination programs because of market failure caused by a lack of participation in vaccination programs.

Market Failure: is a situation in which a market leads to either an under-allocation or over-allocation of resources to a specific economic activity

Influenza vaccines are merit goods since the vaccines are private goods with positive externalities

Positive Externalities: are uncompensated benefits accruing to a third party (consumers/producers)

With respect to influenza vaccines, by getting a vaccination an individual is stopping the spread of the illness to others. This represents an additional benefit to society.

At the same time, they are protecting themselves from getting the illness which represents the private benefit

The marginal private benefit (MPB) is less than the marginal social benefit (MSB)

When the external social benefits of these vaccines are added to internal private benefits, total demand for vaccines is greater than that of the private market demand

Society would be willing to pay a higher price to receive a greater quantity of influenza vaccines

If the government doesn’t intervene vaccines would be underprovided by the market mechanism. Thus, a smaller amount of the vaccine would be consumed than is socially optimal

There are two key methods that the government can use to correct the market failure, awareness campaigns and subsidies.

The marginal private benefit (MPB) results in a quantity of Qp consumed at a price of PP

By using advertising and awareness campaigns about influenza the government can increase the demand, thereby correcting the externality and increasing the quantity consumed to QS and the price to PS

Alternatively, the government can subsidize the cost of the influenza vaccines which reduces the costs to businesses/consumers and leads to a downward shift of the Marginal social cost curve (MSC).

This lowers the price from PP to Psubsidy and increases the quantity supplied from QP to QS, thereby correcting the externality

Both policies lead to an increase consumption for influenza vaccines, resolving the market failure and providing a socially optimal level of vaccines