MARKET FAILURE (Part 1) ECONOMICS – A COURSE COMPANION Blink & Dorton , 2007. p135-146

MARKETFAILURE(Part 1) ECONOMICS – A COURSE COMPANION Blink & Dorton, 2007. p135-146 MICROECONOMICS

COMMUNITY SURPLUS • When a market is in equilibrium, with no external influences and no external effects, it is said to be in a state of Pareto optimality. Pareto Optimality • Pareto optimality exists when it is impossible to make someone better off without making someone else worse off. • It does not mean that everyone is equal.

A Pareto Optimal Market • If a market is Pareto optimal, then it is said to be socially efficient. • Social efficiency exists when community surplus is maximised. Community Surplus • Community surplus is the welfare of society and it is made up of a consumer surplus plus a producer surplus.

COMMUNITY SURPLUS As we can see from this graph, the market is in equilibrium. At the equilibrium price, P, and quantity, Q, community surplus is maximised. Given this supply and demand situation, there is no other combination of price and quantity on the diagram that could give a greater community surplus. Thus the market is Pareto optimal/socially efficient, and there is an optimum allocation of resources. No one could be made better off without making someone else worse off. As this graph shows the free market (theoretically) leads to an optimum allocation of resources and maximises community surplus. MSC MSB The supply curve is determined by the marginal costs of production and since this is the marginal cost to the whole community, we refer to it as marginal social cost. The demand curve is determined by marginal utility (marginal benefit) and since this is marginal benefit to the whole community, it is known as marginal social benefit.

MARKET FAILURE • In the “real world” markets are not perfect. • There are number of things that prevent markets from being perfect and therefore, from allocating resources in an optimal manner. • In this case, then community surplus is not maximised and we say there is market failure. • When markets fail, governments are often expected to intervene in order to attempt to eliminate the market failure and move towards the optimal allocation of resources.

TYPES OF MARKET FAILURE There are many reasons why markets fail. These include: • Imperfect Competition • Lack of Public Goods • Under-supply of Merit Goods • The existence of externalities

TYPES OF MARKET FAILUREImperfect Competition • Monopolists, and other imperfect markets, restrict output in order to push up prices and maximise profits. • They are not producing at the socially efficient level of output . • Any imperfect market will fail to equate marginal social cost (MSC) and marginal social benefit (MSB). This is shown in the next graph.

IMPERFECT COMPETITION As profits are maximised where MC=MR, Q1 will be produced at a price of P1 and the socially efficient level of output Q*, is not reached. There is therefore a loss of consumer surplus, shown by the shaded dark blue triangle , and a loss of producer surplus, shown by the shaded pale blue triangle. Thus community surplus is not maximised and we have a situation of market failure. When community surplus falls from the maximum , we say that there has been a welfare loss. This is because the units Q1-Q* are not produced, even though the marginal social benefit is greater than the marginal social cost. The welfare loss is shown by the combination of the two triangles.

Government Intervention to address Market Failure Governments may try to reduce market failure by intervening in a number of ways: • They make use legal measures to make markets more competitive.

GOVERNMENT INTERNVENTIONLegislation Restricting Market Share • They may pass laws that do not permit mergers of takeovers that give an individual firm more than a certain percentage of the market. Eg: 25%. • They may also pass laws that do not permit mergers or takeovers that enable a specified number of the largest firms in an oligopoly to control more than a certain percentage of the market: Eg: The four largest firms may be restricted to 60%.

GOVERNMENT INTERNVENTIONRegulatory Bodies • Governments may also set up regulatory bodies to investigate markets where it is felt that the monopoly power is being used against the public interest. • For example most countries have some sort of “Monopolies Commission” or “Monopoly Watchdog”. • These bodies are empowered to take action of some kind or to recommend that the government should take action, if it can be shown that the pubic interest is being harmed.

Standard Level vs High Level ContentMarket Failure Chapter • Standard level students do not need to understand the details of profit maximisation. They simply need to know that imperfect competition leads to lower output at higher prices and that the socially efficient equilibrium level of price and output is not reached.

TYPES OF MARKET FAILURELack of Public Goods What are public goods? • Public goods are goods that would not be provided at all in a free market. • Since they are goods that are of benefit to society, the lack of public goods in a free market is considered to be a market failure. • Examples of public goods would be national defence and flood barriers. • There is much debate about what is a public good and what is not • A number of goods often considered to be public goods could in theory be supplied by the free market, such as street lighting. Such goods are sometimes known as quasi public goods

TYPES OF MARKET FAILURELack of Public Goods • The reasons that pubic goods will not be provided at in a free market is that they have two characteristics – they are non-excludable and non-rivalrous and that makes it pointless for private individuals to provide the goods themselves. If a good does not have both of these characteristics, then it is not a pubic good. • If a good is completely non-excludable and non-rivalrous, such as national defence, then it is called a pure public good

TYPES OF MARKET FAILURELack of Public Goods Non-Excludable • A good is said to be non-excludable if it is impossible to stop other people consuming it once it has been provided. • Eg: If a private individual erects a flood barrier to protect a house, the other people in the area may gain a benefit, even though they have paid nothing. • This is known as the free rider problem. • Logically, no one will pay for a flood barrier, in the hope that someone else will do it. • The good will not be provided by the free market.

TYPES OF MARKET FAILURELack of Public Goods Non-Rivalrous • Very similar concept to non excludable. • A good is said to be non-rivalrous when one person consuming it does not prevent another person from consuming it as well.

TYPES OF MARKET FAILURELack of Public Goods Governments may try to reduce this market failure in a number of ways: • They may provide the public goods themselves. This is usually the case with national defence, road pavements, street lighting etc. The use of taxpayers money to fund the provision spreads the cost over a large number of people who would not be prepared to pay individually. • They may subsidise private firms, covering all costs, to provide the good.

TYPES OF MARKET FAILURE Under-supply of Merit Goods What are Merit goods? A merit good has two characteristics: • People often do not fully realize the true benefit. People may underestimate the true value of education or vaccinations. • These goods usually have positive externalities. • In a free market (where people would have to pay the full cost for these services) there would be under-consumption and therefore under-supply of merit goods.

TYPES OF MARKET FAILUREUnder-Supply of Merit Goods • Most merit goods are not actually goods but services. • They are goods that the government thinks provide a positive benefits for both the people that use them and society as a whole, and therefore they think that such goods should be consumed to a greater degree. • All public goods are merit goods. • Some examples of merit goods are education, health care, and sport facilities.

TYPES OF MARKET FAILUREUnder-Supply of Merit Goods • Governments will attempt to increase the supply, and thus the consumption of merit goods. • How they do this will depend upon how important they think the merit good is. • In the case of extremely important merit goods like education and health care, the government may well provide them directly or subsidise them to the point where they are available at no direct cost to the consumer. • This does not mean they have no actual cost. • The cost is simply shared among taxpayers.

TYPES OF MARKET FAILUREUnder-Supply of Merit Goods • Some merit goods are less important than others and therefore will be subsidised to a lesser extent. • Sports facilities may well receive subsidies but not to the same extent as health care.

TYPE OF MARKET FAILUREOversupply of Demerit Goods What are demerit goods? A demerit good has two characteristics: • People don’t realize or ignore the costs of doing something. eg: smoking and drugs. • There goods have negative externalities.

TYPES OF MARKET FAILUREOver-Supply of Demerit Goods • Demerit goods are goods that are over-provided by the market (often due to large profit margins and addicted consumers) They are often over used by consumers with negative side effects • All governments believe that demerit goods have negative side effects from excessive consumption. • They can be bad not only for the individual, but also for society as a whole. • Examples of demerit goods are cigarettes, alcohol, hard drugs.

TYPES OF MARKET FAILUREOver-Supply of Demerit Goods • Governments may attempt to reduce the supply and or demand for demerit goods. • How much they do this will depend upon harmful they think the demerit good is. • In the case of extremely harmful demerit goods such as hard drugs and child pornography, the government will make then illegal and ban them completely. • This does not mean that they will completely disappear, because in realty illegal black markets appear, attracted by the chance to make profits by fulfilling an existing demand.

TYPES OF MARKET FAILUREOver-Supply of Demerit Goods High Taxes on Demerit Goods • More harmful goods such as cigarettes may be taxed more highly than slightly less harmful goods such as alcohol. However, this varies greatly between countries.

Take the Online Quiz • http://www.proprofs.com/quiz-school/search.php?search=Market+Failure+ • If this link does not work do the following. Go to the following website: www.proprofs.com • Click on get started for free • In the Search Quizzes box at the top of the page type in Market Failure. • Click on the link to do the quiz.

MARKET FAILURE (Part 1) ECONOMICS – A COURSE COMPANION Blink & Dorton , 2007. p135-146