Market Failure - A2 Economics

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Business Economics: Microeconomics for A2 by Robert Nutter.

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  • Created on: 15-06-13 10:10
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Market Failure
The reasons why markets fail
Lack of provision of public goods
Public goods are defined by two characteristics: nonexcludability and nonrivalrous.
Many are nonrejectable ­ it is not possible to choose not to consume the good.
Other goods possess some, but not all, characteristics of public goods and are known as
quasipublic goods. This might include TV signals ­ they are nonexcludable and
nonrivalrous, but signals are rejectable.
The market is unlikely to be interested in supplying public goods because of the freerider
problem. These include sea defences, but if the public knows that other people will pay
for it, they will not ­ the free rider problem.
There is a collective need for public goods, such as defence, but this service cannot be
marketed since anyone that does not pay for the service cannot be excluded from
benefitting from it. Therefore, the government provides this through taxation.
As marginal cost represents the opportunity cost of providing a good or service, it follows
that allocation is efficient if marginal cost equals price.
Example: If the government could establish what each individual was prepared to pay for a
public good, and assume that supply was variable, then its supply could be expanded until
the marginal cost of the last equalled the price which the community was collectively
prepared to pay for it.
This is illustrated below:
The joint price P2 (OP0+OP1) = marginal cost. Therefore, the allocation of resources to
defence would be allocatively efficient.
Assuming that the demand curves D1 and D2 represent the demand of defence of two
individuals, the demand curve D3 is then possible to draw, which represents their joint
demand. The efficient allocation of the community's resources to defence is represented by

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OQ, where the joint price which the two individuals are prepared to pay equals the
marginal cost.
The issue would be to get people to reveal what they are willing to pay for a particular quantity
of defence. The individual would understate their true valuation as this is in their best interests
to do so, thereby depending on the rest of the community to provide the service. The
marginal cost of providing a public good to one extra person is zero.…read more

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Consumption of demerit goods lead to regret in the future
Good reason for high taxes/negative advertising as it appears there are no longterm
Therefore, there is an information gap
The government could increase output to the socially efficient level by a per unit
subsidy, increasing supply to S1. It lowers price and increases output by Q1Q. The
socially efficient outcome is at E', at this point MPB=MSC. There are no external
costs, but external benefits.…read more

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External costs from production such as pollution may cause marginal social cost to
diverge from marginal private cost.
The demand curve reflects MSB because there are no external benefits. As there are
external costs, the MSC is greater than the MPC. Socially efficient outcome is at Q1, but
the free market outcome is at Q, where output is too high and price too low for social
efficiency. The welfare loss is represented by FEE'.…read more

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Greater equity can be achieved through the taxation system.
Horizontal equity means that people with a similar ability to pay abilities should pay the
same amount, hence, it makes sure that the tax system does not discriminate on the
basis of race, gender or different types of work.
Vertical equity is the principle that people with a greater ability to pay should pay more
tax in a progressive way, meaning that people with more ability to pay tax should pay
more tax.…read more

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Lemon market' the average value of a product tends to go down, even for those
products of perfect quality.
Example of this is the secondhand car market, where there are good cars and
defective cars, called `lemons.' The buyer of the car does not know if the car is good
or a `lemon' prior to its purchase. Thus buyers assume it is of average quality, and
thus will only offer an average price for it.…read more


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