Market Failure revision sheet

Everything you ever wanted to know about market failure. Probably.

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  • Created on: 05-04-11 08:17
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Ellie Griffiths
Market Failure
Positive/Negative Externalities
Definition: An effect on a third party of someone else's action.
External costs have a negative effect: social costs < private costs
External benefits have a positive effect: social benefit > private benefit
Examples: Pollution from a factory would be a negative externality.
Education, which makes workers more productive, is a positive externality.
Why is this a failure?
Negative externalities shift supply to the left and there is overproduction.
Positive externalities shift demand to the right and there is underconsumption.
Negative Externalities Positive Externalities
(Purple shows deadweight welfare loss.)
Solutions: Indirect taxes, price floors and ceilings. Effectiveness determined by price elasticity
of demand of the good.
Information Failure
Definitions: Adverse selection: One party has more information than the other (asymmetric
information) before a transaction is completed.
Moral Hazard: caused by asymmetric information after a transaction has been
Why is this a failure?
Parties do not have perfect information and make `wrong' choices.
Adverse selection: The party without the information will be willing to pay less due to risk; the party
with the information won't be willing to sell the best at a lower price and will retract the best. This
leaves an adverse selection in the market.
Moral hazard: Creates the incentive to act differently after the transaction than before, so the deal
that was done will end up being inefficient.
Solutions: Create laws about true communication of facts.
Educate those without adequate knowledge.

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Ellie Griffiths
Increase monitoring.
Strengthen incentives to conform. (e.g. Piece rate pay, no-claims bonuses)
Merit and Demerit Goods
Definitions: A type of information failure.
Merit goods: A product valued by society and judged that all should have. It is more
beneficial to a consumer than they realise. Consumption of merit goods leads to
positive externalities.
Demerit goods: Opposite to merit goods. They are more harmful to a consumer than
they realise. Consumption leads to negative externalities.…read more

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Ellie Griffiths
come at the expense of allocative efficiency. They can restrict supply and overprice, leading to low
consumer surplus, high consumer surplus and a welfare loss.
(Pink represents consumer surplus, purple represents producer surplus, and magenta represents the
welfare lost.)
Solutions: The Competition Commission monitors the retail market to ensure that no one
company has too large a market share and ensures that competition exists.
Competition encourages pareto efficiency.…read more

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Ellie Griffiths
for them. This is self-worsening by the nature of the market system.
It is also not an acceptable position for a society.
Solutions: Pensions, benefits, government intervention.…read more


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