Market Failure

Positive Externality: when the consumption of production of a good causes a benefit to a third party. SB>PB

Negative Externality: when the consumption of production of a good causes costs to a third party. SC>PC

Types of externality:

Negative production: an externality generated in the course of producing a good or service in a negative way (external costs)

Positive production: an externality generated in the course of producing a good or service in a positive way (external benefit)

Negative consumption: an externality generated in the course of consuming a good or service in a negative way

Positive consumption: an externality generated in the course of consuming a good or service in a positive way

Externalities are third party effects arising from production and consumption of goods and services for which no appropiate compensation is paid

Private cost: the costs to individual consumers or firms of an econommic activity

Private benefit: the benefits to individual consumers or firms of an economic activity

External cost: spill-over costs to third parties (knock over affects)

External benefits: spill-over benefits to third parties

PC+EC=SC            PB+EB=SB

Ignoring negative production externalities leads to overproduction

Ignoring positive consumption externalities leads to underconsumption

Ignoring negative consumption externalities leads to overconsumption

Ignoring positive production externalities leads to underproduction

Merit goods: are goods whose consumption is regarded as being beneficial to society. The social benefits of consumption exceed the private benefits and are underprovided by the market mechanism.

Examples: health care, education, public parks

Merit goods tend to be underprovided for two main reasons:

• In the free market the positive externalities that merit goods provide are ignored, and production and consumption will be below the socially optimal level
• Due to imperfect information, consumers don't always realise the full benefits that merit goods provide

Merit goods generate positive externalities

• If it's left to the free market then the price and quantity demanded of a merit good will be Pe and Qe respectively, where the MPB curve crosses the MPC/MSC curve.
• The area ABC is the potential welfare gain lost by underconsuming/underproucing the merit good

Demerit goods: are goods whose consumption is regarded as being harmful to the people that consume them, but people are usually unaware (or don't care) about the harm that the demerit goods can cause. The social cost of consumption exceed the private costs and are overprovided by the market mechanism.

Examples: Cigarettes, drugs, alcohol

Demerit goods tend to be overconsumed for two main reasons:

• In the free market the negative externalities that demerit goods cause are ignored, and production and consumption will be above the socially optimal level
• Due to imperfect information, consumers don't always realise the harm that demerit goods cause

Demerit goods generate negative externalities

• If it's left to the free market then the price and quantity demanded of a demerit good will be Pe and Qe respectively, where the MPC/MSC and the MPB curves cross.
• The area DEF is the welfare loss caused by overconsuming/overproducing the demerit good

Public goods: a good, such as street lighting, that is non-excludable and non-rival

Non-exludabliity-people cannot be stopped from consuming the good even if they haven't paid for it

Non-rivalry-one person benefiting from the good doesn't stop others also benefiting

Private goods: a good, such as bread, that is excludable and rival

• Private goods are exludable (you can stop someone consuming them) and they exhibit rivalry
• Unlike public goods, people have a choice as to whether to consume private goods

Public goods are under-provided by the free market

• The non-excludability of public goods leads to what's called the free rider problem
• The free rider problem means that once a public good is provided it's impossible to stop someone from benefiting from it, even if they haven't paid towards it
• The price mechanism cannot work if thee are free riders. Consumers won't choose to pay for a public good that they can get for free because other consumers have paid for it.

• In a competitive market it's assumed that there's perfect information. That means that buyers and sellers are assumed to have full knowledge regarding prices, costs, benefits and availability of products
• Perfect information which is equally available to all participants in a market is known as symmetric information
• When buyers or sellers have more information this is known as asymmetiric information, and information is imperfect

Information failure causes market failure:

• Imperfect information means that merit goods are underconsumed and demerit goods are overconsumed
• Due to information failure, merit goods tend to be underprovided and demerit goods are overprovided, causing a misallocation of resources and market failure

Equity is another word for fairness, so inequity means 'unfairness'. Some people think that big differences in income and wealth between people is unfair and that this is an example of a market failure.

• In economies with high levels of inequality of income and wealth distribution (e.g. Sierra Leone), there can be people who are starving whilst others have very high levels of income and wealth
• Inequality is caused by several things, such as wage differentials, discrimination and regressive taxes
• Some economists argue that the unequal distribution of income and wealth is a consequence of market failure, because the free market has led to this inequitable distribution of income and wealth
• The argument for this is that the benefit to a poor person from an additional £1 of income would be greater than the loss to a rich person who paid £1 extra in tax

Factors of production can be immobile:

• An immobile FoP is one that can't easily be moved to another area of the economy
• Land is an immobile FoP-it cannot be moved from one location to another
• A lot of capital is mobile (e.g. computers)-it can be moved from one location to another, but some is immoblie because of its size or its specialist nature

Labour immobility can be geographical or occupational:

• Labour is mobile if workers are able to move from one job to another-this movement could be between geographical or occupational areas

Immobile factors of production cause market failure:

• Immobile FoP mean there's often inefficient resources-resources are often unused or underused. This inefficiency in the allocation of resources means there's market failure.

Monopolies can cause market failure through inefficiency and by restricting consumer choice

• The diagram shows the supply and demand curves of a market. The market equilibrium would be at point M, where supply is Qe and price Pe
• However, in a monopoly situation there's only one firm in the market, so it could misallocate  resources by restricting supply to Qm and force the price up to Pm
• This is a market failure which causes a welfare loss of KLM. The area of PcPmKL, which would've been part of the consumer surplus, is added to the firm's profits.
• By restricting output monopolies can fail to exploit some EoS. This means that productive  efficiency isn't acheived and the firm isn't producing output at the lowest point on its average cost curve
• Monopoly firms can also experience higher costs of production than firms that exist in a competitive market-this can be because monopolies have less of an incentive to innovate, to make production methods as cost-effective/efficient as possible
• Market failure will be caused by the effect monopolies have on consumers. Consumer  choice is restricted because there are fewer products to choose from, and monopolies won't necassarily react to the wants and needs of consumers because they can set their own prices