IB STUDY

1.4 Market failure 

 

Market failure: the failure for the market to successfully achieve allocative efficiency, because there is an over or under provision of a good. So community surplus is not maximized and the socially desirable level of output is not achieved.

 

Marginal private cost (MPC): private supply curve that is based on the firm's costs of production

 

Marginal social cost (MSC): MPC+/-external cost

 

Marginal private benefit (MPB): private demand curve that is based on the utility or benefits to consumers

 

Marginal social benefit (MSB) = MPB+/-external benefit to third party

 

Negative externalities

 

Externalities: occur when the production or consumption of a good or service has an effect upon a third party. MSC does not equal MPC.

 

Negative externalities of production: occur when the production of a good or service creates external costs that are damaging to third parties (MSC>MPC).

 

Examples: carbon emissions from factories, factory waste disposal, noise pollution, fossil fuels. 

 

The diagram shows that MSC is less than MPC. So the firm is only paying the private costs a Q. This means that the socially efficient output where MSB=MSC at quantity Q* is not being achieved. The triangle shows the welfare loss, as community surplus has decreased.

 

Negative externalities of consumption: occur when the consumption of a good or service creates the external costs that is damaging to third parties (MSB<MPB)

 

Examples: smoking, alcohol, cars, loud music, coal fires.

 

In this diagram we assume that MSC =MPC.  However, MPB is greater than MSB, meaning that the product is not being consumed at the socially desirable level of MSB = MSC and so there is a welfare loss, of the triangle.

 

Demerit goods: goods that the government think are bad for both people who consume them and society as a whole and therefore should be consumed to a lesser degree or not at all. These are goods whose consumption creates external costs.

 

E.g. cigarettes, alcohol, hard drugs, child pornography

 

Policies to reduce negative externalities

 

Indirect taxes may be imposed by the government to reduce the negative externality of production or consumption, such as a tax on carbon or cigarettes. This means that the firm’s costs of production effectively increase and MPC, so the firm will reduce its output, as it becomes less profitable. Therefore, the externality is internalised. 

 

• Indirect taxes do not necessarily stop an activity completely as it is dependent on the individual consumers’ and producers’ reactions to the tax. 

 

• The effectiveness of the tax depends on the ability of the government to determine the correct level.

  • If the tax is too high: too little consumed and produced; if tax is too low: too much is still consumed and produced. Therefore, the deadweight loss is reduced but not eliminated. This is shown in the diagrams on the previous page. 

 

• It also depends on the elasticity of demand. If PED is inelastic the increase in price leads to a smaller percentage decrease in the quantity demanded. So the socially desirable level of output may still not be achieved. 

 

• An increase in tax may also cause consumers and producers to use the black market instead, therefore, the externality will remain. 

 

• An increase in government revenue could allow the government to further invest into reducing the negative externality, such as improving zero carbon alternatives. 

 

Command and control techniques: government legislation to ban activities with negative externalities.

 

For example, the Chinese government could ban firms from dumping factory waste in rivers.

 

Evaluation: this can completely stop an activity, however, it must be monitored effectively with regular checks that may be expensive. Also there must be high penalties to deter firms or consumers from breaking the law, this must be greater than the cost the firm would have from reducing the externality.

 

For instance in order to decrease the number of cars used in a town, the local government may increase the price of car parking tickets which would have to be well monitored to ensure everyone was paying. If they were not then there would be high fines.  

 

Tradable pollution permits (cap and trade): the government sets a limit on the amount of pollution. Each firm is allocated or buys permits allowing it a certain amount of pollution. Permits can be sold is not used.

 

Evaluation: it is in the firms’ interest to reduce pollution as they can receive an income from selling permits and with more pollution they will incur more costs. If the government gradually reduces the permits available then pollution will gradually decease. However, there is difficulty in setting the cap and the effectiveness depends on the permits’ price. If permits were given away for free, then there would be little incentive to reduce pollution. 

 

Advertising: this along with education can also reduce the negative externality, as it raises the awareness of the effects on others. 

 

Positive externalities

 

Positive externalities of production: occur when the production of a good or service creates external benefits for third parties (MPC>MSC). 

 

Even though these types of externality may seem to be a good thing, especially due to the name, they are still a market failure as the goods and sevices with positive externalities are underporvided or underconsumed compared to the socially optimal level. 

 

Examples: industrial training in firms, research into new technologies. 

 

The diagram shows that MSC is less than MPC. So the firm is producing at a level, Q, which is less than the socially desirable level of Q*. Therefore, there is a welfare loss. 

 

Positive externalities of consumption: occur when the consumption of a good or service creates external benefits for third parties (MSB>MPB). 

 

Examples: immunisations, education, healthcare.  

 

The diagram shows that MSB is greater than MPB. So the firm is producing at a level, Q, which is less than the socially desirable level of Q*. Therefore, there is a welfare loss. 

 

Merit goods: goods that the government think are good for both people who consume them and society as a whole and therefore should be consumed to a greater degree. These are goods whose consumption creates external benefits.

E.g. healthcare, education, museums.

 

Policies to reduce positive externalities 

 

Subsidies may be introduced by the government to reduce the private costs associated with positive externalities and therefore shift the MPC curve to the right, so that the quantity of output will be closer to the socially desirable level of output. 

 

• Subsidies are very costly for the government so many developing countries cannot afford them. Also there is always an opportunity cost as the money could be spent differently on other policies and the government may need to either go into debt in order to fund the subsidies or increase taxes. 

 

• Subsidies can encourage inefficiency as producers rely on them rather than more efficiently allocating resources through the free market. 

 

• The effectiveness of the subsiy depends on the ability of the government to determine the correct socially desirable level of output. As shown in these diagrams. 

 

 

 

 

 

 

 

 

 

 

Positive advertising campaign: these explain the benefits of consuming the good or service to consumers, so the MPB curve will shift to the right, closer to the MSB curve.

 

Evaluation: advertising can have very high costs and opportunity costs. Also the benefits may take many years to materialise and so its short term effects are limited.  

 

The direct provision of a good also helps to decrease the private costs associated with consumption, such as the NHS healthcare system and state school education. 

 

Legislation of a good also helps to decrease the private costs associated with consumption, such as secondary school attendance being mandatory. 

 

Lack of public goods

 

Public goods: goods and services not provided by a free market.

They are non-excludable and non-rivalrous. There is therefore a ‘free rider’ problem which means that it is difficult to prevent people who do not pay for the good from consuming it.  Also public goods do not run out after being consumed. 

 

Examples of public goods: lighthouses, streetlights, public statues, education, healthcare, sports centres. 

 

Private goods: an item that yields positive benefits to people that is excludable (owners can exercise private property rights, preventing others from using the good or consuming its benefits) and rivalrous (consumption by one necessarily prevents that of another)

 

Under consumption of public goods causing a market failure: the "free rider" principle says that you cannot charge an individual a price for the provision of a non-excludable good because somebody else would gain the benefit from consumption without paying anything. If left to its own devices, merit goods (a private good that society considers under consumed, often with positive externalities) will be underprovided.

These are goods and services which have a positive effect on society like education, healthcare and sports centers

 

Disadvantages from the government providing public goods: the costs are borne by taxpayers who do not necessarily use the good, there is crowding out of the private sector and there is an opportunity cost.

 

Advantages from the government providing public goods: there is greater equality as everyone has access and greater efficiency as the government can use economies of scale and provide gods collectively. Also it overcomes the free rider problem.

 

Common access resources and the threat to sustainability

 

When there is a lack of a pricing mechanism for common access resources, the goods are susceptible to overexploitation as a result of the producers and consumers actions. Therefore, this is unlikely to be sustainable. 

 

Examples of common access resources: common land, fishing lakes, forests, irrigation system and pastures.

 

The ‘tragedy of the commons’ exists because it is very difficult and expensive to exclude people from using these areas.

 

Sustainability: exists when consumption needs of present generation are met without reducing ability to meet needs of future generations

 

Pursuit of economic growth results in environmental externality problems such as over-exploitation of land, soil erosion, land degradation, and deforestation. For developing countries these problems compound poverty and low standards of living.

 

The government may respond to threats of sustainability by imposing taxes, legislation, cap and trade schemes and using extra revenue from taxes for clean technology.  

 

However, government responses to sustainability are limited by the global nature of the problems and the lack of ownership of common access resources, so effective responses require international cooperation.  

 

Asymmetric information (HL)

 

Asymmetric information: when buyers and sellers do not have equal access to information in a transaction.   

 

Sellers have more information: in the second hand car market and at the doctors/dentists there is unequal information. This is also the case for financial advisers. It could result in a market failure as consumers are less willing to consume due to a lack of trust, so even sellers who are truthful lose out on sales.  

 

Buyers have more information: when purchasing car or health insurance the buyer may know information about themselves which, had the seller known, would have adjusted the price. Also in the labour market, regulation prevents employers from gaining knowledge about the prospective employee that may unfairly impact their opinion, such as age.

 

Government responses: the government may use legislation, like building regulations or legal contracts confirming no information has been withheld.

 

Also the government could provide information. For instance food is labelled with nutrition guidance, whilst the income of consumers is usually validated against the tax office.

 

Licences can also be used. For instance food stores must have licences stating what food can be sold.