Basics of Market Failure

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Unit 2 Markets – Why they fail Steve Margetts
Page 1
CONTENTS
An Introduction To Market Failure 2
Defining Externalities 2
Correcting For Externalities - Government Policies 7
Merit Goods 14
De-Merit Goods 16
Public Goods - Provided By The State 17
Indirect Taxes – Reducing Negative Externalities 18
Subsidies 21
Cost Benefit Analysis (CBA) 22
Barriers to Entry 24
Monopoly 25
Index 28
Unit 2 Markets – Why they fail Steve Margetts
Page 2
AN INTRODUCTION TO MARKET FAILURE
Market failure has become an increasingly important topic at A level. Market failure occurs when resources are inefficiently allocated due to imperfections in the market mechanism. There is a clear economic case for government intervention in markets where some form of market failure is taking place. Government can justify this by saying that intervention is in the public interest.

There are two types of efficiency that we will briefly look at: • Allocative efficiency – occurs when resources are distributed in such a way that no consumers could be made better off without other consumers becoming worse off.

• Productive efficiency – is achieved when production is carried out at its lowest cost.
DEFINING EXTERNALITIES
Externalities are common in virtually every area of economic activity. They are defined as third party (or spill-over) effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid. Externalities can cause market failure if the price mechanism does not take into account the full social costs and social benefits of production and consumption. The study of externalities by economists has become extensive in recent years - not least because of concerns about the link between the economy and the environment. PRIVATE AND SOCIAL COSTS

Externalities create a divergence between the private and social costs of production. Social cost includes all the costs of production of the output of a particular good or service. We include the third party (external) costs arising, for example, from pollution of the atmosphere.

SOCIAL COST = PRIVATE COST + EXTERNALITY
For example: - a chemical factory emits wastage as a by-product into nearby rivers and into the atmosphere. This creates negative externalities which impose higher social costs on other firms and consumers. e.g. clean up costs and health costs. Another example of higher social costs comes from the problems caused by traffic congestion in towns, cities and on major roads and motor ways. It is important to note though that the manufacture, purchase and use of private cars can also generate external benefits to society. This why cost-benefit analysis can be useful in measuring and putting some monetary value on both the social costs and benefits of production. Unit 2 Markets – Why they fail Steve Margetts

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MARKET FAILURE AND EXTERNALITIES
When negative production externalities exist, marginal social cost > private marginal cost. This is shown in the diagram below where the marginal social cost of production exceeds the private costs faced only by the producer/supplier of the product. In our example an externality could be caused by a supplier of fertiliser to the agricultural industry creating some external costs to the environment arising from their production process.

O
SMB
Costs, Benefits
PMC
SMC
Externality
Quantity
WHY DO EXTERNALITIES LEAD TO MARKET FAILURE?
If we assume that the producer is interested in maximising profits - then they will only take into account the private costs and private benefits arising from their supply of the product. We can see from the diagram below that the profit-maximising level of output is at Q1. However the socially efficient level of production would consider the external costs too. The social optimum output level is lower at Q2.

This leads to the private optimum output being greater than the social optimum level of production. The producer creating the externality...
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