Why Do Markets Fail?

Topics: Externality, Market failure, Welfare economics Pages: 9 (2105 words) Published: January 27, 2013
Why do some markets fail?
Market Failure

Market failure – occurs when the price mechanism causes an inefficient allocation of resources and a net welfare loss in society, so resources are not allocated to their best/optimum use. Identifying market failure is difficult because it involves making a value judgement about what is good and what is bad for an economy. However, it can be decided what is good or bad to society. Goods may be bad because of the nature of the good or because some goods are overprovided and over consumed whereas others are underprovided and under consumed.


Externalities are costs or benefits which are external to a transaction – third party effects ignored by the price mechanism.

They are known as indirect costs and benefits or as spillovers from production or consumption of a good or service.

External costs are negative externalities and external benefits are positive externalities.

Social optimum equilibrium:
* Social optimum equilibrium occurs where the MSC equals MSB. * The social cost of producing the last unit of output equals the social benefit from consuming it. * At this point, welfare is maximised.

Private Costs:
* Producers concerned with the private costs of production. * Costs – wages, rent, payment for raw materials, machinery costs, electricity and gas costs, insurance, packaging, transport costs etc. * Determines supply.

* Private costs may also refer to the market price a consumer pays for a good/service – cost to the individual.

Social Costs:
* Private costs + external costs = social costs.
* External costs are the difference between private and social costs, or the vertical distance between the two curves. * The MSC and MPC curves often diverge – external costs increase disproportionately with output.

Private Benefits:
* Consumers only concerned with the private benefits or utility from consuming a good or service. * This is measured by the price consumers are prepared to pay for a good/service – determines demand. * Private benefits may also refer to the revenue a firm obtains from selling a good/service.

Social Benefits:
* Social benefits = private benefits + external benefits. * External benefits are the difference between private and social benefits. * External benefits increase disproportionately with output consumed.

External costs and the triangle of welfare loss:

They may occur in the production/consumption of a good or service, e.g. pollution. On the graph they are represented by the vertical difference between the MSC (marginal social cost) and MPC (marginal private cost) curves.

Free market ignores negative externalities – when external costs are ignored there is under-pricing and over-production.

Where negative externalities exist, the MSC of supply is greater than the MPC – thus at the free market equilibrium there is an excess of social costs over social benefits for the marginal output between Qe and Q1.

The range of output where social costs exceed the private benefits is shown by the shaded region or ‘deadweight welfare loss’.

If a good with external costs is left to market forces, it is likely that welfare would be reduced due to the failure of market forces to account for the impact of its consumption.

Policies to tackle negative externalities:
* Bans – however in reality the good is still consumed e.g. on the black market and the range of output where it would have been socially beneficial (where MPB exceeds MSC) to produce the good is eliminated. A ban is only justified if the MSC always exceeds the MPB (the MSC curve is always above the MPB curve). * Taxes – indirect taxation shifts the supply curve to the left, limiting output and pushing up the price. Thus, if the tax is set at a level equal to the external cost per unit then the supply curve becomes the marginal...
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