Market Failure: Causes and Remedies

Messere IB Economics (CIA 4U7) Victoria Park C.I.

Outline
I. Market Failure A. Definition B. Causes II. Market Power III. Externalities A. Negative B. Positive C. Calculating the Cost D. Allocative Efficiency E. Correcting Externalities IV. Public Goods A. Non-rivalry and Non-excludability B. Free Riding V. Merit and Demerit Goods

Market Failure
Market failure occurs when the competitive outcome of free markets is not efficient from the viewpoint of the economy as a whole
This is because the benefits that the market provides individuals or firms carrying out certain action diverge from the benefits to a society as a whole Results in a sub-optimal amount of good/service being provided

Markets can also fail when firm/individual has insufficient information to recognize returns from undertaking an action

Causes of Market Failure

Market dominance and abuse of monopoly power Imperfect information Externalities causing private and social costs and/or benefits to diverge Pure public goods / Merit goods Factor immobility Equity (fairness) issues. Market can generate an unacceptable distribution of income and social exclusion

Market Power (HL)

Imperfect information can lead to resource misallocation eg. firm does not accurately gauge price of key input (oil) Monopoly prices above those in competitive markets
Loss of consumer surplus Output below competitive equilibrium level Loss of allocative & productive efficiency

Monopoly Power: Good or Bad? (HL)

Monopolists may waste scarce resources
High levels of advertising and marketing to increase brand loyalty and build entry barriers

Monopoly power can bring economic benefits:

Exploitation of economies of scale Higher profits used to fund research & development, leading to faster pace of innovation & gains in dynamic efficiency Greater ability to compete internationally as many domestic markets have become more contestable

Externalities
Imagine you are in your dorm studying and suddenly a loud explosion is heard shaking the walls of your room as other students next door play Call of Duty Modern Warfare on-line.

You complain to your neighbor that you have an economics exam tomorrow and they tell you But I dont have one tomorrow, so what do I care?

Externalities
You have just had first hand experience with an externality. When we talk about how in individual maximizes utility or a firm maximizes profit, we are implicitly assuming that these decisions do not affect other firms profits or other peoples utility.

Externalities
Externalities are the incidental costs (negative externalities) or benefits (positive externalities) that accompany economic activities
Externalities have their effects upon persons whom the market neither compensates for costs or charges for benefits

Why Do We Care?
Externalities arise because transactions that occur in the free market dont always yield socially optimal (or allocatively efficient) outcome
People involved in transaction put their needs first even if they clash with those of society as a whole

When a firm or individual makes a decision without taking into consideration how that action affects others, then that decision (though optimal for that individual & productively efficient for that firm) may not be optimal for the whole of society

Social Cost
Finding the cost of an externality requires us to compare the total social cost with social benefit. The total social cost is the MC of the first unit + MC of the second unit + Marginal social cost (MSC) equals the marginal private cost + the marginal external cost

Social Benefit
We can measure social benefit by looking at the demand curve. The demand curve represents what people are willing to pay (hence the dollar value of the benefit). Thus, we can also think of the demand curve as the Marginal Benefit curve (MB).

Social Benefit
To find the total benefit to society of consuming multiple units of a good, we can add up the marginal benefit of each unit consumed.

Allocative Efficiency
Allocative efficiency occurs when firms produce those goods and services most valued by society
This means scarce resources are allocated to the production of the goods and services so that consumer wants and needs are met in the best way possible

Allocative efficiency in a given market involves comparing the cost of producing an extra unit marginal cost (supply curve) - with the benefit gained from its consumption (demand curve) marginal benefit.

Allocative Efficiency cont

If marginal cost of an extra unit is less than the marginal benefit derived from its consumption (10th unit), then it makes sense to increase production. If marginal cost is more than the marginal satisfaction gained from consumption (30th unit), then it makes sense to reduce production and release resources for alternative, 'better' uses.

Allocative efficiency occurs at 20th unit of output

Negative Externalities in Production (MSC > MPC)

Optimal equilibrium for society is where MSC = MSB at Q* Free market produces at Q1 where MPC = MPB & overproduces good eg. Firm producing petrochemicals dumps effluent (liquid waste) in a river

Negative Externalities in Consumption (MPB > MSB)

Optimal equilibrium for society is where MSC = MSB at Q* Free market produces at Q1 where MPC = MPB & over-provides good eg. Second hand smoke has external costs in form of discomfort & smell of cigarettes and reduced health (i.e lung cancer)

Positive Externalities
Externalities do not always have to be a social cost. Sometimes an individuals behavior affects a third party in a positive way For instance, if that same dorm pal who was loudly playing Call of Duty MW bakes bread every morning and the smell of bread makes you happy - there is a positive externality

Positive Externalities
With a positive externality, the social benefit is higher than the private benefit. Thus, the privately optimal amount to produce is less than the socially optimal amount to produce. There is a loss in net benefit from this underproduction.

Positive Externalities in Production (MSC < MPC)

Optimal equilibrium for society is where MSC = MSB at Q* Free market produces at Q1 where MPC = MPB & under-produces good
eg. Production of solar panels will benefit society via reduced CO2 emissions / private firms training workers who can then transfer those skills over to rest of society with society benefiting from skilled workers

Positive Externalities in Consumption (MSB>MPB)

Optimal equilibrium for society is where MSC = MSB at Q* Free market produces at Q1 where MPC = MPB & under-consumes good
eg. MSB of immunization shots (school age) exceeds private benefits through reduced transmission of diseases and lost work time from illness

What Can Society Do To Correct for an Externality?

The solution for economists is to internalize the externality - to make the private cost (or benefit) equal to the social cost (or benefit). But how to do this is a more difficult problem since it is difficult to calculate & prioritize costs and benefits of activity
How do you assess a firms costs of polluting a river? Must weigh job security (costs) vs. ability to swim in river (benefits)

What Can Society Do To Correct for an Externality?

What Can Society Do To Correct for an Externality?

Property Rights (Coase Theorem)

One way to correct for an externality is to assign property rights Coase theorem proposed if:
property rights existed small number of parties involved transaction costs low Then private transactions efficient & no externalities present since parties take all costs & benefits into account regardless of who has property rights

Applying Coase Theorem: Assigning Property Rights

Assigning property rights in the case of loud video game player vs. peaceful atmosphere seeking student
 You are assigned the right to peace and quiet. If someone wants to play loud music, they have to compensate you to give up that right. This makes your cost part of their cost.  This works the other way as well, though. They could have the right to play music and you have to compensate them not to play. You pay them what it costs you.

Either way, the socially optimal quantity is produced

Other Solutions
Persuasion Voluntary Agreements (eg. Kyoto protocol) Subsidies
Government might subsidize all or part of firms costs of implementing pollution control technology A subsidy will shift the MPC (S) curve toward MSC curve

Taxes
If the government knows exactly how much to shift MPS to correct for the externality, it will tax the production (calculating cost & determining responsible parties difficult) A tax will shift the MPC (S) curve to the left

Public Goods
Public Goods are goods that are available for all to consume, regardless of who pays and who does not. Example: National Defence (pure public good) All public goods must exhibit two characteristics:
Non-rivalry Non-excludability

NonNon-rivalry and Non-excludability Non Non-rivalry means that one persons Nonconsumption of the good does not limit the ability of someone else to consume the good.
Example: A TV Show

Non-excludability means that you cant Nonkeep anyone from consuming the good.
Example: Police Protection

What is Special about Public Goods?

The problem with public goods is getting people to fund them
market fails to provide for these goods

Imagine if we expected everyone who wanted national defence to pay for it. You might be tempted to let other people chip in for it and you get the benefit. This behavior is called free riding and is endemic to the provision of a Public Good

Free Rider Solutions

Often we let the government provide public goods because they can force people to pay for it via taxes Find ways to exclude people (scramble TV signals, private police, etc.)

Merit Goods
Merit Goods are goods that the government deems necessary for society because the social benefits exceed the private benefits Example: health care, education, roads Merit goods can be provided by the private &/or public sector To encourage increased consumption of merit goods, governments will subsidize consumption (and cause an expansion of demand) in order to reduce the private marginal costs of consumption

Demerit Goods
De-merit goods are those goods or services that create negative externalities when the product is consumed
This reduces the social benefit of consumption and also leads to potential market failure through overconsumption. eg. cigarettes, alcohol

Governments may choose to tax or regulate (i.e. gambling) consumption of such goods or in case of illegal goods (i.e. drugs) prohibit use

Public, Merit & Private Goods