1 h2 lecture on market failure 2007 economics dept
TRANSCRIPT
11
H2 Lecture on Market H2 Lecture on Market FailureFailure
2007 Economics Dept2007 Economics Dept
22
Recap of Market SystemRecap of Market System
Market allocates resources by using price Market allocates resources by using price mechanismmechanism
Interaction between Interaction between consumersconsumers and and producersproducers using prices (demand and using prices (demand and supply) to solve the 3 fundamental Qssupply) to solve the 3 fundamental QsWhat to produce?What to produce?How to produce? How to produce? For whom to produce?For whom to produce?
33
Price Mechanism fail?Price Mechanism fail?
"Markets (price mechanism) are "Markets (price mechanism) are usuallyusually a a good and efficient way to organise good and efficient way to organise economic activity (allocate resources)”economic activity (allocate resources)”
Price mechanism can help to allocate Price mechanism can help to allocate resources BUT does it ensure efficient resources BUT does it ensure efficient outcome? outcome?
Only if Only if Perfect KnowledgePerfect Knowledge exist exist
Sometimes markets don't work so well. Sometimes markets don't work so well. When they don't, economists talk about When they don't, economists talk about market failuremarket failure..
44
Price Mechanism fail?Price Mechanism fail?
Sometimes people want more/less of a Sometimes people want more/less of a goodgood
Eg. Eg. Education, HealthcareEducation, Healthcare Eg. Eg. Noise pollution, Road congestionNoise pollution, Road congestion
Presence of Presence of socialsocial benefits/costs benefits/costs Who decides what price to pay?Who decides what price to pay? Who can curb these “nuisance”?Who can curb these “nuisance”?
Government intervenesGovernment intervenes
55
Market FailureMarket Failure
Market Failure - A situation in which a market Market Failure - A situation in which a market left on its own left on its own fails to allocate resources fails to allocate resources efficientlyefficiently. Private. Private markets do not bring markets do not bring about the allocation of resources that best about the allocation of resources that best satisfies society’s wants.satisfies society’s wants. Do you pay the actual cost of your education? Will Do you pay the actual cost of your education? Will
you still come to school if made to pay the full you still come to school if made to pay the full costcost
Are companies producing exactly what consumers Are companies producing exactly what consumers desire?desire?
66
Market FailureMarket Failure
Allocative EfficiencyAllocative Efficiency (aka (aka Pareto Optimality) - where society produces ) - where society produces goods and services at minimum cost that goods and services at minimum cost that are wanted by consumersare wanted by consumers
Vilfredo Pareto (1848 - 1923) Efficiency is achieved when the economy’s
resources & output are allocated in such a way that no reallocation can make anyone better off without making at least one other person worse off
77
Market FailureMarket Failure
Pareto improvement / improvement in Pareto improvement / improvement in social efficiencysocial efficiencySocial welfare can be increasedSocial welfare can be increasedOutcome is not efficient (Outcome is not efficient (Why?Why?))
Pareto optimality / social efficiencyPareto optimality / social efficiencySocial welfare is maximisedSocial welfare is maximisedOutcome is the most efficient possible Outcome is the most efficient possible
from society’s viewpointfrom society’s viewpoint
88
Market FailureMarket Failure
Consumers and Producers engage in Consumers and Producers engage in economic activity for private reasons. This economic activity for private reasons. This will occur only if the gain or benefit will occur only if the gain or benefit received received ((Marginal private benefit)Marginal private benefit) is more is more than or at least equal to the cost incurred than or at least equal to the cost incurred ((Marginal private cost)Marginal private cost)
Marginal private benefit (MPB) Marginal private benefit (MPB) Marginal private cost (MPC)Marginal private cost (MPC)
When MPB = MPC When MPB = MPC No further gains from No further gains from changes changes (ie. Qe is optimal)(ie. Qe is optimal)
99
Market FailureMarket Failure
Example: HealthcareExample: Healthcare Social benefits not captured in private Social benefits not captured in private
consumption (MPB = MPC) [consumption (MPB = MPC) [benefit from benefit from less virus spreadingless virus spreading]]
Social benefits Social benefits External Benefits External Benefits MPB + Ext Benefits = MSB > MPC MPB + Ext Benefits = MSB > MPC Q Q
should be highershould be higher Govt intervenes to encourage more QGovt intervenes to encourage more Q
1010
Market FailureMarket FailureCost/Benefit
QUANTITY
MPB (DD)
MPC (SS)
Qe
Pe
MSB
External benefits
Q1
Govt Subsidizes in order to encourage more consumption of Healthcare
In doing so, society as a whole achieves pareto improvement
P1
1111
Market FailureMarket Failure
Example: Road congestionExample: Road congestion Social costs not captured in private Social costs not captured in private
consumption despite MPB = MPCconsumption despite MPB = MPC Social cost (delays) Social cost (delays) External Cost External Cost MPB < MSC (MPC + External cost) MPB < MSC (MPC + External cost) Q Q
should be reducedshould be reduced Actual Q (based on market) is higher than Actual Q (based on market) is higher than
desireddesired Govt intervenes to discourage QGovt intervenes to discourage Q
1212
Market FailureMarket FailureCost/Benefit
QUANTITY
MPB (DD)
MPC (SS)
Qe
Pe
Q1
P1
MSC
External costs
Govt taxes in order to discourage consumption of road (reduce congestion)
In doing so, society as a whole achieves pareto improvement
1313
Market FailureMarket FailurePRICE
QUANTITY
DD (MPB)
SS (MPC)
Qe
Pe
Q1
P1
Q2
P2
Private consumption or production may not take into account what is best for society ie. Q1 or Q2
Govt needs to intervene in order to encourage /discourage consumption/ production
1414
Market FailureMarket Failure
Occurs when market ignores or is Occurs when market ignores or is unable to capture social unable to capture social costs/benefitscosts/benefits
Pareto improvement is achieved Pareto improvement is achieved when Govt interveneswhen Govt intervenes
1515
Sources of Market Sources of Market Failure Failure
2007 Economics Dept2007 Economics Dept
1616
Sources of Market FailureSources of Market Failure
• Prices as expressed through markets, are Prices as expressed through markets, are “incorrect”, and so transmit wrong signals in “incorrect”, and so transmit wrong signals in the market-based resource allocation the market-based resource allocation mechanismsmechanisms
There are three main causes (types) of There are three main causes (types) of market failure:market failure:Presence of ExternalitiesPresence of ExternalitiesExistence of merit/demerit and public goodsExistence of merit/demerit and public goodsImperfect competitionImperfect competition
1717
Market Failure - ExternalitiesMarket Failure - Externalities
An externality arisesAn externality arises when parties when parties engages in an activity that influences engages in an activity that influences the well-being of bystanders whom the well-being of bystanders whom neither pay nor receive any neither pay nor receive any compensation for that effect.compensation for that effect.
33rdrd Party Effect Party EffectExample – 2Example – 2ndnd hand smoke hand smoke
1818
Market Failure - ExternalitiesMarket Failure - Externalities
1919
Market Failure - ExternalitiesMarket Failure - Externalities
The The chewing gum banchewing gum ban in Singapore in Singapore was enacted in 1992.was enacted in 1992.
… … disposing of spent gum in mailboxes, inside disposing of spent gum in mailboxes, inside keyholes and even on elevator buttons… gum left on keyholes and even on elevator buttons… gum left on floors, stairways and pavements in public areas floors, stairways and pavements in public areas increased the increased the cost of cleaning and damaged cleaning cost of cleaning and damaged cleaning equipmentequipment… stuck on the seats of public buses … stuck on the seats of public buses vexed passengersvexed passengers… chewing gum on the door … chewing gum on the door sensors of MRT trains, causing sensors of MRT trains, causing disruption of train disruption of train servicesservices. Such incidents were rare but . Such incidents were rare but costlycostly and and culprits were culprits were difficult to apprehenddifficult to apprehend..
2020
Market Failure - ExternalitiesMarket Failure - Externalities
Singapore Retailers Go GreenSingapore Retailers Go Green11 stores join campaign to use fewer 11 stores join campaign to use fewer plastic bagsplastic bags
… … campaign to help the retail sector and shoppers campaign to help the retail sector and shoppers reduce waste and go greenreduce waste and go green… project team led by … project team led by the retailers includes representatives of 11 key the retailers includes representatives of 11 key stores namely Carrefour, CK Tang, Cold Storage, stores namely Carrefour, CK Tang, Cold Storage, NTUC FairPrice, Hang Ten, Ikea, Isetan, Robinsons, NTUC FairPrice, Hang Ten, Ikea, Isetan, Robinsons, Seiyu, Shop N Save, and Takashimaya, and the Seiyu, Shop N Save, and Takashimaya, and the public waste collectors… public waste collectors… achieve environmental achieve environmental sustainabilitysustainability kick off a pilot recycling programme kick off a pilot recycling programme … … save the environmentsave the environment
2121
Market Failure - ExternalitiesMarket Failure - Externalities
Road pricing started in Singapore in June 1975
… … a small city state experiencing rapid a small city state experiencing rapid industrial growth, found itself faced with the industrial growth, found itself faced with the new problem of urban traffic congestion … new problem of urban traffic congestion … small land area of the central business district small land area of the central business district led to led to severe traffic conditionssevere traffic conditions including including congestion, reduced traffic speeds, and congestion, reduced traffic speeds, and environmental problems … automobile user environmental problems … automobile user causes causes externalitiesexternalities which which impose impose unfavorable conditions on othersunfavorable conditions on others
2222
Market Failure - ExternalitiesMarket Failure - Externalities
• When a market activity (economic activity) When a market activity (economic activity) affects external parties other than the affects external parties other than the buyers and sellers involved, side-effects buyers and sellers involved, side-effects called called externalitiesexternalities are created are created
• Additional cost / benefits to societyAdditional cost / benefits to society, over & , over & above those experienced by the individual above those experienced by the individual producer & consumerproducer & consumer
2323
Market Failure - ExternalitiesMarket Failure - Externalities
• When the impact on the bystander is When the impact on the bystander is adverse, the externality is called a adverse, the externality is called a negative externalitynegative externality..
• Eg. Dog shit near the reservoirEg. Dog shit near the reservoir
• When the impact on the bystander is When the impact on the bystander is beneficial, the externality is called a beneficial, the externality is called a positive externalitypositive externality..
• Eg. Immunisation against bird flu results in Eg. Immunisation against bird flu results in no transmission to others in the societyno transmission to others in the society
2424
Market Failure - ExternalitiesMarket Failure - Externalities
Examples of Positive Examples of Positive externalities:externalities:
• ImmunizationsImmunizations• Restored historic buildingsRestored historic buildings• EducationEducation
2525
Market Failure - ExternalitiesMarket Failure - Externalities
Examples of Negative Examples of Negative externalities:externalities:
• Automobile exhaustAutomobile exhaust• Smog from factorySmog from factory• Barking dogs (loud pets)Barking dogs (loud pets)• Loud stereos in an apartment Loud stereos in an apartment
buildingbuilding
2626
Market Failure - ExternalitiesMarket Failure - Externalities
• ExternalitiesExternalities cause markets to be inefficient cause markets to be inefficient (presence of external benefits or costs)(presence of external benefits or costs)
• Wedge is driven between what individuals want Wedge is driven between what individuals want privately and what society wants collectivelyprivately and what society wants collectively
Negative Externalities:Negative Externalities:
MSC = MPC + MEC (Marginal External Cost)MSC = MPC + MEC (Marginal External Cost)
Positive Externalities:Positive Externalities:
MSB = MPB + MEB (Marginal External Benefit)MSB = MPB + MEB (Marginal External Benefit)
2727
Market Failure - ExternalitiesMarket Failure - Externalities
Negative Negative externalities – externalities – presence of presence of marginal marginal external costsexternal costs
QUANTITY
MPB (DD)
MPC (SS)
Qe
Pe
Q1
P1
MSC
External costs
Cost/Benefit
2828
Market Failure - ExternalitiesMarket Failure - Externalities
Positive Positive externalitieexternalities – s – presence of presence of marginal marginal external external benefitsbenefits
QUANTITY
MPB (DD)
MPC (SS)
Qe
Pe
MSB
External benefits
Q1
P1
Cost/Benefit
2929
Market Failure - ExternalitiesMarket Failure - Externalities
Measures that Govt can undertake to Measures that Govt can undertake to tackle externalities:tackle externalities:
(1)(1) Impose tax (Impose tax (shift MPC to coincide MSCshift MPC to coincide MSC))
(2)(2) Provide subsidy (Provide subsidy (shift MPB to coincide shift MPB to coincide MSBMSB))
(3)(3) Impose price controls (Impose price controls (affect Qaffect Q))
(4)(4) Use of regulations (Use of regulations (affect Qaffect Q))
But Govt needs to know exactly the But Govt needs to know exactly the magnitude of externalitiesmagnitude of externalities
3030
Market Failure – Public goodsMarket Failure – Public goods
Most goods in our economy are Most goods in our economy are allocated in markets…for these allocated in markets…for these
goods, prices are the signals that goods, prices are the signals that guide the decisions of buyers and guide the decisions of buyers and
sellers.sellers.
““Free goods” provide a special Free goods” provide a special challenge for economic analysischallenge for economic analysis
3131
Market Failure – Public goodsMarket Failure – Public goods
Would you pay for this? Or this?
3232
Market Failure – Public goodsMarket Failure – Public goods
Examples of Public Examples of Public Goods:Goods:
(1) National Defense(1) National Defense(2) Street Lightings(2) Street Lightings(3) Road signs(3) Road signs
Two Two characteristics:characteristics:Non-excludabilityNon-excludabilityNon-rivalryNon-rivalry
3333
Market Failure – Public goodsMarket Failure – Public goods
Non-excludabilityNon-excludabilityit is impossible or prohibitively costly to it is impossible or prohibitively costly to
confine the benefits of the good to confine the benefits of the good to selected persons. selected persons.
Person paying for the benefit cannot Person paying for the benefit cannot prevent anyone else from also prevent anyone else from also benefiting (benefiting (‘free rider’‘free rider’))
ImplicationImplicationNo one will want to pay – No demand No one will want to pay – No demand
means that there will be no supplymeans that there will be no supply
3434
Market Failure – Public goodsMarket Failure – Public goods
Non-rivalryNon-rivalryConsumption of the good by one person Consumption of the good by one person
does not diminish the consumption of does not diminish the consumption of the good by anotherthe good by another
The cost of providing the good to The cost of providing the good to another person is zeroanother person is zero
ImplicationsImplicationsSocially desirable but not profitable to Socially desirable but not profitable to
supply! supply! No one will supply if price = 0No one will supply if price = 0
3535
Market Failure – Public goodsMarket Failure – Public goods
Non-depletability (Non-depletability (non-rivalrynon-rivalry) and non-) and non-excludability imply that public goods will excludability imply that public goods will not be provided in “efficient” quantities, or not be provided in “efficient” quantities, or will not be provided at all, through will not be provided at all, through standard market mechanismsstandard market mechanisms
No one willing to pay for itNo one willing to pay for it no one no one willing to supplywilling to supply
Price mechanism cannot workPrice mechanism cannot work Govt Govt needs to provide such goodsneeds to provide such goods
3636
Market Failure – Merit goodsMarket Failure – Merit goods
Goods where the consumption of which is Goods where the consumption of which is deemed to be deemed to be intrinsically desirableintrinsically desirable for the for the individual as well as for the society as a wholeindividual as well as for the society as a whole
Eg. education, medical services, sports Eg. education, medical services, sports facilitiesfacilities
Could be provided by the market but Could be provided by the market but consumers may not be able to afford or feel consumers may not be able to afford or feel the need to purchase – market would not the need to purchase – market would not provide them in the quantities society needsprovide them in the quantities society needs
3737
Market Failure – Merit goodsMarket Failure – Merit goods
Intrinsic Intrinsic benefits of benefits of merit good merit good means that means that higher higher consumptioconsumption (Q1) is n (Q1) is more more desirable & desirable & beneficial to beneficial to individualindividual
MPB (DD)
MPC (SS)
Qe
Pe
Q1
Cost/Benefit
3838
Market Failure –Merit goodsMarket Failure –Merit goods
Reasons why there is under-consumption:Reasons why there is under-consumption: Individuals may not be able to afford it Individuals may not be able to afford it
(eg. education)(eg. education) Uncertainty or lack of information (eg. Uncertainty or lack of information (eg.
health risks from smoking)health risks from smoking) Individual as poor judge of long term Individual as poor judge of long term
benefitsbenefits
3939
Market Failure – Demerit Market Failure – Demerit goodsgoods
•Goods which society over-produces•Goods and services provided by the market which are not in our best interests!
• Examples:(1) Tobacco and alcohol(2) Drugs(3) Gambling(4) Smog from heavy industy
4040
Market Failure – Demerit Market Failure – Demerit goodsgoods
Intrinsic ills Intrinsic ills of demerit of demerit good means good means that lower that lower consumptioconsumption is more n is more desirable & desirable & beneficial to beneficial to individualindividual
Cost/Benefit
QUANTITY
MPB (DD)
MPC (SS)
Qe
Pe
Q2
4141
Market Failure – Imperfect Market Failure – Imperfect InformationInformation
In the In the Price MechanismPrice Mechanism, both buyers and , both buyers and sellers have perfect information about the sellers have perfect information about the marketmarket
The price that is paid and accepted The price that is paid and accepted efficient outcome (efficient outcome (no one is made worse offno one is made worse off))
With With imperfect informationimperfect information, one party can , one party can be made better off while the other worse off be made better off while the other worse off (and they won’t even know!)(and they won’t even know!)
Example of Example of monopolymonopoly – one firm selling the – one firm selling the good with no close substitutesgood with no close substitutes
4242
Market Failure – Imperfect Market Failure – Imperfect InformationInformation
Imperfect knowledgeImperfect knowledge::Consumers do not have adequate Consumers do not have adequate
technical knowledgetechnical knowledgeAdvertisingAdvertising can mislead or mis-inform can mislead or mis-inform
(eg. Nike vs Adidas)(eg. Nike vs Adidas)Decisions often based on past Decisions often based on past
experience rather than future experience rather than future knowledge (lack of knowledge (lack of innovationinnovation))
Lack of environment controls Lack of environment controls (externalities)(externalities)
4343
Market Failure – Imperfect Market Failure – Imperfect InformationInformation
Goods/Services are differentiated:
•Branding•Designer labels•Technology – lack of understanding•Labelling and product information
Which one is the ‘quality’ item and why?
4444
Market Failure – Imperfect Market Failure – Imperfect InformationInformation
Factors of production are not perfectly Factors of production are not perfectly mobilemobile
Labour immobility – geographical and Labour immobility – geographical and occupationaloccupational
Capital immobility – what else can use Capital immobility – what else can use an ice making machine for?an ice making machine for?
Land – cannot be easily moved to Land – cannot be easily moved to where it might be neededwhere it might be needed
Imperfect Competition existsImperfect Competition exists
4545
Market Failure – Imperfect Market Failure – Imperfect InformationInformation
Imperfect Imperfect information information allows firm allows firm (monopoly) (monopoly) to produce to produce less, charge less, charge higher higher pricesprices
Inefficiency Inefficiency occurs – occurs – consumers consumers worse offworse off
PRICE
QUANTITY
DD
SS
Qe
Pe
Q1
P1
E0
E1
4646
Problems with efficient Problems with efficient MarketsMarkets
Efficient markets will allocate resources Efficient markets will allocate resources according to pricesaccording to prices
Efficiency v. EquityEfficiency v. EquityEfficiencyEfficiency means society gets the means society gets the mostmost
that it can from its scarce resources.that it can from its scarce resources.EquityEquity means the benefits of those means the benefits of those
resources are distributedresources are distributed fairly fairly among among the members of society.the members of society.
4747
Problems with efficient Problems with efficient MarketsMarkets
If $100 was to be taken from Bill Gates If $100 was to be taken from Bill Gates and given to a homeless person, will and given to a homeless person, will society’s overall utility increase or society’s overall utility increase or decrease?decrease?
Attempts to make market outcomes Attempts to make market outcomes more equitable often results in the loss of more equitable often results in the loss of economic efficiency. economic efficiency.
Will Bill Gates or a Homeless person benefit more if given another $100 extra in income
4848
Problems with efficient MarketsProblems with efficient Markets
Basic Economic Problems solved by the market system?
What to produce - Goods that command the higher prices will be produced
How to produce - Cheapest possible way For Whom - Produced goods will be
given to those willing and able to pay
Richer people gets most of the goods due to unequal distribution of income
4949
Problems with efficient MarketsProblems with efficient Markets
Unequal distribution of ResourceUnequal distribution of ResourceUnequal opportunities for peopleUnequal opportunities for people
Inequality will lead to political unrest and Inequality will lead to political unrest and turmoilturmoil
Need for intervention to redistribute Need for intervention to redistribute resources (policies such as taxes and resources (policies such as taxes and subsidies used by government)subsidies used by government)
5050
Food for ThoughtFood for Thought
What measures can the Govt undertake to What measures can the Govt undertake to tackle market failure (presence of tackle market failure (presence of externalities, Public Goods, Merit & externalities, Public Goods, Merit & Demerit goods, Imperfect information)?Demerit goods, Imperfect information)?
Is the Govt the best judge of what is best Is the Govt the best judge of what is best for us?for us?
Should the Govt focus on efficiency or Should the Govt focus on efficiency or equity?equity?
Can the Govt fail?Can the Govt fail?