MARKET FAILURE

Community Surplus

• When a market is in equilibrium, with no external influence and no external effects it is said to be in a sate of Pareto optimality.

• Pareto optimality exists when it is impossible to make someone better without making someone else worse off.

• It does not mean that everyone is equal..

Externalities

• Have you consumed a good that benefited others?

• Have you ever consumed a good that had a negative effect on others?

Short term and long-term environmental concerns

• The Basic issue is not whether growth is detrimental to the environment and uses limited resources, bur rather to what degree this is sustainable in the long run.

• A country with real growth rate of 2% per year will have doubled its income in 35 years.

• This can have serious implications on the use of non –resources.

• Fossil fuels not only are limited but contribute to the greenhouse effect.

• Nuclear energy although very clean in the short run has grave consequences for future generations.

• What about no emissions, this would fail to consider the opportunity cost of less energy at a higher cost.

• Much of the present wealth in MDCs was created by exploiting natural resources.

• This is the present debate in LDC “ How far should these counties go in limiting their use of natural resources in order to sustain future level of outputs knowing full well that this limits present growth an present living standards.

Sustainable development

• “Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs”.

• However any action taken today will have impact on the future.

• It is also a common assumption that when production of a good negatively impacts the environment the good should be banned.

Net marginal benefits

• Additional external costs and benefits must be looked at when setting output and price.

• The reality is that it is impossible not to adversely affect future generations’ use of non- renewable to some degree.

• Improved technology in MCDs has lowered the use of non-renewable resources.

• Some would argue that we are creating a better future for the next generation with our new technology.

• What if all the LDC has as many cars and air conditioners as the USA?”

Lack of public goods

• Public goods are goods that would not be provided at all in a free market.

• Since they are goods that are of benefit to society, the lack of public goods in a free market is considered to be a market failure.

• The reason that public goods will not be provided at all in a free market is that they have two characteristics—they are non- excludable and non-rivalrous—and that makes it pointless for private individuals to provide the goods themselves.

• If a good does not have both of these characteristics, then it is not a public good.

• If a good is completely non-excludable and non-rivalrous, such as national defense and flood barriers, then it is called a pure public good.

non-excludable • A good is said to be non-excludable if it is

impossible to stop other people consuming it once it has been provided.

• If a private individual erects a flood barrier to protect a house, the other people in the area will gain the benefit, even though they have paid nothing.

• This is known as the free-rider problem. Logically, no one will pay for a flood barrier, in the hope that someone else will do it. The good will not be provided by the free market.

non-rivalrous• A good is said to be non-rivalrous when one person

consuming it does not prevent another person from consuming it as well.

• If a person eats an ice cream, then another person cannot consume that ice cream as well.

• However, if one person is protected by a flood barrier, it does not stop other people from being protected at the same time.

• The private benefit from a flood barrier would be very small relative to the cost, although the social benefit to all of the people who were protected by it would be huge and probably greater than the cost. Thus there is no incentive for a private individual to erect a flood barrier.

Government intervention

• They may provide the public good themselves. This is usually the case with such things as national defense, flood barriers, roads, sidewalks, street lighting.

• The use of taxpayers’ money to fund the provision spreads the cost over a large number of people who would not be prepared to pay individually.

• They may subsidize private firms, covering all costs, to provide the good.

Merit Goods

• Merit goods are goods that will be underprovided by the market and, because of this, they will be under-consumed.

• (We call them merit goods, but they are usually services.)

• They are goods that the government thinks provide positive benefits for both the people that use them and society as a whole, and therefore they think that such goods should be consumed to a greater degree.

• All public goods are merit goods. Some examples of merit goods are education, health

care sports facilities and the opera.

• Governments will attempt to increase the supply, and thus the consumption, of merit goods.

• How they do this will depend upon how important they think the merit good is.

• In the case of extremely important merit goods, such as education and health care, the government may well provide them directly or subsidies them to the point where they are available at no direct cost to the consumer.

• Of course, this does not mean that they have no actual cost. The cost is simply shared among taxpayers.

• As merit goods become less important in the eyes of the government, then they will be subsidized, but to a lesser extent.

• Sports facilities are considered to have positive benefits for people and so may well gain subsidies from the government.

• The opera may be the same, but since the benefits may be considered to be smaller, the subsidy given to the opera may well be smaller.

Overprovision of a demerit good

• Demerit goods are goods that will be over-provided by the market and, because of this, they will be over-consumed.

• They are goods that the government thinks are bad both for people who consume them and for society as a whole, and therefore government would like to see them consumed to a lesser degree, or not at all.

• Examples of demerit goods are cigarettes, alcohol, hard drugs, and child pornography.

• Governments may attempt to reduce the supply and/or the demand for demerit goods.

• How much they do this will depend upon how harmful they think the demerit good is.

• In the case of extremely harmful demerit goods, such as hard drugs and child pornography, the government will make them illegal and ban them completely.

• Of course, this does not mean that they will completely disappear, because in reality illegal black markets appear, attracted by the chance to make profits by fulfilling an existing demand.

• As demerit goods become less harmful in the eyes of the government, then they will be taxed.

• More harmful goods, such as cigarettes, may be taxed more highly than slightly less harmful goods, such as alcohol.

Abuse of Monopoly power

• When the market provides the correct amount of a good at the right price then the basic economic problem has been successfully addressed and resources allocation is optimal.

• As soon as this is not the case, the market fails, this would be the case for firms operating under conditions of imperfect competition (monopoly, oligopoly, monopolistic competition) so the firms would be in a position to gain at the expense of the consumers.

• A firm with monopoly power, is being threatened by few if any viable substitutes on the market.

• They can set the price and output with considering potential rivals, they will have an incentive to lower costs, by lowering output, and subsequently set the price as high as possible in order to maximize profits.

P mon

P pcm

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Dead weight loss

Imperfect competition

• This is perhaps the most common form of market failure, since whenever the market is in long turn disequilibrium (where supply and demand is suboptimal)

• Imperfect competitive firms – monopolies usually – can enter new markets by settling low “predatory prices” which could force other firms out of the market, which would lower competition and give the monopolist more power.

• The Monopoly firm could also set prices at a level which would dissuade any potential entrants from attempting to gain a foothold in the market.

• Monopolies can restrict market access and competitive markets – by buying up rivals, – owning/controlling raw materials, – refusing to sell to retail outlets which do not

observe a minimum price set by the monopolies,

– setting different prices on different markets (price discrimination)

– and finally by being able to disregard market demand to a certain degree, since few substitutes are available.

• Monopolies and near monopolies can use their market power in many different ways.

• The firm can attempt to control the market by– price fixing (collusion) – division of the market in order to limit head-

to-head competition been powerful firms– limiting market entry by withholding access to

raw materials or suppliers

– forcing suppliers and buyers into disadvantageous contracts

– discriminating against consumers by charging different prices in different locations.

• All this leads to enhance the monopolist’s profit and the expense of the consumer and ultimately leads to higher prices and lower output than would be the case in a competitive market.

• http://economics.fundamentalfinance.com/positive-externality.php

• http://tutor2u.net/economics/revision-notes/as-marketfailure-positive-externalities.html