Market Failure

• Where resources are inefficiently allocated due to imperfections in the working of the market mechanism

• When markets do not provide us with the best outcome in terms of efficiency and fairness

Sources of Market Failure• Externalities• Merit and demerit Goods• Public Goods• Common access resources (‘tragedy

of the commons’)• Asymmetric Information• Monopoly Power

Merit and Demerit Goods

Merit Goods

• Goods that are underprovided in a market economy.

• The price mechanism allocates fewer resources to their production than is thought socially desirable.

• Underproduced and underconsumed• Education and healthcare

3 Reasons why there are underprovided

• The social benefits are greater than the private benefits- the external benefits of healthcare are not considered when people choose to take medicine

• Individuals may underestimate the private benefits (imperfect information)- for eg. The benefit of being vaccinnated against a disease (they may not know the chances of them catching the disease)

• Private benefits may be discounted because benefits may be received in the future, rather than when they are paid for

Merit Goods

D2D1

P1

PriceS1

Q*

P*

Q1 Quantity

Handout

• Education and Training: What lessons should the government learn?

• Answer the following questions• Explain how education is described as a

merit good• What other market failures are associated

with education?• How does the UK government try to

overcome market failure associated with education?

Demerit Goods

• Goods that are overprovided in the market economy.

• The price mechanism allocates more resources to their production than is thought socially desirable

• Eg. Alcohol, drugs and cigarettes

Why are they overprovided?

• The social costs of consumption exceed the private costs (negative externalities associated with their consumption)

• Individuals may underestimate the private costs (imperfect information)- risk and future costs

Demerit Goods

D1D2

P1

PriceS1

Q*

P*

Q1 Quantity

Activity

• ET- The Economics of Binge Drinking

• h/w- q1-3• Q4-6

Answers

1. Private and external costs and benefits of binge drinking

2. Factors which have led to an increase in demand for alcohol in recent year?

Answers3. The Law of Diminishing Marginal Utility:As the consumption of a good increases, the total utility

derived from consumption of that good rises at a diminishing rate

Eg. I have 3 watches , consuming a 4th watch would give me extra utility. If the price of the new watch is RM500, but I only gain RM 400 satisfaction, I would not buy it as it would be irrational to do so.

With alcohol consumption, consumers do not conform to this rule governing rational behaviour.

A 7th pint of beer may only yield utility less than the cost of the pint, thus a rational consumer would not consume the 7th pint (or continue beyond this point)

Why? Alcohol distorts ‘rational’ decision making

Public Goods

Article and Questions

1. What is meant by the ‘free rider problem’?2. Explain the difference between a private

and a public good3. What is meant by a quasi- public good?4. Why are public goods considered to be a

type of market failure?5. Why does the government provide public

goods? (known as state provision)6. Why is it difficult to decide on the quantity

to produce?

Public Goods• Non-rivalrous- one person’s use of them does

not deprive others from using them• Non- excludable- if one person consumes

them it is impossible to restrict others from consuming them

• Non- rejectable- individuals cannot abstain from their consumption even if they want to

• Eg. National defence, street lighting• Non-excludability and Non- rejectability

means no market can exist and provision must be made by the government

Answers

• The price mechanism will not reveal the true level of consumers’ demand. The gov. in aiming to achieve the socially optimum level of output, has to estimate marginal social benefit.

• It could do this by asking people the max they would be willing to pay to work out MPB, then have to estimate any MEB.

Merit Goods

• In deciding the quantity of merit goods to provide, the gov. has to consider the extent to which consumers fail to appreciate their full private benefits, the positive externalities they create and the benefits poor people can get from their provision

Evaluating State Provision

• Same as subsidies:• May help to improve the efficiency of

resource allocation (increasing consumption of merit goods and goods with positive externalities)

• Effectiveness of increasing consumption depends on PED (more elastic= more effective)

• May support inefficient firms• Opportunity cost

Also…

• Cost of state provision v. expensive• Danger of inefficient production and

waste enhanced if gov. run organisations because of the lack of profit motive

• Governments may attempt to reduce risk of inefficiency by paying private firms to produce the service (PPPs)- controversial, reduced quality?

• The effectiveness of state provision in increasing consumption is likely to be limited only by the resources available

NHS on a diagram?

• When a good or service is free of charge, economic theory suggests that any consumer who gets any utility from it at all will choose to use it

• Excess demand?

• Question sheet- State Provision

• PP- state provision

Monopoly Power

Market Failure Under Monopoly/ Imperfect Competition

• One firm dominates the market (monopoly) or firms collude (oligopoly)

• Restricting output and raising price (market power exists)• Thus ‘too little’ is being produced and consumed-

allocation of resources is inefficient• Monopoly prices will normally be above those in

competitive markets– Loss of consumer surplus (because price is above

marginal cost)– Output of the monopolist is below the competitive level

• Monopoly may waste scarce resources in maintaining their position– High levels of advertising and marketing designed to

increase brand loyalty and build barriers to the entry of new firms (this is known as “rent-seeking behaviour”)

Simple monopoly diagram to show welfare loss

The Pure Monopolist

MR

D= MSB

S= MSC

QM

PM

Output

P= MC

Imperfect markets restrict output and raise price in order to maximise profits (MC=MR)Thus output is below the socially optimum level

There is a welfare loss to society-Lost consumer surplus= Lost producer surplus=

HL students need to refer back and provide more detail re. monopoly power in the exams/ IA

Features• Firms can do this because there are barriers to entering

the market (difficult for new firms to enter the market and compete)- little/ no competition

• Market power shifts the influence over the use and allocation of resources from consumers to producers

• The government will often intervene to reduce market power through regulation- specifically competition policy

• But Remember …. monopoly power can also bring economic benefits– Exploitation of economies of scale (lower unit costs)– Profits used to fund research and development – leading to a faster pace of

innovation and gains in dynamic efficiency– Many monopolies face international competition and markets have become

more contestable

Monopoly Power Created through growth of the firm (internal) or merger/

takeover (external)

Monopoly power can be maintained through Barriers To Entry (barriers to new firms entering the market). Examples…?

A clearly differentiated product with brand loyalty

Economies of scale which result in low l/r ACs

Legal and Regulatory barriers

Ownership/control of key factors of production

Other barriers include; aggressive trading tactics, the threat of aggressive merger and takeover, ownership/control of retail outlets and intimidation.

Handout

• Back to basics… Competition Policy• ET Sept 2003