IB Economics/Microeconomics/Market Failure

2.4 Market Failure
- When the price mechanism fails to take into account all the costs and/or benefits in providing and/or consuming the good, the market will fail to supply the socially optimal amount
 * The competitive forces of supply and demand will not produce quantities of goods where the prices reflect the marginal benefit (utility) of consumption - this in turn leads to over-/under consumption of the good, i.e. allocative inefficiency

Reasons for market failure
- Most markets are NOT successful, and the government intervenes to some degree


 * Perfect markets are socially efficient, they are operating at Pareto optimality in which no one can be made better off with someone being made worse off (zero sum)
 * Consumer surplus is maximized
 * P=MC where MSC=MSB


 * In the real world, markets are not perfect; MSC does not equal MSB and market failure occurs
 * This is because of externalities, underprovision of merit goods, the overprovision of demerit goods, a lack of public goods, and imperfect markets
 * If the free market is left to its own devices, Pareto market failure will occur


 * Inefficient Producers: producers do not produce where the average costs are at minimum
 * Therefore they are using more resources than they need to


 * Positive and Negative externalities: an externality is an effect on a third party which is caused by the consumption and/or production of a good or service
 * There are four types of externalities


 * Short-term and long-term environmental concerns, with reference to sustainable development
 * Lack of public goods : public goods are goods which total cost of production does not increase with the number of consumers

Public goods are: 1. non-rivalrous (consumption by one consumer will not reduce the amount available for other consumers in the market, i.e. they do not have to compete to obtain the good/service) 2. non-excludable (no consumer is excluded from consuming such good/service)


 * The classic example is national defence
 * Other examples: street lights, roads
 * Public goods will not be provided by the market


 * Underprovision of merit goods: if left to its own devices, merit goods (a private good that society considers underconsumed, often with positive externalities) will be underprovided
 * These are goods and services which have a positive effect on society like education, healthcare and sports centers


 * Overprovision of demerit goods: if left to its own devices, demerit goods (a private good that society considers overconsumed, often with negative externalities) will be overprovided
 * These are such things as prostitution, alcohol and cigarettes
 * To discourage these demerit goods the government creates: negative advertising, tax on the good, or bans it altogether


 * Abuse of monopoly power: imperfect markets such as oligopolies and monopolies restrict output in an attempt to maximize profit
 * Thus, MSB is not equal to MSC / MSC is equal to MR

Possible government responses
-
 * Legislation: antitrust legislation can be brought in an attempt to break monopoly power and collusive oligopolies
 * Legislation to make high school attendance mandatory
 * Ban smoking in restaurants


 * Direct provision of merit and public goods: governments can control the supply of goods that have positive externalities by supplying a high amount of education, public roads, parks, libraries, etc.
 * Taxation: place an excise tax on the sale of tobacco products or alcohol to discourage consumption
 * This will internalize some of the external costs (i.e., smokers will pay for their second hand smoke through the tax)


 * Subsidies: reduce the cost of university education because it has beneficial externalities
 * The price will be reduced to reflect the benefit society attains through the education of individuals


 * Tradable permits: tradable permits are permits allowing a firm to produce a given amount of pollution
 * There is limited supply for how much pollution a firm can produce so if a firm would want to pollute more it has to purchase tradable permits from other firms
 * A Carbon Tax (taxing consumption which causes pollution, such as fossil fuels) achieves the same result
 * In both cases, firms and individuals are motivated to reduce costs by reducing environmental damage


 * Extension of property rights: form of privatization to privatize certain non-private goods
 * e.g., lakes, rivers, beach=> create a market for pollution and charge people if they want to pollute something


 * Advertising to encourage and discourage consumption: by the government to ensure the social optimum level of consumption is being achieved


 * International cooperation among governments: in the case of acid rain, for example international cooperation among governments is necessary in order to reduce its occurrence