types of market failure externalities external costs and benefits diagrams and explanations public goods information gaps solutions to market failure
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PEARSON (PEARSON)
Economics A
Unit 1 - Introduction to markets and market failure
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1.3 Market Failure
1.3.1 Types of Market Failure
Market Failure: when the price mechanism causes an inefficient allocation of resources, leading to a net
welfare loss. Consequently, resources aren’t allocated to their best/optimum use.
Types of market failure:
1. Externalities
An externality is the cost or benefit a third party receives from an economic transaction outside of the
market mechanism. In other words, it is the spillover effect of the production or consumption of a good or
service.
2. The under-provision of public goods
Public goods are non-excludable and non-rival, and they are underprovided in a free market because of the
free-rider problem.
3. Information gaps
It is assumed that consumers and producers have perfect information when making economic decisions.
However, this is rarely the case, and this imperfect information leads to a misallocation of resources.
1.3.2 Externalities
Externalities can be positive (external benefits) or negative (external costs).
External Costs – negative third party effects outside of a market transaction.
External Costs from Production: when social costs are greater than private costs of the action,
eg. overfishing, pollution, dumping toxic waste in the sea
External Costs from Consumption: when social benefits are less than private benefits, eg.
second-hand smoking/excessive alcohol intake vandalism
External costs increase disproportionately with increased output.
These are the difference between private costs and social costs.
Caused by demerit goods, and are associated with information failure, since consumers aren’t
aware of the long run implications of consuming the good, and they are usually overprovided.
For example, cigarettes and alcohol are demerit goods. The negative externality to third parties
of consuming cigarettes is second-hand smoke or passive smoking.
External Benefits – positive third party effects outside of a market transaction.
External Benefits from Production: when social costs are less than private costs, eg. use of wind
turbines to generate electricity, recycling plants.
External Benefits from Consumption: when social benefits are greater than private benefits, eg.
education programmes, vaccinations.
The difference between private benefits and social benefits.
External benefits increase disproportionately as output increases.
Are caused by merit goods. These are associated with information failure too, because
consumers do not realise the long run benefits to consuming the good. They are underprovided
in a free market.
For example, education and healthcare are merit goods. The positive externality to third parties
of education is a higher skilled workforce, or vaccinations – reduces the possibility of other
people catching the disease – less strain on NHS.
The extent to which the market fails involves a value judgement, so it is hard to determine what the
monetary value of an externality is.
Eg. hard to decide what the cost of pollution to society is. Different individuals put a different value on it,
depending on their own experiences. This makes determining government policies difficult, too.
, Private Costs - Costs internal to a market transaction, which are therefore taken into account by the price
mechanism.
Producers are concerned with private costs of production – the costs internal to the firm that it pays
for directly, eg. the rent, wages, the cost of machinery and labour this determines how much the
producer will supply.
It also could refer to the market price which the consumer pays for the good.
Social Costs – the sum of external costs and private costs from a market transaction
It can be seen that marginal social costs (MSC) and marginal private costs (MPC) diverge from each
other.
Private Benefit – benefits internal to the market transaction, which are therefore taken into account by the
price mechanism.
Consumers are concerned with the private benefit derived from the consumption of a good.
This is measured by the price the consumer is prepared to pay.
Private benefits could also be a firm’s revenue from selling a good.
Social Benefit – the sum of external benefits and private benefits from a market transaction.
Free Market Equilibrium Position:
Supply curve for the firm is the MPC.
Demand curve for producers is the MPB.
Market equilibrium occurs where MPC = MPB.
Social Optimum Position:
This is where MSC = MSB and it is the point of maximum welfare.
The social costs made from producing the last unit of output is equal to the social benefit derived from
consuming the unit of output.
When this position is reached, welfare is maximised.
External Costs of Production Diagram:
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