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IB Economics/Microeconomics/Market Failure - Wikibooks, open books for an open world
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
Positive Consumption
Externality
Negative Consumption
Externality
Negative Production
Externality
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
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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 a 'sin tax' on the sale of tobacco products 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
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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:
International cooperation among governments: in the case of acid rain, for example international
cooperation among governments is necessary in order to reduce its occurrence
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