Unit 1.3 Market failure

What are demerit goods?

*Demerit goods* are goods whose *consumption* is regarded as being *harmful* to the people that consume them and society. (negative externality) e.g. cigarettes, heroin and alcohol

What is an example of a positive (consumption) externalities that are usually ignored

*Education* - better educated workforce are more productive which increases output, *reduced levels of crime and happier population.* *Health care* - healthier workers are more productive, so output increases, better for society because *longer life expectancy*

What are externalities?

*Externalities* are the *effects* that producing or consuming a good *has on people* who *aren't involved* in the making, buying/selling and consumption of the good. These people are often called *'third parties'.* Externalities can be positive or negative

Why are public goods under-provided because of the free rider problem

*Free rider problem* - *once* a public good is *provided it's impossible to stop someone from benefiting from it, even if they haven't paid for it.* For example, a firm providing street cleaning cannot stop a *free rider*, who has *refused to pay for street cleaning, benefiting from a clean street*

Why are public goods under-provided because of the valuation problem?

*Valuation problem* - Consumers *won't* choose to *pay* for a public good that they can get for free because other consumers have paid for it. *If everyone decides to wait *and see who will provide and pay for a public good, then it *won't be provided*. It's also *difficult to set a price* for public goods because *producers will tend to overvalue the benefits* of a public good in order to *increase the price*. *Consumers* will *undervalue* their *benefits* to try to get a *lower price.*

What is moral hazard?

*lack of incentive to guard against risk where one is protected from its consequences, e.g., by insurance.*

How can banks or governments cause moral hazard

- *nationalised industries* tend to be *inefficient* because they're *not driven to reduce costs* and make *profit*. There's also little incentive for a nationalised firm to act prudently, as the *firm will know* that the *government and tax payers will bail them out* if they get into trouble. - Governments may feel *future debts will be cancelled,* in debt relief so they just *borrow more* Banks - a bank might *provide risky loans* (to chase higher profits) *if it knows that it'll be bailed out by taxpayers* if things go wrong which causes market failure.

What is a private and social benefit

- A *private benefit* is the *benefit* gained by a *consumer or a firm by doing something*. For example, the private benefit a consumer might get from purchasing a skiing holiday is their enjoyment. - *Adding the private benefit to the external benefit gives the social benefit*. The social benefit is the *full benefit received by society* from a good or service.

What is a private and social cost

- A *private cost* is the *cost of doing something* to either a *consumer or a firm*. For example, the *cost* a firm pays to *make a good* is its private cost and the *price a consumer pays* to buy the good is *their private cost.* - *Adding the private cost to the external cost* gives the *social cost*. The social *cost* is the full cost *on society* of a good or service.

Why does market failure occur

- A market fails when the *price mechanism* (i.e. the forces of supply and demand) *fails to allocate scarce resources efficiently* and *society suffers* as a result. - *too much or too little of a good is produced* and/or consumed *compared to the socially optimal level* of output.

What is the impact of external costs on consumers and producers

- Overproduction (exceeds socially optimum quantity) - Underpricing (below socially optimum price) - Concerns over resources for future generations e.g. overfishing in North Sea - Pollution leading to global warming and migration of people and respiratory diseases - Calls for government intervention to internalise external costs fix market failure

Negative externality/external cost diagram (MSC, MSC, EXC)

- The *marginal private cost (MPC) is the cost of producing the last unit of a good*. - The marginal social cost (MSC) = the marginal private cost + the external cost. - If the MPC and MSC curves are *parallel* then *external costs* per unit produced are *constant.* If the curves *diverge (V)* then *external costs* per unit *increase with output* e.g. pollution.

Positive externality/external benefit diagram

- The marginal private benefit (MPB) is the *benefit to someone of consuming the last unit of a good.* - The marginal social benefit (MSB) = the marginal private benefit + the external benefit - An example of when the curves might diverge is *vaccination* — the *more people that are vaccinated, the greater the protection* for unvaccinated people.

What is the impact of external benefits on consumers and producers

- Underproduction (below socially optimum quantity) - Under pricing (below socially optimum price) - Potential welfare gain - Calls for government intervention to internalise external benefits to fix market failure

How is market failure caused when externalities are ignored

- When *supply and demand are equal *there's *equilibrium* in the free market. - In a free market *consumers and producers only consider their private costs and private benefits* — they *ignore any social costs or benefits*. As a result, the *MPC curve* can be seen as the *supply curve* and the *MPB curve* can be seen as the *demand curve*. - This means there is market equilibrium at MPB=MPC and not at the socially optimum level at MSC=MSB - This causes market failure as positive/negative externalities are ignored.

Why are demerit goods overconsumed? (2)

1) In the free market the *negative externalities that demerit goods cause are ignored*, and production and *consumption will be above the socially optimal level*. For example, producers and consumers *won't consider* the wider disadvantages to society of cigarettes, such as *smoking-related health issues putting a strain on health care services.* 2) Due to *imperfect information,* consumers *don't always realise the harm that demerit goods cause*.

Why are merit goods usually underconsumed (2)

1) In the free market the *positive externalities* that merit goods provide are *ignored*, and production and consumption will be below the socially optimal level. For example, *producers and consumers won't consider the wider benefits to society of a good education*, such as having a more productive workforce. 2) Due to *imperfect information, consumers don't always realise the full benefits that merit goods provide*.

What happens when negative externalities are ignored and the triangle of welfare loss

1) In this diagram the *social optimal output level* of this good is Qe and Pe . Assuming there are *no positive externalities, MPB = MSB*. 2) However, in the *free market only private costs are considered*. So output would be Qm and Pm . 3) This would cause *overproduction and underpricing* of this good — *more is produced* and *sold at a lower price than is desirable for society.* For each unit of this good produced *between Qe and Qm* the *marginal social cost is greater than the marginal social benefit*. 4) The *area between the marginal social cost* and *marginal social benefit* is shown by the green triangle ABC. This is the area of *welfare loss* — the loss to society caused by *ignoring negative externalities*

What happens when positive externalities are ignored and the triangle of welfare gain

1) In this diagram the *socially optimal level* of output for this good is Q2 and P2 . Assuming there are *no negative externalities, MPC = MSC*. 2) In the free market *only private benefits are considered*. So output would be Q1 and P1 . 3) This would cause *underconsumption and underpricing* of this good — *less is consumed and sold at a lower price than is desirable for society*. For each unit of this good consumed between Q1 and Q2 the *marginal social benefit is greater than the marginal social cost.* 4) The *area between the marginal social benefit and marginal social cost* is shown by the red *triangle DEF*. This is the *area of potential welfare gain* — the *gain to society lost by ignoring externalities.*

What is an example of market failure caused by ignoring negative externalities

A *chemical factory* may *ignore the externalities* it produces, such as the release of *harmful waste gases* into the atmosphere. If this happens then *output* from the factory will be *higher than the socially optimal level* (where MSC = MSB) and that will lead to a *welfare loss to society* (e.g. problems caused by the *harmful waste gases*).

What are public goods

A good that displays 2 features: 1) *Non-excludability* — people *cannot be stopped from consuming the good even if they haven't paid for it* 2) *Non-rivalry/non-diminishability* — *one person benefiting from the good doesn't stop others also benefiting equally* (the same utility is gained). e.g. *flood defense scheme, public beaches, firework displays, positive externalities and clean air are public goods*

How does asymmetric/imperfect information cause market failure

Imperfect information means that *merit goods* (e.g. education, health care and pensions) are *underconsumed* and *demerit goods* (e.g. tobacco and alcohol) are *overconsumed* causing a *misallocation of resources* and *market failure*

How do externalities cause market failure

Market failure occurs because in a *free market the price mechanism will only take into account the private costs and benefits*, but not the external costs and benefits. *(Externalities are ignored)*

What are merit goods?

Merit goods are goods whose consumption is regarded as being beneficial to society (positive externalities) e.g. Education and Healthcare

How can moral hazard cause market failure

Moral hazard is another possible result of *asymmetric information.* This happens when *people take risks* because they *won't suffer the consequences* themselves if things go wrong. For example, an individual could *buy home insurance*, but then *behave recklessly* (for example not locking their doors), safe in the *knowledge that they're covered.* This can happen because the *insurance provider lacks information* on the *individuals actions.* This leads to the *insurance company* making *huge financial losses* and market failure.

What are positive production and consumption externalities/external benefits

Positive externalities are the *external benefits to a third party (social benefit > private benefit)* e.g. - A *positive externality* of *producing* military equipment could be an *improvement in technology* that benefits society. - A *positive externality* of *producing* energy from renewable sources is *less CO2 emissions* - A *positive externality* of someone *consuming* a *vaccine* would *reduce the spread of a disease* - A *positive externality* of someone *consuming education* would be *increased productivity levels and reduced crime*

What is a private good?

Private goods are *excludable* (you can stop someone consuming them) and they show *rivalry* For example, biscuits are a private good — if you eat a biscuit you stop anyone else from eating it

What is symmetric information

Symmetric information - In a *competitive market* it's *assumed* that there's *perfect information*. That means that buyers and sellers are assumed to have *equal and perfect knowledge* regarding prices, costs, benefits and availability of products. This will allow *efficient allocation of resources*

What is asymmetric information

Usually *sellers have more information* on a product than buyers. For example, a *used car salesman* will have *more information about the history of a car* they're selling than a prospective buyer. *(unequal and imperfect information)*

What are negative production and consumption externalities/external costs

negative externalities are the *external costs to a third party. (social costs > private costs)* e.g. - A negative externality of *producing steel* could be *pollution* that harms the local environment. - A negative externality of *consuming a chocolate bar* could be *litter* that's dropped on the street. - A negative externality of *consuming*/smoking cigarettes would be *passive smokers* being affected

What is the socially optimum point

when marginal social costs = marginal social benefits

Why does imperfect information affect the provision of merit and demerit goods (scams) (3)

• *Pension providers* have a greater *knowledge* of the *pension schemes* available than their clients — this can lead to scam and selling *unnecessary schemes* or more expensive schemes than may be needed. • *Doctors have a greater knowledge of medicine* — they may *persuade (scam) their clients* to purchase more *expensive care* than is required. • *Information* on a good/service may be *too complex to understand*, e.g. the spec differences between computers may be confusing to a consumer, so they might *struggle to work out which is best for their needs.*

Why does imperfect information affect the consumption of merit and demerit goods (3)

• Consumers may *not know the full benefit* of a merit good. e.g. they may not realise that a good education could lead to improved future earnings. Or regular hospital visits may increase life expectancy. • Consumers may *lack the information* to *decide which good or service is right for them*. • Consumers *may not know how harmful a demerit good*, such as alcohol, can be and would be *persuaded by advertising* for buying a demerit good.

How was the 2008 financial recession caused by a speculative housing market bubble (4)

• Growth in the '*sub-prime' mortgage market* (the mortgage market for borrowers with a *poor credit* rating) caused *house prices to rise, as demand increased*. • *Rising house prices* led to *more people investing* in property, *pushing prices up further*. • The *bubble burst when people who'd taken on mortgages they couldn't afford began to default*, and *house prices began to fall.* • This meant that banks' levels of capital fell, so banks *reduced their lending*, creating a *'credit crunch'*. • This triggered a *loss of confidence in the wider economy,* a *fall in demand, and a deep recession.*

What are the sources of market failure

• externalities • under-provision of public goods (free rider probleom • information gaps • (moral hazard)