UNIT 11 – MARKET FAILURE Market failure happens when the price mechanism fails to allocate scarce resources efficiently, i.e., when producers fail to supply the goods and services that consumers demand, in the right quantities and at the lowest possible cost. It also occurs when production or consumption of a good or service causes additional positive or negative externalities (spillover effects) on a third party not involved in the economic activity. Market failure may be caused by the following: Negative Externality - Production of goods or services which cause negative side-effects on a third party. Examples: Loud music – Playing loud music and preventing one’s neighbour to fall asleep. Pollution - Producing chemicals that cause pollution as a side effect, and prevent local fishermen from catching fish. The loss of income will be the negative externality. Congestion – Driving a car creates air pollution and contributes to congestion. These are both external costs imposed on other people who live in the city. Positive Externality - Production of goods or services which cause a positive spillover effect (benefit) on a third party. Examples: Education – Training programmes like first-aid or coaching skills for employees can create benefits that can be enjoyed by others. Also, if someone consumes education, they can benefit the rest of society by educating others Production - A farmer who grows apple trees provides a benefit to a beekeeper. The beekeeper gets a good source of nectar to help make more honey. Demerit Goods – Goods or services which can have a negative impact on the consumer but consumers are not aware of the long run implications due to information failure. They cause a negative spillover effect on a third party. Examples include cigarettes, alcohol, gambling and drugs. Merit Goods – Goods or services which government thinks everybody ought to have. These goods are usually under-consumed by consumers due to their lack of knowledge about the long run benefits of these goods, hence under-produced by producers. They cause a positive spillover effect on a third party. Examples include education, health care and vaccinations. Public Goods – Goods or services which are provided by the government because of the failure of the private sector to provide these goods due to the lack of a profit motive. These goods have two characteristics, non-rival and non-excludable. Non-rival means consuming these goods does not reduce the amount available for others, while, nonexcludable occurs when non-paying customers cannot be prevented from consuming these goods. The problem with these goods is that they have a free rider problem since consumers who are unwilling to pay for these goods can enjoy benefits in the same way as paying consumers. Examples are street lighting, road signs and national defence. Monopoly – Monopoly firms tend to charge higher prices by restricting supply which violates consumers’ welfare.
© Niaz Mahmud
Page # 1
niaz.mahmud@gmail.com niaz@harmonicinvestment.com
Private and Social Costs The private costs of production and consumption are the actual costs of a firm, individual or government. Example: the driver of a car pays for the insurance, road tax, petrol and cost of purchasing the car. The external costs are the negative side-effects of production or consumption incurred by third parties, for which no compensation is paid. Example: a car driver does not pay for the cost of the congestion and air pollution created when driving the car. This leads to market failure because the private costs (of driving) do not represent the true costs (of driving) to society. The true cost of a car journey is called the social cost. Social costs = private costs + external costs Consumption or production decision taken based only on the private costs to the individual or firm will lead to over-production, Fig 1. The difference between SxSx and SS is accounted for by the external costs. The allocative efficient output is Qx but the market output is Q.
Private and Social Benefits Private benefits are the benefits of production and consumption incurred by a firm, individual or government. Example: a car owner gains the benefits of driving the car and owning a means of private transport. Similarly, a person who owns a garden enjoys the personal benefits of having green space and plants, flowers and possibly vegetables to enjoy. External benefits are the positive side-effects of production or consumption incurred by third parties, for which no money is paid by the beneficiary. Example: the sight and smell of a well-kept garden gives pleasure to a neighbour or a person walking past. The plants and trees also absorb carbon dioxide and therefore are good for the environment. Other examples of external benefits are education, training, health care and law enforcement. When a person has a vaccination against a certain disease, they receive the private benefit of being immune to the disease, but other people are also protected from this highly contagious disease. To eradicate diseases, many governments make it a legal requirement for children to be vaccinated against certain diseases before they can start school. Many governments provide such vaccinations free of charge to children. This can lead to market failure because there are external benefits to society of vaccination programmes. If vaccinations were left to the choice of individuals, they would be under-consumed, mainly due to the price that would be charged for them, Fig. 2. The true benefit of the vaccination is called the social benefit. Social benefit = private benefit + external benefit Š Niaz Mahmud
Page # 2
niaz.mahmud@gmail.com niaz@harmonicinvestment.com