1.4. Market Failure Market failure is a situation in which the free market leads to a misallocation of society's scarce resources in the sense that either overproduction or underproduction of a particular good occurs, leading to a less than optimal outcome. Reasons for market failure The reasons for market failure include: Positive and negative externalities Lack of public goods Under-provision of merit goods Over-provision of demerit goods Abuse of monopoly power Inequality The meaning of externalities Externalities are costs (negative externalities) or benefits (positive externalities), which are not reflected in free market prices. Externalities are sometimes referred to as 'by-products', 'spillover effects', 'neighbourhood effects' 'third-party effects' or 'side-effects', as the generator of the externality, either producers or consumers, or both, impose costs or benefits on 1
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1.4. Market Failure
Market failure is a situation in which the free market leads to a misallocation of
society's scarce resources in the sense that either overproduction or
underproduction of a particular good occurs, leading to a less than optimal
outcome.
Reasons for market failure
The reasons for market failure include:
Positive and negative externalities
Lack of public goods
Under-provision of merit goods
Over-provision of demerit goods
Abuse of monopoly power
Inequality
The meaning of externalities
The key feature of an externality is that it is initiated and experienced, not
through the operation of the price system, but outside the market.
Proponents of laissez-faire would argue that externalities particularly arise
because of the absence of markets - as no markets exist for such things as clean
air and seas, beautiful views or tranquility, economic agents are not obliged to
take them into account when formulating their production and consumption
Externalities are costs (negative externalities) or benefits (positive externalities), which are not reflected in free market prices. Externalities are sometimes referred to as 'by-products', 'spillover effects', 'neighbourhood effects' 'third-party effects' or 'side-effects', as the generator of the externality, either producers or consumers, or both, impose costs or benefits on others who are not responsible for initiating the effect.
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decisions, which are based on private costs and benefits i.e. those which are
internal to themselves. Another way of putting this is to say individuals have
no private property rights over such resources as the air, sea and rivers, and
thus ignore them in making their production and consumption decisions.
Property rights refer to those laws and rules that establish rights relating to:
Ownership of property;
Access to property;
Protection of property ownership;
The transfer of property.
Thus a firm may feel free to dump effluent into a river as the spoiling of the
environment and the killing of fish is not a cost that it would directly have to
bear. Those on the political left would be more likely to argue that such an
externality would arise because of the market system which is based upon the
private ownership of resources, with individuals acting in their own self interest
and therefore not having to consider what is in the public interest i.e. the
problem is due to an absence of communal property rights and of a system of
Education is a product, which exhibits a positive consumption externality i.e., has
positive effects on third parties following the private consumption of this
product. The MSB exceeds the MPB (MXB exists); it is under-provided and hence
under-consumed in the free market.
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Example of the external benefit from consuming education
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Government strategies to create a socially efficient equilibrium in
education market
1. Public Provision
2. Subsidisation
3. Vouchers
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Demerit goods
What are demerit goods?
Demerit goods are goods, which are deemed to be socially undesirable, and which
are likely to be over-produced and over-consumed through the market
mechanism. Examples of demerit goods are cigarettes, alcohol and all other
addictive drugs such as heroine and cocaine.
The problem arises from the fact that so long as an effective demand is present,
such goods are, in all probability, going to be extremely profitable to produce, and
this is all that a price system takes into account - the market neither possesses a
'heart' to enable it to help those in need, nor is it inherently able to make value
judgments about which commodities are good or bad for society as a whole: it is
prices and profits which act as the 'guiding light' to resource allocation.
However, the consumption of demerit goods imposes considerable negative
externalities on society as a whole, such that the private costs incurred by the
individual consumer are less than the social costs experienced by society in
general; for example, cigarette smokers not only damage their own health, but
also impose a cost on society in terms of those who involuntarily passively smoke
and the additional cost to the National Health Service in dealing with smoking-
related diseases. Thus, the price that consumers pay for a packet of cigarettes is
not related to the social costs to which they give rise i.e. the marginal social cost
will exceed the market price and overproduction and over-consumption will
occur, causing a misallocation of society's scarce resources. This is illustrated
in figure 11 below.
Figure 11 Over-consumption of a demerit good
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The diagram illustrates how the market fails in the case of demerit goods. At a
market price of OP, OQ quantity of the demerit good is consumed, where demand
(private marginal benefit) equals supply (private marginal cost). However, at OQ
the social marginal cost exceeds the price by the vertical distance XY, the value of
the marginal external cost. Social optimality would require a smaller level of
consumption at OQ1, where price = social marginal cost = social marginal
benefit.
Government responses - demerit goods
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Possible government responses to correct market failure arising from
demerit goods
The government may attempt to reduce the consumption of demerit goods
such as cigarettes, alcohol and addictive drugs through persuasion; this is
most likely to be achieved through negative advertising campaigns,
which emphasize the dangers of drink-driving, drug abuse etc. The aim
here is the opposite of normal commercial advertising, namely to shift the
demand curve for demerit goods to the left.
Figure 12 Negative advertising campaign
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A contraction of demand (movement along the demand curve for a
demerit good) could be achieved by the imposition of a tax on the demerit
good. This would have the effect of shifting the supply curve to the
left, raising the price and reducing the amount consumed. If the
government could accurately assess the value of the marginal external cost
caused by the consumption of the demerit good a tax equivalent to this
value could be imposed, and a socially optimum outcome could be
achieved. However, in practice, ascribing an accurate monetary value to
negative externalities is extremely difficult to do, and the demand for such
goods as cigarettes and alcohol is often highly inelastic, so that any increase
in price resulting from additional taxation causes a less than proportionate
decrease in demand.
Figure 13: Imposition of a tax
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The government may use various forms of regulation. In its most extreme
form, regulation could be used to impose a complete ban on a demerit
good, such that its consumption is made illegal; for example, the
Prohibition Laws in the USA in the 1930s criminalized the sale and
consumption of alcohol, as does the law at the moment in Saudi Arabia; also
in the UK and many other countries today anyone found guilty of selling or
consuming heroin can be imprisoned. However, the effect of such
regulation is rarely to completely eliminate the market for the demerit
good; rather, it is usually driven underground in the form of an unofficial or
hidden market.
Less severe regulatory controls might take the form of spatial restrictions e.g.
people may be disbarred from smoking in their place of work, on public transport
and in cinemas and restaurants; there may be time restrictions in that it may be
illegal to sell alcohol during certain periods of the day, or there may be age
restrictions in terms of a minimum age being stipulated at which young people
are permitted to buy cigarettes and alcohol.
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Merit goods
What are merit goods?
Merit goods are the opposite of demerit goods - they are goods which are deemed
to be socially desirable, and which are likely to be under-produced and under-
consumed through the market mechanism. Examples of merit goods include
education, health care, welfare services, housing, fire protection, refuse collection
and public parks.
In contrast to pure public goods, merit goods could be, and indeed are, provided
through the market, but not necessarily in sufficient quantities to maximize social
welfare. Thus goods such as education and health care are provided by the state,
but there is also a parallel, thriving private sector provision. Indeed, there is
considerable disagreement between economists on the right and left of the
political spectrum over the extent to which such goods should be provided by the
state or the private sector. We consider these arguments later in this section.
Before we proceed with our discussion of merit goods, and in particular the
question of why merit goods tend to be underprovided by the market, it would be
useful at this stage to summarize the main differences between public goods,
private goods and merit goods. Have a go at filling in the blank table below (we
have put in a few entries to help you along). Once you have had a go, follow the
link under the table to compare your answers with ours.
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Public goods
What are public goods?
Pure public goods are ones that when consumed by one person can be consumed
in equal amounts by the remainder of society, and where the possibility of
excluding others from consumption is impossible.
Examples of public goods are:
national defense;
the police service;
street lighting;
lighthouses;
flood-control dams;
pavements;
public drainage.
It is likely that the market, left to itself, will seriously under-produce such goods,
or possibly not produce them at all. This is because the market will only provide
goods for which a profit can be made, and pure public goods possess two
important properties that together make their production on the basis of private
profitability extremely difficult. These features are:
non-rivalry (or non-diminishability);
non-excludabilty.
Firstly, consider the characteristic of non-rivalry: this means that one person's
use of the public good does not deprive any other person of such use or does not
diminish the amount available to others; for example, if one person enjoys the
benefits of being protected by the police-force, a flood control dam or the
national defense system, it does not prevent everyone else doing the same;
similarly, if one person benefits from walking along a street at night-time which
is paved, free of pot-holes, and well-lit, the benefits and the availability to others
would not be diminished.
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Secondly, consider the characteristic of non-excludability: this means that when
the public good is provided to one person, it is not possible to prevent others
from enjoying its consumption - sometimes summarized as: provision at all
means provision for all. For example, if a police force, a flood-control dam or a
national defense system is successful in offering protection to citizens of a
country, once it has been provided it is impossible to exclude anyone within the
country from consuming and benefiting from them. Similarly, for a paved and
well-lit public street, nobody can be prevented from enjoying its benefits.
Thus, in the case of public goods, the market fails because the private sector
would be unwilling to supply them - their non-excludabilty makes them non-
marketable, because non-payers cannot be prevented from enjoying the benefits
of consumption, and therefore prices cannot be attributed to particular
consumers. This involves the free-rider problem, which arises when it is
impossible to provide a good or service to some without it automatically and
freely being available to others who do not contribute to its cost. For example,
imagine a situation in which you shared an island with five other inhabitants; if
you paid privately for an army to defend the island against violent invaders, your
five co-inhabitants could 'free-ride' off you by enjoying the benefits of the
defenze, without having to pay anything towards it; there would probably come a
point when you would withdraw your payments and, like the others, leave it to
someone else to foot the bill; eventually, the army would not be provided at all.
The concept of a 'public good' can perhaps best be understood by comparing it with its opposite, a private good.
A private good possesses two features, excludability and rivalry, and when consumed by one person, it is not available to others; thus, a person buying a new washing machine can exercise private property rights over it and exclude others from enjoying its cleaning abilities, whilst, at the same time, diminishing the total stock of washing machines available for sale to others.
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Hence, in a free market, a whole range of pure public goods may not be provided,
and the only answer is for the state to provide them, financed out of general
taxation. Moreover, the non-rivalry aspect of public goods means that the cost of
supplying one more user i.e. the marginal cost, is zero; for example, once paving
stones have been laid, it makes no difference how many people walk along them
as there is no additional cost involved. As the condition for the achievement
of allocative efficiency is that price should be set equal to marginal cost, it would
therefore follow that to achieve an optimum level of output and consumption of
public goods the state should provide them at zero prices.
Task: Fill in the table below with the relevant information
Main features Public goods Merit goods Private goods
Rivalry in
consumption
Non-rivalrous
Excludability Excludable
Benefits Individual and
communal (strong
positive externalities)
Provider Usually private
enterprise
Financed by Usually taxation
Examples
Why might merit goods be under-provided by the market?
Market failure in production occurs when the production of a good or service
creates external costs that are harmful to third parties, e.g. when a factory
pollutes a river with waste or the atmosphere with greenhouse gasses. The total
costs to society of these activities are the private costs of the firm plus the
external costs that the firm creates, but does not pay for. Since the producer does
not pay the total cost, the good or service is over-produced, which results in
a welfare loss.
National governments can respond to negative externalities of production and to
resource depletion and CO2 pollution using a number of mechanisms designed to
reduce emissions of global greenhouse gasses and promote sustainability. These
include:
Environmental taxation, such as carbon taxes, to recover the external costs
of pollution
Legislation setting environmental standards and banning firms which fail
to meet these standards
Adoption of cap and trade schemes for carbon trading
Funding for cleaner technologies
Taxation and financial penalties increase the market price of carbon. This
provides strong incentives to reduce carbon emissions by sending signals:
1. To consumers about what goods and services produce high carbon
emissions and which should be used more sparingly.
2. To producers about which inputs emit more carbon, and which emit less, so
encouraging them to move to lower-carbon technologies.
3. To inventors and innovators to develop and introduce lower-carbon
products and processes.
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Cap and Trade Schemes
Cap and trade schemes set specific limits on GHG emissions for countries and
organizations. They promote the trading of emissions allowances between
emitters, who can meet the cap efficiently and those who face more of a challenge
in reducing emissions.
The choice between environmental taxation and cap and trade schemes to
address climate change has generated considerable discussion with impassioned
arguments on both sides.
Taxation has the advantage that individual governments without international
agreement can implement it, but environmental taxes have dead-weight losses in
addition to their beneficial effects in addressing externalities. It is also argued
that establishing a price for GHGs through cap and trade schemes has the
advantage of providing some certainty about reductions in quantities of
emissions and creates a market to achieve the climate change mitigation target at
the lowest cost.
Promoting Clean technologies
Cap and trade schemeA cap and trade scheme is a market-based approach to reduce carbon emissions via financial incentives that allows corporations or national governments to trade emissions allowances under an overall cap, or limit, on those emissions. Fines are imposed for producers exceeding those limits, while producers operating below their carbon limits can sell or "trade" their offsets to companies that are operating above the limits.
Clean technologiesClean technologies are designed to minimize pollution and the emissions of greenhouse gasses, by creating electricity and fuels with a smaller environmental and carbon footprint. These technologies include recycling, renewable energies (wind and solar power, biomass and biofuels and hydropower), green transportation, waste-water recycling and energy efficient lighting, homes, buildings, electric motors and commercial and domestic appliances.
The Non-Drip paint company is considering whether or not to locate a new factory near the town of Greensville. The company estimates that the new paint will cost $5 million a year to run, but should add $6 million to revenue from the sale of the paint it produces.
The people of Greensville are worried that the new factory will release smoke, containing harmful chemicals, into the air. These chemicals will pollute the air and even get into the soil and water supplies, as rain will bring the chemicals down from the air.
The local health authority estimates that over many years this smoke will damage people’s health and increase the need for medical care at an estimated cost of $4 million a year.
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The local authority believes that the smoke will blacken the walls of historic buildings in the area, and cause their eventual erosion. Regular cleaning will therefore be needed at an estimated cost of $2 million each year.
On a more positive note, it estimates that the paint factory will encourage other firms to locate in the area as suppliers of materials, providers of transport etc, and that this will reduce local unemployment and help other local businesses. These external benefits are valued at $3 million.
(a): What two factors does the Non-Drip paint company take into account when deciding whether or not to produce paint with its resources?
(b): From society’s point of view should the firm take other factors into consideration?(c): Using the figures presented in the case study, calculate:
i. The paint company’s estimated yearly profit.ii. Whether or not paint production at the factory is worthwhile for society.
(d): A conflict of interest between the paint company and the local community has arisen. How does this illustrate the central economic problem?
2: Smoking
(a): List three private costs that a cigarette manufacturer will have to pay.
(b): How will the manufacturer calculate the total revenue from the sale of
cigarettes?
(c): How are other people in a café affected by a man’s decision to consume a
cigarette?
(d): Many countries have introduced laws to ban smoking in public places. What
sort of costs will a government have to pay for in order to make sure the ban is
observed?
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(e): Research has shown that smoking can damage your health.
i. What is the opportunity cost of increased health spending on treating
smokers?
ii. Who will bear the cost of increased health spending?
(f): Imagine that the government decides to increase the tax payable on a packet
of cigarettes. What effect may this have on?
i. The number of cigarettes consumed?
ii. The revenue of cigarette-makers?
iii. The workers in cigarette factories?
3: Belt up
Amiya Bundhun was an economics student at college and now works for a bank. She was injured in a car accident and has just spent six months in a hospital paid for by the government.
Amiya decides to work out the opportunity cost of not wearing her seat belt. She values the wages she has lost over six months at $12000 and she values her social life at $4000. Amiya calculates that the opportunity cost of not wearing her seat belt is $16,000.
The police and ambulance driver that attended to her at the scene of her accident said that Amiya would not have been hurt had she been wearing her seat belt.
(a): What is meant by the term opportunity cost?
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(b): What type of cost has Amiya forgotten about when she calculated the opportunity cost of not wearing her seat belt?
(c): “Wearing a seat-belt is up to me to decide. It’s my life and if I get hurt in an accident it affects nobody else”. Car drivers often say this, but would an economist agree with them? Explain your answer and say whether or not you agree that wearing a seat belt should be law.
Data Response Questions
1:
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(a) Use an appropriate diagram explain how a subsidy is likely to affect the
price and quantity of wind-generated energy
(b) Evaluate the decision to construct the world’s largest wind farm (at the
time) in Texas
2:
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(a) Using an appropriate diagram, explain how rising biofuel production will
affect the market for corn
3:
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(a) Using an appropriate diagram, explain why the problem discussed in the
text is an example of market failure
(b) Evaluate the use of regulation as a solution to the market failure caused
bu the pollution of the Cisadane River
4:
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(a) Using an appropriate diagram, explain why illegal dumping of toxic
waste by these manaufacturing firms is an example of a market failure
(b) Using an appropriate diagram, explain the expected effect on the local
carrot market resulting from the contamination of the river
(c) Evaluate the solutions that the government could employ to reduce the
negative externalities caused by the river pollution in Viotia
5:
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(a) Using an appropriate diagram, explain why in a free market, low-
emission vehicles may be under-provided
(b) Using an appropriate diagram, explain how ‘halving the indirect tax on
cars with smaller engines is likely to affect the car market in China
(c) Evaluate three of the policies that the Chinese government has
introduced or might introduce to bring cleaner, low-emission vehicles to
its roads
6:
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(a) Using an appropriate diagram, explain the possible effect on the market
for cigarettes of a ban on tobacco advertising in Ireland
(b) Evaluate the economic effects of the imposition of a minimum price for
cigarettes in Ireland
7:
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(a) Using an appropriate diagram, explain why the Emissions Trading
Scheme (ETS) could lead to higher prices for electricity
(b) With the aid of a diagram, explain how carbon emissions are a form of
market failure
(c) Evaluate the possible effects on the Australian economy of