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Economics Chapter 14

Market failure occurs when economic activities lead to externalities affecting third parties, resulting in inefficient resource allocation. Examples include underprovided public goods like education and healthcare, and overprovided demerit goods like tobacco and alcohol. Government intervention, such as taxation, is often necessary to correct these failures and ensure a more efficient market outcome.

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Economics Chapter 14

Market failure occurs when economic activities lead to externalities affecting third parties, resulting in inefficient resource allocation. Examples include underprovided public goods like education and healthcare, and overprovided demerit goods like tobacco and alcohol. Government intervention, such as taxation, is often necessary to correct these failures and ensure a more efficient market outcome.

Uploaded by

fergusdorward
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Economics

CHAPTER 14
Market failure

 Market failure occurs when the production and consumption of a


product causes additional positive or negative externalities on a
third party not involved in the economic activity.
 Externality refers to the spill-over effect (or side-effects) of economic
activity.
 The market forces of demand and supply fail to allocate resources
efficiently.
Examples of market failure

 In a free market education and healthcare are provided only to


those who are willing and able to pay.
 Street lighting is underprovided due to the lack of exclusion.
 Tobacco, alcohol, overprovided.
 Damage caused to green space.
 Monopolists extorting the market.
Private and social costs

 The private costs of production and consumption are the actual


costs for a firm, individual or the government.
 External costs are the negative side effects of production or
consumption incurred by third parties for which no compensation is
paid.
 Driving a car, maintenance and fuel is the private cost. Pollution
and congestion are external costs, which are not paid for. Hence,
this is market failure.
The true cost to society is known as the social cost.
 Social costs= private costs + external costs
Private and social benefit

 Private benefits are the benefits of production and consumption


experiences by an individual firm, household or government. E.g.,
driving a car and the benefit of transportation.
 External benefits are the positive side effects of production or
consumption, experienced by third parties for which no money is
paid by the beneficiary. e.g., the smell of a well kept garden and
the positive impact of it on nature. Vaccinations etc.
 Social benefits are the true or full benefits of consumption or
production.
 Social benefits = private benefit + external benefit
Causes of and consequences
Market failure
 Public goods
 Merit goods
 Demerit goods
 Abuse of monopoly power
 Factor immobility
Public goods

 Public goods are goods and services that are non-excludable and
non-rivalrous, and which are a cause of market failure as there is a
lack of a profit motive to produce them.
 Non-excludable and non-rivalrous means that those who do not
pay can still enjoy access to the product, and there is no
competition to purchase the product.
 Street lighting, law and order, public firework displays, national
defence
Merit goods

 Merit goods are goods or services which when consumed create a


positive spillover effect in the economy.
 Have social benefits and are under provided and under-consumed
without government intervention or provision.
 Education, healthcare, vaccinations, research and development,
subsidised housing, libraries.
Demerit goods

 Demerit goods are goods or services which when consumed cause


negative spillover effects in the economy.
 Without government intervention they are over-produced and over-
consumed.
 Cigarettes, alcohol, junk food, gambling, recreational drugs.
Abuse of monopoly power

 Existence of a monopoly can cause market failure.


 Without government control, certain private sector firms can grow
to monopolies and exploit their market power.
 They exploit by charging higher prices or reducing supply.
 Profit-maximising monopolists lack incentives to be competitive.
Therefore this creates inefficiencies in the market.
Factor immobility

 A cause of market failure is factor immobility.


 If factors of production are unable to move or switch between
different uses and locations.
 Factor immobility results in a free market being unable to allocate
resources efficiently.
 Geographical immobility – occurs when it is difficult to move a
factor of production from one geographical location to another.
 Occupational immobility – when it is difficult to move a factor of
production from one type of work to another.
Causes of Market Failure
detailed
 Production of goods or services which have negative side effects on a third
party. E.g., production of oil may cause damage to the environment and a
loss of green space.
 Production of goods or services which have positive consequences on a
third party. E.g., training such as first aid, which creates benefits that can be
enjoyed by others.
 Consumption of goods and services which have a negative spill-over, such
as cigarettes. Known as demerit goods.
 Consumption of goods and services which have a positive spill-over, such as
education. Known as merit goods.
Causes of Market failure

 Failure of private sector to provide public goods due to a lack of


profit motive. E.g., street lighting, national defence.
 The existence of a firm in a monopoly market that charges prices
which are too high and exploits customers.
Government intervention

 Governments intervene to correct market failure. One way of doing


this is by imposing a tax.

 The level of taxation is the distance between the supply curves.


 The more inelastic the demand curve is, the greater the proportion
of the tax burden is on consumers.
 More on next chapter.

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