MARKET FAILURE- Chap 13 - IBC

Pareto optimality = market is at equilibrium, however, impossible to make someone better off without making someone else worse off. If Pareto optimal, then the market is Socially efficient or community surplus (chap 12) is maximized with optimum allocation of resources. The supply curve is determined by the marginal costs of production and since this is the marginal cost to the whole community, we refer to it as the marginal social cost (MSC) The demand curve is determined by the marginal utility (marginal benefit) and, since this is the marginal benefit to the whole community = known as marginal social benefit (MSB)

MARKET FAILURE

MARKETS ARE NOT PERFECT= Resources are not allocated in an optimal manner.

Community surplus is not maximized. Governments are then asked to intervene to Correct market failures.

TYPES OF MARKET FAILURES (p.135)

Imperfect competition: Monopolists restrict output (which pushes prices up) to maximize profits. This results in a socially inefficient level of output. An imperfect market will fail to equate marginal social cost (MSC) and marginal social benefit (MSB) (See chart on p. 135). Community surplus is mot maximized leading to market failure. Governments try to reduce market failure by: a) Pass laws to restrict mergers/takeovers that would increase market share ( anti trust law) b) Set up regulatory bodies to oversee monopolies control/benefit to the public. Lack of public goods Public goods = goods/services that are NOT PROVIDED in a free market (perhaps in a centrally planned govt). Public good = good for the public. They benefit society. Examples: highways, libraries, bridges, dams, etc. The lack of public goods in a free market is a characteristic of a market failure (in a free market). Public goods are those goods whereby it would be inefficient for the free market (private sector) to pay for such services. Accordingly, the government is seen as the logical suppliers for such goods. They use tax revenue to pay for this and in some cases subsidize private firms to provide the good. Under supply of merit goods(P.136) Merit goods: Goods that provide a positive benefit to society as a whole. Usually they are classified as services vs. tangible products. All Public goods are considered merit goods. Examples: education, health services, opera, sports
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facilities. If education, health services, etc are not supplied by the government in sufficient quantity, it is considered a market failure (in a free market). Over supply of Demerit goods Demerit goods: Goods that are considered bad for both consumers and as a society as a whole. Examples include: cigarettes, alcohol, hard drugs, etc. More harmful demerit goods will be outlawed while less severe demerit goods will be taxed to discourage their usage. Externality: Where production or consumption of a good/service has an effect upon a third party. There is an external cost to society that is added on to the private cost of the producer. Such an externality can be positive or negative. Marginal Social Cost (MSC) equals the Marginal Private Cost (MPC) PLUS or MINUS any external cost/benefit of production to society (externality). If there are no externalities (= / -) of production, then MSC=MPC. Marginal Social Benefit (MSB) equals to Marginal Private Benefit (MPB) PLUS or MINUS any external cost/benefit of consumption to society (externality). If there are no externalities of consumption (+/-), then MSB=MPB. If there are no externalities in the market, then MSC=MSB and we have social efficiency and maximum community surplus. If externalities do exist, then MSC does not equal MSB and we have market failure and an inefficient allocation of societys resources. Types of externalities (pp.138-143) 1) Negative externalities of production / external costs: Production of good/services that are damaging to third parties. Found mainly with environmental problems. The marginal social cost exceeds the marginal private cost because there is an additional cost to society dealing with the problem of pollution. The firm will produce an amount greater than the benefit to society. This is a welfare loss to society (market failure) or MSC>MSB. Businesses only concerned themselves with the MPC and therefore government needs to rectify the situation as follows: a) Tax the firm = increasing MPC = lowered output = social efficiency or equal to MSC (chart 13.3 p.138) b) Legislate /ban the firms from producing too much of the product. This could lead to restrictive laws leading to increase MPC which could lead to job losses and diminished supply of a perhaps valuable good. c) Government could issue tradable emission permits= splitting of allow units of pollution between firms. Firms could buy/sell such permits. This solution does not lead to an overall reduction in pollution. 2) Positive externalities of production/external benefits: Production of good/service that creates external benefits to third parties. On p. 140 we speak about an overall benefit to society of those skilled workers who are trained by a particular company (increased MPC for that company). However, the benefit to society (MSC) in the long run exceeds MPC of the single firm. (MSB>MSC). This is a form of market failure (inefficiency) in that the firm takes on additional cost as society gains. Government can rectify this by: a) Subsidize the firm offering training. MPC would shift down towards MSC. If full subsidy, MPC=MSC and the socially efficient point would be reached. Problem- hard to estimate amount of subsidy and would take away spending on other government/societal needs. b) Provide training through state programs. Cost would be high, trainers could lack experience, dissuade
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firms to train on their own

3) Negative externalities of consumption: Cigarettes (see chart 13.6 on p. 141). The negative externality of consumption make the marginal social benefits les than the marginal private benefit (MSB< MPB). Since MSC is greater than MSB, there is a welfare loss to society and a market failure. The government can rectify this by: a) Ban cigarette smoking altogether. This would negatively impact the tobacco industry, lost jobs, and losses for shareholders. This would also eliminate a vital source of tax revenue for cigarettes (which has an inelastic demand). b) Impose indirect taxes=leads to reduce consumption. (See chart 13.7 on p. 141). This will raise cost, raise the market, price, raise government tax revenue (inelastic demand remember), and reduce consumption of cigarettes. However, although tax revenue rises, the fall in consumption does not reach the reduced level desired. In addition, higher prices can lead to the creation of a Black market c) Provide education to warn of the dangers of smoking. Can be expensive to produce ad campaigns.

4) Positive externalities of consumption: Health care and education Government can aide in the increased consumption of health related goods/services by : a) Subsidize the supply of health care. Main issue is cost. Developed economies take on this cost better than developing economies who cannot. b) advertise the benefits of health care. Again the main problem is cost. c) pass laws requiring vaccinations. Only successful if govt provides free of charge- legal issue of infringement of civil liberties. Recent court decisions declaring Obama care as being unconstitutional. Other causes of market failure (p.144-145) -Immobility of factors of production: Resources may not be able to be used/available so quickly or efficiently. Leads to structural unemployment due to occupational/geographical immobility. Government can encourage training programs or take the work to the workers or the workers to the work. Problems of information

Creation of inequality: leads to gaps in income and wealth. Could create a new system of taxation to redistribute income from wealthy to poorer populations. See recent tax deal. Very controversial Sort termism: pursuing short term solutions at he expense of creating long term problems by both firms and the government.