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Why markets fail

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  • 1. 2 nd Part – how the market fails For Markets to work ‘correctly’ – and to follow all that nice economic theory we have been studying – there needs to be conditions of perfect competition (no monopolies, cartels, nepotism…) and perfect information (everyone knows the products out there and what the market price is). In perfect competition the ‘right’ price is set by the forces of supply and demand – they come together to set market price – this price is the ‘best fit’ between peoples wants and what is available for sale. That is not always the case… The Market (its job) -> how/why it fails to do its job -> how/why Government intervenes -> how/why Government intervention can fail
  • 2. To Do at Home
    • Read the Handout on The Function of prices in the Market (p. 99) and do question 2 on The Japanese Electronics Industry
  • 3. What is Market Failure
    • The Market Mechanism allocates resources – this means that in a situation where there is limited resources ‘stuff’ (raw materials, labour, money) the market, through free competition decides who gets what, and for how much.
    • The Market Mechanism (machine as it were) – is made up of the interplay between supply and demand. Where they intersect a Market (Equilibrium) Price is reached.
    • For many reasons this ideal situation doesn’t happen in real life. These reasons are said to be the reasons for market failure
  • 4. These reasons are:
    • Productive or allocative inefficiency
    • (this is an issue in many of the others below)
    • Externalities (costs/benefits outside the market transaction)
    • The Nature of the Good (e.g. necessary but not economically viable..)
    • Immobility of factors of production
    • Imperfect Information
    • Monopoly / Cartel behaviour
  • 5. Market Failure due to Inefficiency
    • If the whole point is to allocate resources – then good economic decisions should be made about where and which factors of production should be used.. Where is the labour force best put to use. How should the capital be invested, which industries etc. We have scarce resources and we want to get the most out of them..
    • Could more be produced if our resources were allocated in a different way – what might stop this ‘market’ mechanism from making the ‘right’ economic decisions.
  • 6. 2 kinds of efficiency to think about at this level
    • Productive efficiency
    • Is production achieved at the lowest cost. Are we using our factors of production in the most efficient manner. It may make more economic sense to fire workers and buy a machine to make the product. Why might we not do that?
    • Allocative efficiency
    • Are resources used to make the products that customers wish to buy. If not then the market is not achieving allocative efficiency.
    When you have read about the other kinds of market ‘failure’ read the CAP pp 107-108 data and take notes where you can find evidence of market Failures including ones about efficiency.
  • 7. Market Failure due to Externalities This is a BIG topic ! Be warned
    • One of the functions of price (and profits) in a market was as a signalling device – they told the market where best to put resources in production. So if there are high prices or profits in a particular market then labour, capital and entrepreneurship should be put into the production of the goods/services for that market. However.. in reality Prices and Profits might not reflect the true costs/benefits of the production of these goods and services
  • 8. Market Failure due to Externalities
    • The differences between the market cost/price and the reality are called Externalities .
    • E.G. cutting down Brazilian rainforest to rear cattle for the US and European Beef Market makes economic sense within the market. But the long term environmental effects are not accounted for. Therefore the market is putting out the wrong signals, leading to a misallocation of resources.
    • If the true cost of the production of beef was taken into account either we would not produce as much beef (use alternatives, get out of eating meat altogether etc) or we would pay more for our beef.
  • 9. Graphing Externalities
    • Read (and practice drawing!!) the information on The Market Mechanism: Failures and imperfections (pp. 23-26)
    • Especially Changes in Consumer / Producer Surplus and Welfare Gain/Loss.
  • 10. The Economic Jargon around calculating ‘externalities
    • How do you start to factor in the ‘true cost’ of production / consumption into the market mechanism (into the intersection between supply and demand)
    • First you still have a diagram that looks like a D and S diagram.
    • But it is labelled differently
    • We now look at the D curve as showing us the benefits that consumers get from what they buy. Before the D curve was a graphical illustration of what consumers were willing (had the dosh to..) to buy. Why do we buy? To get some benefit from it..
    • So the D curve becomes the MPB curve – the Marginal Private Benefit Curve – for each extra unit we purchase what extra benefit do we get from it.
    • The S curve becomes the MPC curve - Marginal Private Cost curve – for each unit of product the supplier puts up for sale what private cost does he incur.
    • What is left is for economists to see what is missing from this market mechanism. Yes we get some benefit from that extra purchase – but does society benefit in some way? If they benefit as well (e.g. our extra unit of education helps us – but also society in the sense of a more educated workforce) – this ‘new curve’ which takes that into account is called the MSB curve – the Marginal Social Benefit Curve.
    • Then on the Cost side – yes the supplier incurs a extra cost for each extra unit he produces – but what is the extra cost on top of that to society e.g. what extra pollution is spewed out into the air. A curve that takes that into account is called the MSC curve – the Marginal Social Cost Curve.
    • When these are all ‘put on the graph’ or taken into account in the market transaction – the true cost of production or consumption can be shown – and from this we can see whether the private reality of the market is giving us a situation of Welfare Gain or Welfare Loss.
    • If it is a situation of Welfare Gain – that means we are consuming benefits without taking into account the way society benefits – if we did we would consume more of the product. WE ARE UNDERCONSUMING THIS GOOD . This is thinking like an economist NOT an ordinary person
    • If it is a situation of Welfare Loss – that means we are producing costs without paying for them. If we factor in the costs then the product would be more expensive and demand for the good would be less. WE ARE OVER PRODUCING THIS GOOD.
  • 11. Market Failure due to the Nature of the Good
    • This is sometimes called ‘missing markets’.
    • There may be goods that don’t fit into standard economic reasoning – i.e. it doesn’t seem economically sensible to produce them for sale. E.g. bus journeys from Aberystwyth to Tregaron. Very few people would want to take the bus there, therefore it is not economically sound to have a bus going there 2 times a day.
    • However – what if the pensioners of Tregaron needed to shop in Aberystwyth – or disabled people needed a lift to work. How can these goods be provided on the market. These are M erit Goods and the Government has to step in and either subsidise or wholly provide this service.
    • It is called a market failure because these goods can be produced / supplied – and there is a demand for them – and a need – but the demand does not meet the minimum required for the supplier side of the market to enter the market. In economic theory that would state that the good or service would not be provided. But the problem arises when it is deemed necessary for the good to be provided within society.
  • 12. Market Failure due to Imperfect Information
    • In an efficient market both buyers and sellers have full knowledge of the product. In theory then a ‘best fit’ market price can be reached. The supplier knows what they need to sell the product for. The buyer, through a good knowledge of the market (the alternatives out there, the true nature of the product etc) knows what price he is willing (or should) pay.
    • But in cases of imperfect information a mistake could be made. Buyers might not know about alternatives – they might not know the ‘true’ cost of the product.
    • Either the buyer or the seller might have more information that the other – this leads to unfair advantage during the market exchange. In economics for the market mechanism model to ring through there can be no such advantage.
    • Classical example given is private dentists – the seller (the dentist) knows more about teeth and the problems they have, and the service he is providing (the fixing of teeth) than the buyer. He can over charge. You may not be getting the realistic market price.
  • 13. Market Failure due to Factor Immobility
    • In common language this means that some of the factors of production can not be moved about to be used in the most efficient manner – that leads to inefficient use of resources and that can be defined as market failure.
    • An example is Capital as a factor of production – Money – Banks had the money to lend to people wanting houses. The houses were there to be bought. Consumers were willing to borrow the money. But the Banks did not want to lend the money.. Market Failure in the Housing Market.
    • Labour immobility is a bit example in this category of market failure.
    • And this crosses over with Unit 2 and Employment. Labour can not just move all around the country (and back again!) as required for the most efficient allocation of labour. The introduction of part-time work and job sharing eases this problem a little.
    Do the Data Question on Market Failure on page 109. Also the Data Question on Nuclear Power Generation on p. 118
  • 14. To do at home
    • Imperfect Information
    • Do the Data Question On Smoking (pp.132-3)
    • Government Intervention in the Agricultural Market Read the information on the CAP on pp. 139-142 and underline and explain the ways the EU distorts the normal workings of the market. Why do the governments of the EU pursue this policy?