Market failure occurs when markets lead to an inefficient allocation of resources, resulting in a situation where total surplus is not maximized. There are several key causes of market failure: market power, where producers dominate the market and raise prices; information gaps that prevent rational decision making; externalities where costs and benefits to third parties are not taken into account; and public goods where private supply and demand are lacking. When externalities exist, prices do not reflect the true social costs of production or consumption, resulting in over or underproduction from the efficient level.

1. YEAR 11 MARKET FAILURE REVISION

2. SYLLABUS
 the concept of market failure
 the distinction between a competitive and an imperfect market
 how under and overproduction in a market can result in a deadweight loss
 Market Power
 Externalities
 Public Goods and common resources

3. WHAT IS MARKET FAILURE?
 Occurs when markets lead to an inefficient allocation of resources so total surplus is not maximized.
 Market failure occurs when
They fail, for example when :
1. Market Power: Producers have scarcity or monopoly power (and they dominate the market, raise prices and
earn excessive profits
2. Information gaps: buyer or sellers have insuffiecent information to make rational decisions
3. Merit and de-merit goods: buyers consume less or more of a goods than society thinks is desirable
4. Externalities are not taken into account (and bystanders suffer collateral damage as a result of peoples
decisions)
5. Public goods: products where there is no private sector demand or supply
6. The tragedy of the commons: common resources are exploited or damaged through over use
7. Club goods and natural monopolies: economies of scale create conditions where only one can profitably
suplly a market

4. Efficiency and Equity (c) Andrew Tibbitt 2008
SLIDE 4
MONOPOLISTS RESTRICT SUPPLY AND PUSH UP PRICES.
Monopolists have the
power to control supply
in the market. This can
lead to prices that are
higher than those set in
competitive markets.
The result is inefficiency.
Price
Quantity
Supply
(competitive)
Demand
New Supply
(monopoly)
Deadweight
loss
Consumer
surplus
Producer
surplus

5. Efficiency and Equity (c) Andrew Tibbitt 2008
SLIDE 5
INFORMATION GAPS
Markets fail because consumers nad producers
 Lack of information to make rational decisions because the
necessary information is unavailable or too expensive to access.
E.g. the prices and quality of all other competing products
 Do not understand the information because it is too complex
e.g. insurance policies and electrical/mechanical goods.
 Take a short rather than long term view e.g. smoking, binge
drinking, education
 Don’t take itno account externalities, education, health care

6. Efficiency and Equity (c) Andrew Tibbitt 2008
SLIDE 6
WHEN THERE ARE EXTERNALITIES
Bystanders (third parties) can be affected by economic decisions made by
others. These spin-off or side effects of an economic decision are called
externalities.
Bystanders can be affected in a good or positive way (e.g. your neighbour
has nice garden). These positive externalities create social benefits.
Bystanders can be harmed or affected in a negative way (e.g. people
become sick from factory pollution). These negative externalities create
social costs.

7. GENERAL OVERVIEW
 Externalities are a type of market failure
-prices in a market do not reflect the true marginal costs and/or marginal benefits
associated with the goods and services traded in the market.
 Externalities may be related to production activities, consumption
activities, or both.
 Production externalities: production activities of one individual imposes
costs/benefits on other individuals that are not transmitted accurately through a market.
 Consumption externalities: consumption of an individual imposes costs or benefits on
other individuals that are not accurately transmitted through a market.

8. EXAMPLES OF PRODUCTION EXTERNALITIES
 Air pollution from burning coal
 Ground water pollution from fertilizer use
 Food contamination and farm worker exposure to toxic chemicals from
pesticide use
 Irrigation water and consequential decline of waterfowl population in nearby
wildlife refuge
 Production of refrigerators using CFC’s
 Health issues resulting from gold mining

9. NEGATIVE CONSUMPTION EXTERNALITY
 Consumption imposes loss of benefits for people not directly
involved in making decision.
 Example: using mobile phones when driving, smoking in public
 Result if not corrected:
 Social benefit less than private benefit.
 Demand curve is to far to the right
 Product is over consumed
 Deadweight loss is always the area of triangle pointing to the
efficient or socially correct equilibrium
 Role of the government::
 Reduce consumption to correct social level
 Internalise the externality
 Make consumers pay for socially bad behavior
 Move MPC down
 Tax consumers excise tax, social penalties
 Shift MPB to the left
 Regulate against harmful social behavior (penalties)

10. POSITIVE CONSUMPTION EXTERNALITY
 Consumption creates a benefit fro people not directly involved in
making that consumption decision.
 Examples: Flu vaccinations, education
 Result if not corrected:
 Social benefit is greater than private benefit
 Demand curve is too far to left
 Products are undervalued
 Role of the government:
 Raise consumption to correct level for society
 Internalise externality
 Reward consumers for socially good behavior
 Shift MPC down
 Provide subsidies to producers (reduce public transport fares)
 Provide a subsidy to consumers (child care, health care cards)
 Shift MPB up
 Educate people about the benefits of consumption (five veg a day)

11. POSITIVE PRODUCTION EXTERNALITIES
 Production of a product reduces costs for people not directly
involved in making that production.
 Examples: renewable energy, training
 Result if not corrected
 Social costs lower than private coats
 Supply curve is too high (too far to the left)
 Products are under produced
 Role of the government
 Increase production to correct level for society
 Internalise the externality
 Reward producers for socially good behavior
 Shift MPC down
 Pay producers a subsidy (e.g. wind farms, training and research
grants)
 EMS
 Shift MPB to the right
 Educate producers (corporate responsibilities)

12. NEGATIVE PRODUCTION EXTERNALITES
 Production of a product imposes costs on people not directly involved in
making that production decision.
 Examples: Using fossil fuels to produce electricity, musical festivals
 Result if not corrected
 Social costs more than private costs
 Supply curve is too low
 Product is over produced
 Role of the government
 Reduce production to correct social level
 Internalise the externality
 Make polluters pay for socially bad behaviour
 Shift MPC upwards
 Tax producers
 Regulations (pass laws)
 Make producers buy permits to pollute
 Shift MPB to the left
 Pressure consumers and interest groups

13. Slide 13
IGNORING EXTERNALITIES LEADS TO INEFFICIENCY
If market players do not take these
negative externalities or social
costs into account (do not include
them in their demand and supply
decisions) the market will not work
efficiently.
Too much will be produced and
consumers will pay too low a price.
D
S
airlines
Air travel
Price
Quantity
S total
Greenhouse Gases are emitted by planes.
So do free markets create too many flights
at too low a price?