Market failure IB Economics

Unit 1.4 and Chapter 6
CPS GLOBAL SCHOOL - IB ECONOMICS - MONICA

Market Failure
 Situation where alloc of resources by a free
market is not efficient.
 D -> MB and S -> MC. Alloc efficiency
achieved when MC = MB and D =S .
 Include benefits and costs to the society
- MB -> MSB (Marginal Social Benefit).
- MC -> MSC (Marginal Social Cost).
 When MSB = MSC, Community surplus
(Consumer surplus + Producer Surplus) is
highest

 At normally functioning competitive market
equilibrium, state of Pareto Optimality.
 ‘PARETO OPTIMAL” -> market situation where
no one can be made better off without making
someone else worse off. Maximization of surplus
is achieved only at Pe and Qe.
Where MSB = MSC -> Social Efficiency.
 Competitive markets provide Pareto optimality.
Delivering goods society wants where MSB =
MSC
 Markets do not meet conditions of free mkt and
can FAIL . Resources are not allocated in an
optimal or socially efficient manner. This is
“MARKET FAILURE”

Types of Market Failure
 Negative externalities (of production and
consumption). Too much is produced
 Positive externalities (of production and
consumption). Too little is produced.
 Lack of public goods.
 Common access to resources and threat to
sustainability
 Asymmetric information.
 Abuse of monopoly power.

Meaning of externalities:
 Externality -> transaction where someone other
than the buyer/seller (third party) experience a
benefit /loss due to the transaction.
 Positively -> enjoying benefits. Negatively ->
suffering costs.
 Side – effects good – Positive externality. Side-
effects bad -> Negative externality.
 Externality / Spillover -> Cost / Benefit beyond the
initial actors of the transaction.
 Enjoying benefits -> Spillover benefits. Suffering
costs -> Spillover costs.

Negative externality of
Production
 When a pdn of a good creates spillover costs
(environmental costs, health costs) to the
society.
 MPC -> Marginal pvt costs: Actual monetary
costs to firms of producing a good (R.M,
Wages and other input costs).
 At every quantity incl Qe, there is a cost borne
to society. Which is greater than cost borne by
actual producers of the pdt.
 MSC -> There are total costs of pdn borne by
society as a whole (MPC and All external
costs).
 Qso-> Socially optimal Qty of pdn when all
costs are taken into account (external & pvt)
 Costs inc -> price inc
 Pso -> The price if ALL costs(pvt and social)
were taken into account.
 MSC > MB, Too much is produced. Resources
are over allocated.
 DWL -> Dead weight loss – loss of welfare
resulting from over pdn of a commodity
contrast to prev chapter where it was due to
govt intervention

 Negative externality of Consumption.
 Positive externalities of Production and
Consumption . – As discussed in class. Kindly
refer the text book

Lack of Merit goods and public
goods
 Under supply of Merit Goods and Public goods
–
 Merit Goods – G/S that create +ve spillover
benefits (MSB > MSC). Under produced by the
free market.
 Public Goods – non-rivalrous and non-excludable
and is typically provided by the Govt. Extreme
case of a merit good.
 Non-Rivalrous -> one person’s consumption of it
doesn’t prevent others from enjoying it. Eg. National
defense
 Non-Excludable -> if a producer cannot prevent

Types of Goods
EXCLUDABLE NON-ECLUDABLE
RIVALROUS Private Goods
Clothing, food,
electronics
Common Goods
Fish, seafood, coral,
timber, air
NON-RIVALROUS Collective/ Club goods
Movie theatre, internet
websites
Public goods
National defense, police
and fire departments,
lighthouses

Over-supply of Demerit Goods
 A demerit good is one for which the MSC
exceeds the MSB when sold in the open
market. Create negative spillover costs.
 Over produced and over-consumed. Eg.
Cigarettes, alcohol, gambling, addictive drugs
etc…
 Heavily taxed and large warnings issued to
reduce consumption.

Common access resources and
threat to sustainability
 Common access resources are subjected to
overexploitation due to their non-excludability .
Recent attempts to privatize the commons
have helped achieve a more sustainable level
of resources
 The TRAGEDY OF THE COMMONS is a
dilemma posed when common resources are
used or degraded rapidly by pvt individuals
who enjoy the short-term benefits of the
resource but are ignorant or negelctful of its
long term depletion.

Fossil Fuel Consumption
 Production and burning causes greenhouse
gases emissions. Produces air pollutants.
Blamed for acid rain and threatening water
and vegetation habitats. Causing severe
NEGATIVE externalities. Global problem more
widespread.

Poverty in less developed
Countries
 Less Developed Countries (LDCs)more
desperate for Income as it rises more slowly
than in rich countries.
 Rely on agriculture or primary goods to keep
up puts pressure on resource base. More
intensive cultivation resulting soil erosion.
Widespread slashing of trees and forests to
increase farmland
 For extractable resources, result in mining and
drilling operations without regard for the effect
on landscape or on soil and water resources.

Potential Solutions to
SUSTAINABILITY Problems:
 Extension of Property Rights -> in case of
common access resources, lack of prie
mechanism ends up in depletion. Calls for an
extension of property rights to encourage
protection and management of the resources to
increase user’s long term interest in the survival of
the resources.
 Carbon taxes -> charge levied by Govt on firms
burning fossil fuels in their production processes.
Tax fuel by carbon level. ‘internalizing the
externality’. The tax acts as a disincentive to use
fossil fuels and encourages demand for non
carbon-emitting substitutes. US and China failed
to enact such policies as it will harm econ growth.

Potential Solutions to
SUSTAINABILITY Problems:
(Contd...)
 Tradable Permits-> a tradable permit scheme is
a system for taxing pollution levels where pollution
licenses are exchangeable between firms on a
secondary market.
 To encourage clean pdn and reward innovation
also called Cap and Trade policy
 Govt licenses permitted amount of pollution in
shares and permits. Works like a tax as firms pay
for the “right “ to pollute. If a firm’s pdn is more
clean below the limit then it can sell it permits to
other firms. If a firm expects to exceed the
licensed pollution amount, they can try and buy up
extra permits from the other firms

Additional Forms of Market
Failure:
 Factor Immobility-> Factor resources are
immobile. Workers stay in places where
opportunities are slim and weak. Land and natural
resources are quite locally fixed.
 Inequality -> income inequality is a market failure
in itself. The free market doesn’t allocate enough
resources towards improving the lives of the
world’s poor. Inequality exits at he current level as
jobs are paid differently and exists at the future
level where income disparities can lead to a block
on educational and life opportunities for the
youngest members of the society.

Additional Forms of Market Failure:
(Contd...)
 Govt Failure or Policy Failure -> exists when
govt action to correct some form of market
failure actually creates a worse set of negative
outcomes. Due to poorly designed incentives,
unforeseen consequences or self-interested
politics.
 Short-termism-> how pursuit of rational short
term objectives can create long term problems.
Exists both in public and pvt spheres

Asymmetric Information and abuse
of Monopoly power: (HL Only)
 Asymmetric Information -> consumers are
constrained by time and access to info. Even in
the digital information age, consumers rarely
possess anything close to perfect info hence its
more likely for consumers to make mistakes
regarding purchases.
 Sophisticated marketing techniques that aims to
limit info and choice. Another variety is one person
holding more information than the other party.
 One particular form occurs when individuals
neglect to take responsibility for their actions –
MORAL HAZARD.

Potential Solutions to Asymmetric
Information
 Legislation to punish ‘insider’ information use
 Active dissemination of information – internet
is the best means to address the gap in info. In
the US, internet access is considered a human
right
 Monopoly Power: power of a firm to raise the
the price above the prices of competitors. Firm
able to influence or increase the price by
restricting output. The producer gains at the
expense of the consumer, the overall

Potential soultins to monopoly
power
 Legislation -> anti-trust legislation aimed at
preventing concentration of market powers. Laws
specify max percentage of the market to be
controlled by 1/ few firms.
 Regulation-> govt track pricing and pdn decisions
of the firms and enact power to recommend
changes in the firm’s behaviour Eg. Setting the
price
 Natural Monopolies -> granted in some industries
as they keep costs lower than a competitive
market. Eg. Public utilities of Water and Power.
Market may under produce these goods but Govt
can address this wit a subsidy to improve output
to a more optimal position

Market failure IB Economics

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