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Micro 11: Market Failure

Micro 11: Market Failure

At the end of this set of notes, you should be able to explain:

1. Introduction .....................................................................................................................2
2. Resource allocation in the free market: Price mechanism ................................3
3. Sources of market failure ............................................................................................5
4. Correcting market failure .............................................................................................9
5. Cost-benefit analysis ..................................................................................................15

Note: This set of notes is meant to concise with just enough information for “A” level
students. It is best used as a cheat sheet, complementary with official school notes.

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Micro 11: Market Failure

1. Introduction

1.1 Private costs are the costs incurred by those who buy products and by those
who produce products, and includes both implicit and explicit costs.

1.2 Marginal private cost (MPC) is the cost incurred when an additional unit of a
good is produced, by those who bought it and by those who produced it.

1.3 Private benefits are the benefits received by those who buy the products and
by those who produce the products.

1.4 Marginal private benefit (MPB) is the benefit received when an additional unit
of a good is produced, by those who bought it and by those who produced it.

1.5 An externality arises when one party's action has a beneficial or an adverse
effect on other parties, but there is no payment. When the other parties are:
a. Affected beneficially, the externalities are called external benefits;
b. Affected adversely, the externalities are called external costs.

1.6 Social costs are the total costs to society of an economic activity, and are the
sum of private costs and externalities in production.

1.7 Marginal social cost (MSC) is the additional cost to society when an additional
unit of a good is produced.

1.8 Social benefits are the total benefits to society of an economic activity, and
are the sum of private benefits and externalities in consumption.

1.9 Marginal social benefit (MSC) is the additional benefit gained by society when
an additional unit of a good is produced.

1.10 A private good is one that fulfils the following properties:


a. Rivalry;
Which occurs in a situation where consumption by one party reduces the
quantity available for others.
b. Excludability;
Which occurs in a situation where a party that does not pay for the good or
service is excluded from enjoying its benefits.

1.11 A public good, on the other hand, is one that fulfils the following properties:
a. Non-rivalry;
Which occurs in a situation where once the good or service is supplied to a
single party, there is no additional cost in supplying it to others.
b. Non-excludability;
Which occurs in a situation where the good or service cannot be supplied
to one customer without simultaneously being supplied to others.
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1.12 Productive efficiency refers to the production of any particular bundle of


goods and services in the least costly way, and is characterised by when:
a. Every firm in the economy is producing at the lowest point on the
lowest possible average cost curve;
b. All resources in the economy are fully employed;
c. The economy is producing on any point of the PPC;
d. It is impossible to produce more of one product without producing
less of another product.

1.13 Allocative efficiency refers to the production of that particular bundle of goods
and services most wanted by society, and is characterised by when:
a. Every market in the economy produces an output where MSB = MSC
(i.e. no market failure).
b. The sum of producer and consumer surplus are maximised.

1.14 Pareto efficiency is achieved when it is not possible to change the existing
allocation of resources in a way that will make one person better off without
making someone else worse off.

1.15 Pareto efficiency is achieved only when both productive and allocative
efficiency are achieved.

1.16 Only one combination on the production possibility curve is pareto


efficient (i.e. the bundle of goods and services that maximizes consumers'
satisfaction and is produced in the least costly manner).

2. Resource allocation in the free market: Price mechanism

2.1 Because in a society, wants are unlimited and resources are limited, the
basic problem confronting all societies is how to allocate scarce resources
between alternative uses.

2.2 This resource allocation problem can be summarised with three choices
that every society will have to make:
a. What to produce;
b. How to produce;
c. For whom to produce.

2.3 The free market allocates resources through the price mechanism, which in
turn is derived through:
1. The decisions of producers which determine the supply of products;
2. The decisions of buyers which determine the demand of products.
3. The interactions of demand and supply which give rise to prices.

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2.4 The allocation of resources through the countless decisions of individual


agents in the economy is essentially decentralised, and behave as the
"invisible hand" of the market.

a. What to produce

2.5 Using an example to explain, we first assume that there are only two
competitive industries in the economy, namely, coffee and tea, and both
industries are initially in long run equilibrium (i.e. normal profits).

2.6 Perhaps due to changing tastes and preferences, the demand for coffee
increases and the demand for tea falls.

2.7 Therefore, the price of coffee will increase and coffee producers will earn
supernormal profits.

2.8 This attracts new firms into the industry, causing market supply to increase and
market price will fall until every firm in the industry is earning normal profits.

2.9 On the other hand, in the tea industry, the fall in demand means fewer dollar
votes will result in a fall in the price of tea.

2.10 As result, existing firms will earn subnormal profits, and force some firms to
leave the industry.

2.11 This will cause market supply of the tea to fall, and market price to rise until
every firm in the industry is earning normal profits.

2.12 Therefore, demand for resources (e.g. land, labour and capital) in the coffee
industry will rise but that of tea will fall, causing a transfer of resources from
tea industry into the coffee industry.

2.13 In the absence of market failures, the price mechanism will result in
allocative efficiency (i.e. the right goods are produced in the right).

b. How to produce

2.14 Producers in competitive markets compete for the spending votes of the
consumers, who will buy from producers that offer the lowest price.

2.15 Therefore, producers can continue production in the long-run only if they
produce at the lowest cost.

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2.16 Hence, in the long run, a free and competitive market enjoys productive
efficiency, because every firm in the economy will be producing at the lowest
point on the lowest possible average cost curve.

c. Form whom to produce

2.17 In the free market, output is distributed according to the willingness and
ability of the household to pay for the good.

2.18 The ability to pay the equilibrium prices for the goods depends on the income,
which often depend on
a. The quantity of property and human resources;
b. Resource prices (wages, rent, interest and profit).

2.19 Those with high income and wealth are therefore able to buy large amounts of
goods and services, and vice versa for those with low income and little wealth.

2.20 In a market economy where income is unevenly distributed, the wealthy often
determine what goods to be produced and gain a relatively larger share of what
is produced than the poor, frequently resulting in inequity (i.e. “unfair
distribution of resources).

3. Sources of market failure

3.1 Market failure occurs whenever the price mechanism performs


unsatisfactorily, and are often categorised either as:
a. Inefficiency;
Externalities, imperfect competition and missing markets
or
b. Inequity.
Unfair distribution of resources.

a. Over-production due to external costs of production

3.2 As shown in Figure 1 below, a perfectly competitive industry produces an output


0Q1 where MPC=MPB.

3.3 However, the socially efficient output occurs at 0Q2 where MSC=MSB

3.4 Due to the presence of external costs of production, MSC is then greater than
MPC at every output level.

3.5 There is thus an overproduction of Q1 - Q2 of the good which results in a


deadweight loss equal to the area E2BE1.

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Figure 1: Over-production due to external costs of production

b. Over-production due to external costs in consumption (demerit


good)

Figure 2: Over-production due to external costs in consumption

3.6 As shown in Figure 2 above, a perfectly competitive industry produces an


output 0Q1 where MPC=MPB.

3.7 However, the socially efficient output occurs at 0Q2 where MSC=MSB.

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3.8 Due to the presence of external costs in consumption (such goods are often
referred to as demerit goods), MPB is greater than MSB at every output level.

3.9 There is thus an over-production of Q1 - Q2 of the good which results in a


deadweight loss equal to the area E2BE1.

c. Under-production due to external benefits in consumption (merit


good)

Figure 3: Under-production due to external benefits in consumption

3.10 As shown in Figure 3 above, a perfectly competitive industry produces an


output 0Q1 where MPC=MPB.

3.11 However, the socially efficient output occurs at 0Q2 where MSC=MSB.

3.12 Due to the presence of external benefits in consumption (such goods are often
referred to as merit goods), MSB is greater than MPB at every output level.

3.13 There is thus an under-production of Q2 – Q1 of the good which results in


a deadweight loss equal to the area E2BE1.

d. Non-provision of public goods

3.14 If left to the free market, public goods will not be supplied at all.

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3.15 This is because of the characteristic of non-excludability – once the good is


provided, the producer is unable to exclude non-paying consumers from
consuming the good.

3.16 Since people can enjoy the good without paying for it, consumers will not
demand for the good as they can “free-ride”.

3.17 Hence, there will be no provision of the public good in the free market.

e. Economic inefficiencies due to imperfect competition

3.18 In the real world, because markets are imperfectly competitive, the equilibrium
output of markets tend to be allocatively and productively inefficient.

3.19 As shown in Figure 4, the equilibrium output of a monopoly, Q, is allocatively


inefficient as P > MC, and therefore the good is underproduced, causing a
deadweight loss equal to the area ABC.

3.20 The firm is also productively inefficient because it is producing on the falling
portion of the AC curve.

Figure 4: Economic inefficiencies in a monopoly

f. Unequal allocation of resources due to income inequality

3.21 In the real world, income is often unevenly distributed, and people with the
highest incomes often determines what goods and services should be
produced through the price mechanism.

3.22 Therefore, resources will be used to produce luxury goods for the rich while the
poor might not be able to meet their needs.

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4. Correcting market failure

a. Internalising the external costs in production

4.1 Method 1: Impose a Pigovian tax – this is a tax which is set at a rate that is
equal to the marginal external cost.

4.2 As shown in Figure 5 below, this will shift the MPC curve to MSC, and the
industry will attain the socially efficient output at Q2.

Figure 5: Pigovian tax to correct external costs in production

4.3 In practice it is difficult to measure the external cost of an activity and thus it is
difficult to fix the correct amount of tax to correct the external cost in production.

4.4 Method 2: Regulation – The government may legislate binding requirements


for firms to abide by.

4.5 For example, maximum pollution levels, pollution abatement equipment (such
as a filters or scrubbers that remove harmful emissions), and regular
inspections may be mandated in the case of pollutive industries.

4.6 For regulations to be effective, the government will need to be able to enforce
the regulations effective, and the penalties must be high enough to deter.

4.7 Method 3: Tradeable pollution permits – The government sets a limit on the
amount of pollution each firm can discharge, and the firms are then issued with
permits which they can trade.

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4.8 A firm which can reduce its pollution below the permitted level can sell some of
its emission rights to firms which have high pollution levels.

4.9 In theory, overall pollution levels will be reduced, because firms will have
financial incentives to reduce pollution levels, and so gain cost advantages.

4.10 However, it is also possible for pollution levels to remain the same overall, but
instead shift sources between firms.

4.11 Also, determining the permitted pollution level for each firm is often difficult and
prone to disagreements given the complex nature of production emissions.

4.12 Method 4: Extending property rights – Since externalities arise because of


the lack of property rights, ensuring that property rights exist enables the market
to determine the socially optimum level of output.

4.13 For example, if the inhabitants of a town are given ownership rights over the
river running through it, they can negotiate to charge it for the pollution.

4.14 On the other hand, if firm has ownership rights over the river, the firm can
negotiate with the inhabitants for compensation for reduction in production so
as to reduce pollution.

4.15 The optimum level of pollution will occur where the amount of compensation is
equal to the marginal external cost.

4.16 Extending property rights has the advantage of compensating victims directly.

4.17 However, extending property rights is difficult when there are many parties
adversely affected or generating negative externalities.

4.18 This is because people tend to have different views on the extent to which they
have been adversely affected and the amount of compensation they require,
and an agreement may then be harder to reach.

4.19 Rich people or firms are also often in stronger position than poor people or firms
to take legal action because they are able to afford the legal cost, potentially
skewing compensation agreements to their favour.

b. Internalising the external costs in consumption (demerit good)

4.20 Method 1: Taxation – The government can impose a specific tax on the
consumers, or an indirect tax on producers.

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4.21 A specific tax will shift the MPB curve downwards to the position of MSB as
shown in Figure 6 below, and the equilibrium output will fall from Q1 to the
socially optimum output, Q2.

Figure 6: Specific tax to correct demerit good

4.22 An indirect tax will shift S1 to S2 as shown in Figure 7 below, and the equilibrium
output will fall from Q1 to the socially optimum output, Q2.

Figure 7: Indirect tax to correct demerit good

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4.23 However, demerit goods often exhibit price inelastic demands, and therefore
the tax may not be very effective in reducing consumption.

4.24 Method 2: Laws and provision of information – The government can enact
laws prohibiting or regulating behaviour that impose external costs in
consumption.

4.25 For these laws to be effective, the government will need to be able to enforce
the laws effective, and the penalties must be high enough to deter.

4.26 If ignorance is a reason for excess consumption of demerit goods, direct


provision of information by the government (e.g. the harmful effects of smoking
and drinking) may help to discourage the consumption of demerit goods.

c. Internalising the external benefits in consumption (merit good)

4.27 Method 1: Subsidies – The government can grant subsidies to either


consumers or producers.

4.28 A subsidy for consumers will shift the MPB curve upwards to the position of
MSB as shown in Figure 8 below, and the equilibrium output will increase from
Q1 to the socially optimum output, Q2.

Figure 8: Subsidy for consumers to correct merit good

4.29 A subsidy for producers will shift the MPC curve downwards to the position of
MSC as shown in Figure 9 below, and the equilibrium output will increase from
Q1 to the socially optimum output, Q2.

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Figure 9: Subsidy for producers to correct merit good

4.30 Subsidies often require high levels of funding by the government, forcing it to
increase taxes, which may disincentivise workers and investors.

4.31 In addition, once subsidies are granted, they are often politically difficult to
remove from the economy when necessary.

4.32 Method 2: Laws and provision of information – The government can enact
laws that make the consumption of merit goods compulsory.

4.33 For these laws to be effective, the government will need to be able to enforce
the laws effective, and the penalties must be high enough to deter.

4.34 If ignorance is a reason for under-consumption of merit goods, direct provision


of information by the government (e.g. the benefits of education and
vaccination) may help to encourage the consumption of merit goods.

4.35 Method 3: Direct provision – The government may provide for the short-fall
directly, or contract private firms instead.

4.36 Direct provision may require high levels of funding by the government, forcing
it to increase taxes, which may disincentivise workers and investors.

4.37 In addition, the government is not profit-driven unlike firms in the free market,
and will likely be productively inefficient.

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d. Solving missing markets

4.38 Since the marginal cost of supplying public good is zero at the socially optimum
output due to non-rivalry, the socially efficient price will be zero.

4.39 Hence, to maximize welfare, the government should supply the good at and set
the price to be zero, by either:
a. Directly producing these goods itself; or
b. Contracting the production of these goods to the private sector.

4.40 However, in practice it is very difficult to estimate the quantity to be supplied for
public goods because people may not reveal their true demand for the good.

4.41 The government finances the production of these goods from tax revenue, and
may require tax rates to be raised, which disincentivises workers and investors.

e. Solving imperfect competition

4.42 Method 1: Competitive policies – The government may impose rules and
regulations to compel the monopoly to sell at competitive prices.

4.43 In many countries, the existence of anti-collusion and anti-trust (monopoly) laws
prohibits firms from merging into a monopoly.

4.44 In practice, it is difficult for the govt. to implement anti-monopoly and anti-union
policies as such policies will alienate the business community and the workers.

4.45 In addition, competitive policies will make it difficult for the economy to enjoy
economies of scale and a higher rate of technological progress.

4.46 Method 2: Nationalisation – In the case of a natural monopoly, the govt. can
take over such firms and produce an output where P=MC.

4.47 However, state-owned firms are usually sheltered from competition and tend to
be inefficient, which may mean losses and subsidies may be necessary to keep
such firms from shutting down.

f. Solving inequity

4.48 Method 1: Taxes – The government can tax the rich more proportionally than
the poor so that post-tax distribution of income will be more equal than the pre-
tax distribution (i.e. progressive tax).

4.49 However, this may discourage work, investment, savings and hence the future
growth of the country.

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4.50 Method 2: Subsidies – The government. can also grant subsidies in the form
of cash-benefits and benefits-in-kind such as subsidized housing, education
and healthcare.

4.51 However, such expenses will have to be financed from tax revenue, and may
require tax rates to be raised, which disincentivises workers and investors

5. Cost-benefit analysis

5.1 The cost-benefit approach (CBA) is an appraisal technique used by a


government to evaluate all the social costs and social benefits of public
projects such as the construction of a bridge and airport.

5.2 CBA takes place over the following steps:


1. Identify all costs and benefits, including:
a. Private monetary and non-monetary costs;
b. Private monetary and non-monetary benefit;
c. External monetary and non-monetary costs;
d. External monetary and non-monetary benefits.
2. Quantity (in dollars) all identified costs and benefits;
3. Discount all future costs and benefits to derive the associated
present values.
4. Compare and decide whether the project should proceed:
a. If the benefits exceed costs, the project yields net benefits to
society and should proceed;
b. If the costs exceed benefits, the project yields net costs to society
and should not proceed.

5.3 CBA frequently encounters the following difficulties:


a. Quantifying non-monetary benefits and costs of the project is
often difficult.
b. The data collected from surveys may not be reliable, as
respondents have few incentives to tell the truth.

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