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Revision Notes for Market Failure

Type (A): Externality + Imperfect knowledge and/ or equity


Part (a): Explanation of the various sources of market failure
Introduction
• Scarcity (unlimited wants + limited resources)
• Need to allocate resources efficiently.
• How?  Economic efficiency (comprised of productive efficiency and allocative efficiency)
• In the case of market failure, emphasis is on allocative efficiency (MSB=MSC) (define)
• In the event if there is misallocation of resources  market failure exists (define)

Negative Externality (smoking/ traffic congestion/ pollution)


• Define negative externality
• Define, explain and illustrate MPC and MEC
• Divergence between MPC and MSC
• Illustrate using a diagram (assuming there is no positive externality)
• Explain what happens in an unregulated market and where is the socially optimal level of output
• Hence, due to over-consumption/ production  results in deadweight loss

Positive Externality (education/ housing/ healthcare)


• Define positive externality
• Define, explain and illustrate MPB and MEB
• Divergence between MPB and MSB
• Illustrate using a diagram (assuming there is no negative externality)
• Explain what happens in an unregulated market and where is the socially optimal level of output
• Hence, due to under-consumption/ production  results in deadweight loss

Other sources of market failure could include imperfect knowledge and/ or equity
• Define imperfect knowledge
• Explain the causes of imperfect knowledge which leads to market failure
• Explain equity

Part (b): Discussion of the various policies to tackle the problem of externality
Negative externality
• Taxation (explain using a diagram)
• Legislation
• Moral suasion
• Tradable permits (for pollution)
• Nationalisation

Positive externality
• Grants (explain using a diagram)
• Subsidies (explain using a diagram)
• Legislation
• Moral suasion

Limitations/ Evaluations of the policies


Positive Externality

Sweet are the uses of adversity, which like the toad, ugly and venomous, wears yet a precious jewel in his
head.
Revision Notes for Market Failure
• Difficult to estimate the level of external benefits  level of subsidies/ grants may not be adequate
 too high a grant/ subsidy may lead to substantial wastage
• Government may need to impose higher taxes to finance the spending  adverse effects on the
economy
• For legislation to be effective, there must be some form of monitoring and the costs involved
should be kept low for the implementation
• For moral suasion, the effectiveness of persuasion is not certain since it is voluntary

Negative Externality
• Difficult to estimate the amount of tax + there is administrative costs incurred in collecting the
taxes
• For tradable permits  provides incentives to create and use less polluting technologies + difficult
for government to determine the optimal quantity of pollution
• For legislation, cost of intervention may be high because of the administrative costs incurred in
monitoring and enforcing compliance with the legislation
• Legislation does not provide incentives for firms to further reduce their external costs
• Government may create inefficiencies when they intervene through direct production as it may not
produce the efficient level of output even with nationalization. Besides, the government may not
have adequate resources
• For moral suasion, the effectiveness of persuasion is not certain since it is voluntary

Type (B): Market dominance (usually comes in the form of a market structure question)
• In the absence of externality  allocative efficiency is achieved when P=MC
• For Monopoly, monopolistic competition and oligopoly, when MR=MC, at the Qe, P>MC  under-
allocation of resources  allocative efficiency is not achieved  market fails
• Ways to correct this form of market failure  price regulations/ legislations/ etc.

Type (C): Public Goods


• Define public goods
• Explain non-rivalry and non-excludability
• Implications of non-rivalry and non-excludability
o MC=0  P=0  There is no market for this good since the private will not be willing to
provide it for free  need for government intervention
o Problem of free-rider  people who do not pay for the good can also get to consume it 
price mechanism fails to provide the producer with an effective means to exclude
people who do not pay from consuming the good  the market will not produce  the
need for government intervention

Sweet are the uses of adversity, which like the toad, ugly and venomous, wears yet a precious jewel in his
head.