IB Economics/Microeconomics/Market Failure

2.4 Market Failure

When the price mechanism fails to take into account all the costs and/or benefits in providing and/or consuming the good, the market will fail to supply the socially optimal amount

The competitive forces of supply and demand will not produce quantities of goods where the prices reflect the marginal benefit (utility) of consumption - this in turn leads to over-/under consumption of the good, i.e. allocative inefficiency

Reasons for market failure

Most markets are NOT successful, and the government intervenes to some degree

Perfect markets are socially efficient, they are operating at Pareto optimality in which no one can be made better off with someone being made worse off (zero sum)

Consumer surplus is maximized
P=MC where MSC=MSB

In the real world, markets are not perfect; MSC does not equal MSB and market failure occurs
This is because of externalities, underprovision of merit goods, the overprovision of demerit goods, a lack of public goods, and imperfect markets
If the free market is left to its own devices, Pareto market failure will occur

Inefficient Producers: producers do not produce where the average costs are at minimum
Therefore they are using more resources than they need to

Positive and Negative externalities: an externality is an effect on a third party which is caused by the consumption and/or production of a good or service
There are four types of externalities

Positive Consumption Externality
Negative Consumption Externality
Negative Production Externality

Short-term and long-term environmental concerns, with reference to sustainable development
Lack of public goods : public goods are goods which total cost of production does not increase with the number of consumers

Public goods are:
1. non-rivalrous (consumption by one consumer will not reduce the amount available for other consumers in the market, i.e. they do not have to compete to obtain the good/service)
2. non-excludable (no consumer is excluded from consuming such good/service)

The classic example is national defence
Other examples: street lights, roads

Public goods will not be provided by the market

Underprovision of merit goods: if left to its own devices, merit goods (a private good that society considers underconsumed, often with positive externalities) will be underprovided

These are goods and services which have a positive effect on society like education, healthcare and sports centers

Overprovision of demerit goods: if left to its own devices, demerit goods (a private good that society considers overconsumed, often with negative externalities) will be overprovided

These are such things as prostitution, alcohol and cigarettes
To discourage these demerit goods the government creates: negative advertising, tax on the good, or bans it altogether

Abuse of monopoly power: imperfect markets such as oligopolies and monopolies restrict output in an attempt to maximize profit

Thus, MSB is not equal to MSC / MSC is equal to MR

Possible government responses

Legislation: antitrust legislation can be brought in an attempt to break monopoly power and collusive oligopolies

Legislation to make high school attendance mandatory
Ban smoking in restaurants

Direct provision of merit and public goods: governments can control the supply of goods that have positive externalities by supplying a high amount of education, public roads, parks, libraries, etc.
Taxation: place an excise tax on the sale of tobacco products or alcohol to discourage consumption

This will internalize some of the external costs (i.e., smokers will pay for their second hand smoke through the tax)

Subsidies: reduce the cost of university education because it has beneficial externalities

The price will be reduced to reflect the benefit society attains through the education of individuals

Tradable permits: tradable permits are permits allowing a firm to produce a given amount of pollution

There is limited supply for how much pollution a firm can produce so if a firm would want to pollute more it has to purchase tradable permits from other firms
A Carbon Tax (taxing consumption which causes pollution, such as fossil fuels) achieves the same result
In both cases, firms and individuals are motivated to reduce costs by reducing environmental damage

Extension of property rights: form of privatization to privatize certain non-private goods

e.g., lakes, rivers, beach=> create a market for pollution and charge people if they want to pollute something

Advertising to encourage and discourage consumption: by the government to ensure the social optimum level of consumption is being achieved

International cooperation among governments: in the case of acid rain, for example international cooperation among governments is necessary in order to reduce its occurrence