Market Failure

...is the presence of inefficiency in a market Market Failure ...is the presence of inefficiency in a market Type of Efficiency Efficient when... Failure when... Productive efficiency when ATC is at a minimum When costs are higher than the minimum Allocative efficiency when MC = AR [or when S = D] What is produced is what is demanded When more or less than the true equilibrium is produced Pareto efficiency When it is not possible to make anyone better off, without making someone worse off When either productive or allocative efficiency is missing

So what causes Market Failure? Externalities - Consumers not paying the true cost Information Failure -lack of understanding Inequality - Waste of resources So what causes Market Failure? Free-riders – consumers who don’t pay at all Market Structure – lack of competition Discrimination - Inefficient choices

Positive and Negative Externalities

Positive and Negative Externalities The effects of a decision by consumers and producers that has an impact on a third party Negative Externalities – costs incurred by third parties Positive Externalities – beneficial effects on third parties

Negative Externalities Cost to third parties (externality) £9 Social Cost (to the whole of society) £12 Private Cost (to the consumer) £3

Negative Externalities Costs in production and consumption: External costs in production – where MSC > MPC (there are external costs) e.g. air and water pollution, congestion, housing development on green belt areas, destruction of hedgerows and wildlife, noise, pollution… External costs in consumption – where MPB > MSB (there are external costs) e.g. passive smoking, litter, noise, anti-social behaviour, binge drinking...

If there are externalities present... ...the market is inefficient

Why are externalities inefficient? Negative Externalities– socially efficient output should be less than current output. So true allocative equilibrium in not achieved..too much is produced. Allocative Efficiency is only achieved where MSC = MSB [true supply = true demand]

True Equilibrium – allocative efficiency The Marginal Social Benefit curve (MSB) represents the sum of the benefits to everyone in society as a whole – the private and external benefits together. This is the true Demand. The Marginal Social Cost (MSC) curve represents the sum of the costs to everyone in society as a whole – the private and external costs together. This is the true Supply curve. Price MSC=S £5 The slide has been designed to try to lead students through the distinction between the private costs of production and the social cost. The diagram starts out with a basic supply and demand position with price at £5 and Quantity at 100. The demand curve has been labelled MSB – a brief explanation of the concept here is useful. The true supply curve should be the MSC. This is true equilibrium. MSB=D 100 Quantity Bought and Sold

Negative External Costs of Production The MPC does not take into account the cost to society of production. The producer reaches equilibrium at 130 units of output. But what is the cost to society of this over production? Price MSC=S MPC £5 Welfare loss caused by externality The slide has been designed to try to lead students through the distinction between the private costs of production and the social cost. The diagram starts out with a basic supply and demand position with price at £5 and Quantity at 100. The demand curve has been labelled MSB – a brief explanation of the concept here is useful. The supply curve is the marginal private cost – the cost to the producer. To try to link the theory to the practice it is suggested that the item in question is the production of rolls of Clingfilm! The reason is that in producing cellophane products there is an amount of air pollution. If students are told that the cost to the producer of manufacturing 100 rolls of Clingfilm is £5 (don’t forget to remind them that this figure includes the element of profit they make) but, the company do not take into consideration the cost imposed on society of the pollution they cause. This cost is then highlighted by a dashed line moving up from the bottom and is priced at £12 . The supply curve that considers the true cost (the MPC and MSC) is then drawn in and the right brace appears to indicate the extent of the social cost (£7). The welfare loss triangle is then imposed – this may need to be explained and students could be reminded of the work done on consumer surplus to help reinforce the concept of the ‘value’ here. Finally, the socially efficient output is highlighted; students can be told that there would be benefits to society if less were produced but that we would be paying more as a result! MSB=D 100 130 Quantity Bought and Sold

Negative External Costs of Consumption The MPB does not take into account the cost to society of consumption. The consumer reaches equilibrium at 140 units of output. But what is the cost to society of this over consumption? Price MSC=S Welfare loss caused by externality £5 The slide has been designed to try to lead students through the distinction between the private costs of production and the social cost. The diagram starts out with a basic supply and demand position with price at £5 and Quantity at 100. The demand curve has been labelled MSB – a brief explanation of the concept here is useful. The supply curve is the marginal private cost – the cost to the producer. To try to link the theory to the practice it is suggested that the item in question is the production of rolls of Clingfilm! The reason is that in producing cellophane products there is an amount of air pollution. If students are told that the cost to the producer of manufacturing 100 rolls of Clingfilm is £5 (don’t forget to remind them that this figure includes the element of profit they make) but, the company do not take into consideration the cost imposed on society of the pollution they cause. This cost is then highlighted by a dashed line moving up from the bottom and is priced at £12 . The supply curve that considers the true cost (the MPC and MSC) is then drawn in and the right brace appears to indicate the extent of the social cost (£7). The welfare loss triangle is then imposed – this may need to be explained and students could be reminded of the work done on consumer surplus to help reinforce the concept of the ‘value’ here. Finally, the socially efficient output is highlighted; students can be told that there would be benefits to society if less were produced but that we would be paying more as a result! MPB MSB=D 100 140 Quantity Bought and Sold

Positive Externalities Benefit to third parties (externality) £10 Social Benefit (to the whole of society) £15 Private Benefit (to the consumer) £5

Positive Externalities Benefits in production and consumption: External benefit in production where MPC > MSC (there are external benefits) e.g. human resource development, research and development in industry, pleasant looking buildings, clean water… External benefits in consumption – where MSB > MPB (there are external benefits) e.g. preventative health care – vaccinations, public transport, attractive private gardens, bathing regularly, pretty balloons in the sky...

If there are externalities present... ...the market is inefficient

Why are externalities inefficient? Positive Externalities– socially efficient output would be greater than current output. So true allocative equilibrium is not achieved...too little is produced. Allocative Efficiency is only achieved where MSC = MSB [true supply = true demand]

True Equilibrium – allocative efficiency The Marginal Social Benefit curve (MSB) represents the sum of the benefits to everyone in society as a whole – the private and external benefits together. This is the true Demand. The Marginal Social Cost (MSC) curve represents the sum of the costs to everyone in society as a whole – the private and external costs together. This is the true Supply curve. Price MSC=S £5 The slide has been designed to try to lead students through the distinction between the private costs of production and the social cost. The diagram starts out with a basic supply and demand position with price at £5 and Quantity at 100. The demand curve has been labelled MSB – a brief explanation of the concept here is useful. The true supply curve should be the MSC. This is true equilibrium. MSB=D 100 Quantity Bought and Sold

Positive External Benefits of Production The MPC does not take into account the benefits to society of production. The producer reaches equilibrium at only 80 units of output. But what is the cost to society of this under production? MPC Price MSC=S £5 Welfare loss caused by externality The slide has been designed to try to lead students through the distinction between the private costs of production and the social cost. The diagram starts out with a basic supply and demand position with price at £5 and Quantity at 100. The demand curve has been labelled MSB – a brief explanation of the concept here is useful. The supply curve is the marginal private cost – the cost to the producer. To try to link the theory to the practice it is suggested that the item in question is the production of rolls of Clingfilm! The reason is that in producing cellophane products there is an amount of air pollution. If students are told that the cost to the producer of manufacturing 100 rolls of Clingfilm is £5 (don’t forget to remind them that this figure includes the element of profit they make) but, the company do not take into consideration the cost imposed on society of the pollution they cause. This cost is then highlighted by a dashed line moving up from the bottom and is priced at £12 . The supply curve that considers the true cost (the MPC and MSC) is then drawn in and the right brace appears to indicate the extent of the social cost (£7). The welfare loss triangle is then imposed – this may need to be explained and students could be reminded of the work done on consumer surplus to help reinforce the concept of the ‘value’ here. Finally, the socially efficient output is highlighted; students can be told that there would be benefits to society if less were produced but that we would be paying more as a result! MSB=D 80 100 Quantity Bought and Sold

Positive External Benefits of Consumption The MPB does not take into account the benefit to society of consumption. The consumer reaches equilibrium at 90 units of output. But what is the cost to society of this under consumption? Price MSC=S Welfare loss caused by externality £5 The slide has been designed to try to lead students through the distinction between the private costs of production and the social cost. The diagram starts out with a basic supply and demand position with price at £5 and Quantity at 100. The demand curve has been labelled MSB – a brief explanation of the concept here is useful. The supply curve is the marginal private cost – the cost to the producer. To try to link the theory to the practice it is suggested that the item in question is the production of rolls of Clingfilm! The reason is that in producing cellophane products there is an amount of air pollution. If students are told that the cost to the producer of manufacturing 100 rolls of Clingfilm is £5 (don’t forget to remind them that this figure includes the element of profit they make) but, the company do not take into consideration the cost imposed on society of the pollution they cause. This cost is then highlighted by a dashed line moving up from the bottom and is priced at £12 . The supply curve that considers the true cost (the MPC and MSC) is then drawn in and the right brace appears to indicate the extent of the social cost (£7). The welfare loss triangle is then imposed – this may need to be explained and students could be reminded of the work done on consumer surplus to help reinforce the concept of the ‘value’ here. Finally, the socially efficient output is highlighted; students can be told that there would be benefits to society if less were produced but that we would be paying more as a result! MPB MSB=D 90 100 Quantity Bought and Sold

Quick Diagram Test MSC=S MPC MPC MSC=S Negative Production Externality Positive Production Externality MSB=D MSB = D “Deforestation” “Water purification during production” MSC=S MPB MSC=S Negative Consumption Externality MSB=D MPB Positive Consumption Externality MSB=D “Litter” “Christmas house lights”

Quick Diagram Test Where’s the Welfare Loss? MSC=S MPC MPC MSC=S MSB=D MSB = D Negative Production Externality Positive Production Externality MSC=S MPB MSC=S MSB=D MPB MSB=D Negative Consumption Externality Positive Consumption Externality