7.1: Introducing Market Failure
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Market Failure
learning objectives
- Identify common market failures and governmental responses
Market failure occurs when the price mechanism fails to account for all of the costs and benefits necessary to provide and consume a good. The market will fail by not supplying the socially optimal amount of the good.
Prior to market failure, the supply and demand within the market do not produce quantities of the goods where the price reflects the marginal benefit of consumption. The imbalance causes allocative inefficiency, which is the over- or under-consumption of the good.
The structure of market systems contributes to market failure. In the real world, it is not possible for markets to be perfect due to inefficient producers, externalities, environmental concerns, and lack of public goods. An externality is an effect on a third party which is caused by the production or consumption of a good or service.
Air pollution : Air pollution is an example of a negative externality. Governments may enact tradable permits to try and reduce industrial pollution.
During market failures the government usually responds to varying degrees. Possible government responses include:
- legislation – enacting specific laws. For example, banning smoking in restaurants, or making high school attendance mandatory.
- direct provision of merit and public goods – governments control the supply of goods that have positive externalities. For example, by supplying high amounts of education, parks, or libraries.
- taxation – placing taxes on certain goods to discourage use and internalize external costs. For example, placing a ‘sin-tax’ on tobacco products, and subsequently increasing the cost of tobacco consumption.
- subsidies – reducing the price of a good based on the public benefit that is gained. For example, lowering college tuition because society benefits from more educated workers. Subsidies are most appropriate to encourage behavior that has positive externalities.
- tradable permits – permits that allow firms to produce a certain amount of something, commonly pollution. Firms can trade permits with other firms to increase or decrease what they can produce. This is the basis behind cap-and-trade, an attempt to reduce of pollution.
- extension of property rights – creates privatization for certain non-private goods like lakes, rivers, and beaches to create a market for pollution. Then, individuals get fined for polluting certain areas.
- advertising – encourages or discourages consumption.
- international cooperation among governments – governments work together on issues that affect the future of the environment.
Causes of Market Failure
Market failure occurs due to inefficiency in the allocation of goods and services.
learning objectives
- Explain some common causes of market failure
Market failure occurs due to inefficiency in the allocation of goods and services. A price mechanism fails to account for all of the costs and benefits involved when providing or consuming a specific good. When this happens, the market will not produce the supply of the good that is socially optimal – it will be over or under produced. To fully understand market failure, it is important to recognize the reasons why a market can fail. Due to the structure of markets, it is impossible for them to be perfect. As a result, most markets are not successful and require forms of intervention.
Reasons for market failure include:
- Positive and negative externalities : an externality is an effect on a third party that is caused by the consumption or production of a good or service. A positive externality is a positive spillover that results from the consumption or production of a good or service. For example, although public education may only directly affect students and schools, an educated population may provide positive effects on society as a whole. A negative externality is a negative spillover effect on third parties. For example, secondhand smoke may negatively impact the health of people, even if they do not directly engage in smoking.
- Environmental concerns: effects on the environment as important considerations as well as sustainable development.
- Lack of public goods: public goods are goods where the total cost of production does not increase with the number of consumers. As an example of a public good, a lighthouse has a fixed cost of production that is the same, whether one ship or one hundred ships use its light. Public goods can be underproduced; there is little incentive, from a private standpoint, to provide a lighthouse because one can wait for someone else to provide it, and then use its light without incurring a cost. This problem – someone benefiting from resources or goods and services without paying for the cost of the benefit – is known as the free rider problem.
- Underproduction of merit goods: a merit good is a private good that society believes is under consumed, often with positive externalities. For example, education, healthcare, and sports centers are considered merit goods.
- Overprovision of demerit goods: a demerit good is a private good that society believes is over consumed, often with negative externalities. For example, cigarettes, alcohol, and prostitution are considered demerit goods.
- Abuse of monopoly power: imperfect markets restrict output in an attempt to maximize profit.
When a market fails, the government usually intervenes depending on the reason for the failure.
Introducing Externalities
An externality is a cost or benefit that affects an otherwise uninvolved party who did not choose to be subject to the cost or benefit.
learning objectives
- Give examples of externalities that exist in different parts of society
In economics, an externality is a cost or benefit resulting from an activity or transaction, that affects an otherwise uninvolved party who did not choose to be subject to the cost or benefit. An example of an externality is pollution. Health and clean-up costs from pollution impact all of society, not just individuals within the manufacturing industries. In regards to externalities, the cost and benefit to society is the sum of the value of the benefits and costs for all parties involved.
Externality : An externality is a cost or benefit that results from an activity or transaction and that affects an otherwise uninvolved party who did not choose to incur that cost or benefit.
Negative vs. Positive
A negative externality is an result of a product that inflicts a negative effect on a third party. In contrast, positive externality is an action of a product that provides a positive effect on a third party.
Negative Externality : Air pollution caused by motor vehicles is an example of a negative externality.
Externalities originate within voluntary exchanges. Although the parties directly involved benefit from the exchange, third parties can experience additional effects. For those involuntarily impacted, the effects can be negative (pollution from a factory) or positive (domestic bees kept for honey production, pollinate the neighboring crops).
Economic Strain
Neoclassical welfare economics explains that under plausible conditions, externalities cause economic results that are not ideal for society. The third parties who experience external costs from a negative externality do so without consent, while the individuals who receive external benefits do not pay a cost. The existence of externalities can cause ethical and political problems within society.
In regards to externalities, one way to correct the issue is to internalize the third party costs and benefits. However, in many cases, internalizing the costs is not financially possible. Governments may step in to correct such market failures.
Externality Impacts on Efficiency
Economic efficiency is the use resources to maximize the production of goods; externalities are imperfections that limit efficiency.
learning objectives
- Analyze the effects of externalities on efficiency
Economic Efficiency
In economics, the term “economic efficiency” is defined as the use of resources in order to maximize the production of goods and services. An economically efficient society can produce more goods or services than another society without using more resources.
A market is said to be economically efficient if:
- No one can be made better off without making someone else worse off.
- No additional output can be obtained without increasing the amounts of inputs.
- Production proceeds at the lowest possible cost per unit.
Externalities
An externality is a cost or benefit that results from an activity or transaction and affects a third party who did not choose to incur the cost or benefit. Externalities are either positive or negative depending on the nature of the impact on the third party. An example of a negative externality is pollution. Manufacturing plants emit pollution which impacts individuals living in the surrounding areas. Third parties who are not involved in any aspect of the manufacturing plant are impacted negatively by the pollution. An example of a positive externality would be an individual who lives by a bee farm. The third parties’ flowers are pollinated by the neighbor’s bees. They have no cost or investment in the business, but they benefit from the bees.
Externality : This diagram shows the voluntary exchange that takes place within a market system. It also shows the economic costs that are associated with externalities.
Externalities and Efficiency
Positive and negative externalities both impact economic efficiency. Neoclassical welfare economics states that the existence of externalities results in outcomes that are not ideal for society as a whole. In the case of negative externalities, third parties experience negative effects from an activity or transaction in which they did not choose to be involved. In order to compensate for negative externalities, the market as a whole is reducing its profits in order to repair the damage that was caused which decreases efficiency. Positive externalities are beneficial to the third party at no cost to them. The collective social welfare is improved, but the providers of the benefit do not make any money from the shared benefit. As a result, less of the good is produced or profited from which is less optimal society and decreases economic efficiency.
In order to deal with externalities, markets usually internalize the costs or benefits. For costs, the market has to spend additional funds in order to make up for damages incurred. Benefits are also internalized because they are viewed as goods produced and used by third parties with no monetary gain for the market. Internalizing costs and benefits is not always feasible, especially when the monetary value or a good or service cannot be determined.
Externalities directly impact efficiency because the production of goods is not efficient when costs are incurred due to damages. Efficiency also decreases when potential money earned is lost on non-paying third parties.
In order to maximize economic efficiency, regulations are needed to reduce market failures and imperfections, like internalizing externalities. When market imperfections exist, the efficiency of the market declines.
Key Points
- Prior to market failure, the supply and demand within the market do not produce quantities of the goods where the price reflects the marginal benefit of consumption.
- The structure of market systems contributes to market failure. In the real world, it is not possible for markets to be perfect due to inefficient producers, externalities, environmental concerns, and lack of public goods.
- Government responses to market failure include legislation, direct provision of merit goods and public goods, taxation, subsidies, tradable permits, extension of property rights, advertising, and international cooperation among governments.
- A price mechanism fails to account for all of the costs and benefits involved when providing or consuming a specific good. When this happens, the market will not produce the supply of the good that is socially optimal – it will be over or under produced.
- Due to the structure of markets, it may be impossible for them to be perfect.
- Reasons for market failure include: positive and negative externalities, environmental concerns, lack of public goods, underprovision of merit goods, overprovision of demerit goods, and abuse of monopoly power.
- In regards to externalities, the cost and benefit to society is the sum of the benefits and costs for all parties involved.
- Market failure occurs when the price mechanism fails to consider all of the costs and benefits necessary for providing and consuming a good.
- In regards to externalities, one way to correct the issue is to internalize the third party costs and benefits. However, in many cases, internalizing the costs is not feasible. When externalities exist, it is possible that the particular industry will experience market failure.
- In many cases, the government intervenes when there is market failure.
- An economically efficient society can produce more goods or services than another society without using more resources.
- An externality is a cost or benefit that results from an activity or transaction and affects a third party who did not choose to incur the cost or benefit. Externalities are either positive or negative depending on the nature of the impact on the third party.
- Neoclassical welfare economics states that the existence of externalities results in outcomes that are not ideal for society as a whole.
- In order to maximize economic efficiency, regulations are needed to reduce market failures and imperfections, like internalizing externalities. When market imperfections exist, the efficiency of the market declines.
- In order for economic efficiency to be achieved, one defining rule is that no one can be made better off without making someone else worse off. When externalities are present, not everyone benefits from the production of the good or service.
Key Terms
- public good : A good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others.
- merit good : A commodity which is judged that an individual or society should have on the basis of some concept of need, rather than ability and willingness to pay.
- externality : An impact, positive or negative, on any party not involved in a given economic transaction or act.
- public good : A good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others.
- free rider : One who obtains benefit from a public good without paying for it directly.
- monopoly : A market where one company is the sole supplier.
- intervene : To interpose; as, to intervene to settle a quarrel; get involved, so as to alter or hinder an action.
- externality : An impact, positive or negative, on any party not involved in a given economic transaction or act.
- efficient : Making good, thorough, or careful use of resources; not consuming extra. Especially, making good use of time or energy.
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