1.4 Market failure
In the previous sections we explained markets, the rules of supply and demand, market equilibrium, the price mechanism and market efficiency and how demand and supply are used to calculate market price and plot market equilibrium. We then explained the concepts of elasticity and considered the role and effects of government intervention in the economy. In this section we examine the concept of market failure.
By the end of this section you should be able to:
- Analyse the concept of market failure as a failure of the market to achieve allocative efficiency, resulting in an overallocation of resources (overprovision of a good) or an under-allocation of resources (under-provision of a good).
- Describe the concepts of marginal private benefits (MPB), marginal social benefits (MSB), marginal private costs (MPC) and marginal social costs (MSC).
- Describe the meaning of externalities as the failure of the market to achieve a social optimum where MSB = MSC.
- Explain, using diagrams and examples, the concepts of negative externalities of production and consumption, and the welfare loss associated with the production or consumption of a good or service.
- Explain that demerit goods are goods whose consumption creates external costs.
- Evaluate, using diagrams, the use of policy responses, including market-based policies (taxation and tradable permits), and government regulations, to the problem of negative externalities of production and consumption.
- Explain, using diagrams and examples, the concepts of positive externalities of production and consumption, and the welfare loss associated with the production or consumption of a good or service.
- Explain that merit goods are goods whose consumption creates external benefits.
- Evaluate, using diagrams, the use of government responses, including subsidies, legislation, advertising to influence behaviour, and direct provision of goods and services.
- Using the concepts of rivalry and excludability, and providing examples, distinguish between public goods (non-rivalrous and nonexcludable) and private goods (rivalrous and excludable).
- Explain, with reference to the free rider problem, how the lack of public goods indicates market failure.
- Discuss the implications of the direct provision of public goods by government.
- Describe, using examples, common access resources and sustainability.
- Explain that the lack of a pricing mechanism for common access resources means that these goods may be overused/depleted/degraded as a result of activities of producers and consumers who do not pay for the resources that they use, and that this poses a threat to sustainability.
- Explain, using negative externalities diagrams, that economic activity requiring the use of fossil fuels to satisfy demand poses a threat to sustainability.
- Explain that the existence of poverty in economically less developed countries creates negative externalities through over-exploitation of land for agriculture, and that this poses a threat to sustainability.
- Evaluate, using diagrams, possible government responses to threats to sustainability, including legislation, carbon taxes, cap and trade schemes, and funding for clean technologies.
- Explain, using examples, that government responses to threats to sustainability are limited by the global nature of the problems and the lack of ownership of common access resources, and that effective responses require international cooperation.
- Explain, using examples, that market failure may occur when one party in an economic transaction (either the buyer or the seller) possesses more information than the other party.
- Evaluate possible government responses, including legislation, regulation and provision of information.
- Explain how monopoly power can create a welfare loss and is therefore a type of market failure.
- Discuss possible government responses, including legislation, regulation, nationalization and trade liberalization.