Download Merit goods

Market Failure
• Where resources are inefficiently
allocated due to imperfections in the
working of the market mechanism
• When markets do not provide us with
the best outcome in terms of efficiency
and fairness
Sources of Market Failure
Externalities
Merit and demerit Goods
Public Goods
Common access resources (‘tragedy of
the commons’)
• Asymmetric Information
• Monopoly Power
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Merit and Demerit Goods
Merit Goods
• Goods that are underprovided in a
market economy.
• The price mechanism allocates fewer
resources to their production than is
thought socially desirable.
• Underproduced and underconsumed
• Education and healthcare
3 Reasons why there are
underprovided
• The social benefits are greater than the
private benefits- the external benefits of
healthcare are not considered when people
choose to take medicine
• Individuals may underestimate the private
benefits (imperfect information)- for eg. The
benefit of being vaccinnated against a disease
(they may not know the chances of them
catching the disease)
• Private benefits may be discounted because
benefits may be received in the future, rather
than when they are paid for
Merit Goods
Price
S1
P*
P1
D2
Q1
Q*
D1
Quantity
Handout
• Education and Training: What lessons should
the government learn?
• Answer the following questions
• Explain how education is described as a merit
good
• What other market failures are associated with
education?
• How does the UK government try to overcome
market failure associated with education?
Demerit Goods
• Goods that are overprovided in the
market economy.
• The price mechanism allocates more
resources to their production than is
thought socially desirable
• Eg. Alcohol, drugs and cigarettes
Why are they overprovided?
• The social costs of consumption exceed
the private costs (negative externalities
associated with their consumption)
• Individuals may underestimate the
private costs (imperfect information)risk and future costs
Demerit Goods
Price
S1
P1
P*
D1
Q*
Q1
D2
Quantity
Activity
• ET- The Economics of Binge Drinking
• h/w- q1-3
• Q4-6
Answers
1. Private and external costs and benefits
of binge drinking
2. Factors which have led to an increase
in demand for alcohol in recent year?
Answers
3. The Law of Diminishing Marginal Utility:
As the consumption of a good increases, the total utility
derived from consumption of that good rises at a
diminishing rate
Eg. I have 3 watches , consuming a 4th watch would give me
extra utility. If the price of the new watch is RM500, but
I only gain RM 400 satisfaction, I would not buy it as it
would be irrational to do so.
With alcohol consumption, consumers do not conform to this
rule governing rational behaviour.
A 7th pint of beer may only yield utility less than the cost of
the pint, thus a rational consumer would not consume the
7th pint (or continue beyond this point)
Why? Alcohol distorts ‘rational’ decision making
Public Goods
Article and Questions
1. What is meant by the ‘free rider problem’?
2. Explain the difference between a private and
a public good
3. What is meant by a quasi- public good?
4. Why are public goods considered to be a type
of market failure?
5. Why does the government provide public
goods? (known as state provision)
6. Why is it difficult to decide on the quantity to
produce?
Public Goods
• Non-rivalrous- one person’s use of them does not
deprive others from using them
• Non- excludable- if one person consumes them it
is impossible to restrict others from consuming
them
• Non- rejectable- individuals cannot abstain from
their consumption even if they want to
• Eg. National defence, street lighting
• Non-excludability and Non- rejectability means
no market can exist and provision must be made
by the government
Answers
• The price mechanism will not reveal the
true level of consumers’ demand. The
gov. in aiming to achieve the socially
optimum level of output, has to estimate
marginal social benefit.
• It could do this by asking people the
max they would be willing to pay to work
out MPB, then have to estimate any
MEB.
Merit Goods
• In deciding the quantity of merit goods
to provide, the gov. has to consider the
extent to which consumers fail to
appreciate their full private benefits,
the positive externalities they create
and the benefits poor people can get
from their provision
Evaluating State Provision
• Same as subsidies:
• May help to improve the efficiency of
resource allocation (increasing consumption
of merit goods and goods with positive
externalities)
• Effectiveness of increasing consumption
depends on PED (more elastic= more
effective)
• May support inefficient firms
• Opportunity cost
Also…
• Cost of state provision v. expensive
• Danger of inefficient production and waste
enhanced if gov. run organisations because
of the lack of profit motive
• Governments may attempt to reduce risk
of inefficiency by paying private firms to
produce the service (PPPs)- controversial,
reduced quality?
• The effectiveness of state provision in
increasing consumption is likely to be
limited only by the resources available
NHS on a diagram?
• When a good or service is free of
charge, economic theory suggests that
any consumer who gets any utility from
it at all will choose to use it
• Excess demand?
• Question sheet- State Provision
• PP- state provision
Monopoly Power
Market Failure Under Monopoly/ Imperfect Competition
• One firm dominates the market (monopoly) or firms collude
(oligopoly)
• Restricting output and raising price (market power exists)
• Thus ‘too little’ is being produced and consumed- allocation of
resources is inefficient
• Monopoly prices will normally be above those in competitive
markets
– Loss of consumer surplus (because price is above marginal
cost)
– Output of the monopolist is below the competitive level
• Monopoly may waste scarce resources in maintaining their
position
– High levels of advertising and marketing designed to
increase brand loyalty and build barriers to the entry of
new firms (this is known as “rent-seeking behaviour”)
Simple monopoly diagram to show
welfare loss
The Pure Monopolist
Imperfect markets
restrict output and raise
price in order to maximise
profits (MC=MR)
Thus output is below the
socially optimum level
There is a welfare loss to
societyLost consumer surplus=
Lost producer surplus=
HL students need to refer
back and provide more
detail re. monopoly power
in the exams/ IA
S= MSC
PM
P= MC
D= MSB
QM
Output
MR
Features
• Firms can do this because there are barriers to
entering the market (difficult for new firms to enter
the market and compete)- little/ no competition
• Market power shifts the influence over the use and
allocation of resources from consumers to producers
• The government will often intervene to reduce market
power through regulation- specifically competition
policy
• But Remember …. monopoly power can also bring economic benefits
– Exploitation of economies of scale (lower unit costs)
– Profits used to fund research and development – leading to a faster pace of
innovation and gains in dynamic efficiency
– Many monopolies face international competition and markets have become more
contestable
Monopoly Power

Created through growth of the firm (internal) or merger/
takeover (external)
 Monopoly power can be maintained through Barriers To Entry
(barriers to new firms entering the market). Examples…?
 A clearly differentiated product with brand loyalty

Economies of scale which result in low l/r ACs

Legal and Regulatory barriers
 Ownership/control of key factors of production

Other barriers include; aggressive trading tactics, the
threat of aggressive merger and takeover,
ownership/control of retail outlets and intimidation.
Handout
• Back to basics… Competition Policy
• ET Sept 2003