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MARKET FAILURE
Negative / Positive Externalities
Social Benefit and Cost
MARKET FAILURE
What is Allocative Efficiency and Maximization of Welfare?
Burgers
$9
Consumer
Surplus
$5
Producer
Surplus
$1
1
3
1st Burger
Consumers willing to buy 1st burger for $9 but pays market rate of
$5 (market equilibrium price). Thus the consumers enjoy $9-$5
=$4 of consumer surplus, while producer enjoy $$5-$1=$4 of
producer surplus.
MARKET FAILURE
What is Allocative Efficiency and Maximization of Welfare?
Burgers
$9
$7
Consumer
Surplus
$5
Producer
Surplus $3
$1
1 2
4
2nd Burger
Sellers willing to buy 2st burger for $7 but pays market rate of $5
(market equilibrium price). Thus the consumer enjoys $7-$3 =$4
of consumer surplus, while producer enjoy $$5-$3=$4 of producer
MARKET FAILURE
What is Allocative Efficiency and Maximization of Welfare?
Burgers
$9
$7
$6
$5
$4
$3
$1
2 3 4
Ultimately, when consumers pay the equilibrium price, we say
that consumers and producer’s surplus is maximized. Another
way to put is that allocative efficiency has been reached
whereby welfare has been maximized. In this state resources
are fully and efficiently used.
1
MARKET FAILURE
What is Allocative Efficiency and Maximization of Welfare?
Burgers
$9
$7
$6
$5
$4
$3
Welfare lost giving
rise to inefficient use
of resources
$1
1
2 3
4
If society does not produce at ( up to the market
clearing equilibrium of 4 units of at $5, then we say that
the market is not allocative efficient. When this happens
market failure occurs
MARKET FAILURE
When a market has failed to achieve
economic efficiency it has failed to achieve
allocative efficiency. This means that the
market has failed to allocate the usage of
resource in an efficient manner resulting in a
society not achieving maximum welfare.
MARKET FAILURE
In a failed market, at market equilibrium,
something is causing the market to not be able
to allocate efficiently so that welfare is not
maximized. The welfare of all in society
(consumers, producer and all 3rd parties) has not
been considered.
MARKET FAILURE
There are 4 causes of Market Failure
1. Externalities
2. Public Goods
3. Merit Good
4. Existence of Monopolies
O level focus
MARKET FAILURE
1. A. Negative Externalities
They are defined as third party
(or spill-over) effects arising from
the production and/or consumption
of goods and services for which
there exist an external cost to
society and no appropriate
compensation is paid to society.
- Negative externalities – smoking
MARKET FAILURE
1. B. Positive Externalities
They are defined as third party
(or spill-over) effects arising from
the production and/or consumption
of goods and services the external
benefit of which society has not
paid for.
- Positive externalities - education
MARKET FAILURE
2. Public Goods
Null
MARKET FAILURE
3. a. Merit Good
b. Demerit Good
MARKET FAILURE
4. Existence of Monopolies
Null
MARKET FAILURE
Social Cost
When one consumes a cigarette, others around
him (the 3rd party) will also end up inhaling 2nd
hand smokes. For these 3rd parties, long term
exposure to these smokes will result in
respiratory diesease and they will need to pay
for medication. As such, the smoking of
cigarettes (a demerit good) will give rise to social
cost.
MARKET FAILURE
Social Benefit
When one is injected with anti-flu vaccination,
others around him (the 3rd parties) will not be
infected and the person will also be healthier
having less MCs. 3rd parties benefit by the
person’s continued contribution to society as a
productive unit of labour. As such, vaccination (a
merit good) will give rise to social benefit.
MARKET FAILURE
1. Positive or Negative Externalities?
2. Social Benefit or Social Cost?
Activity
Identified
Externality
Positive/
Negative
Externality
Social
Cost or
Benefit
Solution
Drinking
Coke
Obesity/MC
-ve
Cost
Tax or Min
Price
Driving a
Car
Carbon
Emission
-ve
Cost
Gas tax/ERP
University
Education
Volunteerism
+ve
Benefit
Subsidy
Using Solar
Energy
Clean
Environment
+ve
Benefit
Subsidy
Edcucation
MARKET FAILURE
4. Existence of Negative Externalities
How Will A Tax (GST) Affect Producers and Consumers
1. Taxes will increase the cost of production of
the firm.
2. Owing to the tax, producers will cut back on
production so as they now have less
resources and they need to maintain a level
of profit.
3. This will cause the prices of the cigarettes to
increase causing consumers to decrease the
quantity demanded for cigarettes.
4. The tax, therefore has succeeded in reducing
the consumption of a demerit good that
gives off negative externalities.
Advantage and Disadvantages of the Tax Reduce Consumption
of a Demerit Good
Advantage
1. The consumption tax increases the price of the demerit good causing consumers to
consume less of the good.
2. The tax is easy to implement and government does not have to spend a lot of money
to implement it.
Disadvantage
1. The tax may not be severe enough to deter consumer to reduce their
consumption.
2. The tax maybe too severe and may reduce employment in the firms significantly
as firms reduce their production due to the tax.
3. It the demerit good (cigarette in this case) is price inelastic in demand, then the
consumers will in the long run get use to the high prices and will not significantly
reduce the quantity demand of the good by much.