Chapter 14

We learned from Ch 13:

There is a risk that the market forces of demand and supply

may not work well. In fact market failure may occur. We will
take the following notes from Ch 13 and elaborate them in
Ch 14.

14.1 The Nature of Market Failure

Definition: Market Failure: market forces (demand and

supply interaction) resulting in an inefficient allocation of
resources.

Market Failure occurs when market forces fail to produce

the products that consumers demand, in the right quantities
at the lowest possible cost.
Market failure means inefficiency (remember a Market
economy survives on efficiency- allocative, productivity,
dynamic)
14. 2 Failure to take into account all costs and benefits

1. Consumers and private sector firms may only take into

account the costs and benefits to themselves. These
are called Private Costs and Benefits. They do not
take into account the costs and benefits of others.
EXAMPLE: Some people may smoke even if it annoys
and endangers the health of those around them. This
is called an External Cost: a cost to third parties not
involved in production or consumption
Key TERMS
Private Costs: costs borne by those directly
consuming or producing the product. Examples: A
factory (firm) has the private cost of paying their
workers. A consumer has the private cost of buying the
product.
External Costs: costs imposed on those who are not
involved in the consumption and production of the
product. EXAMPLE: Somebody lives near a factory
producing pollution, gets sick and has to go to the
hospital- this costs the person and government money.
These people are third parties to consumption and
production.
Third party: those not directly involved in producing or
consuming a product.
Social Costs: The TOTAL costs to society of an
economic activity. Basically they are Private Costs +
External Costs
 Draw Fig 14.1
This figure shows an over-production of a product
because external costs are not being calculated.
Curve SS shows only Private costs to the firm
Curve SxSx shows total costs to society (private costs
plus external costs). Which raises the price level
The allocative efficient output is Qx
The government taxes products and factories that
harm the environment and health.
Example: for the consumer-The government taxes
cigarettes and alcohol and other harmful products.
For the firm- the government taxes how much
pollution they create- because people living near the
factory can breathe the pollution and get sick causing
costs to society.

Private Benefits- benefits received by those directly

producing or consuming the product. Example: a
student benefits from attending university.
External Benefits - benefits enjoyed by those not
involved in the consumption and production activities
of others directly.
Social benefits= Private benefits + External Benefits,
the total benefits to society.
Example: students attending university and get a good
education to get a good job as doctor and now they
make good money- This is a private benefit
University education benefits society because now the
economy has skilled labour and doctors, lawyers and other
professionals- these are External benefits.
This makes living standards higher- these are called
External Benefits: you have better products and services
thanks to educated people.
Since external benefits are not considered, the government
gives subsidies (gives money) to increase education.
Fig 14.2 shows Under -production. DRAW
This diagram shows the demand for degree courses
DD shows the private benefits
DxDx shows all the benefits to society.
If left to market forces the quantity would be at Q, but since
the government gives subsidies we can get to Qx.
Immagine in the diagram that the gap between DD and
DxDx is filled with a subsidy.

Conclusion
Whenever there is a gap between the total effects on those
directly consuming and producing products, markets will fail
to allocate resources efficiently:
-Therefore with over-production the government fills the
gap with taxes. (external costs)
-with under-production the government fills the gap with
subsidies. (external benefits)
Therefore, the government steps in and corrects market
failure.
Socially Optimum Output: the level of output where social
costs equal social benefit and society’s welfare is
maximised.
Social Costs = Social Benefits (the goal)

Social Costs> Social Benefits = diagram like 14.1 showing

over-production-----this means we need to tax the products

Social Benefits > Social Costs = diagram 14.2 showing

under-production-----this means we need to give a subsidy
to the product

An example of where social costs exceed social benefits in

most countries is the use of road space by private cars.
Rather than use the train to travel on a long trip: Example
Bologna to Paris, people take their private car.
With this choice there are many external costs:
-use of gasoline
-pollution
- car accidents
- wear and tear on the vehicle (consuming the car will
make the car have less of a life time- leads to waste)

To correct these external costs, many governments, like in

Singapore and the UK, started using road pricing
schemes: people are charged money to use the road.

Individual Activity 1
a. materials to build the factory and the cost of labour
b. external costs are costs that do not involve those who

produce or consume the product.

people can breathe the pollution and get sick: now they go to
the hospital which costs money (both the government and the
patient)
another example is the pollution damages natural life like
animals and the river
and this destroys the ecosystem. bad ecosystems can ruin
and economy

14.3 Information Failure

Workers need to be well informed before taking a job

or they risk taking a job they are not skilled for or in a
location that requires commuting- can lead to stress
and inefficiency.

Advertising can distort consumer choice persuading

people to buy products they do not want. Consumers
and producers may also lack information and make
inefficient choices. Remember wasting money is
market failure in your own home.
Firms can have lack of information about where to buy
the cheapest raw materials and spend too much on
their product, leading to inefficiency.
Example of information failure for a producer: A
firm makes cotton t-shirts. They buy their raw materials
from a supplier who sells cotton fabric for 14
euro/meter. Meanwhile there is another supplier the
firm does not know about who can sell them cotton
fabric for 7 euro/meter.
Therefore the firm increases their cost of production
and this is market failure.

14.4 Merit Goods

SUBSIDY- money given by the government to a firm to

increase and encourage production

Merit Goods: Products which the government

considers consumers do not fully appreciate how
beneficial they are and so which will be
under-consumed if left to market forces. Such goods
generate positive externalities. (external benefits)

Examples:
Healthcare: some people may not recognize the
importance of regular medical check-ups and visiting
the doctor. They do not realize the benefits to others
of their fitness.
This good healthcare is a benefit to all people so we
have healthy workers that do not stay home sick and
also it prevents giving diseases to other workers.

First diagram shows market failure due to under

consumption (people do not consume the product or
service)

The second diagram shows market correction with the

government granting a subsidy (supply increases,
Demand and Supply are in equilibrium)

Group Activity 1
a. to create a skilled labour force for everyone, to create
equity so even poor people can go to school
b. people do not realize the benefits of education. Also if
governments do not provide subsidies only families who
can pay for school will go.

Demerit Goods
Products which the government considers consumers
do not fully appreciate how harmful they are and so
which will be over-consumed if left to market forces.
Such goods generate negative externalities (external
costs)

Demerit goods over-consumed and hence

over-produced. To tackle this problem, a government
could raise their price by imposing a tax on them.
 Group Act 2
a. Alcohol has negative externalities because people
drinking it can harm others by creating a traffic
accident, or being aggressive and fighting with
other people.

b. The government can impose taxes on alcohol so

it’s more expensive to buy and it can make
legislation for high cost tickets/fines for driving
under the influence or one can also go to jail.

14.6 Public and Private Goods

Firms will not make products unless they can charge

for them. Some products like military defense, which
most people want, will not be provided by a private
sector because of free -riders: someone who
consumes a good or service without paying for it.

public good: a product which is non-rival and

non-excludable and hence needs to be financed by
taxation.
If left to market forces public goods would not be
produced because the private sector is interested in
profit. So we need the mixed market economy and
intervention of the government to provide public goods
like military defense and things like a flood defense
system in a coastal town.

remember the objective of the public sector is public welfare

4 characteristics of Public goods:

1. non-excludability : no one is excluded from using the
public good (even if they do not pay taxes)- these are
called free-riders. example: street lights, military
defence
2. Non-rivalry: consumption of the product by one
person does not reduce another person’s ability to
consume it. Example: walking on the street everyone
can enjoy the street lights.
3. non-rejectable: it is not possible for people to reject
the services of the police for example.
4. Zero cost to other users: the cost of supplying a
public good to more than one person is often zero.
Example: defending more than one person in a
country does cost extra money.

private good: a product which is both rival and

excludable

Most products, including merit goods and demerit

goods, are private goods. These products are both
rival and excludable:
Education and healthcare are private good (merit
good) because if a place at school or a hospital bed is
occupied by one person, no one else can occupy it.
 So even though Merit goods are subsidised by the
government they still have this aspect of rivalry and
excludability so are private goods.

14.7 Abuse of Monopoly Power

Lack of competition leading to a possible monopoly:

leading to high prices and low quality.

If one firm dominates the market they may not be

allocatively, productively and dynamically efficient
since there are no competitors:
remember competition creates efficiency and helps
firms respond to consumer demand better.
Monopolies create products that have high prices and
low quality since there is no competition.

Market failure can also occur when there is more than

one firm producing the product - they can get together
and create the effect of a monopoly by keeping the
price high with price fixing.

The government corrects the market failure of monopolies

existing by lowering barriers to entry and making price fixing
illegal. They may also stop firms from merging (when two
firms join together) only if the merge goes against the
interest of the consumer.
Immobility of Resources

Unable to respond to consumer demand because of

lack of workers with the right skills or geographical
immobility.
The government can take measures to promote
occupational mobility of labour by improving education
and provide training.
Geographical mobility of workers can be made making
it easier for workers to rent or buy houses in an area
where demand for labour is high. Government can
provide financial help to workers seeking to move to
these locations.

Short Termism

When market forces may not result in sufficient

resources being devoted to capital goods. Short
termism is when an economy produces a high quantity
of consumer goods without considering the future so
the increase in living standards is temporary.
 the government intervenes by stimulating the private
sector investment by for example cutting taxes on
firms and undertaking some investment itself.

Group activities

1 a. The merit good and equity arguments.

b. Education is likely to be under-consumed, if left to market forces

as people underestimate its value to themselves. Also, while
making their consumption decisions, they do not take into account
the associated benefits to others.

Individual activities

1
a . Among the private costs are the costs of buying the land and
the building materials and the wages of the workers.

b. Pollution is an external cost, as it harms those who are not

directly involved in the production and consumption of the products
involved. For example, those living near the factories may suffer
from poor health as a result of carbon dioxide emissions from the
factories.

Individual Activity 2

a. To respond to consumer demand and earn more profit

b. competition gives choice so consumers can choose the higher quality
at the best and lowest price

14.8 Immobility of Resources

Remember on page 96 we studied Allocative
Efficiency and the problems with shortages and
surpluses. Allocative Efficiency means
equilibrium price: Demand and Supply meet at
the same price.
Immobility of Resources interferes with
Allocative Efficiency: this happens when
consumer demand increases for a product or
service and there are not resources available
that are occupationally or geographically
mobile.
Examples: If there is an increase in consumer
demand for financial services and there are not
workers that are occupationally and
geographically mobile then we have a shortage
and inefficiency. So we need workers who can
fulfill consumer demand with their mobility.
If we previously had a demand for the steel
industry - it is very hard for steel workers to
move to the financial sector. We need training
and education or geographical mobility to fulfill
the new demand.

How does the government correct Market

Failure with Immobility of Resources?
By improving education and provide training in
the new skills needed. The government can also
provide investment to make it easier for firms to
use land and buildings. Geographical mobility of
workers can be encouraged to buy or rent
housing where demand for labour is high.

14.9 Short-Termism
There is a risk that market forces may not result
in sufficient resources being devoted to capital
goods.
Look at page 21 : the PPC curve is important in
evaluating the allocation of resources toward
both capital goods and consumer goods.
If all your resources go to consumer goods you
will not be able to produce more as you need to
invest in new capital goods to produce more
consumer goods.
This is called making money in the short run.
You are not looking at the future.
The government solves this problem but
stimulating investment into the private sector’s
ability to buy new capital goods- they cut taxes
and may also provide a subsidy.
a. An external cost is a harmful effect on third
parties, that is on people not directly
involved in consuming and producing a
product. For example, people living near a
steel factory may suffer from the pollution
the factory creates.

b. A merit good is one that the government

considers is more beneficial to consumers
than they realise and it generates external
benefits. The social benefit of a merit good
exceeds the private benefits. As a result, a
merit good is underconsumed and
underproduced if left to market forces. In
contrast a demerit good is one that the
government thinks is more harmful to
consumers than they appreciate and it
causes external costs. It is overconsumed
and so overproduced if left to market forces.
c. Social benefit includes private and
external benefits. The social benefit of
education exceeds the private benefits of
education because education has external
benefits. The private benefits of education
include the development of skills, increased
earning potential and an increased range of
interests. As well as the benefits to those
being educated, others may gain. The
external benefits include increased output
and better quality output due to higher
labour productivity. More and better
products can be consumed. There may also
be increased tax revenue arising from higher
incomes. This extra tax revenue may be
spent on, for example, healthcare, which can
be enjoyed by third parties. A more educated
country may also be a more civilised and
compassionate society.

d. The rainforests, in the Amazon region of

Brazil, are being cleared at a relatively rapid
rate. The firms that are engaged in logging
in the forests are only taking into account
private costs and benefits. In the case of a
logging firm, private costs will include, for
example, the cost of transporting the wood
and the cost of labour. The private benefit a
logging firm receives from selling the wood
is the revenue it earns. The company will
continue cutting down trees, as long as the
revenue received by it exceeds its costs.
External costs caused by the logging firms
may include damage to wildlife habitats,
loss of plant species that could be used to
develop medicines, global warming and
interference with the lifestyle of local tribes.
External benefits may include reduced
transport costs for tourism firms in the area
due to construction of roads by logging
firms and tax revenue. While making its
decisions on the number of trees to be cut
down, a logging company will not take these
external costs and benefits into account.
The decision as to whether trees should
continue to be cut down in the Brazilian
rainforests should be based on the
relationship between social cost and social
benefit. If the social cost exceeds the social
benefit, no more trees should be cut down.