1.3.1 types of market failure
misallocation of resources = leads to net welfare loss
- market failure e,g! price mechanism ignoring external benefits / ignore external costs
- OTOH allocatively efficient = social optimum output reached if price mechanism
internalises external benefits / internalising external costs
- missing market: market where market mechanism fails to supply any of a good which
is demanded
- partial market failure: when market for a good exists but there is overproduction or
underproduction of the good
market failure = market power / public goods / externalities / inequality / moral hazard /
irrational behaviour / information gaps (asymmetric information)
mixed externalities: occurs when an economic activity generates both positive and negative
externalities simultaneously (e,g use of pesticides in farming // plastic packaging in
supermarkets.)
1.3.2 externalities
externality/spillover effect: impact on third party
- social cost = private cost + external cost
- social benefit = private benefit + external benefit
Private benefit:
- benefit internal to an exchange
- benefit the price mechanism takes into account
- e,g increased income from employment
Private costs:
- costs internal to an exchange
- costs the price mechanism takes into account
- e,g wages, raw materials, rent, machinery costs, labour costs, R&D costs
External benefit:
- benefit external to an exchange
- benefit the price mechanism fails to take into account
- positive third party effect / positive spillover effects from consumption
- e,g bus travel = reduction in road congestion
- e,g education = more skilled productive workforce: = greater income =
increase quality of life for workers / = lower costs = greater profits to firms /
increased tax revenue for government
- e,g vaccinations = healthier population as less spread of disease = more
productive workforce = lower production costs as less absenteeism from
employers = more profits
External costs:
- costs external to an exchange
- costs the price mechanism fails to take into account
- negative third party effects / negative spillover effects from consumption
- e,g noise pollution / fall in nearby property prices / air pollution / damage to
wildlife like birds / visual eyesore / road congestion / decrease tourism visits
If net social benefit > net private benefit = positive externality (external benefit)
.
, Marginal (MSB/MSC/MPB/MPC): social and private costs and benefits of the last unit
produced or consumed
+ potential welfare gain = excess of social benefit over social cost for a given output
- net welfare loss = excess of social cost over social benefit for a given output
social optimum output = optimum allocation of resources: where MSB = MSC
Supply = costs (MPC) / demand = benefits (MPB)
In a perfect market, allocative efficiency is achieved when P = MC, but if externalities
exist, then the social optimum level of output is achieved when MSC = MSB
Negative externality: over consumption relative to the socially optimal level
Positive externality of production
- MPC exceeds MSC
- e,g employing the homeless /
R&D / training and education
- welfare gain
under provision resources
- too few scarce resources allocated
to production and consumption of
the good
Negative externality of production
- MSC exceeds MPC
- e,g air / noise pollution /
environmental damage
- welfare loss
MSC curve isn't parallel to MPC as it’s
marginal, so loss worsens after each unit of
output
overprovision of resources (Q1-Q2)
- too many scarce resources
allocated to production and
consumption of the good
.
misallocation of resources = leads to net welfare loss
- market failure e,g! price mechanism ignoring external benefits / ignore external costs
- OTOH allocatively efficient = social optimum output reached if price mechanism
internalises external benefits / internalising external costs
- missing market: market where market mechanism fails to supply any of a good which
is demanded
- partial market failure: when market for a good exists but there is overproduction or
underproduction of the good
market failure = market power / public goods / externalities / inequality / moral hazard /
irrational behaviour / information gaps (asymmetric information)
mixed externalities: occurs when an economic activity generates both positive and negative
externalities simultaneously (e,g use of pesticides in farming // plastic packaging in
supermarkets.)
1.3.2 externalities
externality/spillover effect: impact on third party
- social cost = private cost + external cost
- social benefit = private benefit + external benefit
Private benefit:
- benefit internal to an exchange
- benefit the price mechanism takes into account
- e,g increased income from employment
Private costs:
- costs internal to an exchange
- costs the price mechanism takes into account
- e,g wages, raw materials, rent, machinery costs, labour costs, R&D costs
External benefit:
- benefit external to an exchange
- benefit the price mechanism fails to take into account
- positive third party effect / positive spillover effects from consumption
- e,g bus travel = reduction in road congestion
- e,g education = more skilled productive workforce: = greater income =
increase quality of life for workers / = lower costs = greater profits to firms /
increased tax revenue for government
- e,g vaccinations = healthier population as less spread of disease = more
productive workforce = lower production costs as less absenteeism from
employers = more profits
External costs:
- costs external to an exchange
- costs the price mechanism fails to take into account
- negative third party effects / negative spillover effects from consumption
- e,g noise pollution / fall in nearby property prices / air pollution / damage to
wildlife like birds / visual eyesore / road congestion / decrease tourism visits
If net social benefit > net private benefit = positive externality (external benefit)
.
, Marginal (MSB/MSC/MPB/MPC): social and private costs and benefits of the last unit
produced or consumed
+ potential welfare gain = excess of social benefit over social cost for a given output
- net welfare loss = excess of social cost over social benefit for a given output
social optimum output = optimum allocation of resources: where MSB = MSC
Supply = costs (MPC) / demand = benefits (MPB)
In a perfect market, allocative efficiency is achieved when P = MC, but if externalities
exist, then the social optimum level of output is achieved when MSC = MSB
Negative externality: over consumption relative to the socially optimal level
Positive externality of production
- MPC exceeds MSC
- e,g employing the homeless /
R&D / training and education
- welfare gain
under provision resources
- too few scarce resources allocated
to production and consumption of
the good
Negative externality of production
- MSC exceeds MPC
- e,g air / noise pollution /
environmental damage
- welfare loss
MSC curve isn't parallel to MPC as it’s
marginal, so loss worsens after each unit of
output
overprovision of resources (Q1-Q2)
- too many scarce resources
allocated to production and
consumption of the good
.
