eal Mi Despite the appealing logic of the argument, the free operation of the price mechanism will never achieve ces, This is referred an optimum allocation of resour to as market failure because th fails to allocate resources to their optimum use. In other words, there is a suboptimal allocation of resources. Let us examine the reasons for market failure, e price mechanism40 INTRODUCTORY ECONOMICS When resources are allocated through the price mechanism, consumers decide which goods and services to purchase on the basis of their money price, Similarly producers make decisions about what to produce on the basis of money prices, in particular, the price consumers are prepared to pay for the product and the costs of hiring the factors of production to produce the product. However, these prices do not always reflect the true value of the product to society of the rue cast of producing the produc. Consuming and producing certain products ‘often has side efferts which do not simply affect the consumer or the producer: these side effects are referred to as externalities and their existence is an important source of market failure. Externalities are costs (negative externalities) or benefits (positive externalities) which are not reflected in free market prices. They can arise from acts of consumption or acts of production. An ‘example of @ postive consumption externality would ‘occur if ene person had himself or herself vaccinated against a contagious disease, thus reducing the risk ‘of passing on the disease to someone else. Similarly & person who has their car converted to se unleaded petrol improves the environment for everyone. An example of a negative consumption externality ‘occurs when people smoke in a public place, cause they impose passive smoking on others ‘Similarly there are examples of externalities from production, For example, a firm which ofes training to workers benefits society because the greater skill ofthe workforce improves its productivity which is a ‘major factor in raising the standard of living fr all (seep. 362, A negative production externality occurs ‘when a firm pollutes a river with its toxic wastes, thus depriving anglers of the use ofthe rive; more —— seriously she drinking-water of local residents tight also be affecced, ‘Let us consider the case of a frm polluting a iver to see the implications of externalities fr the alloca tion of resoures. A firm which discharges its waste materials int a river i treating the environment a3 a free resource. Iti imposing a cost on society as a whole, rather than simply on consumers of the product. Consumers are not therefore paying the true ‘ost ofthe product. If the firm was forced to teat its waste materials 90 that they were harmless before tischarging them int the river, its cost of production ‘woul rise. Ie would therefore charge a higher price for its product and in consequence consumers would desire es of Resources would thn be relensed for the production of other goods and services ‘To illustrate the point economists dstingiy Deon the pl at and the el ey production. The private cost simply the mon st of production, and it refers to the costo me fmatrials the ctst of lbour and all other ren sts that firms must pay in order to unde rodutin. Social cost, on the oer ard, ist Davate cost of production fs the vale of exter ies. Let us consider Figure 43 Th Figure 43D, is the demand curve far; ular fs the supply curve when ai incom ee coir the ca ‘then the fll socal costs of prediction are con tro Tio clear that when the fll soil enw prodocton are considered price i higher ard op Tower than when supply # bose simply ont private costs of prodcion. In this case, fs tere foreed to pay the fll oc cost of pradug this product, they would consume Q-Q, less of z than if they simply paid the private cost of pri: tion, When prices do nt reflect negative ext-ia society ‘veroonsumes in relation tothe uptiu. and therefore the market fails to allcate renzo oprimaly in such eases. More neal, you ni Hike to consider the effect on the allocation resources when thre ate postive and oe externalities in consumption a= wel as post ‘xteralies in production. Ruble abode “These have song externalities, an pace ares have the properties of nese0 MARKET sovriocrousnes. (Note that alt “AILURE i of referrnn tt conomists {Ere adopted the hal fs are Tonexcable’ because, Se) Public 5 proson at al means provtion f= es include defence, street lighting te ‘all. Exam Sais In each case, once the faciny ern 2 fpossible to exclude individ iets aber words, such goods are ‘nd therefore their prices cannot . the “Queen's pact wih ait’ by oe eet in 0 sense "uses up this peace and there is stil tzacty the same amount left fr everyone doe the Itisis the nonexcludabilty of public goods which Ebert tote gi ‘aclode non-payers, the private sector would be eee oe them, However, while it is very iy thatthe main way of financing public goods fabs ug pera ston, pe gods a tot necessarily provided by the government ight oxses onthe Beith coast for example. ae provided ty Trinity House, a registered charity: whe drains ame provided bythe water companies which are public limited companies. However, many people fel that in order to avoid a preponderance of free riders ~ that is, consumers who use public good thot contributing towards its cost ~ pubic gods ‘bru in general, be provided by the goverment and financed out of general taxation. Payment is therefore averaged among. the whole community, ther than being billed to the marainal consume. WRERBEEGOREN 8 ‘Teese confer benefits on society in excess of the benefits conferred on individual consumers. Fer example, health care and education benefit oe individuals who receive them, but there are 2h ‘benefits to society from having 3 healthy, wel ‘educated workforce. If merit goods were Sora mart inst wood bent Erton othe optimum. Te gover ‘Sxourages consumption of merit goods BY SUBS, gtr lower hr marke prior PON ‘them free of charge to consumers. Tis important tote tat ke ‘merit goods could be produced by the Pri “Ths happen the ce of uch iN ie rats Pete ean gia cate at the national level and recreation ‘Sais such as public parks, at te loa level. In ‘these cases examples of private provision are 28y to find, but it i believed that if these goods ‘Were supplied entirely through the market, they ‘would be soderconsumed and this again implies @ Suboptimal allocation of resources. The government therefore uses tax revenues to ensure an optimal provision of merit gods. ‘These are seas which impose negative external: ‘ules on society rather than jut onthe iniviual consumer. Crete smoking is ofen cited a8 an example. The dangers of smoking cigrettes ae wel ‘now, bt the pie consumers pay for a packet of ciate sot rated othe ents of proving the health eae thao wil on averaye, necessitate These cnt ar, in part, Dome by the tax payer -Adain, provision tog the maret eds to a sub pina allocation of resources, bazuse the market pei ess than te tre price of eosumpson and therefore encourages overemsunption in raion 0 the opin level ies offen sad that goverament intervention to encourage the consumption of ment geods and to iscourage consumption of demerit goods is futeratte inples thatthe government knows fest and therefore acts to reduce consumer soverinty. The compttive pring system can be ried takes acon only of fc demand fat i demane backed by the money to pay. Te oes not respond t0 people's needs, and where ‘Suet udes that cain facts, sch as hospital treat, should be allocated according to need father than on the basis of fective demand, then ‘Srne modifaton ofthe pice mechanism i deemed reese. ‘We shall seein Chapter 11 that « monopoly exists ven thee isa single supplier ofa good or service Ihe the only supplier of this good or service, the Snopolis: has the power to influence the price by ‘Boteaing ot reducing market supply. Ths gives & mongpolist considerable power, and it is usually frgued that e will se this power to acien’ fhaximmum profit ftom his operabons. It 2 that by restricting market supply monopoly cuss Market faire, because society i Gepeved42 INTRODUCTORY ECONOMICS ‘output which it values more highly than the output which it currently consumes. In other words, the allocation of resources could be improved if the ‘monopolist expanded production (see p. 97) Apart from criticisms of market failure there are other possible problems of allowing resources to be allocated through the price mechanism. Wlpslabilty in the Economy. ey ‘The argument is that, lef to its own devices, the ‘market system is subject to periods of boom and slump, historically referred to as the trade cyle: the ‘boom is associated with periods of inflation whereas the sump is characterised by heavy unemployment. AS we shall see in Chapter 28 inflation imposes costs fon society, and it is clear that when workers are ‘unemployed the economy is producing at below its ‘maximum productive potential. Because of this, all ‘governments intervene to some extent in order to ‘regulate the economy and to try to iron out the peaks and troughs in economic activity. Although there is some disagreement among economists about the nature and extent of intervention, very few people would seriously dispute the principle of at last; minimal level of government intervention. ‘The free operation of markets leads to vast inequal ities in the distribution of income and wealth, Thos physical assets such as capital and land ear relatively large incomes while the vast majority, with only their labour to sell, earn relatively low incomes Some idea of what this implies is given the exper ‘ence of Britain during the Victorian period, Here, few fortunate individuals were able to gonsume to excess, but the vast majority lived in poverty To avoid what is considered an undesirable Aistribution of income and wealth the government uses the tax and benefit systeim (see p. 152) 0 redistribute income and wealth, We shall see in Chapter 36 that supplementary benefit is availabe to those on relatively low incomes along with a host of other concessions ~ for example, free prescription’ to those on pensions, and so on. The progressive taxation of income and levying no VAT on food for hhouschold consumption (a major item of expenditure for those on lower incomes) are ex:imples of how the ‘ax system is used to redistribute income.