ECONOMICS

UNIT V
Market Failure

Market Failure: Prior Definitions

Before analyzing market failures:

What are the basic assumptions behind a
perfectly competitive market?

A perfectly competitive market exists when every

participant is a "price taker", and no participant
influences the price of the product it buys or sells

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Economics – 4° Year
Pablo J. Torrecilla

Perfect Competition: Basic Characteristics

 Infinite buyers and sellers: Infinite consumers with the willingness

and ability to buy the product at a certain price, and infinite
producers with the willingness and ability to supply the product at
a certain price.
 Zero entry and exit barriers: It is relatively easy for a business to
enter or exit in a perfectly competitive market.
 Perfect factor mobility: In the long run factors of production are
perfectly mobile allowing free long term adjustments to changing
market conditions.
 Perfect information: Prices and quality of products are assumed to
be known to all consumers and producers.
 Zero transaction costs: Buyers and sellers incur no costs in making
an exchange (Perfect mobility) Colegio San Jorge Chacras
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Economics - Unit IV Market Failure 1

 Perfect Competition: Basic Characteristics

 Profit maximization - Firms aim to sell where marginal costs meet

marginal revenue, where they generate the most profit.
 Homogeneous products – The characteristics of any given market
good or service do not vary across suppliers.
 Non-
Non-increasing returns to scale - Non
Non--increasing returns to scale
ensure that there are sufficient firms in the industry.

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Market Failure

What is MARKET FAILURE?

FAILURE?
When or where the market mechanism fails to
allocate resources efficiently
 Social Efficiency
 Allocative Efficiency
 Technical Efficiency
 Productive Efficiency
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Market Failure

 Social Efficiency
• Where external costs and benefits are accounted
for
 Allocative Efficiency
• Where society produces the goods and services
that are wanted by consumers at minimum cost
 Technical Efficiency
• Production of goods and services using the
minimum amount of resources
 Productive Efficiency
• Production of goods and services at lowest factor
cost Colegio San Jorge Chacras
Economics – 4° Year
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Economics - Unit IV Market Failure 2

 Market Failure

Allocative Efficiency
A.K.A.:
 Pareto Efficient Allocation:
• Resources cannot be readjusted to make one
consumer better off without making another
consumer worse off.
• That is, no reallocation is possible at zero
opportunity cost (In other words, if efficiently
allocated, any change has to have an opportunity
cost).
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Economics – 4° Year
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Market Failure

Factors affecting the efficiency of markets

 The amount of information about the markets held by consumers
and producers
 The ease with which factors of production can be put to alternative
uses
 The extent to which price is an accurate signal of the true utility
and true cost in determining the level of demand and supply:
Externalities
 The degree to which firms hold monopoly power
 The degree to which property rights are clearly defined
 Whether the market can provide certain special goods and
services: Public goods Colegio San Jorge Chacras
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Market Failure

When do markets fail?

 Imperfect knowledge
 Goods are differentiated
 Resource immobility
 Market power
 Services and goods would or could not be provided in
sufficient quantity by the market on itself
 Existence of external costs and benefits
 Inequalities Colegio San Jorge Chacras
Economics – 4° Year
Pablo J. Torrecilla

Economics - Unit IV Market Failure 3

 Market Failure

Imperfect Knowledge:
 Consumers do not have adequate technical
knowledge
 Advertising can mislead or mis-
mis-inform
 Producers can be unaware of all alternative
opportunities
 Producers cannot accurately measure productivity
 Decisions often based on past experience rather
than future knowledge
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Pablo J. Torrecilla

Market Failure

Goods and Services differentiation:

 Branding
 Designer labels: They cost three times as much,
but are they three times the quality?
 Technology: Lack of understanding
 Labelling and product information

Which one is the BEST

product, and why? Colegio San Jorge Chacras
Economics – 4° Year
Pablo J. Torrecilla

Market Failure

Resource Immobility:
 Factors are not fully mobile
 Labour immobility: Geographical and
occupational
 Capital immobility: What else can we use the
International Tunnel to Chile for?
 Land cannot be moved to where it might be
needed: Downtown vs. the suburbs

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Economics – 4° Year
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Economics - Unit IV Market Failure 4

 Market Failure

Market Power:
 Monopolies and oligopolies
 Collusion
 Price fixing
 Abnormal profits
 Rigging of markets
 Barriers to entry

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Economics – 4° Year
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Market Failure
Inadequate Provision:
 Merit Goods
 Merit Goods: Could be provided by the market but
consumers may not be able to afford or feel the need to
purchase –> The market would not provide them in the
quantities society needs
 Education, health care, vaccines. They could all be
provided by the market, but would everyone be able to
afford them?
 De--merit Goods: Goods which society over-
De over -produces,
provided by the market which are not in society’s best
interests
Tobacco and alcohol, drugs, gambling
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 Economics – 4° Year
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Market Failure

Inadequate Provision:
 Public Goods
 Non-excludability: A person paying for the benefit
Non-
cannot prevent anyone else from also benefiting: The
‘free rider’ problem
 Non--rivalry: Each individual's consumption leads to
Non
no subtractions from any other individual's
consumption of that good.

Markets would not provide such goods and

services at all!
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Economics – 4° Year
Pablo J. Torrecilla

Economics - Unit IV Market Failure 5

 Market Failure

Inequality
 Poverty – absolute and relative
 Distribution of factor ownership
 Distribution of income
 Wealth distribution
 Discrimination
 Housing

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Market Failure

External Costs and Benefits:

 External or social costs:
• The cost of an economic decision to a third
party
• Decision makers do not take into account the
cost imposed on society and others as a result
of their decision
• E.g.: Pollution, traffic congestion, misuse of
alcohol, tobacco, environmental degradation,
depletion of the ozone layer… Colegio San Jorge Chacras
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Pablo J. Torrecilla

Market Failure

External Costs and Benefits:

 External benefits:
• The benefits to a third party as a result of a
decision by another party
• By
By--products of production and decision
making that raise the welfare of a third party
• E.g. education and training, public transport,
preventative medicine, refuse collection
• Recycling plants, apiculture, alternative energy
sources… Colegio San Jorge Chacras
Economics – 4° Year
Pablo J. Torrecilla

Economics - Unit IV Market Failure 6

 Market Failure: External Costs
MSC = MPC + External Costs
$ (Marginal SOCIAL Cost)
S=MPC
(Marginal Private Cost)

The MPC does not take into

account the cost to society of
production. At an output level
$e Social
A of Qe Private, the private cost to
$e Private
Social the supplier is $e Private per unit

$S1
Cost but the cost to society is
higher than this: $e Social.

D=MPB=MSB
(Marginal Private Benefit,
Marginal SOCIAL Benefit)

Qe Private
Qe Social Q
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The difference between the value of the MSB and the MSC
Economics – 4° Year
Pablo J. Torrecilla
represents the welfare loss to society of Qe units being produced.

Market Failure: External Benefits

The output at market equilibrium is less than

$ it would be socially desirable (E.g.: Education)
In this case, the sum of the benefits to society
S=MPC=MSC
(Marginal Private Cost,
is greater than the private benefit to the
Marginal Social Cost)
individual

$e Social A Social Welfare

=
$e Private
$D1
Benefit Loss
MSB = MPC + External
(Marginal SOCIAL
Benefit)
Benefits

D=MPB
(Marginal Private Benefit)

Qe Private
Qe Social Q
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Economics – 4° Year
Pablo J. Torrecilla

Economics

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Economics – 4° Year
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Economics - Unit IV Market Failure 7

 The Market in Perfect Competition

The quantity demanded by consumers equals the

amount suppliers are willing to provide.
$
S
From the point of view of a single firm the demand price
A is “fixed”: any quantity taken to the market by any
$e 50 individual producer will be cleared at the equilibrium price

$ S1 Sn
D S2
S
Qe 60 Q
Equilibrium Price: Balance between demand & supply.
A
$e 50
D

Q1 5 Q2 20 Qn 35 Qe 60
Q
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Economics – 4° Year
Pablo J. Torrecilla

Production Possibility Frontier: Efficiency

Good A At point A on the PPF, the combination of Yo Capital

e.g. Capital Goods Goods and Xo Consumer Goods can be produced
If resources are reallocated (moving round the PPF
Ym from A to B), more Consumer Goods can be
produced, but only at the expense of fewer Capital
Goods. The opportunity cost of producing an extra Xo
Goods
Yo A
– X1 Consumer Goods is Yo – Y1 Capital Goods

Yc C
Y1 B
More Capital and/or more
Consumer Goods can be
produced without sacrifice of
other goods.
Xc Xm Good B
Xo X1
Production inside the PPF – e.g. point C
means the country is not using all its e.g. Consumer Goods
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resources or prodution capabilities Economics – 4° Year

Pablo J. Torrecilla

Economics - Unit IV Market Failure 8