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Notes (11/04/2021) Chapter 14 Market Failure

Economics 14.1 The nature of market failure

Market failure occurs when market forces fail to produce the product that consumers demand,in
the right quantities and at the lowest possible cost. Or, market failures arise when markets are
inefficient.
- It means that markets are inefficient
- If left to market forces, some products may be under-produced, some over-produced, and
some not produced at all
- Prices may be high due to lack of competition
- A lack of investment and reduction in expenditure on research and development can also
slow down the improvement in products

14.2 Failure to take into account all costs and benefits.

❖ The consumption and production of some products may affect people who aren’t
involved in their consumption or production directly. Also referred to as third-parties.
- In such cases, the total benefits and the total costs to the society, called social
benefits and social costs, are greater than the benefits and costs to the consumer
and producers known as private benefit and private cost.

Definitions:
- Third Parties: those not directly involved in producing or consuming a product.
- Social Benefit: the total benefit to a society of an economic activity.
- Social Costs: the total costs to a society of an economic activity.
- Private Benefits: benefits received by those directly consuming or producing a product.
- Private Costs: costs borne by those directly consuming or producing a product.

❖ Costs to the third parties are called external costs.

- Private cost to the firm will include buying raw-materials, fuel and wages.
- External Cost if usually imposed on people living nearby, it may include noise
pollution, air pollution and water pollution

- External Cost: costs imposed on those who are not involved in the consumption and
production activities of others directly.
- External Benefits: benefits enjoyed by those who are not involved in the consumption
and production activities of others directly.
- Socially optimum output: the level of output where social cost equals social benefit and
society’s welfare is maximised
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14.4 & 14.5 Merit Goods and Demerit Goods

1. 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.
- Eg; Healthcare, education, fire protection etc.

2. 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.
- Eg; Alcohol, drugs, tobacco etc.
- Demerit goods are over-consumed and hence over-produced. To tackle this
problem, a government could raise their price by imposing a tax on them.

14.6 Public and Private Goods

- A Public Good: is a product which is non-rival and non-excludable and hence needs to
be financed by taxation
- They are non-rejectable. It is not possible for people to reject their services of the
police, for example.
- The cost of supplying a public good to one more consumer if often zero.
Defending one more person in the country will be unlikely to cost the army
anything.

- A Private Good: is a product which is both rival and excludable (meaning consumers
don’t need access to it)

14.7 Abuse of monopoly power

- Monopoly is when there is a single seller of a product
- Price Fixing is when two or more firms agree to sell a product at the same price
❖ Both of these terms give power to the producer, rather than the consumer
❖ This can lead to market failure.

14.8 Immobility of resources

- To achieve allocative efficiency, it is necessary for resources to move from producing
products that are decreasing in demand towards those which are experiencing an increase
in demand.
- This requires resources to be both occupationally and geographically mobile. In
practice, some resources may be immobile.
- Example: demand for a country’s financial services might be increasing, whilst
demand for its steel may be decreasing, there may be a shortage of financial
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services, unemployment of workers and under-utilisation of capital equipment if

resources cannot easily move between the two.
- Where there is lack of competition, a firm may not keep its costs down, may charge a
high price and may produce a poor quality product.
- The most efficient allocation of resources may not be achieved due to a lack of mobility
of resources.

14.9 Short-termism

● When firms are looking to make profits quickly

● They use all the available resources, which can lead to over consumption
● There is no thought to what might happen in the future
● This leads to short-term gains for both consumer and producer, but there will be negative
impacts in the long term
● Therefore, private sector firms, keen to earn profits in the short term, may under-invest.

End of chapter question and answers.

Multiple Choice Questions (MCQs)

1. D
2. B
3. D
4. B or A

Four part question

a. External Cost: costs imposed on those who are not involved in the consumption and
production activities of others directly
b.
Merit Goods Demerit Goods

- Products which the government - Products which the government

considers consumers do not fully considers consumers do not fully
appreciate how beneficial they are. appreciate how harmful they are.

- Which will be under-consumed if - Which will be over-consumed if

left to market forces left to market forces.

- Also known as positive - Also known as negative

externalities externalities.
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- Eg: Healthcare - Alcohol

c.