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Market Failure definition.

Market failure occurs when freely

functioning markets, operating without government intervention,
fail to deliver an efficient or optimal allocation of resources;
economic and social welfare may not be maximised, leading to a loss
of allocative and productive efficiency.
Types of market failure:
1. Negative externalities (e.g. the effects of environmental pollution) causing the social
cost of production to exceed the private cost.
2. Positive (or beneficial) externalities (e.g. the provision of education and health care)
causing the social benefit of consumption to exceed the private benefit
3. Imperfect information means merit goods are under-produced while demerit goods are
over-produced or over-consumed
4. The private sector in a free-markets cannot profitably supply to consumers pure public
goods and quasi-public goods that are needed to meet peoples needs and wants
5. Market dominance by monopolies can lead to under-production and higher prices than
would exist under conditions of competition
6. Factor immobility causes unemployment hence productive inefficiency
7. Equity (fairness) issues. Markets can generate an unacceptable distribution of income
and consequent social exclusion which the government may choose to change

Key Terms in Market Failure

Externalities: These occur when a third party is affected by the decisions and actions of

Social benefit: is the total benefit to society =

Private Marginal Benefit (PMB) + External Marginal Benefit (XMB)

Social Cost: is the total cost to society =

Private Marginal Cost (PMC) + External Marginal Cost (XMC

Social Efficiency: This occurs when resources are utilised in the most efficient way. This
will occur at an output where social marginal cost (SMC) = Social Marginal Benefit.

Asymmetric information

The knowledge of one party in a transaction is greater than that

of the other party.


Externalities are third party effects arising from production and consumption of
goods and services for which no appropriate compensation is paid.

Positive Externality

Positive externalities exist when third parties benefit from the spill-over effects of
production/consumption e.g. the social returns from investment in education &
training or the positive benefits from health care and medical research.

Negative Externality

Negative externalities occur when production and/or consumption impose

external costs on third parties outside of the market for which no appropriate
compensation is paid.

Merit Good

Merit Goods are those goods and services that the government feels people will
under-consume due to imperfect information. Merit goods have positive
externalities MSB>MPB

Demerit Good

Demerit goods are goods that society deems to be 'bad' for society. Examples
include alcohol, cigarettes and various drugs. The over consumption of demerit
goods can lead to negative externalities which causes a fall in social welfare.
Consumers may be unaware of the negative externalities
that these goods create - they have imperfect information.

Market failure results in

Productive inefficiency: Businesses are not maximising output from given factor inputs.
This is a problem because the lost output from inefficient production could have been
used to satisfy more wants and needs

Allocative inefficiency: Resources are misallocated and producing goods and services
not wanted by consumers. This is a problem because resources can be put to a better use
making products that consumers value more highly

Sometimes there is complete market failure when the market does not produce (a missing

Other times there is partial market failure when the market produces too much or too

Government intervention definition. Government

intervention is defined Actions on the part of government
that affect economic activity, resource allocation, and
especially the voluntary decisions made through normal
market exchanges.
Government failure refers to situations where allocative efficiency may have been reduced
following government intervention in markets that was designed to correct market failure.
Government InterventionIf markets wont deliver or wont deliver enough there are several
things that government can do.

Direct provision.
Supply them directly to consumers e.g. schools and hospitals
It could buy it directly or pay a company to provide it
Advantages.Government controls the supply e.g. number of hospital beds and number of
May be inefficient employees of the state have no incentive to minimise costs
The wrong mix of goods may be produced (too many soldiers and too few hospital beds)
If the market produced too many soldiers they would be left unsold and firms would move
resources out of production of defence.

Government could subsidise provision

It might pay for part of the service and expect consumers to pay the rest
Prescriptions and dentistry
Increases the amount of dental care provided which hopefully maximises economic welfare
Can help those on low incomes
Government is captured by the industry
The EU government listens to the powerful farming lobby and gives them subsidies that have
become very large
This causes the welfare gains to the farmers to be higher than the loss to the consumers and

Government can regulate

Leave provision to the private sector but force consumers to purchase or suppliers to produce
Motorists are forced to buy car insurance
Some say workers should be forced to pay for pensions
Motorway service stations are forced to provide free toilet facilities whether or not they buy
This requires little or no taxpayers money to provide the good
Consumers will shop around in the free market looking for the best value which ensures
productive and allocative efficiency
Regulation can impose heavy costs on the poor in society
How many poor families could afford to pay private health insurance if it was a requirement for
them to do so?
Regulations can be ignored
Some parents would not send their children to school if they had to pay for it
The more likely citizens are likely to evade regulations the less efficient they are as a method of
providing services.
The essay will discuss the following 3 types of market failure.

Monopoly and Welfare Loss.

Definition of Monopoly: A pure Monopoly is defined as a single seller of a
product. i.e. 100% of market share. In the UK a firm is said to have monopoly power
if it has more than 25% of the market share. For example, Tesco @30% market
share or Google 90% of search engine traffic.

Government Interventions to control Monopoly.

Price controls - Government or regulators

Privatisation and Deregulation

Breaking up the monopoly
Reducing Entry Barriers
Welfare loss is the loss of community benefit, in terms of consumer and producer
surplus, that occurs when a market is supplied by a monopolist rather than a large
number of competitive firms.

If the market is constrained to a price higher than the economically efficient equilibrium price, a price
floor can be introduced by the government.
When government introduces a price floor, the price signal to producers is distorted, indicating that
consumers are demanding more.
This provides an incentive for producers to increase output because there is increased profit
opportunity. This results in over supply.
The price signal to consumers is also distorted, indicating that the product is scarce so that demand

Deadweight loss triangles, B and C, give a good estimate of efficiency cost of policies that
force price above or below market clearing price.
Measuring effects of government price controls on the economy can be estimated by
measuring these two triangles.
In both of these cases of price control government intervention has failed because it has
created welfare loss and worsened allocative efficiency - government failure.

Privatisation is it good or bad for economic efficiency?

Supporters of privatisation believe that the private sector and the discipline of free market forces
are a better incentive for businesses to be run efficiently and thereby achieve improvements in
economic welfare.
Privatisation was also seen as a way of reducing trade union power, widening share ownership
and increasing investment, as privatised businesses were now free to raise finance through the
stock market. Privatisation was regarded as an important supply-side policy designed to drive
competition and improve productive and dynamic efficiency.
Opponents of privatisation argued that state owned enterprises had already faced competition
when part of the public sector and that in several instances the transfer of ownership merely
replaced a public sector monopoly with a private sector monopoly that then required regulation.

There were criticisms that state assets were sold off by the government at too low a price and that
the consequences of privatisation has been a decrease in investment and large scale reductions in
employment as privatised businesses have sought to cut their operating costs.
Deregulation of markets
Deregulation involves opening up markets and encouraging the entry of new suppliers.
Examples of this in the UK include the opening up of markets for bus services, household energy
supplies, the liberalisation of household mail services and financial deregulation affecting both
banks and building societies.
The expansion of the European Single Market has accelerated the process of market
liberalisation. The Single Market seeks to promote four freedoms namely the free movement
of goods, services, financial capital and labour. In the long term we can expect to see the
microeconomic effects of the EU Single Market working their way through many British markets
and the general expectation is that competitive pressures for all businesses working inside the
European Union will continue to intensify.
Product market liberalisation involves breaking down barriers to entry, boost market supply,
bring down prices for consumers, and encourage an increase in competition, investment and
productivity leading to a rise in economic efficiency. In the long term, if product markets become
more competitive and investment flows into these industries, there are macroeconomic
implications for example an increase in an economys underlying trend rate of economic growth
which might contribute to an improvement in average standards of living.

Government Intervention - The Private Finance Initiative


The Private Finance Initiative (PFI) is an important but controversial policy designed to
change the model of funding for large-scale investment projects

The PFI was first launched in 1992 by a Conservative government and was extended
heavily by the Labour government of 1997-2010. At the end of 2011, more than 700
hospitals, schools, prisons and other public sector projects had been built under the PFI

It encourages groups of private investors manage the design, build, finance and operation
of public infrastructure such as new schools, hospitals, social housing, defence contracts,

prisons and road improvements. Typically a PFI contract is repaid by the government
over a 30 year period.
Benefits of the PFI

Efficiency: Belief that the private sector is better at managing investment projects and
achieving overall cost efficiencies

Extra Investment: Extra funding can kick-start many more projects bringing economic
and social benefits. The PFI provides extra private sector funds for projects that might
prove difficult for the government to finance through higher borrowing and taxes

Delivery: The private sector is not paid until the asset has been delivered. New PFI
projects are nearly all fixed price contracts with financial consequences for contractors if
delivered late

Dynamic efficiency: Private sector better placed to bring innovation and good design to
projects, higher quality of delivery, lowering maintenance costs

Disadvantages of PFI

Debt costs: Since 2007 the cost of private sector finance has increased - financing costs
of PFI are typically 3-4% over that of government debt. Some estimates find that paying
off a 1bn debt incurred through PFI cost the UK taxpayer equivalent to a direct
government debt of 1.7bn

Inflexibility and poor value for money: Long service contracts may be difficult / costly
to change especially when the management of a project seems to have gone wrong.
There have been many stories of flawed projects for example private firms contracted out
to provide car parking, cleaning and other services in hospitals built and run as part of a

Risk: The ultimate risk with a project lies with the public sector (government). Private
finance agreements are very complicated to organise and there is no guarantee that the
private sector will make a better cost benefit analysis of a project than the public sector

Administration: High spending on advisors and lawyers and the costs of the bidding
process. The Royal Institute of British Architects estimated that the cost of bidding for a
PFI hospital was more than 11 million

Addiction: Governments can become addicted to PFI - "the only game in town" rather
than using government borrowing for key projects. The PFI has added to public sector
debt but created many private sector fortunes

The media is rife with examples of some of the wasteful spending built into the public sector
procurement agreements that are part of PFI projects for example the Prison Service renting
computersfor 120 per month, anger at rising car parking charges at many local hospitals, road
and bridge projects over-budget (the M25 widening scheme cost 1 billion more than forecast.
Another well known example is the kennels at the Defence Animal Centre in Melton Mowbray,
which cost more per night than rooms at the London Hilton.

2nd External costs/ Externalities

Negative externanilites definition. Negative externalities occur when production and/or
consumption impose external costs on third parties outside of the market for which no
appropriate compensation is paid.
Definition of External costs

An external costs occurs when producing or consuming a good or service imposes a cost
upon a third party.

If there are external costs in consuming a good (negative externalities), the social cost
will be greater than the private cost.

The existence of external costs can lead to market failure. This is because the free market
generally ignores the existence of external costs

Example of Production External Cost

Producing chemicals can cause pollution to air and water.Diagram Showing Effect of
External Cost

This diagram shows how the existence of external costs will cause the social marginal cost to be
greater than the private marginal cost. Therefore, in a free market there will be overconsumption
of the good (Q1) . Social efficiency will occur at Q2 where SMC = SMB

Social benefit: is the total benefit to society =

Private Marginal Benefit (PMB) + External Marginal Benefit (XMB)

Social Cost: is the total cost to society =

Private Marginal Cost (PMC) + External Marginal Cost (XMC

Social Efficiency: This occurs when resources are utilised in the most
efficient way. This will occur at an output where social marginal cost (SMC) =
Social Marginal Benefit. (SMB)

Socially Optimum Output .The output at which Marginal Social Benefit equals
Marginal Social Cost.
Marginal Private Benefit. The marginal benefit enjoyed by the individual from the
consumption of an extra unit of a product or service.

Marginal Social Benefit.

The total benefit to society from consumption of
one extra unit of a good. The MSB = Marginal private benefit (MPB) + marginal
external benefit
Marginal Private Cost. The marginal cost incurred by the individual firm from the
production of one extra unit of product.
Marginal Social Cost. The total cost to society from the production of one extra
unit of a good. MSC = MPC + marginal external cost.

By taxing the firm.

The marginal private costs increase
The supply decreases
The quantity reduces from Q1 to Q2
The welfare loss is decreased
The turquoise triangle is decreased

However, the socially optimum amount is Q* but to get this amount government would
have to accurately measure the external cost (the pollution) and also the tax may be so
large that firms may exit the market Q2 is still better than Q1.

Pollution Taxes
One common approach to adjust for externalities is to tax those who create negative externalities.

This is known as making the polluter pay.

Introducing a tax increases the private cost of consumption or production and ought to
reduce demand and output for the good that is creating the externality.

Some economists argue that the revenue from pollution taxes should be ring-fenced
and allocated to projects that protect or enhance our environment.

For example, the money raised from a congestion charge on vehicles entering busy
urban roads, might be allocated towards improving mass transport services; or the
revenue from higher taxes on cigarettes might be used to fund better health care

Examples of Environmental Taxes include some of the following

The Landfill Tax - this tax aims to encourage producers to produce less waste and to
recover more value from waste, for example through recycling or composting and to use
environmentally friendly methods of waste disposal.

The Congestion Charge: -this is a high profile environmental charge introduced in

February 2003. It is designed to cut traffic congestion in inner-London by charging
motorists 8 per day to enter the central charging zone.

Plastic Bag Tax: A tax on plastic bags in Wales has seen the number given away drop by
sizeable amounts according to this news report Since 1 October 2011, there has been a
minimum charge of 5p on all single use carrier bags. The Welsh government acted in a
bid to encourage re-use of bags and therefore lower demand for single-use free bags. The
justification was on economic and environmental grounds:

Vehicle excise duty (VED): Also known as road tax VED starts from a theoretical
'nil' rate and accelerating up depending on the carbon emissions of the vehicle

Problems with Environmental Taxes

Many economists argue that pollution taxes can create problems which lead to government

Assigning the right level of taxation: There are problems in setting tax so that private
cost will exactly equate with the social cost.

Consumer welfare effects: Producers may pass on the tax to the consumers if the
demand for the good is inelastic and, as result, the tax may only have a small effect in
reducing demand. Taxes on some de-merit goods (for example cigarettes) may have a
regressive effect on lower-income consumers and leader to a widening of inequalities in
the distribution of income.

Employment and investment consequences: If pollution taxes are raised in one country,
producers may shift to countries with lower taxes. This will not reduce global pollution,
and may create problems such as structural unemployment and a loss of international

3rd Public Goods

A public good is often (though not always) under-provided in a free market because of its
characteristics of non-rivalry and non-excludability.
Public goods have two characteristics:
1. Non-rivalry: This means that when a good is consumed, it doesnt reduce the amount
available for others.
- E.g. benefiting from a street light doesnt reduce light for others, but eating an apple
2. Non-excludability: This occurs when it is not possible to provide a good without it being
possible for others to enjoy. E.g erecting a dam to stop flooding, or providing law and
Free Rider Problem
The problem with public goods is that they have a free rider problem. This means that it is not
possible to prevent anyone from enjoying a good once it has been provided. Therefore there is no
incentive for people to pay for the good because they can consume it without paying for it.

However this will lead to there being no good being provided.

Therefore there will be social inefficiency.

Therefore there will be a need for the govt to provide it directly out of general taxation.

Examples of Public Goods

Public Defence,

Street Lights,

Police service

Flood defences

Quasi-Public Goods

These are goods which have an element of non-excludability and non-rivalry, roads are a good
example. Once provided most people can use them, for example, those who have a driving
licence. However, when you use a road, the amount others can benefit is reduced to some extent,
because there will be increased congestion