Market Failure Unit 1

Aims and Objectives

Aim: To understand externalities Objectives: Define market failure and externalities Describe positive and negative externalities Analyse marginal costs and benefits Evaluate externalities causing market failure.

Market Failure
Define a market. A place where buyers and sellers meet to exchange goods and services. Define a free market. A market in which goods and services are traded free of governments intervening and providing goods and services Define market failure. When the free market fails to deliver an efficient allocation of resources.or. When there is a completely missing market: Complete market failure

Causes of Market Failure

1

Negative Externalities. E.g. effects of pollution.

Positive externalities. E.g. causing social benefits to outweigh private.

Imperfect information.

Private sector being unable to supply important public goods profitably to consumers.

Lack of competition/monopoly.

Immobility of factors of production

Equity and issues of fairness.

Externalities
The costs or benefits that spill over to third parties external to a market. No market in which it can be sold or produced.

What externalities may exist from opening a nuclear power plant in Scotland?

Who may be affected by these externalities?

Externalities

What externalities may exist from the Glastonbury Festival?

Externalities
What externalities may exist from the government providing street lighting? Who may be affected by these externalities?

Externalities cause market failure if: 1) There is no market for it. 2) No account is taken of the social costs.

Definitions
Private Costs Social Costs Private Benefits Social Benefit
The cost to an individual or firm of an economic transaction

Cost to society of an economic transaction, including private and external costs

Benefit to an individual or firm of an economic transaction.

Benefit to society of an economic transaction, including private and external benefits.

Definitions

External Costs

The spill-over cost to third parties of an economic transaction The spill-over benefits to third parties of an economic transaction

External Benefits

Negative Externalities
Production
Private costs Social costs Private benefits Social benefits

Consumption

When social costs exceed private costs negative externalities exist. When social benefits exceed private benefits positive externalities exist. This incentivises the producer to produce in a manor that does not benefit society as much as if private costs exceeded social costs. This leads to the producer not accounting for externalities in their calculations.

Negative Externalities
When you go on holiday, what costs would you consider when calculating its total cost?

Marginal Costs and Benefits

Marginal cost or benefit is the additional cost or benefit derived from producing or consuming one more of something.

Positive Externalities
When third parties benefit from the spill over effects of production and consumption.

Does education cause positive externalities?

Marginal Social Cost

Marginal Social Cost Marginal Private Cost Marginal External Cost

Full cost to society, including private and external costs

Cost to an individual or firm of an economic transaction.

The spill over cost to third parties of an economic transaction.

Marginal Social Benefit

Marginal Social Benefit Marginal Private Benefit Marginal External Benefit

Full benefit to society of an economic transaction.

Benefit to an individual or firm of an economic transaction.

The spill over benefit to third parties of an economic transaction.

Types of Externality
Read through the types of externality. Complete the remaining two columns. Discussion

Types of Externality

External Costs
Acid rain pollution discharged by a power station which harms a nearby forest.

External Benefits

Pure production externalities (generated and received in production)

A farmer benefiting from drainage undertaken by a neighbouring farm.

Mixed production externalities (generated in production but received in consumption)

Dust pollution discharged by a brickworks breathed by asthmatic children living nearby.

Commercially owned bees pollinating fruit trees in neighbouring gardens.

Pure Consumption Noisy music being played by externalities (generated and a group of teenagers received in consumption) disturbing neighbours. Mixed consumption externalities (generated in consumption but received in production) Congestion caused by private motorists increasing firms transport and delivery costs.

Households benefiting from the well kept neighbours gardens. Commercial beekeepers benefiting from the private gardens of nearby houses.

Externalities as Market Failure

Problem created by externalities is that too much or too little is being produced. The free market fails to produce an efficient allocation of resources.

US Pollution May Damage UK Health

1. What is meant by the term external cost? (2 Marks) 2. Why are externalities considered to be an example of market failure? (4 Marks) 3. What solutions can you think of to lessen the effects of the pollution on the UK and Ozone layer? Is there any way of correcting this market failure? (6 Marks)