1 H2 Lecture on Market Failure 2007 Economics Dept.

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H2 Lecture on Market H2 Lecture on Market FailureFailure

2007 Economics Dept2007 Economics Dept

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Recap of Market SystemRecap of Market System

Market allocates resources by using price Market allocates resources by using price mechanismmechanism

Interaction between Interaction between consumersconsumers and and producersproducers using prices (demand and using prices (demand and supply) to solve the 3 fundamental Qssupply) to solve the 3 fundamental QsWhat to produce?What to produce?How to produce? How to produce? For whom to produce?For whom to produce?

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Price Mechanism fail?Price Mechanism fail?

"Markets (price mechanism) are "Markets (price mechanism) are usuallyusually a a good and efficient way to organise good and efficient way to organise economic activity (allocate resources)”economic activity (allocate resources)”

Price mechanism can help to allocate Price mechanism can help to allocate resources BUT does it ensure efficient resources BUT does it ensure efficient outcome? outcome?

Only if Only if Perfect KnowledgePerfect Knowledge exist exist

Sometimes markets don't work so well. Sometimes markets don't work so well. When they don't, economists talk about When they don't, economists talk about market failuremarket failure..

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Price Mechanism fail?Price Mechanism fail?

Sometimes people want more/less of a Sometimes people want more/less of a goodgood

Eg. Eg. Education, HealthcareEducation, Healthcare Eg. Eg. Noise pollution, Road congestionNoise pollution, Road congestion

Presence of Presence of socialsocial benefits/costs benefits/costs Who decides what price to pay?Who decides what price to pay? Who can curb these “nuisance”?Who can curb these “nuisance”?

Government intervenesGovernment intervenes

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Market FailureMarket Failure

Market Failure - A situation in which a market Market Failure - A situation in which a market left on its own left on its own fails to allocate resources fails to allocate resources efficientlyefficiently. Private. Private markets do not bring markets do not bring about the allocation of resources that best about the allocation of resources that best satisfies society’s wants.satisfies society’s wants. Do you pay the actual cost of your education? Will Do you pay the actual cost of your education? Will

you still come to school if made to pay the full you still come to school if made to pay the full costcost

Are companies producing exactly what consumers Are companies producing exactly what consumers desire?desire?

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Allocative EfficiencyAllocative Efficiency (aka (aka Pareto Optimality) - where society produces ) - where society produces goods and services at minimum cost that goods and services at minimum cost that are wanted by consumersare wanted by consumers

Vilfredo Pareto (1848 - 1923) Efficiency is achieved when the economy’s

resources & output are allocated in such a way that no reallocation can make anyone better off without making at least one other person worse off

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Pareto improvement / improvement in Pareto improvement / improvement in social efficiencysocial efficiencySocial welfare can be increasedSocial welfare can be increasedOutcome is not efficient (Outcome is not efficient (Why?Why?))

Pareto optimality / social efficiencyPareto optimality / social efficiencySocial welfare is maximisedSocial welfare is maximisedOutcome is the most efficient possible Outcome is the most efficient possible

from society’s viewpointfrom society’s viewpoint

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Consumers and Producers engage in Consumers and Producers engage in economic activity for private reasons. This economic activity for private reasons. This will occur only if the gain or benefit will occur only if the gain or benefit received received ((Marginal private benefit)Marginal private benefit) is more is more than or at least equal to the cost incurred than or at least equal to the cost incurred ((Marginal private cost)Marginal private cost)

Marginal private benefit (MPB) Marginal private benefit (MPB) Marginal private cost (MPC)Marginal private cost (MPC)

When MPB = MPC When MPB = MPC No further gains from No further gains from changes changes (ie. Qe is optimal)(ie. Qe is optimal)

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Example: HealthcareExample: Healthcare Social benefits not captured in private Social benefits not captured in private

consumption (MPB = MPC) [consumption (MPB = MPC) [benefit from benefit from less virus spreadingless virus spreading]]

Social benefits Social benefits External Benefits External Benefits MPB + Ext Benefits = MSB > MPC MPB + Ext Benefits = MSB > MPC Q Q

should be highershould be higher Govt intervenes to encourage more QGovt intervenes to encourage more Q

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Market FailureMarket FailureCost/Benefit

QUANTITY

MPB (DD)

MPC (SS)

Qe

Pe

MSB

External benefits

Q1

Govt Subsidizes in order to encourage more consumption of Healthcare

In doing so, society as a whole achieves pareto improvement

P1

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Example: Road congestionExample: Road congestion Social costs not captured in private Social costs not captured in private

consumption despite MPB = MPCconsumption despite MPB = MPC Social cost (delays) Social cost (delays) External Cost External Cost MPB < MSC (MPC + External cost) MPB < MSC (MPC + External cost) Q Q

should be reducedshould be reduced Actual Q (based on market) is higher than Actual Q (based on market) is higher than

desireddesired Govt intervenes to discourage QGovt intervenes to discourage Q

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Market FailureMarket FailureCost/Benefit

QUANTITY

MPB (DD)

MPC (SS)

Qe

Pe

Q1

P1

MSC

External costs

Govt taxes in order to discourage consumption of road (reduce congestion)

In doing so, society as a whole achieves pareto improvement

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Market FailureMarket FailurePRICE

QUANTITY

DD (MPB)

SS (MPC)

Qe

Pe

Q1

P1

Q2

P2

Private consumption or production may not take into account what is best for society ie. Q1 or Q2

Govt needs to intervene in order to encourage /discourage consumption/ production

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Occurs when market ignores or is Occurs when market ignores or is unable to capture social unable to capture social costs/benefitscosts/benefits

Pareto improvement is achieved Pareto improvement is achieved when Govt interveneswhen Govt intervenes

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Sources of Market Sources of Market Failure Failure

2007 Economics Dept2007 Economics Dept

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Sources of Market FailureSources of Market Failure

• Prices as expressed through markets, are Prices as expressed through markets, are “incorrect”, and so transmit wrong signals in “incorrect”, and so transmit wrong signals in the market-based resource allocation the market-based resource allocation mechanismsmechanisms

There are three main causes (types) of There are three main causes (types) of market failure:market failure:Presence of ExternalitiesPresence of ExternalitiesExistence of merit/demerit and public goodsExistence of merit/demerit and public goodsImperfect competitionImperfect competition

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Market Failure - ExternalitiesMarket Failure - Externalities

An externality arisesAn externality arises when parties when parties engages in an activity that influences engages in an activity that influences the well-being of bystanders whom the well-being of bystanders whom neither pay nor receive any neither pay nor receive any compensation for that effect.compensation for that effect.

33rdrd Party Effect Party EffectExample – 2Example – 2ndnd hand smoke hand smoke

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The The chewing gum banchewing gum ban in Singapore in Singapore was enacted in 1992.was enacted in 1992.

… … disposing of spent gum in mailboxes, inside disposing of spent gum in mailboxes, inside keyholes and even on elevator buttons… gum left on keyholes and even on elevator buttons… gum left on floors, stairways and pavements in public areas floors, stairways and pavements in public areas increased the increased the cost of cleaning and damaged cleaning cost of cleaning and damaged cleaning equipmentequipment… stuck on the seats of public buses … stuck on the seats of public buses vexed passengersvexed passengers… chewing gum on the door … chewing gum on the door sensors of MRT trains, causing sensors of MRT trains, causing disruption of train disruption of train servicesservices. Such incidents were rare but . Such incidents were rare but costlycostly and and culprits were culprits were difficult to apprehenddifficult to apprehend..

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Singapore Retailers Go GreenSingapore Retailers Go Green11 stores join campaign to use fewer 11 stores join campaign to use fewer plastic bagsplastic bags

… … campaign to help the retail sector and shoppers campaign to help the retail sector and shoppers reduce waste and go greenreduce waste and go green… project team led by … project team led by the retailers includes representatives of 11 key the retailers includes representatives of 11 key stores namely Carrefour, CK Tang, Cold Storage, stores namely Carrefour, CK Tang, Cold Storage, NTUC FairPrice, Hang Ten, Ikea, Isetan, Robinsons, NTUC FairPrice, Hang Ten, Ikea, Isetan, Robinsons, Seiyu, Shop N Save, and Takashimaya, and the Seiyu, Shop N Save, and Takashimaya, and the public waste collectors… public waste collectors… achieve environmental achieve environmental sustainabilitysustainability kick off a pilot recycling programme kick off a pilot recycling programme … … save the environmentsave the environment

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Road pricing started in Singapore in June 1975

… … a small city state experiencing rapid a small city state experiencing rapid industrial growth, found itself faced with the industrial growth, found itself faced with the new problem of urban traffic congestion … new problem of urban traffic congestion … small land area of the central business district small land area of the central business district led to led to severe traffic conditionssevere traffic conditions including including congestion, reduced traffic speeds, and congestion, reduced traffic speeds, and environmental problems … automobile user environmental problems … automobile user causes causes externalitiesexternalities which which impose impose unfavorable conditions on othersunfavorable conditions on others

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• When a market activity (economic activity) When a market activity (economic activity) affects external parties other than the affects external parties other than the buyers and sellers involved, side-effects buyers and sellers involved, side-effects called called externalitiesexternalities are created are created

• Additional cost / benefits to societyAdditional cost / benefits to society, over & , over & above those experienced by the individual above those experienced by the individual producer & consumerproducer & consumer

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• When the impact on the bystander is When the impact on the bystander is adverse, the externality is called a adverse, the externality is called a negative externalitynegative externality..

• Eg. Dog shit near the reservoirEg. Dog shit near the reservoir

• When the impact on the bystander is When the impact on the bystander is beneficial, the externality is called a beneficial, the externality is called a positive externalitypositive externality..

• Eg. Immunisation against bird flu results in Eg. Immunisation against bird flu results in no transmission to others in the societyno transmission to others in the society

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Examples of Positive Examples of Positive externalities:externalities:

• ImmunizationsImmunizations• Restored historic buildingsRestored historic buildings• EducationEducation

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Examples of Negative Examples of Negative externalities:externalities:

• Automobile exhaustAutomobile exhaust• Smog from factorySmog from factory• Barking dogs (loud pets)Barking dogs (loud pets)• Loud stereos in an apartment Loud stereos in an apartment

buildingbuilding

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• ExternalitiesExternalities cause markets to be inefficient cause markets to be inefficient (presence of external benefits or costs)(presence of external benefits or costs)

• Wedge is driven between what individuals want Wedge is driven between what individuals want privately and what society wants collectivelyprivately and what society wants collectively

Negative Externalities:Negative Externalities:

MSC = MPC + MEC (Marginal External Cost)MSC = MPC + MEC (Marginal External Cost)

Positive Externalities:Positive Externalities:

MSB = MPB + MEB (Marginal External Benefit)MSB = MPB + MEB (Marginal External Benefit)

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Negative Negative externalities – externalities – presence of presence of marginal marginal external costsexternal costs

QUANTITY

MPB (DD)

MPC (SS)

Qe

Pe

Q1

P1

MSC

External costs

Cost/Benefit

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Positive Positive externalitieexternalities – s – presence of presence of marginal marginal external external benefitsbenefits

QUANTITY

MPB (DD)

MPC (SS)

Qe

Pe

MSB

External benefits

Q1

P1

Cost/Benefit

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Measures that Govt can undertake to Measures that Govt can undertake to tackle externalities:tackle externalities:

(1)(1) Impose tax (Impose tax (shift MPC to coincide MSCshift MPC to coincide MSC))

(2)(2) Provide subsidy (Provide subsidy (shift MPB to coincide shift MPB to coincide MSBMSB))

(3)(3) Impose price controls (Impose price controls (affect Qaffect Q))

(4)(4) Use of regulations (Use of regulations (affect Qaffect Q))

But Govt needs to know exactly the But Govt needs to know exactly the magnitude of externalitiesmagnitude of externalities

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Market Failure – Public goodsMarket Failure – Public goods

Most goods in our economy are Most goods in our economy are allocated in markets…for these allocated in markets…for these

goods, prices are the signals that goods, prices are the signals that guide the decisions of buyers and guide the decisions of buyers and

sellers.sellers.

““Free goods” provide a special Free goods” provide a special challenge for economic analysischallenge for economic analysis

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Would you pay for this? Or this?

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Examples of Public Examples of Public Goods:Goods:

(1) National Defense(1) National Defense(2) Street Lightings(2) Street Lightings(3) Road signs(3) Road signs

Two Two characteristics:characteristics:Non-excludabilityNon-excludabilityNon-rivalryNon-rivalry

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Non-excludabilityNon-excludabilityit is impossible or prohibitively costly to it is impossible or prohibitively costly to

confine the benefits of the good to confine the benefits of the good to selected persons. selected persons.

Person paying for the benefit cannot Person paying for the benefit cannot prevent anyone else from also prevent anyone else from also benefiting (benefiting (‘free rider’‘free rider’))

ImplicationImplicationNo one will want to pay – No demand No one will want to pay – No demand

means that there will be no supplymeans that there will be no supply

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Non-rivalryNon-rivalryConsumption of the good by one person Consumption of the good by one person

does not diminish the consumption of does not diminish the consumption of the good by anotherthe good by another

The cost of providing the good to The cost of providing the good to another person is zeroanother person is zero

ImplicationsImplicationsSocially desirable but not profitable to Socially desirable but not profitable to

supply! supply! No one will supply if price = 0No one will supply if price = 0

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Non-depletability (Non-depletability (non-rivalrynon-rivalry) and non-) and non-excludability imply that public goods will excludability imply that public goods will not be provided in “efficient” quantities, or not be provided in “efficient” quantities, or will not be provided at all, through will not be provided at all, through standard market mechanismsstandard market mechanisms

No one willing to pay for itNo one willing to pay for it no one no one willing to supplywilling to supply

Price mechanism cannot workPrice mechanism cannot work Govt Govt needs to provide such goodsneeds to provide such goods

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Market Failure – Merit goodsMarket Failure – Merit goods

Goods where the consumption of which is Goods where the consumption of which is deemed to be deemed to be intrinsically desirableintrinsically desirable for the for the individual as well as for the society as a wholeindividual as well as for the society as a whole

Eg. education, medical services, sports Eg. education, medical services, sports facilitiesfacilities

Could be provided by the market but Could be provided by the market but consumers may not be able to afford or feel consumers may not be able to afford or feel the need to purchase – market would not the need to purchase – market would not provide them in the quantities society needsprovide them in the quantities society needs

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Market Failure – Merit goodsMarket Failure – Merit goods

Intrinsic Intrinsic benefits of benefits of merit good merit good means that means that higher higher consumptioconsumption (Q1) is n (Q1) is more more desirable & desirable & beneficial to beneficial to individualindividual

MPB (DD)

MPC (SS)

Qe

Pe

Q1

Cost/Benefit

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Market Failure –Merit goodsMarket Failure –Merit goods

Reasons why there is under-consumption:Reasons why there is under-consumption: Individuals may not be able to afford it Individuals may not be able to afford it

(eg. education)(eg. education) Uncertainty or lack of information (eg. Uncertainty or lack of information (eg.

health risks from smoking)health risks from smoking) Individual as poor judge of long term Individual as poor judge of long term

benefitsbenefits

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Market Failure – Demerit Market Failure – Demerit goodsgoods

•Goods which society over-produces•Goods and services provided by the market which are not in our best interests!

• Examples:(1) Tobacco and alcohol(2) Drugs(3) Gambling(4) Smog from heavy industy

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Market Failure – Demerit Market Failure – Demerit goodsgoods

Intrinsic ills Intrinsic ills of demerit of demerit good means good means that lower that lower consumptioconsumption is more n is more desirable & desirable & beneficial to beneficial to individualindividual

Cost/Benefit

QUANTITY

MPB (DD)

MPC (SS)

Qe

Pe

Q2

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Market Failure – Imperfect Market Failure – Imperfect InformationInformation

In the In the Price MechanismPrice Mechanism, both buyers and , both buyers and sellers have perfect information about the sellers have perfect information about the marketmarket

The price that is paid and accepted The price that is paid and accepted efficient outcome (efficient outcome (no one is made worse offno one is made worse off))

With With imperfect informationimperfect information, one party can , one party can be made better off while the other worse off be made better off while the other worse off (and they won’t even know!)(and they won’t even know!)

Example of Example of monopolymonopoly – one firm selling the – one firm selling the good with no close substitutesgood with no close substitutes

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Imperfect knowledgeImperfect knowledge::Consumers do not have adequate Consumers do not have adequate

technical knowledgetechnical knowledgeAdvertisingAdvertising can mislead or mis-inform can mislead or mis-inform

(eg. Nike vs Adidas)(eg. Nike vs Adidas)Decisions often based on past Decisions often based on past

experience rather than future experience rather than future knowledge (lack of knowledge (lack of innovationinnovation))

Lack of environment controls Lack of environment controls (externalities)(externalities)

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Goods/Services are differentiated:

•Branding•Designer labels•Technology – lack of understanding•Labelling and product information

Which one is the ‘quality’ item and why?

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Factors of production are not perfectly Factors of production are not perfectly mobilemobile

Labour immobility – geographical and Labour immobility – geographical and occupationaloccupational

Capital immobility – what else can use Capital immobility – what else can use an ice making machine for?an ice making machine for?

Land – cannot be easily moved to Land – cannot be easily moved to where it might be neededwhere it might be needed

Imperfect Competition existsImperfect Competition exists

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Imperfect Imperfect information information allows firm allows firm (monopoly) (monopoly) to produce to produce less, charge less, charge higher higher pricesprices

Inefficiency Inefficiency occurs – occurs – consumers consumers worse offworse off

PRICE

QUANTITY

DD

SS

Qe

Pe

Q1

P1

E0

E1

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Problems with efficient Problems with efficient MarketsMarkets

Efficient markets will allocate resources Efficient markets will allocate resources according to pricesaccording to prices

Efficiency v. EquityEfficiency v. EquityEfficiencyEfficiency means society gets the means society gets the mostmost

that it can from its scarce resources.that it can from its scarce resources.EquityEquity means the benefits of those means the benefits of those

resources are distributedresources are distributed fairly fairly among among the members of society.the members of society.

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Problems with efficient Problems with efficient MarketsMarkets

If $100 was to be taken from Bill Gates If $100 was to be taken from Bill Gates and given to a homeless person, will and given to a homeless person, will society’s overall utility increase or society’s overall utility increase or decrease?decrease?

Attempts to make market outcomes Attempts to make market outcomes more equitable often results in the loss of more equitable often results in the loss of economic efficiency. economic efficiency.

Will Bill Gates or a Homeless person benefit more if given another $100 extra in income

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Problems with efficient MarketsProblems with efficient Markets

Basic Economic Problems solved by the market system?

What to produce - Goods that command the higher prices will be produced

How to produce - Cheapest possible way For Whom - Produced goods will be

given to those willing and able to pay

Richer people gets most of the goods due to unequal distribution of income

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Problems with efficient MarketsProblems with efficient Markets

Unequal distribution of ResourceUnequal distribution of ResourceUnequal opportunities for peopleUnequal opportunities for people

Inequality will lead to political unrest and Inequality will lead to political unrest and turmoilturmoil

Need for intervention to redistribute Need for intervention to redistribute resources (policies such as taxes and resources (policies such as taxes and subsidies used by government)subsidies used by government)

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Food for ThoughtFood for Thought

What measures can the Govt undertake to What measures can the Govt undertake to tackle market failure (presence of tackle market failure (presence of externalities, Public Goods, Merit & externalities, Public Goods, Merit & Demerit goods, Imperfect information)?Demerit goods, Imperfect information)?

Is the Govt the best judge of what is best Is the Govt the best judge of what is best for us?for us?

Should the Govt focus on efficiency or Should the Govt focus on efficiency or equity?equity?

Can the Govt fail?Can the Govt fail?

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1 H2 Lecture on Market Failure 2007 Economics Dept.

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