What is Market Failure? | Economics for Grade 12 PDF Download

Market Failure Defined

• In a free market, the price mechanism determines the most efficient allocation of scarce resources in response to the competing wants and needs in the marketplace
  • Scarce resources are the factors of production (land, labour, capital, enterprise)
• Free markets often work very well
•  However, there is sometimes a less than optimum allocation of resources from the point of view of society. This is called Market Failure
  • Sometimes there is an over-provision of goods/services which are harmful (demerit goods) & therefore an over-allocation of the resources (factors of production) used to make these goods/services e.g. cigarettes 
  • Sometimes there is an under-provision of the goods/services which are beneficial (public goods & merit goods) & therefore an under-allocation of the resources (factors of production) used to make these goods/services e.g. schools
  • Sometimes the market causes a lack of equity (inequality) - the rich get richer and the poor get relatively poorer
  • Sometimes, environmental damage occurs during the production or consumption of a good/service
•   In each of these cases, from society’s point of view there is a lack of efficiency in the allocation of resources

Private, Social & External Costs

• Externalities occur when there is an external impact on a third party not involved in the economic transaction between the buyer & seller
  • These impacts can be positive or negative & are often referred to as spillover effects
  • These impacts can be on the production side of the market (producer supply) or on the consumption side of the market (consumer demand)
• External costs occur when the social costs of an economic transaction are greater than the private costs
  • A private cost for the producer, consumer or government is what they actually pay to produce or consume a good/service e.g. a consumer pays $9 for a McDonald's meal
  • An external cost is the damage not factored into the market transaction e.g. the consumer throws their McDonalds packaging onto the street & the Government has to hire cleaners to collect the litter
•  The social cost includes both the private cost & the cost to society
  • It is a better reflection of the true cost of an economic transaction
  • Social cost = private cost + external cost 

Private, Social & External Benefits

• External benefits occur when the social benefits of an economic transaction are greater than the private benefits
  • A private benefit for a consumer, producer or government is what they actually gain from producing or consuming a good/service e.g. a bee farm gains the private benefit of the income from selling their honey
  • An external benefit (positive externality) is the benefit not factored in to the market transaction e.g. The bees from the bee farm pollinate the nearby apple orchards
•  The social benefit includes both the private benefit & the external benefit to society
  • It is a better reflection of the true benefit of an economic transaction
  • Social benefit = private benefit + external benefit

Causes & Consequences of Market Failure

• Market Failure occurs when free market activity results in a less than optimum allocation of resources from the point of view of society

The Causes & Consequences of Market Failure

Intervention to Address Market Failure

• Four of the most commonly used methods to address market failure in markets are indirect taxation, subsidies, maximum prices, & minimum prices
• Additional methods of intervention include regulation, nationalisation, privatisation, & State provision of public goods

Maximum Prices

• A maximum price is set by the government below the existing free market equilibrium price & sellers cannot legally sell the good/service at a higher price
• Governments will often use maximum prices in order to help consumers. Sometimes they are used for long periods of time e.g. housing rental markets. Other times they are short-term solutions to unusual price increases e.g. petrol
  

Diagram Analysis

• The initial market equilibrium is at P_eQ_e
• A maximum price is imposed at Pmax
  • The lower price reduces the incentive to supply & there is a contraction in Q_S from Q_e → Q_s
  • The lower price increases the incentive to consume & there is an extension in Q_D from Q_e → Q_d
  • This creates a condition of excess demand Q_sQ_d 

The Advantages & Disadvantages of Using Maximum Prices

Minimum Prices

• A minimum price is set by the government above the existing free market equilibrium price & sellers cannot legally sell the good/service at a lower price
• Governments will often use minimum prices in order to help producers or to decrease consumption of a demerit good e.g. alcohol
  

Diagram Analysis

• The initial market equilibrium is at P_eQ_e
• A minimum price is imposed at Pmin
• The higher price increases the incentive to supply & there is an extension in QS from Q_e → Q_s
• The higher price decreases the incentive to consume & there is a contraction in QD from Q_e → Q_d
• This creates a condition of excess supply Q_dQ_s 

The Advantages & Disadvantages of Using Minimum Prices In Product Markets

Minimum Prices in Labour Markets

• Minimum prices are also used in the labour market to protect workers from wage exploitation
  • These are called national minimum wages
•  A national minimum wage (NMW) is a legally imposed wage level that employers must pay their workers
  • It is set above the market rate
  • The minimum wage/hour varies based on age
    

Diagram Analysis

• The demand for labour (D_L) represents the demand for workers by firms
• The supply of labour (S_L) represents the supply of labour by workers
• The market equilibrium wage & quantity for truck drivers in the UK is seen at W_eQ_e
• The UK government imposes a national minimum wage (NMW) at W₁
• Incentivised by higher wages, the supply of labour increases from Q_e to Q_s
• Facing higher production costs, the demand for labour by firms decreases from Q_e to Q_d
• This means that at a wage rate of W₁ there is excess supply of labour & the potential for unemployment equal to Q_dQ_s

The Advantages & Disadvantages of a Minimum Wage In Labour Markets

Indirect Taxation

• An indirect tax is paid on the consumption of goods/services
  • It is only paid if consumers make a purchase
  • It is usually levied by the government on demerit goods to reduce the quantity demanded (QD) and/or to raise government revenue
  • Government revenue is used to fund government provision of goods/services e.g education
•  Indirect taxes are levied by the government on producers. This is why the supply curve shifts
• Producers and consumers each pay a share (incidence) of the tax
  

The impact of an indirect tax is split between the consumer (A) & the producer (B)

Diagram Analysis

• The government places a specific tax on a demerit good
  • The supply curve shifts left from S₁→S₂ by the amount of the tax
• The price the consumer pays has increased from P₁ before the tax, to P₂ after the tax
• The price the producer receives has decreased from P₁ before the tax to P₃ after the tax
• The government receives tax revenue = (P₂-P₃) x Q₂
  • The consumer incidence (share) of the tax is equal to area A: (P₂-P₁) x Q₂
  • The producer incidence (share) of the tax is equal to area B: (P₁-P₃) x Q₂
• The QD in this market has decreased from Q₁→Q₂
  • If the decrease in QD is significant enough, it may force producers to lay off some workers

The Advantages & Disadvantages Of Indirect Taxes

Producer Subsidies

• A producer subsidy is a per unit amount of money given to a firm by the government
  • To increase production
  • To increase the provision of a merit good
• The way a subsidy is shared between producers & consumers is determined by the price elasticity of demand (PED) of the product
  • Producers keep some of the subsidy & pass the rest on to the consumers in the form of lower prices
    

A diagram which demonstrates the cost of a subsidy to the government (A+B) and the share received by the consumer (A) & producer (B)

Diagram Analysis

• The original equilibrium is at P₁Q₁
• The subsidy shifts the supply curve from S → S + subsidy:
  • This increases the QD in the market from Q₁→Q₂
  • The new market equilibrium is P₂Q₂
  • This is a lower price and higher QD in the market
• Producers receive P₂ from the consumer PLUS the subsidy per unit from the government 
  • Producer revenue is therefore P₃ x Q₂
  • Producer share of the subsidy is marked B in the diagram
• The subsidy decreases the price that consumers pay from P₁ → P₂
  • Consumer share of the subsidy is marked A in the diagram
• The total cost to the government of the subsidy is (P₃ - P₂) x Q₂ represented by area A+B

The Advantages & Disadvantages Of Producer Subsidies

Other Government Policy Measures to Address Market Failure

Other Methods Used to Address Market Failure