Market Failure Terminology

Market Failure Defined

• In a free market, the price mechanism decides how scarce resources, such as land, labor, capital, and enterprise, are efficiently allocated to fulfill the various wants and needs within the marketplace.
• Free markets often operate effectively.
• However, there are instances of suboptimal resource allocation, known as Market Failure:
  • Over-provision of harmful goods/services (demerit goods), leading to excessive allocation of resources (e.g., cigarettes).
  • Under-provision of beneficial goods/services (public goods & merit goods), resulting in insufficient allocation of resources (e.g., schools).
  • Market-driven inequality, where the rich become wealthier while the poor lag behind.
  • Environmental damage during production or consumption of goods/services.
• In each of these scenarios, society experiences inefficiency in resource allocation.

Private, Social & External Costs

• Externalities arise when there is an impact on a third party not directly involved in a transaction between a buyer and a seller. These impacts, known as externalities, can be either beneficial or detrimental and are commonly referred to as spillover effects.
• These effects can manifest on both the production side (related to producer supply) and the consumption side (linked to consumer demand) of the market.
• Private costs represent what a producer, consumer, or government pays to produce or consume a good or service. For instance, if a consumer pays $9 for a McDonald's meal, that is a private cost.
• External costs, on the other hand, are the unaccounted-for damages in a market transaction. For example, if a consumer discards their McDonald's packaging on the street, leading the government to hire cleaners to collect the litter, this cost is an external one.
• Social cost encompasses both the private cost and the cost to society as a whole. It provides a more accurate reflection of the actual cost of an economic transaction, as it considers both the direct and indirect costs involved.
• Mathematically, the social cost is calculated as the sum of the private cost and the external cost: Social cost = private cost + external cost

Private, Social & External Benefits

• External benefits arise when the overall benefits of an economic activity surpass the benefits perceived by individuals directly involved.
• Private benefits represent the gains realized by a consumer, producer, or government from producing or consuming a good or service. For instance, a bee farm benefits privately from the revenue generated by selling honey.
• External benefit, also known as a positive externality, denotes a benefit that is not considered in the market exchange. For example, bees from a bee farm pollinating nearby apple orchards is an external benefit.
• The overall social benefit encompasses both the benefit to individuals directly involved (private benefit) and the benefit extended to society as a whole (external benefit).
  • A better reflection of the true benefit of an economic transaction
  • This concept can be represented by the equation: Social benefit = Private benefit + External benefit