Basics of Market Failure
Unit 2 Markets – Why they fail Steve Margetts
Page 1
CONTENTS
An Introduction To Market Failure 2
Defining Externalities 2
Correcting For Externalities - Government Policies 7
Merit Goods 14
De-Merit Goods 16
Public Goods - Provided By The State 17
Indirect Taxes – Reducing Negative Externalities 18
Subsidies 21
Cost Benefit Analysis (CBA) 22
Barriers to Entry 24
Monopoly 25
Index 28
Unit 2 Markets – Why they fail Steve Margetts
Page 2
AN INTRODUCTION TO MARKET FAILURE
Market failure has become an increasingly important topic at A level. Market failure occurs when resources are inefficiently allocated due to imperfections in the market mechanism. There is a clear economic case for government intervention in markets where some form of market failure is taking place. Government can justify this by saying that intervention is in the public interest.
There are two types of efficiency that we will briefly look at:
• Allocative efficiency – occurs when resources are distributed in such a way that no consumers could be made better off without other consumers becoming worse off.
• Productive efficiency – is achieved when production is carried out at its lowest cost. DEFINING EXTERNALITIES
Externalities are common in virtually every area of economic activity. They are defined as third party (or spill-over) effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid.
Externalities can cause market failure if the price mechanism does not take into account the full social costs and social benefits of production and consumption. The study of externalities by economists has become extensive in recent years - not least because of concerns about the link between the economy and the environment.
PRIVATE AND SOCIAL COSTS
Externalities create a divergence between the private and social costs of production.
Social cost includes all the costs of production of the output of a particular
Page 1
CONTENTS
An Introduction To Market Failure 2
Defining Externalities 2
Correcting For Externalities - Government Policies 7
Merit Goods 14
De-Merit Goods 16
Public Goods - Provided By The State 17
Indirect Taxes – Reducing Negative Externalities 18
Subsidies 21
Cost Benefit Analysis (CBA) 22
Barriers to Entry 24
Monopoly 25
Index 28
Unit 2 Markets – Why they fail Steve Margetts
Page 2
AN INTRODUCTION TO MARKET FAILURE
Market failure has become an increasingly important topic at A level. Market failure occurs when resources are inefficiently allocated due to imperfections in the market mechanism. There is a clear economic case for government intervention in markets where some form of market failure is taking place. Government can justify this by saying that intervention is in the public interest.
There are two types of efficiency that we will briefly look at:
• Allocative efficiency – occurs when resources are distributed in such a way that no consumers could be made better off without other consumers becoming worse off.
• Productive efficiency – is achieved when production is carried out at its lowest cost. DEFINING EXTERNALITIES
Externalities are common in virtually every area of economic activity. They are defined as third party (or spill-over) effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid.
Externalities can cause market failure if the price mechanism does not take into account the full social costs and social benefits of production and consumption. The study of externalities by economists has become extensive in recent years - not least because of concerns about the link between the economy and the environment.
PRIVATE AND SOCIAL COSTS
Externalities create a divergence between the private and social costs of production.
Social cost includes all the costs of production of the output of a particular