NOTES Market Failure
Market Failure
In theory, the free market is regarded as an efficient system in the allocation of scarce resources. The market economy makes use of the price mechanism to make the above decisions to allocate resources according to the wishes or preferences of the consumers.
However, in reality, the free market does not always allocate scarce resources efficiently in a way that maximizes society's welfare. This is known as market failure. (Resources are said to be allocated efficiently if the market produces an output that is socially efficient or socially optimal)
The Private Marginal Benefit (PMB) measures the value that the consumer places on the additional unit of good purchased or bought from the market. For the rational consumer, it is equal to price (P) and is represented by the demand curve.
The Private Marginal Cost (PMC) measures the cost to producers or firms of supplying an additional unit of the good to the market. Under a perfectly competitive market, PMC is represented by the supply curve.
Social Marginal Benefit (SMB) measures the benefit to society from the consumption of an additional unit of good.
Social Marginal Cost (SMC) measures the cost incurred or borne by society from the production of an additional unit of the good.
Assuming no externalities, DD=PMB=SMB and SS=PMC=SMC. Condition for socially efficient allocation of resources is SMB=SMC.
*When SMB=SMC, this means that the additional benefit of producing/consuming one more unit of good is equal to the additional cost incurred in producing/consuming one more unit of that good. Social welfare is thus maximized.
*If SMB>SMC, society values an additional unit of Good X more than the additional cost that would be incurred in its production. There is underproduction/consumption of the good.
*If SMB<SMC, society values an additional unit of Good X less than the additional cost that will be incurred in its production. There is overproduction/consumption of the good.
The market is said to have
In theory, the free market is regarded as an efficient system in the allocation of scarce resources. The market economy makes use of the price mechanism to make the above decisions to allocate resources according to the wishes or preferences of the consumers.
However, in reality, the free market does not always allocate scarce resources efficiently in a way that maximizes society's welfare. This is known as market failure. (Resources are said to be allocated efficiently if the market produces an output that is socially efficient or socially optimal)
The Private Marginal Benefit (PMB) measures the value that the consumer places on the additional unit of good purchased or bought from the market. For the rational consumer, it is equal to price (P) and is represented by the demand curve.
The Private Marginal Cost (PMC) measures the cost to producers or firms of supplying an additional unit of the good to the market. Under a perfectly competitive market, PMC is represented by the supply curve.
Social Marginal Benefit (SMB) measures the benefit to society from the consumption of an additional unit of good.
Social Marginal Cost (SMC) measures the cost incurred or borne by society from the production of an additional unit of the good.
Assuming no externalities, DD=PMB=SMB and SS=PMC=SMC. Condition for socially efficient allocation of resources is SMB=SMC.
*When SMB=SMC, this means that the additional benefit of producing/consuming one more unit of good is equal to the additional cost incurred in producing/consuming one more unit of that good. Social welfare is thus maximized.
*If SMB>SMC, society values an additional unit of Good X more than the additional cost that would be incurred in its production. There is underproduction/consumption of the good.
*If SMB<SMC, society values an additional unit of Good X less than the additional cost that will be incurred in its production. There is overproduction/consumption of the good.
The market is said to have