1.3.

5 Market failure
1. Sources of market failure
a. Why market failure occurs

Market failure is where too much or too little of a good is being produced and/or
consumed compared with the socially optimal level of output, or when the price
mechanism leads to an inefficient allocation of resources.

b. Sources of market failure

The different types of market failure
1.Externalities,
2.Non-provision of public goods,
3.Imperfect market information,
4.Moral hazard and market bubbles.

1.Externalities,

a. The distinction between private benefits, external benefits and

social benefits
External benefits (positive externalities) exist when the social benefits
of an economic action are greater than the private benefits. MSB> MPB
For example, the education received by a child means that he or she
can get a job that pays a reasonable income (i.e. there is a private
benefit to education); however, that child’s education may also benefit
wider society if he or she becomes a doctor and is able to treat people
so that they can return to work (i.e. there is also an external benefit of
consumption).
Social benefits= private benefits+ external benefits
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(b & c) The distinction between private costs, external costs and social
costs
External costs (negative externalities) exist when the social costs of an
economic action are greater than the private costs. MSC > MPC For
example, a chemical manufacturer located on the banks of a river will
incur a number of private costs of production (for example, raw
materials, labour and running machinery) but may also impose costs on
third parties (external costs of production), such as noise from delivery
lorries, an ugly factory affecting the quality of life of local residents and
pollution in the form of chemicals being pumped into the river.
social costs = private costs + external costs
Externalities
• cost or benefit external to an exchange
• positive or negative third party effect
• spill over from production or consumption
• cost or benefits which the price mechanism fails to take into account
• difference between private costs and social costs or private benefits and social benefits

External cost

External costs/negative externalities - cost external to an exchange/negative third party

effect/spill over from production/cost which the price mechanism fails to take into
account/difference between private costs and social costs

Market failure – misallocation/inefficient allocation of resources

Explanation of how these external costs are an example of market failure e.g. over
production/net welfare loss
Examples of external costs of given commodity/service production:
Look at the wider effects linked to above e.g. health services, water companies, fishing
industries, farmers, local communities (water and visual pollution), conservation work.

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Diagram
Showing net welfare loss
Social optimum and market
equilibrium
Accurately labelled MPC and MSC

Evaluation –
• Magnitude of external costs – impact depends on the amount of externality or pollution
caused by production or consumption of the given commodity or service. if the amount is
greater it will have a greater impact on the society or environment and vice versa.
 the source might be biased, It is an estimate and may not be accurate( data may be
inaccurate so the information may be misguiding, the effect may not be as explained in
the data)

• Time period: impact of chemicals/ pesticides may be long term- problems may emerge later,
the effects of pollution on environment may be only seen in the long run.(Ozone layer
depletion, global warming, getting cancer)

 benefits like employment, income etc. export revenue, increase in standard of living.

 Measurement problem – it is difficult to measure the size of any external costs

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 External benefits-(education)

Where third parties are positively affected by a transaction/ where social benefits exceed
private benefits

• External benefits: Firms benefit from a more productive workforce/

the voluntary sector can support more people/

health services are put under less pressure/

increased tax revenue for governments/

less is spent on income support programmes.

• private benefits g.

higher earnings over working life,

receive health insurance and pension benefits,

report higher levels of job satisfaction.

less likely to smoke or be obese.

• Diagrammatic analysis

o Market equilibrium (QE, PE) and Social Optimum (Q1, P1) – can also be written

o Identifying welfare loss/welfare gain / identifying external benefits on diagram

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Evaluation – Indicative content

• Magnitude: depends on what they do- medicine degree save many lives

• SR/LR: it will take time before external benefits are achieved- may take time to accumulate

• Student debt/ unemployment- not achieve private or external benefits

• Workers may work abroad and not benefit domestic firms(brain drain)

Opportunity cost, If government is providing or funding for health or education then less fund
available for other sectors…

Public goods(roads)
Public goods- a good which is non-excludable and non-rival/ good that experiences the free
rider problem.
Non-rival means that the consumption of a product by one person does not prevent another
person from also consuming that product.
Non-excludable means that once a good is provided it is impossible to stop people from using
it.
Free riders- people will consume goods without contributing.
Private firms do not find it profitable to provide due to free riders
• Leads to under-provision of public goods
• Market failure- as resources are allocated inefficiently
Private goods- a good that is both excludable and rival
• Roads- non excludable- it is difficult to prevent others from using the roads
• Roads non-rival- one person’s use does not diminish the consumption of another
Evaluation – Indicative content
• Congestion- with a lot of cars on the road and traffic this means that there is rivalry between
drivers
• One consumers use of the road may affect the utility derived for another driver
• Non excludability- difficult to exclude drivers
• Tolling/ charges could help exclude
• Different times of the day- e.g. rush hour- more private good/ quieter times more public good
 Measurement problem – what quantity of public goods is needed
 Information gap- government may not know how much to provide

b. Why public goods may not be provided by the private sector

Public goods have to be provided by governments, because people cannot be prevented from
using them and firms have no incentive to provide them as they cannot make a profit. The

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problem the private sector faces is the free rider problem, where consumers will benefit from
the product without paying for it.

4. Imperfect market information

Symmetric information held by buyers and sellers means that consumers and producers have
the same level of knowledge about the products and they know everything there is to know
about them.
Asymmetric information means producers know more than consumers or the consumers know
more than the producers or information is incomplete or imperfect.
The significance of information gaps
For markets to work, there needs to be perfect and symmetric information, i.e. consumers and
producers have the same level of knowledge about the products, and they know everything
there is to know about them. In many cases, however information may be asymmetric
(producers know more than consumers) or incomplete/imperfect. In these situations, there is
market failure and resources may not be allocated efficiently.

How imperfect information may lead to a misallocation of resources in various contexts

including healthcare, education, pensions and insurance. For example, in the private healthcare
market, doctors know more than patients about healthcare and treatments (asymmetric
information). There is an incentive, therefore, for doctors to prescribe more expensive
treatment than is necessary in order to increase their profits.

Asymmetric information(education)
- where one group has superior information to other groups.
Asymmetric information does exist
• people may not know- how set fees, course to offer/ how delivered
• people may need more information on teaching arrangements, costs, complaints etc.
• Likely benefits over lifetime uncertain
• Hard to assess external benefits
• application from data

Asymmetric information does not exist

 Asymmetric information seems unlikely due to extensive advertising and public
awareness campaigns in developed economies
• Access to more information due to internet etc may reduce asymmetric information
• Different levels of asymmetric information may exist, e.g. young / more educated likely to
have more environmental knowledge than old / less educated
• Many governments have put measures in place to correct imperfect information
• Level of asymmetric information likely to be reducing over time as we become more
environmentally aware
• Imperfect information caused by chemical company funded research

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5. Moral hazard
Moral hazard is where individuals have incentives to alter their behavior OR make poor
decisions OR bad decisions as the risks are borne by others
• Where a person makes decisions about how much risk to take knowing that someone else
bears the costs if something goes wrong.
a. How moral hazard can occur
Moral hazard can occur when one party takes a risk knowing that another party will bear the
cost of the risk. Therefore, it arises when both parties have incomplete information about each
other.
b. The impact of moral hazard on consumers, producers, workers and governments in
insurance and banking
If people have comprehensive private health insurance then they would be more likely to visit
the doctor. They may also engage in more risk taking activities because they are not responsible
for paying the medical costs if they have an accident.
In the case of banking, prior to the 2008 Financial Crisis, some banks lent money to people to
buy houses even though they had little prospect of repaying those mortgages. The bank
employees may have had financial incentives to arrange as many mortgages as possible.
Therefore, moral hazard arises because the bank does not take the full consequences and
responsibilities of its actions and, therefore, has a tendency to act less carefully than it would
otherwise. This would leave another party e.g. the bank’s shareholders, the bank depositors or
taxpayers to hold responsibility for the consequences of those actions.

Moral hazard

Moral hazard occurs when insured consumers are likely to take greater risks, knowing that a
claim will be paid for by their cover

The consumer knows more about his/her intended actions than the producer (insurer)

If more people have access to health insurance for example, behavioural changes arising from
moral hazard might lead to a substantial rise in health insurance payouts.

Moral hazard has also been applied to the controversial issue of bank bailouts for if a bank
knows that there is a good chance it will get emergency financial support when it encounters
problems, employees of the bank might be tempted to take increased risks.
Adverse selection occurs whenever asymmetrical information — information known to one
party but not the other — makes it difficult for potential trading partners to distinguish
between high-risk and low-risk transactions. This problem is particularly endemic to insurance
markets

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Adverse selection

A good example of adverse selection is in the health insurance insurance market. People most
likely to purchase health insurance are those who are most likely to use it, i.e.
smokers/drinkers/those with underlying health issues

The insurance company knows this and so raises the average price of insurance cover

This risks pricing healthy consumers out of the market, meaning that only high risk individuals
gain insurance – this is clearly a market failure

One interpretation of adverse selection is that "we tend to trust the people we shouldn't!"

6. Speculation and market bubbles

a. How market bubbles may arise

Poor lending decisions by bankers, quantitative easing and speculation can lead to market
bubbles. For example, excessive lending to home buyers who have no deposit and/or poor
credit records might result in a housing bubble in the housing market.

b. The impact of market bubbles

The effects of market bubbles on consumers, producers, workers and governments. For
example, a housing bubble would benefit home owners but would make it more difficult for
prospective first-time buyers to afford a house. Construction companies might benefit from
higher revenues and profits. However, workers might find it more difficult to move from one
area to another if the increase in house prices is not uniform across the country. A government
could benefit from higher tax revenue if there are taxes on the value of a house when
transferred from one person to another.

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