AAR406

Economics & Architecture

Market Failures
 Lecture Outcome

At the end of this lecture students should be able

to:
⦿Understand the definition and concept of market
failures
⦿Name some examples of market failures and ways
to correct market failures
Market Failures
Definition:
⦿ Where the market mechanism fails
to allocate resources efficiently:
› Social Efficiency
› Allocative Efficiency
› Technical Efficiency
› Productive Efficiency
Market Failures
⦿ Social Efficiency = where external costs and benefits
are accounted for
⦿ Allocative Efficiency = where society produces goods
and services at minimum cost that are wanted by
consumers
⦿ Technical Efficiency = production of goods and
services using the minimum amount of resources
⦿ Productive Efficiency = production of goods and
services at lowest factor cost
Market Failures
⦿ Market Failure occurs
where:
› Knowledge is not perfect -
ignorance
› Goods are differentiated
› Market power
› Provisions of public goods
› Existence of external costs
and benefits
› Inequality exists
Market Failures
⦿ Imperfect Knowledge:
› Consumers do not have adequate
technical knowledge
› Advertising can mislead or
mis-inform
› Producers unaware of all
opportunities
› Producers cannot accurately measure
productivity
› Decisions often based on past
experience rather than future
knowledge Example of misleading
advertisement
Market Failures
⦿ Goods/Services are differentiated
› Branding
› Designer labels - they cost three times as much but
are they three times the quality?
› Technology – lack of understanding of the impact
› Labelling and product information

Which one is the ‘quality’ item and why?

Market Failures
⦿ Market Power:
› Existence of monopolies and
oligopolies
› Collusion
› Price fixing
› Abnormal profits
› Rigging of markets
› Barriers to entry
Market Failures
⦿ Public Goods
› Markets would not provide such
goods and services at all!
› Non-excludability – Person paying
for the benefit cannot prevent A non-excludable good
anyone else from also benefiting -
the ‘free rider’ problem
› Non-rivalry – Large external
benefits relative to cost – socially
desirable but not profitable to
supply!

Would you pay for this?

Market Failures
⦿ External Costs and Benefits
› External or social costs
The cost of an economic
decision to a third party

› External benefits
The benefits to a third party as a
result of a decision by another
party
Market Failures
External Costs
› Decision makers do not
take into account the cost
imposed on society and
others as a result of their
decision
› e.g. pollution, traffic
congestion, environmental
degradation, depletion of the
ozone layer, misuse of alcohol,
tobacco, anti-social behaviour,
drug abuse, poor housing
Market Failures
MSC = MPC + External Cost
Price
MPC

$12

Value of the negative

Social Cost
$7 externality (Welfare Loss)

$5
Socially efficient output is where
MSC = MSB

MS Quantity Bought
B & Sold
80 100
MSB : Marginal Social Benefit (Demand)
MPC : Marginal Private Cost (Supply)
MSC : Marginal Social Cost
Market Failures
External benefits
› by products of production and
decision making that raise the
welfare of a third party
› e.g. education and training, public
transport, health education and
preventative medicine, refuse
collection, investment in housing
maintenance, law and order
 Market Failures
Price

MSC

$10 Value of the positive

externality (Welfare Loss)
Social Benefits
$6.50
Socially efficient output is where
$5 MSC = MSB

MS
B

MP Quantity
B Bought & Sold
100 140
MSB : Marginal Social Benefit (Demand)
MPB : Marginal Public Benefit (Supply)
MSC : Marginal Social Cost
Market Failures
⦿ Inequality:
› Poverty – absolute and
relative
› Distribution of income
› Wealth distribution
› Discrimination
› Housing
 Measures to Correct Market Failures
Government intervention is usually to correct
market failure. The steps that can be taken by a
government are:
⦿Direct provision (public services/utilities)
⦿Taxation (pollution taxes, monopoly taxes, etc.)
⦿Subsidies (utilities, healthcare, education, etc.)
⦿Regulation (i.e.: display price, etc.)
⦿Prohibition
⦿Positive discrimination
⦿Redistribution of income (i.e.: DEB)