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Group 5

Market Failure: A market failure exists whenever the free

market equilibrium quantity of output is greater or less than the
socially optimal level of output. The free market will produce
either too much of a good or too little.
Market Failure will exist if these four mechanisms fail.

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
Technical Efficiency = production of goods and
services using the minimum amount of resources
Productive Efficiency = production of goods and
services at lowest factor cost

There are six (6) main types of market failures:
Missing Markets
Asymmetric Knowledge
Lack of Competition in Market
Factor Immobility
Labour Market Failure

Merit Goods
Education nurseries, schools,
colleges, universities could
all be provided by the
market but would everyone
be able to afford them?
Schools: Would you pay if the
Government did not provide them?
Public Goods
Markets would not provide such
goods and services at all!
Person paying for the benefit
cannot prevent anyone else from
also benefiting - the free rider
Large external benefits relative to
cost socially desirable but not
profitable to supply!

A non-excludable good?
Would you pay for this?
De-Merit Goods
Goods which society over-produces
Goods and services provided by the market which are
not in our best interests!
Tobacco and alcohol

Sometimes people have different levels of information about a
You can never be sure about another persons motives and it is
expensive to monitor behavior
Moral hazard - an insured party may take more risks, or less
risk avoidance behavior than is optimal
This simple means

one side of the market knows
more than the other


The market for used cars : Sellers know quality of the cars, but
buyers might not.
Labour market: Workers know their ability or reliability, but
firms might not.
Insurance markets: Drivers may know more about their driving
habits than the insurance companies do.
There is now a Monopoly suffocating in the market.
There is only one seller
Seller restricts production and charges a higher price
This is done in an effort to convert consumer surplus to
monopoly profits
Natural and un-natural monopoly

Factor immobility occurs when it is difficult for factors of
production (e.g. labour and capital) to move between different
areas of the economy. Factor immobility could involve:
Geographical immobility difficult to move from one
geographical area to another.

Occupational immobility difficult to move from one type of
work to another.

Reasons for Geographical Immobility

Cost of moving / difficulty in finding accommodation. House prices
are much higher in London, therefore the cost of buying or even
renting may prohibit a worker moving

Lack of Information. It may be difficult for the unemployment to know
about available jobs and available accommodation

Personal ties. An unemployed worker may have family and social ties
in his place of birth. He may have children in school or partner in
employment. All this makes it difficult to move.

Reasons for Occupational immobility

If coal mines or steel factories closed down in South Wales, it may
be very difficult for the unemployed coal miners to find work in
new industries in the service sector.
They may lack relevant skills / confidence or motivation to work
in completely new industries.

Policies to Overcome Factor Immobility

Improve provision of information
Improve quality and quantity of rented accommodation in
employment hotspots.
Subsidise firms to move to depressed areas.
Education and retraining for workers who dont have relevant skills.

Poverty absolute and relative
Distribution of factor ownership
Distribution of income
Wealth distribution

Externalities are the effect of a decision on a third party that is not
taken into account by the decision-maker. It is divided into 2 sub
categories; Negative and Positive Externalities.
Negative externalities (e.g. the effects of environmental
pollution) causing the social cost of production to exceed the
private cost.
Positive externalities (e.g. the provision of education and health
care) causing the social benefit of consumption to exceed the
private benefit

Negative externalities occur when the effects of a decision not
taken into account by the decision-maker are detrimental to

When there is a negative externality, marginal social cost is
greater than marginal private cost.
A steel plant benefits the owner of the plant and the buyers of steel.
The plants neighbors are made worse off by the pollution caused by the

Marginal social cost includes all the marginal costs borne by
It is the marginal private costs of production plus the cost of the negative
externalities associated with that production.

When there are negative externalities, the competitive price is
too low and equilibrium quantity too high to maximize social
D = Marginal social
S = Marginal private cost
= Marginal social cost
Quantity 0 Q

Marginal cost from
Positive externalities occur when the effects of a decision not
taken into account by the decision-maker is beneficial to others.
Private trades can benefit third parties not involved in the
A person who is working and taking night classes benefits himself directly,
and his co-workers indirectly.

Marginal social benefit equals the marginal private benefit of
consuming a good plus the positive externalities resulting from
consuming that good.
Quantity 0
Marginal benefit of an externality
= Marginal private benefit
= Marginal social benefit

S = Marginal private and social cost
With a positive externality,
the demand curve does not
reflect all the benefits of
the good. As a result, the
demand that is given in D

is less than it would be if
demanders received all the
benefits (including the
external one). D
is the
demand as it would be if
the demanders received
the external benefit.
Pollution Tax
One class of solutions to the externality problems involve
internalizing the costs and benefits, so that the market can
work better.

Pollution Tax: if a firm is creating a negative externality in
the form of pollution, create a tax on the polluting firm
equal to the cost of cleaning up the pollution.
Marketable Pollution Permits
Another approach to pollution is the introduction of
marketable pollution permits.
The government sells the permits, which in total allow the
amount of pollution that the government believes to be
Demanders, typically firms, purchase the permits, allowing
them to pollute up to the amount specified by the permits
they own.
If a firm is able to employ a cleaner technology, then it can
enjoy additional revenues by selling its pollution rights to
someone else.

Another approach is commandrather than imposing a tax or
offering a subsidy, the government simply requires or commands
the activity.
For a negative externality like pollution, the government simply requires
the company to stop polluting.
For a positive externality, like inoculation, the government requires
certain classes of citizens to be inoculated.
Quantity Bought and Sold
S + Subsidy
Amount of subsidy per unit (4)
cost of the subsidy
First we look at the market
before the subsidy
The subsidy will encourage
suppliers to offer more for sale
at every price
The amount of the subsidy is
the vertical distance between
the two supply curves
The effect of the subsidy is to
reduce prices and increase the
amount available but at what
Measures to correct market failure
State provision
Extension of property rights
Positive discrimination
Redistribution of income