Chapter 11.

Market failure - externalities and common pool resources

MB and MC:
The demand curve is based on:
- Marginal utility and marginal benefit
- Because we are talking about a whole community we also refer the D curve as Marginal
Social Benefit (MSB)

The supply curve is based on:

- Marginal cost of production
- Because we are talking about a whole community, we also refer the S curve as Marginal
Social Cost (MSC)

Marginal Private Benefit (MPB) is the MB to the consumers will be

- Additional value enjoyed by households and firms from consumption or producer (output) of
an extra unit of a particular good

Marginal Private Cost (MPC) is the MC to the producer

- Additional value

Marginal = Extra per unit

 Allocative Efficiency/Socially Efficiency/Pareto Optimality
- An equilibrium is allocative efficient
- Market is assumed: products are homogeneous, competitive market, perfect
information
- When it is impossible to make someone better off, without making someone else
worse off
- A state of equilibrium with no external influences or effects
- An optimal allocation of resources

Free market (using price mechanism or market force) lead to optimum allocation of
resources and maximises community surplus
- What makes a free market work?
- Forces of supply and demand are needed!!!
- How do we know if the forces are working? —— Change in price
- External force changes the equilibrium price
- Know if the force is working by observing if there is change in the equilibrium price
- Is there anything that might interfere with these forces?
- Is it possible to have a perfect market ?

Market failure
- Arises when the free market forces, using price mechanism, fail to allocate scarce resources
- Meaning either too much or not enough of a good/service is produced/consumed
- There is suboptimal resource allocation, thus it means non-Pareto outcome
(allocative inefficiency)

What could cause market failure

- Existence of external costs & benefits
- Market power
- Goods are differentiated
- Knowledge is not perfect
- Resources immobility
- goods/services would not or could not be provided with sufficient amount

Imperfect information (HL topic)

- Consumers do not have adequate technical knowledge
- Advertising can mislead or misinform
- Producers unaware of all opportunities
- How does this affect your decision making as a consumer/ producer

Market power (HL topic)

- Existence of monopolies 垄断 and oligopolies寡头垄断
- Collusion 共谋
- An informal action when companies together to get what they
want illegal but hard to prove
- Price fixing 共谋定价
- An agreement on price illegal
 - Abnormal profits
- Barriers to entry

Profit maximisation:
Marginal revenue = marginal cost

Goods/Services are differentiated

- Branding
- Designer labels - they cost three times as much but are they three times the quality?
- Labelling and product information

Resource Immobility
In a perfect market resources can be moved easily, however, how true is this in the real world?
- Factors are not fully mobile
- Labour immobility - geographical and occupational
- Capital immobility - can we move Aberdeen Tunnel to another place?
- Land - can we move the natural resources to another place?

Inadequate provision of Merit goods and Public goods

Merit goods: (definition for paper 2: Merit goods are goods that are, from the angle of the
government, is beneficial to society. [then start listing characteristics below])
- Are products that create positive externalities when they are produced and consumed
- Consumption of this good is very beneficial to society
- And is underconsumed/underproduced
- Could be provided by the market but consumers may NOT:
- Be able to afford or
- Feel the need to buy
- Consumption → positive externalities (the consumption of merit goods lead to
positive externalities)
- Examples:
- Sports facilities?
- Public swimming pools, sports ground
- Schools?
- Education (school, nurseries, universities)
- Could all be provided by the market, but would everyone be able to
afford them?
- Health insurance?
- Flu vaccination

Merit goods - summary

- Provided by both the public and private sectors
- Positive marginal cost to supply to extra users
- Limited in supply - may be a high opportunity cost
- They are underconsumed (still not enough)
- Rival in use - consumption reduces availability for others (when you are using it, you are
reducing the amount available)
- Need to compete
 - Excludable
- Limited on it to those are consuming

Why does the government provide merit goods and services?

1. To encourage consumption so that positive externalities of merit goods can be achieved
2. To overcome the information failures linked to merit goods
3. On grounds of equity →
- Government believes that consumption should NOT be based solely on the grounds
of ability to pay for a good or service

Public Goods
- Markets would not provide such goods and services at all!
- Why?
- Non-excludable goods

Public utilities ≠ Public goods

1. Non-excludability:
- Person paying for the benefit cannot prevent others to benefit at the same time → the
‘FREE RIDER’ problem
- Individuals will hide their ‘true preference’ and take advantage of the
situation
2. Non- rivalry:
- One person’s use does not diminish the use by others → NO NEED to compete
- Implies MC of an extra user = ZERO!

Public goods - summary

- Non-rival: individual need not compete
- Will not diminish the amount available
- Non-excludable: cannot prevent others from using it when consumed
- Giving rise to the free rider problem
- Marginal cost of supply close to zero → if provided to one, it is provided to all
- Normally funded & provided by the government (why?)
- Public goods can be produced by private producer
- But most won’t choose to because
- Free-rider problems and low profit from it

Marginal cost for providing and consuming is zero

What about if some goods are

- Non-rival but excludable?
- Rival but non-excludable

Comparison between public and private goods

Public goods Private goods

Can be concurrently consumed Cannot be concurrently consumed

Not rival in use Rival in use

 Eg. National defence Eg. clothes, bread, cell phones, etc

Good Classified According to Rivalry and Excludability

Rivalrous: consumption by one party reduces utility / ability to use to

another

Yes No

Excludable: it is Private goods (eg. food, clothing, Club goods (eg. cinemas, private
possible to prevent Yes
car, parking spaces) parks, cable TV)
other consumers
who have not paid
for it from having Common access resources (fish in Public goods (eg. lighthouse,
No
access to it open waters, timer, coal, gold) street light, national defence)

Market for public goods

Because public goods, once produced, are available to all in identical

amounts, the demand for a public good is the vertical sum of each
individual’s demand

The market demand for mosquito spraying (D) is the vertical sum of
Maria’s demand, Dm and Alan’s demand, Da

The efficient level: MC of mosquito spraying equals its marginal benefit;

at point e, where the marginal cost curve intersects the market demand
curve

Is privatisation of public goods ever possible?

- Can be produced by private firms
- Not necessarily by the government
- Not really an example of market failure if:
- Firms can find some price arrangements to reduce pricing costs
- Efficiency can still be attained!
- Forcing the consumers to pay for the services of the public good! Such as……
- First degree price discrimination
- Lump sum fee payments (a single payment of money, as opposed to a series of
payments made over time)

Price discrimination: Charge different people differently with the same marginal cost
 Demerit Goods
- Goods which society considers harmful/undesirable and over consumed/over produced
- Consumption → negative externalities
- Examples:
- Tobacco
- Alcohol
- Drugs
- Gambling

Recall some terms discussed

- Private costs (or internal costs) are costs incurred by those who consume or produce
goods.
- The Consumer spent $30 on gas for their car, the Producer spent on getting the gas to
the market.
- Private benefits (or internal benefits) are benefits by those who consume or produce
goods.
- The consumer uses the gas to drive somewhere, the producer gets revenue.
 Chapter 14. Market failure – Market power (HL only)

Market power
The ability of a firm to manipulate the market price of a good or service; the firm can affect the
market outcomes by restricting output to raise price above the marginal cost

Market structure
It is the categorising of firms in a particular industry based on their market power

What is a market?
- Where potential buyers meet potential sellers - no need to be a physical location
- Need and wants of both parties are met
- Price is established
- Exchanges made (goods/services/money)

Different types of market structures:

- Perfect competition
- Imperfect competition
- Monopoly
- Oligopoly
- Monopolistic competition

How do we tell one market structure from another?

Criteria must understand to answer the question
1. No. and size of firms
a. One or numerous? Big or small?
2. Nature of products
a. Homogeneous or heterogeneous?
3. Freedom of entry and exit market (Barriers to Entry)
a. Easy or difficult?
4. Availability of market information
a. Perfect or imperfect?
5. Price takers or price setters?
a. Do they have the power to choose prices different from other seller

1. No. and size of firms

- A large effect on price and competition
- The more firms the greater the competition
- We assume the market is perfectly competitive

2. Nature of products
- Homogeneous - “same” or “identical”
- Heterogeneous - “different”

3. Freedom of entry and exit market (Barriers to entry)

- How costly or difficult it is enter an industry (measured by high/low cost)
- Think about legality (issues with the law)
 - Think about financial (money) issues
- Think about economic issues

4. Availability of market information

- Is market information fully available for both sellers and buyers
- What, how, where, for whom
- How would you say for a market like the supermarket?
- Imperfect information
- Asymmetric information

5. Price takers or price setters?

Price takers Price setters / searchers

Accept whatever the price determined in the Some power to set their prices
market - Because selling differentiated products
- No market power to set a different price
- Their free-entry competitors are selling
identical products

Market Types
http://www.msfairbairn.weebly.com/uploads/1/3/3/5/13353819/different_market_types_in_hong_kong.pdf
Size & No. of Nature of the Availability of Price taker or Examples of
Barrier of Entry
Firms product information Price setter industries in HK

Perfect
Small & large Low Homogenous Perfect Taker Stock market
competition

Monopolistic Relatively many Heterogeneous

Relatively low Imperfect Setter Taxi
competition & small but similar

Oligopoly Dominated by a Both

few and large firms High Imperfect Setter HSBC
寡头垄断 homo & hetro

Very high or Unique with no

Monopoly Single & large Imperfect Setter MTR
even restricted close substitutes

Market failure
When we examine a market, we have to consider if the price mechanism includes all benefits and
costs involved in the consumption / production of that good?

Social Efficiency occurs when:

Marginal Social Benefit (MSB) in the consumption of goods = Marginal Social Cost (MSC) in the
production of goods
MSB = MSC
(the GOLDEN RULE for Social Efficiency)
Thinking Tine! (Raimen)
Market size: No. of firms are high, size of firms are small
Barrier of Entry: Relatively low
 - No need for huge capital requirement
Nature of Product: Heterogeneous but similar
- All sell ramen but different tastes
Availability of information: Imperfect
- Don’t know the taste, how its cook, the % of ingredient use
Price taker or setter: Price setter
- Different price in different shops, even in the same brand

Thinking Tine! (allocative efficiency)

What type of market would create allocative efficiency?
- Explain what is allocative efficiency first → in test
Perfect competition:
- Price mechanism works
- Price decided by demand and supply
- Price is always at equilibrium - community surplus maximised

Is perfect competition realistic? No! But why? Some firms will try…
To gain EOS, larger firms will enjoy lower average cost → incentive to grow in size

To gain monopoly power → incentive to differentiate products → 开源

To maintain abnormal profit → to create entry barriers

Abnormal profit will attracts more producers enter → more competition
→ profit decrease, firms leave → profit earned in this market will only reach a level that can cover
the cost
Normal profit = profit that can cover the total cost

Information is not perfect in real world → uncertainty and risk increase → cost to research

Factors of production not perfectly mobiles

geographically & occupationally

开源节流:
- 开源：open the market
- 节流：reduce cost
- Not making the market large

Why study perfect competition? It is a model which is…

Useful to predict changes
- Most importantly, its efficiency properties are considered desirable

Real world markets can be compared or “corrected”

Factors of production → Capital, Entrepreneur, Labor, Land

If profit can only cover the cost - normal profit (total revenue = total cost)

Externalities (Spillover Effects)

In addition we have:
 - Negative externalities or external cost
- The cost imposed on a third party or communist by the economic activity at hand
- Economic activity: production or consumption
- Positive externalities or external benefits
- Benefits which third parties gain from the consumption or production decisions
of others
- E.g. the use of public transportation → less traffic, accidents and less pollution

Summary
Marginal Social Costs (MSC)
- The total costs to society from an economic activity
- MSC = MPC + externalities
- If cost ⇒ production side

Marginal Social Benefits (MSB)

- The total benefits to society from an economic activity
- MSB = MPB + externalities
- If benefit ⇒ consumption side

Negative Externality of Production: production of chemical products

We assume there is no externalities on the consumption sides

D = MSB = MPB+0 externalities
Production factors need to consider:
- Capital - interest
- Entrepreneur skills - profit
- Labour - wages
- Land - rent
The factory only considers the cost of these factors above.

MSC = MPC + External Cost

The third party bears the external cost.

Optimal - 最优
The current Q1 is suboptimal output
How to find the optimal output? - Use golden rule - Qopt(intersection of MSC and D)
Distance between Q1 and Qopt indicates that there is an overproduction - over allocations of
resources
Q1: People only consider MPC=MPB

Why is the red triangle part deadweight loss?

Because resources are wasted (e.g. Spending on healthcare since people are sick)

Compare MSB and MSC

At Q1, MSC is bigger, spendings for MSC are higher

Explain, with the use of a diagram, why Product X is an example of market failure.
Explain why negative externalities are an example of market failure.
Using an appropriate diagram, explain how negative externalities are a type of market failure.
Using a diagram, explain why demerit goods are considered to be an example of market failure.

Key terms:
- Market failure
- Negative externalities (also remember to state the externalities on which side you’re talking)
- Allocative efficiency
- MSB/MSC

DWL = difference between MSB and MSC

- Write the assumption first (e.g. assume there is no externalities on the demand side)
- Explain what is in the diagram first
- Why the msc is below the mpc/why the mpc is below the msc
- What are the external costs
- DWL, potential gain
- Outside the diagram, Q1 determined by msb=msc is the suboptimal output

The consumption of this demerit good will result in negative externalities on the demand
side

Externalities to explain decision making (individual behaviours)

- Assume the cost is constant in order to interpret easier
 - Indirect tax occurs in market, not individual behaviour

Negative externalities- air pollution,accidents

MPC - fuels, parking

To discourage driving (from Q1 to Qopt)

- Increase parking fees (increase MPC)
- Road tolls

Other examples:
- Food
- Drink
- Litter
- Spit
- rubbish

The Theory of the Firm/Market power

Four things to consider
- Revenue
- Cost
- Profit
- Production function

Production in the Short Run and Long Run

Productive resources = factors of production = inputs

According to their nature:

Factors of production
- Capital
- Land
- Labour
- Entrepreneur skills

According to their flexibility (of quantity):

Factors of production:
- Fixed factors
- Variable factors
Whether the input will change when the output changes.

Fixed Factors and Variable Factors

Fixed factors: inputs that do not vary in quantity as output changes

- Output increases - fixed factors remain unchanged
- However, fixed factors are not fixed forever
- When the business expands (fixed become variable)
- Open more branches & factories
 - Buy more plants, machinery and equipment

Variable factors: inputs that vary in quantity as output changes

- Output increases - employs more variable factors

Any factor of production can be a fixed factor.

Long Run vs Short Run

What is Short Run?

- Short run is the production period when at least one of the factors is a fixed factor.

What is Long Run?

- Long run is the production period when ALL factors are variable.

3 things about SR & LR

1. Technology is assumed to be constant in both SR and LR
2. Variable factors are assumed homogeneous
3. Short Run ≠ Short Period
Long Run ≠ Long Period
Depends on the presence of fixed factors of production

Long Run:
- The film is able to increase its total capacity - not just short term capacity
- Associated with a change in the scale of production
- The period of time varies according to the film and the industry, so long run ≠ long time
In the long run, the firm can change ALL its factors of production thus increasing its total capacity.

Production Function
- Mathematical representation of the relationship
- Q = f (K,L,La)
- Output (Q) is dependent upon the amount of Capital (K), Labour (L) and Land (La) used

Why is the SR and LR Production period carefully expressed in the assumptions?

Different span and different aims

The input-output relationship

- In the short run - diminishing average/marginal returns results from adding successive
quantities of variable factors to a fixed factor
- In the long run - increase in capacity can lead to increasing, decreasing or constant returns to
scale

The input-output relationship in the SR

A. Three different concepts of output
1. Total Product (TP)
The total output produced by a firm
2. Average product (AP)
 The output produced per unit of variable factor.
AP = TP / Quantity of variable factor

How are TP and Ap related?

Assume that there are only 2 factors:
- Capital (K) - fixed factor
- Labour (L) - variable factor
In the SR, we also assume technology fixed and variable factor homogeneous

Marginal Product
Fixed Factor Variable Factor Total Product Average Product
MP
K L TP AP
(MP = ΔTP / ΔL)

1 1 10 10 10

1 2 22 11 12

1 3 36 12 14

1 4 50 12.5 14

1 5 60 12 10

1 6 66 11 6

3. Marginal Product (MP)

The change in total product resulting from employing one extra unit of variable factor
MP of the nth unit of variable factor = TP of n units of variable factor - TP of (n-1)
units of variable factor
MPn = TPn - TPn-1

When drawing the MP, AP diagram. MP must cut AP at its maximum point.
AP is the slope of line drawn from the origin to the TP curve
MP is the slope of TP as well.

IA
Find a news article about market failure in a country

Common Access resources

Sustainability - refers to maintaining the ability of the environment and the economy to continue to
produce and satisfy needs and wants into the future; sustainability depends crucially on preservation
of the environment overtime

Try to strike a balance between environmental and economic goals

Examples of common access resources:

- Fishing grounds
- Forests
 - Pasture
- Groundwater tables

Examples of the things that could be taken out of the commons:

- Seafood from fisheries
- Timber from forests
- Water from groundwater table
- Grass from the pastures

The law of diminishing

Ceteris paribus
Short run
Adding variable factors continuously
A fixed quantity of fixed factors
MP drop eventually

In short run, while adding variable factors continuously, with a fixed quantity of fixed factors, ceteris
paribus, the marginal product will drop eventually.

Machinery (units) Labour (units) AP TP MP

1 3 3 3 3

2 3 6 12 9

3 3 12 36 24

4 3 10 40 4
Quantity of
TP/ Output TFC TVC TC AFC AVC ATC MC
labour
0 0 0 0 400 0 0 0 0
1 10 400 200 600 40 20 60 20
2 25 400 400 800 16 16.0 32 13.3
3 45 400 600 1000 8.89 13.3 22.2 10
4 70 400 800 1200 5.71 11.4 17.1 8
5 90 400 1000 1400 4.44 11.1 15.6 10
6 105 400 1200 1600 3.81 11.4 15.2 13.3
7 115 400 1400 1800 3.48 12.2 15.7 20
8 120 400 1600 2000 3.33 13.3 16.7 40
Quantity of
TP/ Output TFC TVC TC AFC AVC ATC MC
labour
0 0 0 0 400 0 0 0 0
1 10 1000 200 600 40 20 60 20
2 25 400 800 16 16.0 32 13.3
3 45 600 1000 8.89 13.3 22.2 10
4 70 800 1200 5.71 11.4 17.1 8
5 90 1000 1400 4.44 11.1 15.6 10
6 105 1200 1600 3.81 11.4 15.2 13.3
7 115 1400 1800 3.48 12.2 15.7 20
8 120 1600 2000 3.33 13.3 16.7 40

Tradable permit
Green tax
 TEST:
- Use more economic terms
- Cause and effect relationship （因果关系）
- If … then … , so …
- Try to use a flowchart to list out all the steps and sequences
- When asking if one thing is a public good
- First: Definition (what is defined as public good)
- Second: Will it reduce the number of goods in the market? Yes → excludable good →
not public good
- Price function - signalling, incentive, allocate resources (allocate more resources to produce
more goods)
- When talk about changes, focus on change in supply
- When write definition of ped and pes, can use the formula to show
- Assuming no externality on the other side (production)

Suggest the golden rule - what is not market failure - msb=msc

Positive - people …. - will only