The Business

Environment
BU1006
SEMESTER 1: LECTURE 6
THE ECONOMIC ENVIRONMENT: MARKET
FAILURE
 By the end of the session, you should be able
LEARNIN to understand:
G  what market failure is

OUTCOM  what causes market failure

ES  the role of governments in markets that fail

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RECAP
 Markets allow specialisation and division of labour.
 The “invisible hand” guides the economy and produces allocative,
productive and distributive efficiency.
 Allocation is determined by consumer preferences.
 Productive efficiency is ensured through the profit motive and
competition.
 Distribution is resolved through providing people with the incentives to
engage in market activity.

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 Low price – suppliers want to supply small
HOW A amounts of output

FREE
MARKET Low price – customers want to buy lots of
the output
CLEARS
WHEN Creates a shortage which puts upward
THE pressure on prices

INITIAL
PRICE IS Price rises to encourage more supply – until
market clears
TOO LOW
The invisible hand helps to bring about economic
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 WHAT IS MARKET FAILURE?
 Market failure is a situation in which the free market fails to allocate
resources efficiently.

 The main causes of market failure:

• Monopoly power
• Externalities
• Public goods
• Asymmetric information
• Market Bubbles

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 The fundamental cause of
(1) MONOPOLY POWER monopoly is barriers to
entry – a monopoly
Monopoly is characterised by: remains the only seller in
its market because other
 A Single Seller firms cannot enter the
market and compete with
A single firm is the industry it.
Or one dominant seller in the market

 Unique Product
No close substitutes. Monopoly firm faces little or no competition

 High Barriers to Entry THE BUSINESS ENVIRONMENT, 2020-21 SEMESTER 1 6

HIGH BARRIERS TO ENTRY
Barriers to entry arise because the firm:

• owns the vital resource

• has licences and patents that create legal barriers
to other entrants
• has economies of scale (natural monopoly)
• has high brand loyalty through strong advertising
• formed a merger to create dominant market
presence
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THE CASE FOR MONOPOLY
• by maintaining barriers to
entry technological change is
likely
The case
• financial strength gives it the
for ability to innovate and invest
in research and development
programs

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THE CASES AGAINST
MONOPOLY
• overcharges consumers
• fewer resources are allocated to
production of the product
• charges a price greater than
The case marginal cost
against • may exploit employees and
suppliers
• leads to wasteful use or
environmental damage of resources
to minimize costs

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 GOVERNMENT
INTERVENTION: RESTRICTING
MONOPOLY POWER
Many countries around the world have strict laws that restrain the power of
monopolists in order to:

 prevent excess prices – Maximum price-Utility services

 maintain quality of service – performance targets – transport, banks

 promote competition – Deregulation- education

 prevent exploitation of suppliers – Minimum price/ Limiting monopsony

power – The supermarket code of conduct
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EXTERNALITIES
Impact on bystander is

adverse beneficial

negative externality positive externality

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EXTERNALITIES
Externalities are the negative or positive impacts on parties who are not directly
involved in the transaction
1.Negative impacts / costs on parties that are not involved in the transaction
2.Positive impacts/benefits to parties that are not directly involved in the transaction.
The profit motivated private consumers/ firms are only focused on the private costs
or benefits not the social costs or benefits.

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SOCIAL COSTS
Social costs

Social cost is the summation of the private costs and external costs.If social cost exceeds provate
cost,it means that negative externalities exist.

Negative
Social cost = Private cost + externalities/

External cost

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SOCIAL BENEFITS
Social benefits

Social benefit is the summation of private benefits and external benefits.When social benefit
exceed private benefits, positive externalities exist.

= + Positive
Social benefits Private benefit externalities/
Examples
External benefits

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 (2) EXTERNALITIES Price
The supply curve reflects the
production cost to the producer of any
given quantity.

Supply
(private cost)

Pmkt E market

At the equilibrium price in the

market consumer and producer
surplus (welfare) is maximised
Demand
(private value)
Maximisation of The demand curve reflects the value of that product to
total welfare is consumers as indicated by the price consumers are
interpreted as ‘willing and able’ to pay.
‘market efficiency’ O
and occurs because: Qmkt Quantity
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EXTERNALITIES
But markets do not do everything well because
buyers and sellers do not necessarily take into
account the external effects of their actions
Externality: Where a person’s activity affects the wellbeing of a bystander and
yet the bystander neither pays nor receives any compensation for that effect.

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EXAMPLES OF
EXTERNALITIES
Negative externalities
Smokers ignore the harmful impact of toxic 'passive smoking’ and third hand
smoking
Air pollution from road use and traffic congestion and the impact of road fumes on
lungs
External costs of plastic which harms animals and leads to the creation of landfill
sites
The external cost of food waste that results in landfill sites
The External costs of fast fashion such as use of water
External costs of meat production that leads to methane releases

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HOW NEGATIVE
EXTERNALITIES LEAD TO
MARKET FAILURE
Private individuals in a market economy are not concerned by the external cost that
results from the production or consumption of goods or services
These individuals only consider the private cost that is incurred in a transaction
therefore that leads to over allocation of resources.
The overproduction or over consumption of resources leads to market failure

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HOW POSITIVE
EXTERNALITIES LEAD TO
MARKET FAILURE
Private individuals in a market economy are not concerned by the external benefits
that results from the production or consumption of goods or services
These individuals only consider the private benefit that is incurred in a transaction
therefore that leads under allocation of resources as the product is less valued than its
actual value.
The underconsumption / underproduction leads to market failure

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EXAMPLES OF
EXTERNALITIES
Positive externalities
External benefits from development of renewable energy sources such as wind
power
External benefits from other new production technologies such as electric cars
External benefits from vaccination / immunization programmes that leads to a
healthy workforce
A new motorway or road improvement scheme generates third party benefits
including reduced transport cost for local firms and generates a regional multiplier
effect
External benefits from consuming education that leads more skilled labour
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MARKET OUTCOMES ARE
INEFFICIENT IN THE
PRESENCE OF EXTERNALITIES
Market outcomes are inefficient in the
presence of externalities because:

 markets produce a larger quantity than is

socially desirable when there is a
negative externality

 markets produce a smaller quantity than

is socially desirable when there is a
positive externality

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NEGATIVE PRODUCTION
EXTERNALITY Social Cost
Price of
aluminium S(private cost)

E opt Externality(Pollution)
Popt
Pmkt E mkt

D(private value)

Q mkt is inefficient (overproduction)

Quantity of
O Q opt Qmkt Aluminium

Markets produce a larger quantity than is socially desirable (overproduction) when

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NEGATIVE CONSUMPTION
EXTERNALITY
Price of
Alcohol Supply
(Private Cost)
Externalit
y

Pmkt Market Equilibrium

Popt
Optimum equilibrium

Demand
(Private Value)
Social Value
Q mkt inefficiency-overconsumption
O Qopt Qmkt Quantity of Alcohol
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POSITIVE CONSUMPTION
EXTERNALITY
P S
(Private Cost)
Externality
(external value)
Market outcome is inefficient in
the presence of a positive
Popt E opt externality because without
proper incentives, market
Pmkt educates a smaller number of
E mkt students than is socially desirable

Social value
Q mkt inefficiency - D
underconsumption (Private Value)
O Qmkt Qopt Q
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POSITIVE EXTERNALITIES (PRODUCTION) – MARKET
FOR INDUSTRIAL ROBOTS
Externality Supply
Price (Value of technology (Private Cost)
spillover)
Social Cost

Pmkt Emkt

Popt Eopt
Demand
(Private Value)

Qmkt is inefficient (underproduction)

O
Qmkt Qopt Quantity
Markets produce a smaller quantity than is socially desirable when there is a positive
externality
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GOVERNMENT INTERVENTION:
SOLUTIONS TO EXTERNALITIES
If private solution
impossible

Government policies may

solve externality
(Rules and Command-and-
regulations / Laws) Market-based
control

Price Quantity

Corrective Corrective
Pollution Permits
Taxes Subsidies
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CORRECTIVE TAXES
An indirect tax on production of fast fashion for example leads to a rise in cost of
production and a fall in supply, reaching the output to the socially desirable level

Diagram

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CORRECTIVE TAXES
 A corrective tax does not prevent the occurrence of an externality, but
makes the producer of the externality pay for each unit of externality it
produces.

 These taxes provide an economic incentive for industry to reduce

externalities.

 The tax also provides revenue to government which could be used to

reduce the impact of the externality.

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CORRECTIVE SUBSIDIES
A government grant given to the producers of education for example leads to a fall in
cost of production and a rise in supply leading to a socially desirable level of output.
Diagram

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 CORRECTIVE SUBSIDIES
 Subsidies provided by the government that are designed to encourage
production of positive externalities are known as ‘corrective’ subsidies.

 These subsidies provide an economic incentive for industry to increase

positive externalities.

 The subsidy, does however impose a cost on the community –

diversion of resources which the government could spend elsewhere.

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TRADABLE POLLUTION
PERMITS
Carbon trading system is when a cap is placed on carbon emissions of firms through the issue of
permits which can be purchased and sold.
For example in the EU, scheme operates through the allocation and trade of CO2 emissions
allowances. It creates a market in the right to emit C02. One allowance represents one tonne of
C02 equivalent.
The EU gives allowances for all the member countries and these member countries give a certain
amount of their allowances to the main companies that emit carbon in the production process.
These countries don’t give all their allowances to the companies but keep a few permits with
them. If there are companies that need more permits, they need to buy the permits by paying to
the government or from other companies.
If there are companies that don’t use all their allowances, they could sell the remaining permits
to other partner countries.

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BEHAVIORAL NUDGES
Any attempt to influence a person's decision-making using psychology and
behavioural economics theories.
A nudge is like a gentle push towards some type of action.
A nudge is not the same as using financial incentives, disincentives or mandates.
Behavioural nudges are alternatives to using standard government interventions in
markets

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BEHAVIORAL NUDGES
EXAMPLES
1. placing green footprints on the ground, pointing the way to nearest garbage bin. A 2011 study in
Copenhagen study showed a 46% decrease in littering in the streets where green footprints were used.
2. Put junk food on high levels and healthy food on eye level
3. Calorie counts on menus
4. Designing buildings with fewer lifts
5. Making salad the default side option instead of chips
6. Providing information about what others are doing e.g. timely, personalized messages about other
people paying their taxes, donating their organs
7. Displaying social trust: For example, certain hotels can have a logo with trip advisor and say they are
top rated on this particular site
8. Hospitals have sanitary bottles to encourage people to be germ free

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REGULATION
Ban smoking in public areas
Making vaccinations compulsory
Ban littering in beach areas
Banning flavored vapers in the US

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(3) UNDER PROVISION OF
PUBLIC GOODS
Goods that are neither excludable nor rivalrous are called public goods.
Public goods involve a large element of collective consumption. These types of goods possess two
characteristics:
Non-rivalry: Consumption of the good by one person does not reduce the amount available for
consumption by another person. Everyone can simultaneously obtain the benefit from a public
good. The cost of supplying a public good to an extra consumer is zero. This means that the marginal
cost of supplying to an extra person is zero, if its supplied to one, it is supplied to all. These pure
public goods are non-diminishable and non-exhaustible in consumption
Non-Excludability: Once provided, no person can be prevented from benefiting. This means there is
no effective way of excluding individuals from the benefit of the good once it comes into
existence. This means that these goods are non- rejectable in consumption

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 TWO TYPES OF GOODS
Private goods are goods that are both excludable and rival
(ice cream, clothing, congested toll roads)

Public goods are goods that are neither excludable nor rival
(national defence, knowledge, uncongested non-toll roads)
 

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PUBLIC GOODS
Public Goods and the free-rider problem
Public goods are non-excludable. Once a producer had provided a public good,
everyone including non-payers can obtain the benefit. The benefits of the goods
cannot be confined to only those who have paid for it. Since its not excludable and
its non rival there is an issue of free rider problem and the valuation problem
which prevent the profit motivated private firms from providing public goods.
Examples – Street lights, Traffic lights

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PUBLIC GOOD
Non- Non-rival
excludable

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PRIVATE GOOD
Rival

Excludabl
e

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GOVERNMENT
INTERVENTION: PUBLIC
GOODS
 Public Goods
 Leads to the free-rider problem
 Private market not willing to supply
 Leads to underprovision and therefore, market failure
 Government corrects the market failure by providing public goods using tax revenue

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 INFORMATION FAILURE
/IMPERFECT INFORMATION
 Merit
goods are goods that are better for a person than the person who
may consume the good realises (e.g. education,vaccinations).
 Demerit goods are products that are worse for the consumer than the
individual realises (e.g. junk food).
 Due to information failure (consumers do not realise how good or
bad the product is to them), people tend to underconsume merit goods
and overconsume demerit goods – do not have the right information or
lack the relevant information

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 CONSEQUENCES OF
INFORMATION FAILURE
 Moral hazard
Moral hazard is defined as an adverse change of behaviour that results from an agreement or contract.
Moral Hazard occurs where an economic agent makes a risky decision knowing that, if losses are made,
the burden will be borne by another party .This is When firms act immorally due to incentives that exist
in the market .

 Adverse selection
When one party to a transaction has access for better information than the other it leads to a bad selection.
Adverse selection is a problem that arises most commonly in insurance markets, where faced with the
same rates, high risk persons are more inclined to apply for insurance than low risk persons.

A BBC News team previously set up a fake takeaway restaurant on Uber Eats and sold burgers

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INFORMATION FAILURE:
GOVERNMENT INTERVENTION
 Increase the supply of information
 Force producers to provide accurate information through accurate
labelling for example
 Public broadcasts to improve knowledge
 Laws passed to force companies to be more transparent and publish their
financial accounts
 Employers may force job applicants to disclose information about
themselves, such as whether they have a criminal record
Traffic light system for food

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MARKET BUBBLES
A market bubbles occurs when rising demand for whatever reason, drives prices
beyond the level that might normally be expected.
The emotions exceed rational thinking and more and more buyers join the market
which creates an upward pressure on the price.
Once the market bubble reaches the maximum point, just like other bubbles, market
bubbles do collapse due to sudden increase in supply / panic selling which causes the
prices to fall and collapse
Examples – The housing market bubble in the USA, Tulip bubbles in the
Netherlands

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GOVERNMENT FAILURE
Government failure refers to a situation in which the government intervenes to correct market
failure and it leads to a further misallocation of resources
1.Minimum price leads to surpluses
2.Maximum price leads to shortages
3.NMW leads to unemployment
4.Information symmetry leads to red tape and bureaucracy

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ACTIVITY
1.Pick a type of market failure
2.Do a real-life research on the market failure you picked
3.Explain how the government could intervene to fix the type of market failure

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