OCR Economics A-level Microeconomics Topic 2: The Role of Markets 2.8 Market Failure and Externalities Notes https://bit.ly/pmt-edu-cc https://bit.ly/pmt-cc This work by PMT Education is licensed under CC BY-NC-ND 4.0 https://bit.ly/pmt-edu https://bit.ly/pmt-cc https://bit.ly/pmt-ccMarket failure occurs when the free market fails to allocate resources to the best interests of society, so there is an inefficient allocation of scarce resources. Economic and social welfare is not maximised where there is market failure. Types of market failure: o Externalities An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism. In other words, it is the spill- over effect of the production or consumption of a good or service. ● Externalities can be positive (external benefits) or negative (external costs). ● Negative externalities are caused by demerit goods. These are associated with information failure, since consumers are not aware of the long run implications of consuming the good, and they are usually overprovided. For example, cigarettes and alcohol are demerit goods. The negative externality to third parties of consuming cigarettes is second-hand smoke or passive smoking. ● Positive externalities are caused by merit goods. These are associated with information failure too, because consumers do not realise the long run benefits to consuming the good. They are underprovided in a free market. For example, education and healthcare are merit goods. The positive externality to third parties of education is a higher skilled workforce. ● The extent to which the market fails involves a value judgement, so it is hard to determine what the monetary value of an externality is. For example, it is hard to decide what the cost of pollution to society is. Different individuals will put a different value on it, depending on their own experiences with pollution, such as how polluted their home town is. This makes determining government policies difficult, too. Private costs Producers are concerned with private costs of production. For example, the rent, the cost of machinery and labour, insurance, transport and paying for raw materials are private costs. This determines how much the producer will supply. It could refer to the market price which the consumer pays for the good. Marginal private cost is the cost to a firm of producing one extra unit. https://bit.ly/pmt-edu https://bit.ly/pmt-cc https://bit.ly/pmt-ccSocial costs This is calculated by private costs plus external costs On a diagram, external costs are shown by the vertical distance between the two curves. In other words, external costs are the difference between private costs and social costs. It can be seen that marginal social costs (MSC) and marginal private costs (MPC) diverge from each other. External costs increase disproportionately with increased output. Marginal social cost is the extra cost on society derived per extra unit consumed. Marginal social cost = marginal external cost + marginal private cost Private benefit Consumers are concerned with the private benefit derived from the consumption of a good. The price the consumer is prepared to pay determines this. Private benefits could also be a firm’s revenue from selling a good. Social benefit Social benefits are private benefits plus external benefits. On a diagram, external benefits are the difference between private and social benefits. Similarly to external costs, external benefits increase disproportionately as output increases. Marginal social benefit is the extra benefit on society derived per extra unit consumed. Marginal social benefit = marginal external benefit + marginal private benefit https://bit.ly/pmt-edu https://bit.ly/pmt-cc https://bit.ly/pmt-ccSocial optimum position: This is where MSC = MSB and it is the point of maximum welfare. The social costs made from producing the last unit of output is equal to the social benefit derived from consuming the unit of output. External costs of production: External costs occur when a good is being produced or consumed, such as pollution. They are shown by the vertical distance between MSC and MPC. The market equilibrium, where supply = demand at a certain price, ignores these negative externalities. This leads to over-provision and under-pricing. With negative externalities, MSC>MPC of supply. At the free market equilibrium, therefore, there are an excess of social costs over benefits at the output between Q1 and Qe. The output where social costs > private benefits is known as the area of deadweight welfare loss, shown by the triangle in the diagram. The market fails to account for the negative externalities that occur from the consumption of this good, which would reduce welfare in society if it was left to the free market. https://bit.ly/pmt-edu https://bit.ly/pmt-cc https://bit.ly/pmt-ccExternal benefits of production: An example of an external benefit from the production or consumption of a good or service could be the decline of diseases and the healthier lives of consumers through vaccination programmes. Since consumers and producers do not account for them, they are underprovided and under consumed in the free market, where MSB>MPB. This leads to market failure. The triangle in the diagram shows the excess of social benefits over costs. It is the area of welfare gain. Government policies for negative externalities: Indirect taxes: To reduce the quantity of demerit goods consumed. This increases the price of the good. If the tax is equal to the external cost of each unit, then the supply curve becomes MSC rather than MPC, so the free market equilibrium becomes the socially optimum equilibrium. This internalises the externality. In other words, the polluter pays for the damage. Subsidies: To encourage the consumption of merit goods. This includes the full social benefit in the market price of the good. Regulation: To enforce less consumption of a good. For example, the minimum school leaving age. If there was a compulsory recycling scheme, it would be difficult to police and there could be high administrative costs. Bans could be enforced for harmful goods, although they can still be consumed on the black market. Bans are only useful where MSC > MPB (the MSC curve is above MPB). https://bit.ly/pmt-edu https://bit.ly/pmt-cc https://bit.ly/pmt-ccProvide the good directly: The government could provide public goods which are underprovided in the free market, such as with education. Provide information: To ensure that there is no information failure, and consumers and firms can make informed economic decisions. Property rights: This encourages innovation because entrepreneurs can create new ideas, which are protected, and earn profit. Personal carbon allowances: They could be tradeable, so firms and consumers can pollute up to a certain amount, and trade what they do not use. https://bit.ly/pmt-edu https://bit.ly/pmt-cc https://bit.ly/pmt-cc OCR Economics AS-level Microeconomics Topic 3: Market Failure and Government Intervention 3.1 Market failure Notes www.pmt.educationMarket failure occurs when the free market fails to allocate resources to the best interests of society, so there is an inefficient allocation of scarce resources. Economic and social welfare is not maximised where there is market failure. Types of market failure: o Externalities An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism. In other words, it is the spill- over effect of the production or consumption of a good or service. o The under-provision of public goods Public goods are non-excludable and non-rival, and they are underprovided in a free market because of the free-rider problem. o Public goods are missing from the free market, but they offer benefits to society. For example, street lights and flood control systems are public goods. o They are non-excludable so by consuming the good, someone else is not prevented from consuming the good as well, and they are non-rival, so the benefit other people get from the good does not diminish if more people consume the good. o The non-excludable nature of public goods gives rise to the free-rider problem. Therefore, people who do not pay for the good still receive benefits from it, in the same way people who pay for the good do. This is why public goods are underprovided by the private sector: they do not make a profit from providing the good since consumers do not see a reason to pay for the good, if they still receive the benefit without paying. o Public goods are also underprovided because it is difficult to measure the value consumers get from public goods, so it is hard to put a price on the good. Consumers will undervalue the benefit, so they can pay less, whilst producers will overvalue, so they can charge more. o Governments provide public goods, and they have to estimate what the social benefit of the public good is when deciding what output of the good to provide. They are funded using tax revenue, but the quantity provided will be less than the socially optimum quantity. www.pmt.educationo Private goods are rival and excludable. For example, a chocolate bar can only be consumed by one consumer. Moreover, private property rights can be used to prevent others from consuming the good. o Information gaps It is assumed that consumers and producers have perfect information when making economic decisions. However, this is rarely the case, and this imperfect information leads to a misallocation of resources. www.pmt.education OCR Economics A-level Microeconomics Topic 2: How Competitive Markets Work 2.4 Elasticity Notes www.pmt.educationElasticity is how responsive demand or supply is to a change in price. Price elasticity of demand The price elasticity of demand is the responsiveness of a change in demand to a change in price. The formula for this is: A price elastic good is very responsive to a change in price. In other words, the change in price leads to an even bigger change in demand. The numerical value for PED is >1. www.pmt.educationA price inelastic good has a demand that is relatively unresponsive to a change in price. PED is <1. A unitary elastic good has a change in demand which is equal to the change in price. PED = 1. www.pmt.educationA perfectly inelastic good has a demand which does not change when price changes. PED = 0. A perfectly elastic good has a demand which falls to zero when price changes. PED = infinity. www.pmt.educationIf the price of bread increased by 15%, and the quantity demanded decreased by 20%, the PED of bread is: -20% / 15% = -1.33. Since the value is negative, bread is relatively price inelastic. Factors influencing PED: 1) Necessity: A necessary good, such as bread or electricity, will have a relatively inelastic demand. In other words, even if the price increases significantly, consumers will still demand bread and electricity, because they need it. Luxury goods, such as holidays, are more elastic. If the price of flights increases, the demand is likely to fall significantly. 2) Substitutes: If the good has several substitutes, such as Android phones instead of iPhones, then the demand is more price elastic. The elasticity can also change within markets. For example, the market for bread is less elastic than the market for white bread. This is because there are fewer substitutes for bread in general, but there are several substitutes for white bread. Hence, white bread is more price elastic. The closer and more available the substitutes are, the more price elastic the demand. Elasticity also changes in the long and short run. In the long run, consumers have time to respond and find a substitute, so demand becomes more price elastic. In the short run, consumers do not have this time, so demand is more inelastic. 3) Addictiveness or habitual consumption: The demand for goods such as cigarettes is not sensitive to a change in price because consumers become addicted to them, and therefore continue demanding the cigarettes, even if the price increases. 4) Proportion of income spent on the good: If the good only takes up a small proportion of income, such as a magazine which increases in price from £1.50 to £2, demand is likely to be relatively price inelastic. If the good takes up a significant proportion of income, such as a car which increases in price from £15,000 to £20,000, the demand is likely to be more price elastic. 5) Durability of the good: A good which lasts a long time, such a washing machine, has a more elastic demand because consumers wait to buy another one. 6) Peak and off-peak demand: During peak times, such as 9am and 5pm for trains, the demand for tickets is more price inelastic. www.pmt.education Elasticity of demand and tax revenue: The burden of an indirect tax will fall differently on consumers and firms, depending on if the good has an elastic or inelastic demand. It is important to note, however, that taxes shift the supply curve, not the demand curve. If a firm sells a good with an inelastic demand, they are likely to put most of the tax burden on the consumer, because they know a price increase will not cause demand to fall significantly. An increase in tax will decrease supply from S1 to S2, which increases price from P1 to P2, and therefore demand contracts from Q1 to Q2. This is most effective for raising government revenue. If a firm sells a good with an elastic demand, they are likely to take most of the tax burden upon themselves. This is because they know if the price of the good increases, demand is likely to fall, which will lower their overall revenue. This is not as effective for raising government revenue, but if a government wants to reduce the demand of a particular good, it is effective. Demand will fall significantly, from Q1 to Q2. www.pmt.educationElasticity of demand and subsidies: A subsidy is a payment from the government to firms to encourage the production of a good and to lower their average costs. It has the opposite effect of a tax because it increases supply. The benefit of the subsidy can go to both the producer, in the form of increased revenue (C-P1), or to the consumer, in the form of lower prices (P1-P2). PED and total revenue: Total revenue is equal to average price times quantity sold. TR= P x Q If a good has an inelastic demand, the firm can raise its price, and quantity sold will not fall significantly. This will increase total revenue. If a good has an elastic demand and the firm raises its price, quantity sold will fall. This will reduce total revenue. Income elasticity of demand Income elasticity of demand is the responsiveness of a change in demand to a change in income. The formula for this is: Inferior, normal and luxury goods: Inferior goods are those which see a fall in demand as income increases. For example, the ‘value’ options at supermarkets could be seen as inferior. As income increases, consumers switch to branded goods. YED < 0. With normal goods, demand increases as income increases. YED >0. www.pmt.educationWith luxury goods, an increase in income causes an even bigger increase in demand. YED > 1. For example, a holiday is a luxury good. Luxury goods are also normal goods, and they have an elastic income. During periods of prosperity, such as economic growth when real incomes are rising, firms might switch to producing more luxury goods and fewer inferior goods, because demand for luxury goods will be increasing. Cross elasticity of demand Cross elasticity of demand is the responsiveness of a change in demand of one good, X, to a change in price of another good, Y. The formula for this is: Complements, substitutes and unrelated goods: Complementary goods have a negative XED. If one good becomes more expensive, the quantity demanded for both goods will fall. o Close complements: a small fall in the price of good X leads to a large increase in QD of Y. o Weak complements: a large fall in the price of good X leads to only a small increase in QD of Y. www.pmt.educationSubstitutes can replace another good, so the XED is positive and the demand curve is upward sloping. If the price of one brand of TV increases, consumers might switch to another brand. o Close substitutes: a small increase in the price of good X leads to a large increase in QD of Y. o Weak substitutes: a large increase in the price of good X leads to a smaller increase in QD of Y. www.pmt.educationUnrelated goods have a XED equal to zero. For example, the price of a bus journey has no effect on the demand for tables. Firms are interested in XED because it allows them to see how many competitors they have. Therefore, they are less likely to be affected by price changes by other firms, if they are selling complementary goods or substitutes. The incidence of tax and effects of subsidies with different PEDs If demand is more elastic (PED>1), the incidence of the tax will fall mainly on the supplier. www.pmt.educationIf demand is more inelastic (PED<1), the incidence of the tax will fall mainly on the consumer. If demand is price inelastic, the subsidy will have a large effect on equilibrium price. This give a greater consumer gain than when demand is elastic. If demand is price elastic, the subsidy will have a large effect on quantity, and therefore benefit producers more. www.pmt.educationPrice elasticity of supply The price elasticity of supply is the responsiveness of a change in supply to a change in price. The formula for this is: If supply is elastic, firms can increase supply quickly at little cost. The numerical value for PES is >1. www.pmt.educationIf supply is inelastic, an increase in supply will be expensive for firms and take a long time. PES is <1. A perfectly inelastic supply has PES = 0. Supply is fixed, so if there is a change in demand, it cannot be met easily. www.pmt.educationSupply is perfectly elastic when PES = infinity. Any quantity demanded can be met without changing price. If the price of producing wheat increased by 15%, and the quantity supplied decreased by 20%, the PES of wheat is: -20% / 15% = -1.33. Since the value is negative, the supply of wheat is relatively price inelastic. Factors influencing PES: 7) Time scale: In the short run, supply is more price inelastic, because producers cannot quickly increase supply. In the long run, supply becomes more price elastic. 8) Spare capacity: If the firm is operating at full capacity, there is no space left to increase supply. If there are spare resources, for example in a recession there are lots of spare and unemployed resources, supply can be increased quickly. 9) Level of stocks: If goods can be stored, such as CDs, firms can stock them and increase market supply easily. If the goods are perishable, such as apples, firms cannot stock them for long so supply is more inelastic. 10) How substitutable factors are: www.pmt.education If labour and capital are mobile, supply is more price elastic because resources can be allocated to where extra supply is needed. For example, if workers have transferable skills, they can be reallocated to produce a different good and increase the supply of it. 11) Barriers to entry to the market: Higher barriers to entry means supply is more price inelastic, because it is difficult for new firms to enter and supply the market. www.pmt.education