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Market failure grade 12

Economics (St Boniface High School)

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

ECONOMICS NOTES
MARKET FAILURE
GRADE: 12
YEAR: 2021

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

MARKET FAILURE: ESSAYS

1. Discuss in detail how the following factors lead to the misallocation of
resources in the market:
 Externalities
 Missing markets
 Imperfect competition
 Lack of information
 Immobility of factors of production
 Imperfect distribution of income and wealth

2. Discuss in detail state intervention as a consequence of market failures, with

the aid of relevant graphs.
- Direct control
- Imperfect markets
- Minimum wages
- Maximum prices
- Minimum prices
- Taxes and subsidies
- Subsidies on goods and services
- Redistribution of wealth
- Government involvement in production
…………………………………………………………………………………………………
MARKET FAILURE:

- It is when free markets fail to produce the quantities of goods and services that people
want at prices that reflect the marginal utility (value to the consumer) of the product
best available
- When optimal production outcome has not been achieved / markets are unable to
achieve best resource allocation

REASONS (CAUSES) FOR MARKET FAILURE (POSSIBLE ESSAY)

(Discuss in details how the following factors can lead to misallocation of resources in
the market)

 Missing markets
- A significant market failure is the failure to produce some goods and services, despite
being needed or wanted.
- Markets can only form under certain conditions, and when these conditions are absent
markets may struggle to exist.
- The most extreme case of a missing market is the case of pure public goods.
- Pure public goods clearly provide a benefit to the consumer, but, for several reasons,
are unlikely to exist in a market economy.
- Examples of pure public goods include national defence, the police service, and street
lighting.

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

- Due to the fact that markets for these goods are not likely to form they are called
missing markets and are considered a special case where demand exists, but supply
is absent.
Pure public goods
- The market is likely to fail to supply pure public goods, given the impossibility of
charging consumers at the point of consumption.
- Public goods have the following characteristics:
Non-excludable: When a public good is supplied, it is impossible to exclude other
individuals from deriving a benefit.
- For example, once street lighting is made available in an area, all passers-by can
benefit, and no one can be denied access to it.
Non-rivalry: When a pure public good, such as street lighting, is consumed by one
individual, the stock available for others does not diminish, as it would in the case of a
private good.
- A pedestrian passing under a street light has no effect on the supply of lighting
whatsoever.
- Non-rivalry is also known as the principle of non-rivalry.
- Because the stock of a public good does not diminish with use, consumers do not
need to compete with each other to get access to them.
- For example, individuals do not need to queue to get access to street lighting.
- When combined, these three characteristics deter potential suppliers because it would
be impossible to charge users at the point of use.

 Imperfect competition:
- Markets fail because imperfect markets fail to achieve both technical and allocative
efficiency, e.g. a monopolist is considered to be inefficient because it produces less
and charges a higher price hence this leads to allocative inefficiency and lack of
competition in this market structure tends to cause technical inefficiency.
- In market economies, competition is often impaired by power.
- Power often lies to a greater extent with producers than consumers.
- Most businesses operate under conditions of imperfect competition that allows them
to restrict output, e.g. monopoly, duopoly, oligopoly
- Raise prices and produce where price exceeds marginal cost.
- They can also prevent new businesses from entering the industry, e.g. Businesses
had technology to produce long-life light bulbs for some time before they went on the
market, e.g. Technology that allows cars to be driven by fuels other than fossil fuels.
- Imperfect markets fail to achieve technical and allocative efficiency
- The modern market does not always allow for price negotiation.
- Advertising is often employed to promote producer market power.

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

 Externalities/ spill-over effects/ third party effects

- Externalities are when the production or consumption of a good has a negative or
positive effect on third parties (people not directly related to the transaction).

Negative externalities
Goods with negative externalities result in social costs (affect the society negatively).
- Social costs are considered to be the private cost plus external cost. Individuals
often consider only the costs they themselves bear when making decisions (private
costs), not the costs that may be borne by others (external costs).
- Private cost plus external cost form social costs.
- E.g. the social cost involved in building and running an airport can be split up into:
- Private costs of the airport: cost of construction, cost of paying workers to run airport,
etc.
- External cost of the airport: noise and air pollution to those living nearby, risk of
accident to those living nearby, loss of landscape.

Positive externalities
- Goods with positive externalities result in social benefit.
- Social benefit is the total benefit to society from producing or consuming a
good/service
- Social benefit includes all the private benefits plus any external benefits of
production/consumption
- If a good has significant external benefits, then the social benefit will be greater than
the private benefit.
- E.g. cycling to work. If people cycle to work, the private benefits include health benefits
for cycling, avoiding congestion, lower cost of cycling rather than driving. external
benefit of cycling may also include lower congestion for other road users, lower
pollution levels.

 Lack of information
- Technical and allocative efficiency require that both producers and consumers have
complete and accurate information about the costs and benefits of the goods and
services produced and consumed in the market. Producers and consumers make
production and consumption decisions based on the information they have.
- When information is incomplete or inaccurate, it leads to wrong decisions about what
to produce, how to produce and for whom to produce, and a waste of resources
occurs.
- Producers might not know all the different technologies and production techniques that
are available and the different resources that can best be used to produce
goods/services more efficiently
- Consumers might not know that the price of a product is lower from some other
suppliers or about the harmful effects of a product since they might just base their
decisions to consume on the information from a misleading suppliers.

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

 Imperfect distribution of income and wealth

- There is an unequal distribution of income and wealth because the market is only
interested in distributing goods/services for those who can afford it
- Other reasons for unequal distribution of income and wealth:
- Discrimination
- A difference in market power
- Unequal access to markets and educational opportunities

 Immobility of factors of production

- Resources may not be very mobile at the best of times and therefore markets are not
able to adjust as rapidly to changes in demand and supply
- Geographic immobility of labour: people are usually happy where they are, they have
relatives and friends, they know the town and area, and they are members of various
clubs and other social groupings.
- Institutional immobility of labour: pension schemes may tie people into a particular
company – if a worker moves, he or she will probably lose the amount paid in by the
employer on their behalf. Foreign-trained doctors may not be allowed to work in
another country unless they spend several years retraining.
- Married or very close couples may not be able to take a better paid job offered
elsewhere because it would render the other partner unemployed, so total family
income would fall if they moved

CONSEQUENCES OF MARKET FAILURE

Market failure can result in government intervention, externalities and inefficiencies

1. STATE INTERVENTION IN THE MARKET AS A RESULT OF MARKET FAILURE

(possible essay)
 Minimum wages
- It is the lowest wage an employer is by law allowed to pay an employee.
- Minimum wage policy helps to redistribute income.
- This is because unskilled workers (e.g. farm workers) are at a disadvantage at
negotiating and are usually unable to obtain real wage increases.
- Their wages are usually very low, and this continues unfair income distribution of
income
- Their wages are usually very low, and this continues unfair income distribution of
income.

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

MINIMUM WAGES
D
S

W1 Minimum wage
Wage

Q1 Q Q2
Quantity

- The original wage rate is W (market wage) at which quantity of labour employed is Q.
- The implementation of minimum wage policy increased wages to W1 (minimum wage).
- Minimum wage resulted in increase in supply for labour, meaning more workers look
for employment as indicated by Q2.
- Therefore, the effect of minimum wages is that it can result in oversupply of labour or
decreased demand for labour

 Maximum prices
- They are the highest prices that a producer is allowed by law to charge for a product
and are below the market price.
- In other word the government put a price ceiling for the particular product .
- Their effect is that they cause supply to decrease, therefore resulting in excess
demand for the product.
- This usually result in black market where the price charged is higher than the price
ceiling.

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

MAXIMUM PRICES
D
S

P
Price

P1 Maximum price

S
D

Q1 Q Q2

Quantity

- At the original price is P which is the market price, the quantity demanded and
supplied is Q. Q is the equilibrium quantity which indicates that there is a balance
between demand and supply of the product
- The implementation of maximum price P1 will result in increase in demand to Q2 but
the quantity supplied decreased to Q1.
- This means there will be a shortage which is represented by the distance between
Q1 and Q2.

 Minimum prices

- They are the lowest price that the producer is by law allowed to charge for the product.
- They are usually higher than the market prices and are implemented on basic foodstuff
such as maize.
- The aim is to make it useful (worthwhile) for producers of such products to say in the
market.
- Minimum prices can however result in oversupply of the product.

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

MINIMUM PRICE

D S

P1 Minimum price
Price

S
D

Q1 Q Q2

Quantity

- At the market price of P there is equilibrium between demand supply at quantity Q

- When the government impose a minimum price of P1 demand decreased to Q1 but
supply increased to Q2. This created an excess supply of the product.

 Subsidies

- A subsidy is a financial grant to support the production of a good or service.

- It can be direct (such as cash) or indirect such as rent rebates or meeting certain
expenses on behalf of a producer or a person.
- Subsidies can be offered for variety of purposes e.g. production, income, employment
and exports.
- Provision of merit goods is another of such purpose for which the government provide
subsidies for e.g. government often pay subsidy to promote consumption.

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

SUBSIDY

D S

P2/21 c S1

R1
P/ 20 a
P1/ 16 R4 b
PRICE

D
S1

Q Q1
QUANTITY

- The subsidy will cause the price paid by the consumer to decrease from P (20) to P1
(R16) and the quantity consumed increase from Q to Q1.
- For the producer, the subsidy increases the price received from P (R20) to P2 (R21).
- The subsidy is equal to P1P2cb (which is equal to R5) and the producers make a profit
represented by PP2ca (which is equal to R1.00)
- This means from the total subsidy of R5.00, only R4 will benefit the buyer by reducing
the price to R16. The other R1, 00 is a benefit to the producer, which is what is
regarded above as the profit from the subsidy.

 Taxes
- Government sometimes intervene in the market in order to recover external costs
- This means that the government use the taxation to discourage the consumption of
certain goods (demerit goods).
- These are goods which are generally regarded as undesirable and negatively affect
the welfare of the society e.g. cigarettes and alcohol.

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

TAXES

S1
D S

P1
P

S1
Price

S D

Q1 Q Quantity

- Originally, the price of P is charged, and quantity Q is consumed.

- A tax on the products (excise tax), can cause the price (of cigarettes) to increase to
P1 which means consumers will be needed to pay more.
- This would reduce the supply from SS to S1S1 and the quantity supplied from Q to Q1

 Direct Control
- Government can use laws (legislations) to control the behaviour of producers and
consumers who generate negative externalities.
- In South Africa emission of dangerous chemicals and pollution are regulated through
various Acts and policies.
- For example, Advertising by tobacco industry is not allowed and alcohol should not be
sold to persons of under 18 years of age.

 Imperfect markets regulations

- Firms operating in imperfect markets usually produce less quantities and charge
higher prices.
- Government attempt to reduce allocative problems from non-competitive markets
(imperfect markets) by using two instruments which are competition from abroad and
promotion of competition
- Competition from abroad: allowing firms from foreign countries to operate in South
Africa make local market more competitive (having many producers). This tend to
protect the consumers as firms may be careful not to charge too high a price as they
may lose their customers.
- Competition promotion: The Competition Commission, Competition Tribunal and
Competition Appeal court are established to ensure fair competition among firms.

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

 Redistribution of income and wealth

- The government uses fiscal policy to address income and wealth inequality.
The following are some of the measures used
- Progressive income tax system in which higher income group pay higher tax rates
than lower income groups.
- Subsidies on goods and services such as housing, education and primary health care
are provided
- Social grants such as old age, child support grants are provided to improve the
standard of living of the poor.
- Provision of free goods such as free water and electricity to those who are poor.
- Using laws such as the BBBEE/ BEE whereby the previously disadvantaged members
are intended to receive first preference in order to improve their participation in the
economy

 Government involvement in production

- Government intervenes in the markets by supplying goods that are desired by the
society but not sufficiently produced by the market.
- These goods are called public goods since the producer is the public sector.
- Community goods and and collective goods and are types of public goods produced
by government
- Government use income from taxation to provide community goods.
- Collective goods are provided at a user fee e.g. refuse removal, usage of toll road.

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

2. INEFFICIENCIES

Two kinds of inefficiencies occur as a result of market failure, namely productive and
allocative efficiency.

 Productive (technical) inefficiency:

- It when firms do not produce goods at the best possible cost (which is at the lowest
point of the AC curve)
- This means the firms can still reduce cost without reducing the quality of the product
(but firms fail to do so)
- It is also when the firms produce too few products than required by the consumers (the
firm does not maximise output from their production resources)

PRODUCTION POSSIBILITY CURVE (PRODUCTION POSSIBILITY FRONTIER)

A
500
F
B
Production of Clothes

450

300 C

150 E

0
D

0 300 600 900 1000

Production of Food

- The market is productively efficient when it produces any combination of goods along
the PPC (i.e. the combinations at A, B, C, D). these are quantities which are achievable
when all resources are used productively (without wastage).

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

- The area within the PPC (e.g. E) represents productive inefficiency, because fewer
goods than what is possible are produced.
- At point E, while the available resources (workers, capital, raw materials) can allow
the market to produce a combination of 150 clothes and 950 foods, the market
produces only 150 clothes and 300 foods. This represents wastage of resources,
- This means the market produce the quantities that are lower than its potential, there
is a lot of wastage of raw materials, time, labour resource etc.
- Wastage of resources results in the costs of production being higher than they should
be.
- The area outside the PPC e.g. point F represents the unachievable level of production,
because the economy does not have enough resources to produce any quantities
outside the PPC.

 Allocative inefficiency: is when firms do not distribute production resources

correctly. This is indicated when:
- The product mix does not match the tastes of consumers. This means the products
produced are not what the consumers want.
- The quantities required by the consumers are not available e.g. the products are
available at too few quantities
- Allocative inefficiency can still be existing even when the market has achieved
productive efficiency.
- For example, on the PPC curve (above), if the consumers want to consume the
combination of food and clothes represented by point C (more of food and less of
clothes) but the producers supply combination represented by point B, there is
allocative inefficiency. (Both point C and B represent productive efficiency but in this
case only C represents allocative efficiency)
- This means the quantities produced are not exactly what the consumer want to buy,
so resources are not allocated competently.

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

3. EXTERNALITIES / SPILL-OVER EFFECTS

- An externality is an effect (cost/ benefit) of consumption or production that is not

included in the pricing of the products. The effect is on people who are not part of the
transaction (i.e. third parties).
- Externalities can either be negative or positive.

3.1 NEGAVTIVE EXTERNALITY

S1= MSC= (MPC+ External

Price Market
D costs)
failure
S= MPC

P1

Q1 Q Quantity

.
- Supply curve (S) indicates the Marginal Private Cost (MPC) of the producer in order
to produce the product.
- If everything is left up to the market the price charged will be P and equilibrium
quantity will be Q.
- If the cost of harmful externality associated with production e.g. pollution is added
to the MPC, the price will be pushed higher, to P2.
- P2 takes into consideration social costs associated with externality. At this price
the supply curve S1 indicates the Marginal Social Costs (MSC) which means the
cost to the society (External cost) and the cost of producing the product (MPC) are
included.
- The distance between MSC (S1) and MPC (S) indicates market failure. Market has
failed because too much of a product with negative externality is produced.
- P1, DD, S1S1, Q1 represent socially optimal point of production while P1, DD, SS,
Q represent market optimal point of production

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

3.2 POSITIVE RXTERNALITY

D1 S
Price Market
failure
D

P1
P

D1= MSB = (MPB + External benefit)

D= MPB

Q Q1 Quantity

- The demand curve DD represents the Marginal Private Benefit (MPB) for the
consumer and its intersection with supply curve SS result in market output of Q.
- If a positive externality occurs (e.g. a subsidy on education), this benefit will be added
to the MPB to obtain Marginal Social Benefit (MSB). This means the distance between
the MPB and the MSB represents the positive externality benefit.
- P1, D1D1, SS, Q1 represent the socially optimal point of production. Because the
market output is less than the socially optimal output, there is market failure. Market
has failed to produce enough of the product which has benefit for the society.

COST- BENEFIT ANALYSIS

- It is a tool by which social costs and social benefits of a particular project are compared
in order to select the best one.
- CBA is often used in government projects because government is interested in the
welfare of the whole society.
- In private sector because they are only concerned with private costs and private
benefit, an investment is evaluated by undertaking feasibility study (not CBA).
- It involves comparing different projects which can offer solution to a particular
economic problem.
- The project which offer the highest social benefit with lowest social cost should be the
one to be implemented
- Social benefit consists of private benefit and external benefit, while social cost consists
of private cost and external benefit.

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Economics/ Grade 12 Topic 7 notes / Market failure Nkangala District/2021

RATIONALE (REASONS) FOR CBA

- CBA helps in making better decisions on how to use scarce resources to satisfy human
wants.
- Brings objectivity to decision making – by comparing social benefit and social cost for
a particular project.
- To determine whether a project will benefit the country as a whole.
- To evaluates the feasibility of different projects to determine which project will be the
best investment.
- It considers a wider social impact and includes externalities in the decision-making
process.
- To estimate the effects of an investment on social welfare and on the environment.
- The private sector usually only compares the expected private costs and benefits over
the estimated time span of a new project, the public sector on the other hand, needs
to compare the expected social costs and social benefits over the estimated time span
of a new project.

APPLICATION OF CBA IN PRACTICE

- CBA is used where the government wants to produce goods for which consumers will
not pay e.g. public road, railway lines, dams etc.
- To determine the cost and benefit of a project, the cost benefit ratio needs to be
calculated using the following formula:

Cost –benefit ratio (CBR) = Present value of economic benefit

Present value of economic costs

- If the CBR is below 1 (CBR < 1) the project cannot be carried out as it will not improve
the welfare of the society (the costs are higher than the benefit).
- If the CBR is above 1 (CBR > 1), it means the benefits are higher than the costs to the
society therefore the project should be carried out.
- If the CBR is equal to 1 (CBR = 1), the social costs and the social benefit of the project
are equal, therefore the project will not make any change to the welfare of the society.
Therefore, the project should not be carried out.

- Example of CBA: The costs and benefit of supplying reliable public transport

Alternatives/Options Economic Economic Cost benefit

benefits costs ratio
A = buses 1200 000 ÷ 1200 000 1
B= trains 1500 000 ÷ 1300 000 1,15
C= high speed trains 100 000 ÷ 800 000 0,13
D= combination of the three options 4000 000 ÷ 2200 000 1.82

The best option for the country will be to carry out option D as it has the highest positive
CBR.

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