What this lesson teaches
I can explain that a market is efficient at the social optimum, where marginal social benefit equals marginal social cost.
Syllabus 9570, 2.3.1(b). Governments' Microeconomic Objectives: Efficiency in markets occurs when the social optimum is achieved, where Marginal Social Benefit (MSB) = Marginal Social Cost (MSC), maximising society's welfare
I can explain the causes of market failure: public goods, externalities, information failure, immobile factors and market dominance.
Syllabus 9570, 2.3.2(b). Market Failure and its Causes: Markets may fail in terms of; non-provision of public goods due to non-rivalry and non- excludability; non-socially optimal levels of goods and services due to the presence of externalities, information failure (including asymmetric information), immobility of factors of production, and market dominance
Make a guess
Drivers on a busy road at 6pm pay for their own petrol and time. Without road charges, how much driving happens at peak hour?
- Too much, because drivers ignore the delay they cause others.
- The right amount, because drivers pay all their own costs.
- Too little, because traffic jams put many people off driving at that hour.
Show the answer
Too much, because drivers ignore the delay they cause others.
Each driver adds to the jam for everyone else but does not pay for it. The free market output is above the efficient level.
When an activity harms third parties, the free market produces too much of it.
A negative externality is a cost imposed on third parties, people outside the transaction, that nobody pays for. Car exhaust, traffic congestion and noise are examples.
Producers and consumers consider only their private costs (MPC). The true cost to society, the marginal social cost (MSC), is MPC plus the marginal external cost (MEC).
The free market produces where MPB = MPC, at Qp. The efficient output is where MSB = MSC, at Qs. Since MSC is above MPC, Qp is greater than Qs: the good is overproduced.
For each unit between Qs and Qp, the cost to society is more than the benefit. The total of these losses is the deadweight loss.
- MSC
- MPC + MEC.
- Result
- Qp > Qs: overproduction.
- Example
- Congestion; ERP charges drivers.
Worked example: Driving into the city at peak hour
Each extra car on a busy road slows every other driver and adds pollution.
- A driver weighs their own benefit against their own costs: petrol, parking, time.
- They ignore the delay and pollution they cause for others: the external cost.
- So too many people drive at peak hour: Qp is above Qs.
- Singapore's Electronic Road Pricing (ERP) charges drivers at busy times, to make them pay for the congestion they cause.
Watch out for this
With a negative externality, the good should not be produced at all.
The efficient output is Qs, which is usually above zero. The problem is too much, not any at all.
Check your understanding
A factory pollutes a river. Without intervention, how does its output compare with the efficient level?
- It produces the efficient amount, because it maximises profit.
- It produces too much, because it ignores the cost of the pollution to people downstream.
- It produces too little, because the cost of pollution makes it cut back.
Show the answer
It produces too much, because it ignores the cost of the pollution to people downstream.
Right. Qp is greater than Qs when there is a negative externality.