ECONOMICS FOR BUSINESS
DECISIONS
MARKET FAILURES
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MARKET FAILURES
Market failure is a concept within economic theory
wherein the allocation of goods and services by a
free market is not efficient, leading to an inefficient
allocation of resources.
Market failures are often associated with information,
non-competitive markets, externalities, or public
goods.
The term "market failure" encompasses several
problems which may undermine standard economic
assumptions.
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REASONS FOR MARKET FAILURE
1) Agents in a market can gain market power, allowing
them to block the occuring of other mutually beneficial
gains from other trades.
2) The actions of agents can have externalities, which
are innate to the methods of production, or other
conditions important to the market.
3) Some markets can fail due to the nature of certain
goods, or the nature of their exchange.
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HOW MARKET FAILS ??
Where the market mechanism fails to allocate
resources efficiently.
Social Efficiency
Allocative Efficiency
Technical Efficiency
Productive Efficiency
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Social Efficiency : Where external costs and
benefits are accounted for.
Allocative Efficiency : Where society produces
goods and services at minimum cost that are
wanted by consumers.
Technical Efficiency : Production of goods and
services using the minimum amount of resources.
Productive Efficiency : Production of goods and
services at lowest factor cost.
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PARETO PRINCIPLE/80-20 RULE/LAW OF THE VITAL
FEW
The Pareto principle states that, for many events,
roughly 80% of the effects come from 20% of the
causes. It is a common rule of thumb in business.
Example : 80% of a company’s sales come from 20%
of its clients.
There is nothing special about the number 80%
mathematically, but many real systems have this %
value somewhere around this region.
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MARKET FAILURE OCCURS
WHERE
Knowledge is not perfect – Ignorance.
Goods are differentiated.
Resource immobility.
Market power.
Services/goods could not be provided in sufficient
quantity by the market.
Existence of external costs and benefits.
Inequality exists.
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IMPERFECT KNOWLEDGE
Consumers do not have adequate technical knowledge.
Advertising can mislead or mis-inform.
Producers unaware of all opportunities.
Producers cannot accurately measure productivity.
Decisions often based on past experience rather than
future knowledge.
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GOODS/SERVICES ARE DIFFERENTIATED
Branding.
Designer labels - They cost three times as much but
are they three times the quality?
Technology – Lack of understanding of the impact
labelling and product information.
RESOURCE IMMOBILITY
Factors are not fully mobile.
Labour immobility – Geographical and occupational.
Capital immobility – What else can we use the Channel
Tunnel for?
Land – cannot be moved to where it might be needed, e.g.
London and South East!
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MARKET POWER
Existence of Monopolies and Oligopolies!
Collusion
Price fixing
Abnormal profits
Rigging of markets
Barriers to entry
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PROVISION OF GOODS
Merit Goods
Could be provided by the market but consumers may
not be able to afford or feel the need to purchase.
Market would not provide them in the quantities
society needs.
Like,
Education – Nurseries, schools, colleges, universities
could all be provided by the market. But would
everyone be able to afford them??
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De-Merit Goods
Goods which society over-produces.
Goods and services provided by the market, which
are not in our best interests!
Like,
Tobacco and alcohol.
Drugs.
Gambling.
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EXCLUDABLE GOODS
Private agents who produce goods and services for sale
must be able to prohibit the consumption of their
output by those who will not be paying for the
privilege.
Ordinary goods : Excludable and rivalrous.
Art galleries, parks, roads : Excludable but non-
rivalrous.
To avoid “inefficient exclusions” , excludable but non-
rivalrous goods are provided by the government.
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NON-EX CLUDABLE GOODS
Common property resources :
Non excludable but rivalrous.
Examples : Fishing grounds, Grazing lands.
Public goods :
Non excludable but non rivalrous.
Examples : Public goods.
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EXTERNAL COSTS AND
BENEFITS
External or social costs
The cost of an economic decision to a third
party.
External benefits
The benefits to a third party as a result of a
decision by another party.
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EXTERNAL COSTS
Decision makers do not take into account the
cost imposed on society and others as a result of
their decision.
Example :
Pollution, traffic congestion, environmental
degradation, depletion of the ozone layer, misuse
of alcohol, tobacco, anti-social behaviour, drug
abuse, poor housing
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External Costs
MS
C
Price MPC
£12
Value of the negative
externality (Welfare Loss)
£7 Social Cost
£5 Socially efficient output is where
MSC = MSB
MSB
80 100 Quantity Bought and Sold
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DESCRIPTION
The Marginal Social Benefit curve (MSB) represents the
sum of the benefits to consumers in society as a whole –
the private and social benefits.
The Marginal Private Cost (MPC) curve represents the
costs to suppliers of producing a given output.
The MPC does not take into account the cost to society of
production. At an output level of 100, the private cost to
the supplier is £5 per unit but the cost to society is higher
than this (£12).
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The difference between the value of the MSB
and the MSC represents the welfare loss to
society of 100 units being produced.
The true cost therefore is the MSC (the MPC
plus the external cost). Current output levels
therefore (100) represent some element of
market failure – price does not accurately
reflect the true cost of production.
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EXTERNAL BENEFITS
Price MSC
£10 Value of the positive
Social Benefits externality (Welfare
£6.50 Loss)
£5
Socially efficient output
MSB is where
MSC = MSB
MPB
100 140
Quantity Bought and Sold
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DESCRIPTION
There can be a position where output is less than
would be socially desirable (education for example?)
In this case, the sum of the benefits to society is
greater than the private benefit to the individual.
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INEQUALITY
Poverty – absolute and relative
Distribution of factor ownership
Distribution of income
Wealth distribution
Discrimination
Housing
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MEASURES TO CORRECT MARKET FAILURE
State provision
Extension of property rights
Taxation
Subsidies
Regulation
Prohibition
Positive discrimination
Redistribution of income
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THANK YOU!!
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