The Economic Environment of Business

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4008AFE The Economic Environment of Business
Week 6: Market Failures and Government Intervention
Dr Alban Asllani
Lecture Outline
1 Introduction
2 Efficiency
3 Market Failure
4 Government Intervention
5 Conclusion
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Last Time
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Last time wetalked about the different types of market
structures
From perfect competition to monopoly weanalysed how the
equilibrium is achieved
In perfect competition firms are price takers. There are many
firms in the market and the product is identical so no firm has
power over the price of the good.
But the assumptions for perfect competition are not realistic.
Last Time
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In monopolistic competition, products are similar but not
identical and firms have power over the price.
In oligopoly wehave a small number of firms operating in the
market. They have enough power to set their price. They can
compete with each other, or act as a single firm and gain
monopoly power (cartel).
In monopoly there is only one firm in the market. Monopolies
are the result of high barriers due to the nature of the product.
Monopolies have the power to charge any price.

Today
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Do firms meet the interest of consumers and the society?
Does achieving equilibrium in a free market automatically
achieve the best outcome for society?
How governments intervene in markets?
Isgovernment intervention effective?
Learning Outcome
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Market failures
Market Efficiency
Government intervention
Efficiency under perfect competition
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Private efficiency
The consumer or the firm are acting ”rationally” when:
Expanding activity if MB > MC
Contracting activity if MC > MB
Marginal Benefit and Marginal Cost
Marginal Benefit (MB)
The extra benefit you get if you change your activity by one
unit.
Marginal Cost (MC)
The extra cost you face if you change your activity by one
unit.
The person acts efficiently in his or her own private interest if:
MB = MC
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Efficiency and Perf. Competition
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Perfect competition will ensure private efficiency is achieved:
MB = MC
No externalities, all costs and benefits are included in the
price of the product.
MSB = MB = MC = MSC
Social efficiency
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Consumer surplus (CS) is the difference between the price
that the consumer has to pay for a good and what he is
willing to pay.
Producer surplus (PS) is the difference between the price that
the producer receives for the good and what he must receive to
provide the good.
Social welfare = CS + PS
Consumer Surplus
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Producer Surplus
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Total Surplus
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Inefficiencies
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Inefficiencies
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In case of inefficiencies the price is not at the equilbrium level.
The yellow area is called deadweight loss
Deadweight loss is a loss of economic efficiency that can
occur when equilibrium for a good or service is not achieved
or is not achievable.

Social efficiency
Pareto optimality
A Pareto optimal outcome is one such that none could be
made better off without making someone else worse off.
This means that resources are allocated efficiently, e.g. weproduce
the maximum possible with some specific resources.
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Social efficiency
Pareto Improvement
A reallocation of resources that makes at least one person
better off without making anyone else worse off
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Definition
Market Failure
Market failure refers to situations inwhich the market, absent
government intervention, leads to inefficiencies.
Refers to a situation where the quantity of a product demanded by
consumers does not equate to the quantity supplied by suppliers.
This is a direct result of a lack of certain economically ideal factors,
which prevents equilibrium.
The allocation of goods and services is not efficient
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Market Failure
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Markets can fail to be efficient:
Insufficient Competition
Externalities
Public goods
And Markets can be unfair:
Inequality
Poverty
Externalities
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Some economic activities have effects that may not be intended,
e.the effect of things Ido or produce do not fully capture the
benefit. These effects are calledexternalities.
Positive externalities are benefits that are infeasible to charge
to provide
Negative externalities are costs that are infeasible to charge to
not provide
Example: Pollution or education.
Externalities
Externalities
Externality is the cost or benefit that affects a party who did
not choose to incur that cost or benefit.
To overcome externalities, werequire some form of government
intervention
Tax. To reduce consumption of negative externalities, wecan
place a tax on goods with negative externalities
Subsidy. To increase consumption of positive externalities,
wecan place a subsidy on these goods.
Regulation. The government may place regulations which
limit the amount of pollution
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Externality and Supply
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Externality and Demand
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Government Intervention
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Government can intervene to correct inefficiency.
Market power
when markets are imperfect, i.e. monopoly
government can use taxes or regulations
Deadweight Loss in Monopoly
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Government Intervention
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Public goods
Because public goods are non-excludable it is difficult to
charge people for benefitting once a product is available
The free rider problem leads to under-provision of a good and
thus causes market failure with public goods, private sector
markets may fail to supply in part or in whole the optimum
quantity of public goods

Government Intervention
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Common resources
Not owned but are available free of charge to anyone
Non government intervention will result overuse of these
common resources
Example: the rain forest, fish stocks

Government Intervention
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Other cases
Ignorance and uncertainty
the problem of asymmetric information
Protecting people’s interests
the principal–agent issue
Merit goods
goods and services that the government feels that people will
under-consume, e.g. education

Forms of Government Intervention
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Other cases
Price controls
high minimum prices
low maximum prices
Direct provision of goods
providing public goods
other goods
Taxes and subsidies
Legal controls
Regulatory bodies
Provision of information
Government Intervention
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Drawbacks of government intervention
shortages and surpluses
poor information
bureaucracy and
lack of market incentives
shifts in government policy
lack of freedom for the
inefficiency individual
Advantages of the free market
automatic adjustments
dynamic advantages of
capitalism
high degree of competition
even under
monopoly/oligopoly

Conclusion
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Review today’s lesson.
Read the relevant chapters in the book (Including all boxes
and case studies)
Search online for more sources.
Ask questions in seminar if anything is unclear.
Do self-test questions at the end of the chapter and online.
Thank youfor your attention.
Questions?
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