Giovannie Alvarez

Form 5

Economics

Contents
Market Structure and Market Failure..........................................................................................................2
Market Structure.....................................................................................................................................2
Perfect competition.................................................................................................................................3
Monopoly................................................................................................................................................7
Monopolistic Competition.....................................................................................................................13
Oligopoly...............................................................................................................................................18
More information on Perfect Competition............................................................................................23
More information on the Monopoly.....................................................................................................46
More information on Monopolistic Competition..................................................................................64
More information on the Oligopoly.......................................................................................................83
Market Failure.......................................................................................................................................85
Consequences of Market Failure...........................................................................................................98

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Market Structure and Market Failure

Market Structure

Market Structure is defined as the features/characteristics that determine the behavior and
performance of firms in the industry. (how the market operates)

In the economy, there are many different types of firms, each producing different products.
Economists prefer to classify firms and industries according to the type of market in which they
operate.

The following are all examples of market structures:

 Monopoly
 Oligopoly
 Monopolistic competition
 Perfect competition

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Perfect competition

Perfect competition is a market structure in which they are many sellers and many buyers
producing a homogeneous product.

This is a market structure where many sellers produce the same type of good/product.

The following images help to better understand perfect competition.

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One of the best examples of this type of market structure is farming produce. For example,
milk, potatoes, rice, fruits, and vegetables.

For this assume there are two farms producing milk.

Farm A & Farm B

It would be difficult to differentiate between milk in farm A and milk produced in farm B. The
consumer simply wants the purchase the product of milk and it does not matter which farm the
milk was produced in. The product has the same uses.

This example can be used for rice, potatoes, and other farm products.

Gas stations and stock exchange are perhaps two of the best real-world examples of firms that
fall under the perfectly competitive market.

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Features of perfect competition:

 There are many sellers in the industry.

 There are many buyers.

 It is a homogeneous market, in which each unit of the product is identical.

 There is perfect knowledge in the market.

 No one firm can influence price.

 The firm is said to be a price taker. The firms would have to take the market price and
use that to sell their products.

 There is freedom of entry and exit. A new firm can enter the industry and start
producing at any time and an exiting firm is free to leave the industry. There are no
restrictions.

 Perfect Competition is a theoretical concept, and, in the real world, there are no perfect
markets.

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Perfect knowledge - all buyers and sellers are aware of the product, its features, its price, and
they are aware of other buyers and sellers. Perfect knowledge can also be defined as
consumers have all readily available information about prices and products from competing
suppliers and can access this at zero (0) cost.

Price taker – A producer who has no power to influence prices.

In the perfect competition, the market structure will the stay the same for a long period of
time, unless there is a radical change.

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Monopoly

A monopoly is a market in which there is only one seller and there are many buyers. The one
firm is the only producer of the good or service.

Features of the Monopoly:

 There is one seller.

 There are many buyers.

 There is no competition, as the firm has no other firm with which to compete.

 The product is unique and has no close substitutes.

 There is imperfect knowledge in the market.

 The monopolists can only sell more at a lower price, and if price increases, less would
be sold.

 The firm produces a given quantity and sells it at the price the market is willing to pay.

 The firm is a price maker.

 There are extreme barriers to entry. These prevent firms from entering the industry.

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Imperfect knowledge – This means that buyers and sellers are not aware of all the information
in the market.

Price maker – The firm can determine the price of their product. A price maker is a firm who has
enough market power to influence prices.

The following images help to better understand a monopoly.

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Some examples of Monopolies are as follows:

 Carib Brewery Ltd in Trinidad

 State owned water companies
 State owned electricity companies

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Barriers to entry for Monopolies:

A barrier to entry is anything that prevents new firms from entering and competing in an
industry.

The following are some barriers to entry in a monopoly:

 Government regulations
 Patents
 Large capital outlay
 Ownership by the firm of a scarce factor of production

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Government regulations – These are laws that prevent new firms from entering an industry.
For example, in Caribbean economies there is only one firm providing water due to government
regulations.

Patents – A patent grants the inventor exclusive rights to the patented products or process. The
monopoly is the only firm that can produce a commodity in a specific manner. The patent
would make it illegal for others to engage in producing the product. The firm would be able to
sue those who do not abide by the patent.

Large capital outlay – This prevents smaller firms from entering an industry. For example, oil
refining. It is very expensive for a smaller firm to engage in the oil industry.

Ownership by the firm of a scarce factor of production – Secret recipes and trade secrets are
owned by monopolies. For example, Angostura Trinidad Ltd is the only firm that possesses the
knowledge of the secret ingredient in the Angostura bitters recipe. (This is the factor ‘capital’ or
‘know-how.’

Another example could be the Krabby Patty. In this example, assume the Krusty Krab is a
monopoly. The Krusty Krab is the only firm that knows the secret recipe for Krabby Patties.

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A patent is a form of legal protection that a provides a person or legal entity, with exclusive
rights for making, using, or selling a concept or invention. The patent usually prevents others
from doing this for a duration of time. (The duration of the patent)

In the monopoly, the market structure will stay the same, unless there is some radical change.

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Monopolistic Competition

Monopolistic competition is a market structure in which there is competition amongst many

firms.

In this market structure, there are some features of a monopoly and there are some features
on perfect competition.

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Features of monopolistic competition:

There are many buyers and sellers.

The product is similar yet differentiated through branding. (This is product differentiation)

Production differentiation gives the individual firm some degree of market power.

There is imperfect knowledge.

Firms are price makers.

There are some barriers to entry. These barriers are not that difficult to break through.

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The following are images that help to understand monopolistic competition.

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Some common examples of firms that operate under monopolistic competition are as follows:

 Restaurants
 Hair salons
 Beauty salons
 Supermarkets

In this market structure, a firm can experience different situations in both the short-run and the
long-run.

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Product differentiation – This means the product is made to look different in the eye of the
consumer. As seen in the example below.

For example, shoes. There are many different shoe companies. Companies such as Nike, Adidas
and sketchers produce a similar good (shoes) but each company utilizes branding and
marketing differently. Each company would brand and design their show differently.

Production differentiation gives the individual firm some degree of market power. For example,
assume one only firm produces Grace jerk seasoning. There is no substitute for Grace jerk
seasoning, even though other firms produce jerk seasoning. Loyal customers might only
purchase Grace jerk seasoning. These customers would be loyal to the Grace brand.

Firms can be price makers. For example, Nike can charge whatever price they want for their
shoes. Nike could charge different prices for their shoes as compared to other shoe companies.
Nike could believe that their product is specific or unique.

Firms within this market structure are price makers. They can determine their price. This is
based on the fact that their product is different as compared to others.

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Oligopoly

An oligopoly is a market structure in which there are few firms competing in the market.

Some examples of an oligopoly in the region include:

 Commercial banks
 Beer brewing
 Petrol refining
 Household detergent producers
 Producers who produce personal care products.

The following images would help to understand oligopolies.

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Features of an oligopoly.

 There are many buyers.

 There are few sellers.

 The product might be homogeneous or differentiated. An example of homogeneous

product would be unleaded petrol. An example of a differentiated product would be
detergents.

 There is imperfect knowledge in the market.

 Firms avoid price competition and so prices remain rigid or there is price stickiness.

 If firms increase prices, competitors will not follow. And so, the given firm will lose
customers to its rivals. (The given firms being the firm that increase prices.)

 Oligopolies might choose to enter into agreements with, or collude, with other firms to
maximize profits.

 There are high barriers to entry. This is due to the high set up costs.

 Oligopolies are typical in the real world.

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Price rigidity means that prices remain at a certain level over a long period of time. Few sellers
would not want to have a price war. It would not be in their best interest. If they engaged in a
price war, only the biggest firm or firms would win. The smaller firms would not be able to
compete.

A price war occurs when rival firms continuously reduce prices to undercut each other.

Collusion occurs when there are price and quantity agreements with other firms.

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A group of sellers colluding this way is called cartel. In many countries, cartels are illegal. A good
example of a cartel would be Oil Producing Nations (OPEC). These companies agree on all
terms. There is some collusion in the airline industry as well. Many different airlines charge the
same price for their tickets.

Firms in OPEC (Oil Producing Nations) would charge the same price for their oil. They would
also have quantity agreements. Airlines generally charge the same price for their tickets.

Drugs cartels are also an example of a collusion. However, these are illegal.

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The following images summarizes all what was stated.

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More information on Perfect Competition

A perfectly competitive market and its characteristics were described before. As a result of its
characteristics, the perfectly competitive market has the following outcomes:

 The actions of any single buyer or seller in the market have a negligible impact on the
market price.

 Each buyer and seller takes the market price as given.

Perfectly Competitive = Perfect Competition

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A competitive market has many buyers and sellers trading identical products so that each buyer
and seller is a price taker.

Buyers and sellers must accept the price determined by the market. Essentially, the market
forces (supply and demand) determine or the influence the price in the market.

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The Revenue of a Competitive Firm in a Perfectly Competitive Market.

Total Revenue.

 Total revenue for a firm is the selling price times the quantity sold. The following is a
formula for calculating total revenue:
TR = (S.P. X Q)

 Where TR = Total Revenue

 Where S.P. = Selling Price or Price
 Where Q = Quantity

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Average Revenue.

 This tells us how much revenue a firm receives for the typical unit sold. The formula for
calculating average revenue is as follows:
AR = (Total Revenue)/(Quantity)

 Where AR = Average Revenue

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NOTE

In perfect competition, average revenue equals the price of a good.

Recall:

Average Revenue = Total Revenue/Quantity

= (Price x Quantity)/Quantity
= Price

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Marginal Revenue

 Marginal Revenue is the change in total revenue from an additional unit sold. The
following is a formula for calculating marginal revenue.
MR = (Change in Total Revenue)/ (Change in Quantity)

 Where MR = Marginal Revenue

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NOTE:

For competitive firms, marginal revenue equals the price of the good.

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Profit Maximization and the Competitive Firm’s Supply Curve

The goal of a competitive firm is to maximize profit. This means that the firm will produce the
quantity that maximizes the difference between total revenue and total cost.

The formula to calculate Profit for a competitive firm is as follows:

Profit = (TR – TC)

 Where TR = Total Revenue

 Where TC = Total Cost

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The formula to calculate Change in profit for a competitive firm is as follows:
Change in Profit = (MR-MC)

 Where MR = Marginal Revenue

 MC = Marginal Cost

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From using the following formulas and calculations, it is logical to say that the profit
maximization point would be where the marginal revenue equals the marginal cost.

The following images shows the graphs of the perfectly competitive supply curve:

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Notes on the graph.

The straight line is the supply curve. The point where the MC graph intersects the MR graph,
that is known as profit maximization.

When MR > MC, the firm will increase quantity.

When MR < MC, the firm will decrease quantity.
When MR = MC, the firm has maximized profit.

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Decision to Shut Down and Exit in A Perfectly Competitive Market.

A shutdown refers to a short-run decision not to produce anything during a specific period
because of current market conditions. The firm shuts down if the revenue it gets from
producing is less than the variable cost of production.

While an exit refers to a long-run decision to leave the market. The firm considers its sunk costs
when deciding to exist but ignores them when deciding whether to shut down.

Sunk costs – These are costs that have already been committed and cannot be recovered.

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The following are conditions that would a make a firm shut down in the short run. They would
not produce anything the short run. The Firm would choose to shut down if:

 TR < VC
 TR/Q < VC/Q
 P < AVC

Shutdowns help to minimize loss. The following image helps to understand what was stated.

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Notes on the graph:

The portion of the marginal-cost curve that lies above average variable cost is the competitive
firm’s short-run supply curve.

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The following are conditions that would make a firm exit in the long run. They would
completely leave the market. There firm would choose to exist if:

 TR < TC
 TR/Q < TC/Q
 P < ATC

Once revenue is less than cost in the long run, it would be best for the firm to exist the market.
In the long run, a firm cannot be continuously experiencing losses. It would be logical for that
firm to exist. If they stand, they would be continuously losing money.

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The firm would enter the market/industry if any such action is profitable. A firm would enter
the industry/market if:

 TR > TC
 TR/Q > TC/Q
 P > ATC

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The following image helps to understand what was stated.

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Notes on the graph:

The competitive firm’s long run supply curve is the portion of its marginal-cost curve that lies
above the average total cost.

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Graph showing the perfectly competitive firms demand curve.

The perfectly competitive firm has a horizontal demand curve.

The industry has the downward sloping demand curve.

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Profits and Loses in a perfectly competitive market

Firm with profits.

The following image shows a firm within a perfectly competitive market structure. The image
shows the firm experiencing profits.

Profit = Total Revenue – Total Cost

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Firm with Loses.

The following image shows a firm within a perfectly competitive market structure. The image
shows a firm experiencing loses.

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Notes on the two graphs.

Once price is below the ATC, the firm would experience loses
Once price is above the ATC, the firm would experience profits.

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More information on the Monopoly

To reiterate, a monopoly is a price maker.

A firm is said to be a monopoly if:

 It is the sole seller of its product

 Its product does not have close substitutes

Monopolies do possess high barriers to entry. Refer to the previous section on monopolies.
These barriers to entry have three sources:

 Ownership of a key resource

 The government gives a single firm the exclusive right to produce some good.
 Cost of production makes a single producer more efficient than a large number of
producers.

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Monopoly Resources

Although exclusive ownership of a key resource is a potential source of a monopoly, in practice

monopolies rarely arise for this reason.

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Government-Created Monopolies

Governments may restrict entry by giving a single firm exclusive right to sell a particular good in
certain markets.

Patent and copyright laws are two important wa of how a government creates a monopoly to
serve public interest.

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Natural Monopolies

An industry is a natural monopoly when a single firm can supply a good or service to an entire
market at a smaller cost than could two or more firms.

A natural monopoly arises when there are economies of scale over the relevant range of
output.

The graph below shows the economies of scale with respect to a natural monopoly

Economies of scale the benefits are firm receives with an increase in size. It is where the
average cost decreases with an increase in production/output.

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How monopolies make production and pricing decisions.

Monopoly vs Perfect Competition

Monopoly:

 They are the sole producer.

 They face a downward-sloping demand curve.
 They are price makers.
 They reduce prices to increase sales.

Competitive Firm:

 Is one of many producers.

 Faces a horizontal demand curve.
 Is a price taker.
 Sells as much or as little at same price.

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The following graph would show a monopolist demand curve.

The graph happens to be a downward sloping curve.

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A monopoly’s revenue

A monopoly has the following revenues:

 Total Revenue
 Average Revenue
 Marginal Revenue

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Total Revenue for a monopoly.

To calculate Total Revenue (TR) for a monopoly is as follows:

Total Revenue = Price x Quantity

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Average Revenue for a monopoly

To calculate Average Revenue for a monopoly is as follows:

Average Revenue = TR/Q

 Where TR = Total Revenue

 Where Q = Quantity

NOTE THAT AVERAGE REVENUE = PRICE

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Marginal Revenue

To calculate Marginal Revenue for a monopoly is as follows:

Marginal Revenue = Change in TR/ Change in Q

 Where TR = Total Revenue

 Where Q = Quantity

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Note

In order for a monopolist to sell more, they tend to reduces their prices. This is contrasted to
the perfect competitive market.

The table below shows what was stated above.

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A monopoly’s Marginal Revenue

 Their marginal revenue is always less than their price of its good.
 The demand curve is downward sloping
 When a monopoly drops the price to sell one more unit, the revenue received from
previously sold unit also decreases.

The monopoly would have to drop their prices in order to sell more units. (Law of Demand)

When a monopoly increases the amount it sells, it has two effects on total revenue. (P X Q).
Those effects are as follows:
1. The output effect – more output is sold, so Q is higher.
2. The price effect – price falls, so P is lower.

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Marginal Revenue and Demand Curve for a monopoly

The following graph, shows the marginal revenue curve (MR) and the Demand curve (Demand).
Both are downward sloping because price always decrease when quantity increases (law of
demand)

Marginal Revenue tends to go down to negative numbers on the graph.

The demand curve is drawn from the average revenue.

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Profit Maximization for a Monopoly

A monopoly maximizes profit by producing the quantity at which Marginal revenues equals
Marginal cost. (MR = MC)

It then uses the demand curve to find the price that will induce customers to buy that quantity.

The figure below shows the Profit Maximization for a Monopoly.

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Notes on the graph.

The monopoly would find the profit maximization point, but then they would have to use the
demand curve to determine what price corresponds with the maximization point.

As shown from the graph, the monopoly had to move back their quantity from Q2 to Q Max.
They did this because it is at that quantity, that Marginal Cost = Marginal Revenue. Drawing a
vertical line from Q Max to the Profit Maximization point.

The profit Maximization point is where MC = MR. The intersection of both graphs. This
intersection determines the profit maximizing quantity.

The profit maximization point would be the monopoly price. At this price, this can induce
consumers to buy at the specific quantity. So in order to calculate the profit maximization point,
use the demand and curve and draw a line from the demand curve to the cost and revenue.

To find the Monopoly price, the monopolist would have to look at which point corresponds
with the profit maximizing quantity. In this case, it would be point B. Once they obtain this price
from the demand curve, they would be able to determine what price will induce customers to
buy at that quantity.

The monopoly price is draw onto the demand curve. This is done to show the price which is
consistent with the quantity.

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Comparing Monopoly and Perfectly Competitive Firm.

For a competitive firm, price equals marginal cost.

P = MC = MR

For a monopoly firm, price exceeds marginal cost.

P > MR = MC (The price is always greater than the intersection of these two graphs)

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A Monopoly’s Profit

Profit equals total revenue minus total costs

Profit = TR – TC
Profit = ((TR/Q) – (TC/Q)) x Q
Profit = (P – ATC) x Q

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This image

shows profits in a monopoly’s firm.

 The monopolist will receive economic profits as long as price is greater than average
total cost.
 At any point where the ATC is greater than the price, the monopolist will experience
loses.

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More information on Monopolistic Competition

Imperfect Competition refers to those markets structures that fall between perfect competition
and pure monopoly.

Types of Imperfectly Competitive Markets:

 Monopolistic Competition
 Oligopoly

Monopolistic Competition -> Many firms selling products that are similar but not identical.

Oligopoly -> Only a few sellers, each offering a similar or identical product to the others.

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Monopolistic Competition is a market that has some features of perfect competition and some
features of a monopoly.

The following are some characteristics or attributes of Monopolistic Competition:

 Many sellers
 Product differentiation
 Free entry and exit

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  Many sellers

There are firms competing for the same group of customers. These firms produce products.
Product examples include books, CDs, movies, computer games, restaurants, piano lessons,
cookies, furniture and etc.

 Product Differentiation

Each firm produces a product that is at least slightly different from those of other firms. Rather
than being a price taker, each firm faces a downward-sloping demand curve.

 Free entry and or exit

Firms can enter or exit the market without restriction. The number of firms in the market
adjusts until economic profits are zero.

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Notes:

An economic profit or loss is the difference between the revenue received from the sale of an
output and the costs of all inputs used, as well as any opportunity costs. In calculating economic
profit, opportunity costs and explicit costs are deducted from revenues earned.

For Example: If a company had $250,000 in revenues and $150,000 in explicit costs, its
accounting profit would be $100,000. The same company also had $50,000 in implicit, or
opportunity costs. Its economic profit would be $50,000.

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The Monopolistic Firm in the Short Run

Short-run economic profits encourage new firms to enter the market. This:

 Increases the number of products offered.

 Reduces demand faced by firms already in the market.
 Incumbent firms’ demand curve shift to the left.
 Demand for the incumbent firms’ product fall, and their profits decline.

Incumbent – existing, so firms that are already existing in the market.

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69
The method of finding the profit maximization point for monopolistic competition is exactly
similar to finding the profit maximization point for the monopoly and the perfect competition.
(WHERE MR = MC)

However, the monopolistic competition is more similar to that of the monopoly. This means
once you identify the profit maximization point, you would have to find the point that
correlates to it on the demand curve. Then you would have to find the corresponding price.

The profit maximizing quantity is essentially where MR = MC. The firms make a profit at this
point.

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The Monopolistically Competitive Firm in the Short Run

Short-run economic loses encourage firms to exist the market. This:

 Decreases the number of products offered.

 Increases the demand faced by the remaining firms.
 Shifts the remaining firms’ demand curves to the right.
 Increases the remaining firms’ profit.

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The Long-Run Equilibrium

Firms will enter and exit until the firms are making exactly zero economic profits.

Zero economic profits -> it would be the level of the profits the firms are making. This is also
called normal profits.

Normal profit occurs at the point where all resources are being efficiently used and could not
be put to better use elsewhere.

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The ATC is touching the Demand Curve. At this point, the firm would experience normal profits.
The Price is equal to the Average Total Cost.

To reiterate, the profit-maximizing quantity/position would be when MR=MC and when P=ATC.

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Long Run Equilibrium

Two Characteristics:
These qualities of monopolistic competition, are derived from both the monopoly and perfect
competition.

1. As a monopoly, price exceeds marginal cost.

2. As in a competitive market, price equals average total cost.

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As a monopoly, price exceeds marginal cost.

 Profit maximization requires marginal revenue to equal marginal cost.

 The downward-sloping demand curve makes marginal revenue less than price.

As in a competitive market, price equals average total cost.

 Free entry and exit drive economic profit to zero.

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Since there are no barriers to entry, a firm can enter the market once profits are good and leave
if they are not. This drives economic profits to zero.

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Differences between Monopolistic and Perfect Competition.

There are two noteworthy difference between monopolistic and perfect competition. There are
as follows:

 Excess capacity
 Markup

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Excess Capacity

Perfect Competition

 There is no excess capacity in perfect competition in the long run.

 Free entry results in competitive firms producing at the point where average total cost is
minimized, which is the efficient scale of the firm.

Monopolistic Competition

 There is excess capacity in monopolistic competition in the long run.

 In monopolistic competition, output is less than the efficient scale of perfect
competition.

Excess capacity refers to a situation where a firm is producing at a lower scale of output than it
has been designed for.

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In figure (a), a visible space can be seen. This space is known as excess capacity. This space is
located in between the quantity produced and the efficient scale. Essentially between both
points.

The firm can continue to bring down their prices to compete with other firms. This space allows
the firms to do previously mentioned.

Excess Capacity exists in the monopolistic competition.

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Markup Over Marginal Cost

Mark up refers to the value that a player adds to the cost price of a product. Mark up simply
means a person increases the price of a good over the margin.

 For a competitive firm, price equals marginal cost.

 For a monopolistically competitive firm, price exceeds marginal cost.
 Because price exceeds marginal cost, an extra unit sold at the posted price means more
profit for the monopolistically competitive firm.

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The markup is the difference between the Marginal Cost and the Price. The Marginal cost and
Price are shown on the graph.

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More information on the Oligopoly

Graph showing the demand curve under the oligopoly.

Assume the same factors for profit and loss for this market structure

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84
Market Failure

Market failure is the inability of the market to allocate resources efficiently to best satisfy
society’s wants. Markets fail for a number of reasons. The causes of market failure lie in four
areas:

 The provision of public goods

 The provision of merit goods
 Externalities – positive and negative
 Monopoly

When the market fails (breaks down) government can intervene to promote efficiency and
equity.

The resources are supplied by the suppliers and the goods/resources are demanded by the
consumers.

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The provision of public goods

There is a market for public goods, yet no private firms are willing to supply these goods. This is
a case of a ‘missing market,’ a cause of market failure.

Public goods – These are goods that are collectively consumed by society. They possess two
characteristics:

 Non-excludability
 Non-exhaustibility

Non-excludability (rivalry) – This means that a consumer cannot be excluded from consuming
the good, even if he or she did not pay for it. There is an absence of ownership rights attached
to the purchase of these goods.

Non-exhaustibility – This means that the consumption of a public good by one individual does
not reduce the amount available for other individuals to consume.

If a good meets the criteria above, it is said to be a public good.

A public good can be consumed simultaneously by numerous individuals. Examples of public

goods are streetlights, lighthouses and defence. Defence being public defence from the police
force and army.

The concept behind a public good is the government would have to provide or produce it. If it
were up to the market, they would not produce enough. They would have a higher and more
taxing on the good.

The government provides a public good such as streetlights, public parks and defence.

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These goods are provided to the public by the government. These goods are for the public.
These goods are not exclusive to anyone and no one cannot consume more of the good than
another person.

The market fails because the market does not provide enough of these goods. For example,
there are more public school than private schools.

When goods are available free of charge, the market forces (supply and demand) that normally
allocate resources in our economy are absent.

When a good does not have a price attached to it, private markets cannot ensure that the good
is produced and consumed in the proper amounts.

A light house is a public good: it is used by numerous individuals (and ships) who did not pay for
it directly.

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The Free Rider Problem as it relates to Public Goods.

A free rider is a person who receives the benefit of a good but avoids paying for it. People
cannot be excluded from enjoying the benefits of a public good. Individuals may withhold
paying for the good hoping that others will pay for it.

The free-rider problem prevents private markets from supplying public goods.

Solving the Free-Rider Problem

The government can decide to provide the public good if the total benefits exceed the costs.
The government can also make everyone better off by providing the public good and paying for
it with tax revenue.

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As the economic theory states, for resources to be efficiently allocated, the price of the good
must be equal to the marginal cost. (P = MC). This means that the value society places on the
last unit of the good produced – price – must be equal to the value of the additional resources
used to produce that good – its marginal cost.

For economic efficiency to exist, price must also be zero. No firm will supply a good at a price of
zero (which is the implication of non-diminishability) and no firm will supply a good where no
one can be made to pay for it (which is the implication of non-excludability). The issues
mentioned are the reasons why firms will not supply public goods.

When there is market failure as a result of the provision of public goods, there is an economic
role for the government to play. The government intervenes and supplies public goods, and this
is financed out of taxation.

When the government supplies the public good, this market failure is eliminated, as the good is
provided for consumers – government supplies the good, society collectively consumes the
good and it is paid for out of taxation.

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The provision of merit goods.

The socially desirable quantity of these goods is neither produced nor consumed. Since there is
under-production and under-consumption, this causes the market to fail.

Merit goods are goods for which the social benefits to the community of the consumption of
the good far outweigh the private benefits to the consumers.

A merit good is a good which when consumed provides external benefits. When merit good is
consumed it generates positive externalities.

Some examples of merit goods are education and health care. When there is a healthy and
educated workforce, all of society benefits. Productivity increases, crime falls and output
increases. The consumption of merit goods results in benefits falling on the entire society.

Some firms are not willing to provide enough merit goods to supply the entire market.

Since firms are not going to provide enough merit goods, the government has to intervene and
provided it. Governments would provide public hospitals and public schools. The hospitals
provided health care while the schools provide education.

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Demerit goods.

Unlike merit goods, demerit goods are bad for you. Demerit goods are socially undesirable and
are either over-produced or over-consumed due to externalities and the market. These goods
would result in negative externalities.

Some examples of demerit goods are:

 Cigarettes
 Alcohol
 Drugs

If the population uses these goods, it could cause the labor force to become unproductive. It
could lead to more crime; more destruction and output would decrease. These demerit goods
also could cause or influence a person to become uneducated. These goods could also cause a
person to become unhealthy. This could lead to an uneducated, unhealthy and unproductive
labor force. This also leads to market failure. These goods are addictive, meaning there are
always in demand for consumers.

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Externalities – positive and negative

Externalities are the spillover effects of production and consumption that fall on a third party.
When externalities are created, it means the market is not operating as efficiently as it should.
When externalities are created, the market also fails.

The producer and the consumer are the two parties to a transaction. In the course of producing
a good or consuming a good, a third party might be affected. This third party made be affected
positively or negatively.

When the third party is affected, this is an externality. When the third party is affected
negatively, this is an ‘external cost’ or a negative externality.

When the third party is affected positively, this is an ‘external benefit’ or a positive externality.

Externalities that result from production are production externalities

Externalities that result from consumption are consumption externalities.

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Examples of negative externalities.

 Pollution and its varying types (Air, Water and etc.)

 Passive smoking
 Traffic congestion

Examples of positive externalities.

 Walking to work. This reduces congestion

 Receiving an education
 Immunization
 Planting a garden
 Research into new technologies

Positive externalities are underproduced resulting in Market Failure

Negative externalities are overproduced resulting in Market Failure

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Externalities cause markets to be inefficient, and thus fail to maximize total surplus. For
example, if there is a spill or spill over, clearly the market failed to efficiently allocate that
resource.

Logically, if an oil spill falls on a garden. The owner of the garden would be affected. He would
have experienced a negative externality. The oil was spilled because the firm who owned it did
it not allocate it properly.

Negative externalities lead markets to produce a larger quantity than is socially desirable.
Positive externalities lead markets to produce a larger quantity than is socially desirable.

When there are negative and positive externalities, the market fails. In economics, we assume
that the government will do what it can to promote the welfare of citizens. The government will
try to intervene and reduce the market failure.

The government might tax firms that produce negative externalities so that the firm reduces
production. It might even place a direct control, limiting the quantity produced by offending the
firms.

When production is reduced, the negative externality (pollution) will also be reduced. The
government might even use the revenue collected from the tax to clean up the pollution

The market failed because too much was produced and there was a spill over effect that
affected a third party.

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Monopolies

When there is a monopoly operating, prices are higher and output is lower than if a number of
firms were operating in the industry.

Markets also fail when there are monopolies. As mentioned earlier in this chapter, a firm is
allocatively efficient when the price of a product is equal to marginal cost (P = MC). Marginal
Cost is the value of the last unit produced, based on producer costs.

Marginal Cost is the additional cost from the production of an extra unit of output.

Price is the value that society places on the last unit produced. The value that the producer
places on the last unit produced (marginal cost) ought to be the same as the value society
places on this unit (price)

When the above is true, then there will be allocative efficiency and no market failure. However,
the monopolist sells at a price that is greater than marginal cost (P > MC). To little of the good is
produced and it is sold at too high a price.

In a monopoly market, there is therefore market failure.

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The government might intervene in the monopoly market to reduce market failure by:

 Passing laws discouraging or limiting the formation of monopolies

 Encourage firms to enter industries where there are monopolies
 Taking over industries where monopolies cannot be avoided. For example, water and
electricity. The government can thereby regulate prices (water and electricity rates)

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Overview of Market Failure

Cause Result
Public goods ‘missing market’ at zero price
Merit goods Underproduction (too little)
Negative externalities Overproduction (too much)
Positive externalities Underproduction
monopoly Underproduction, as P > MC

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Consequences of Market Failure

When markets fail in an economy, all groups in the economy are affected. Firms, Households,
the government, and the economy as a whole. In developed countries, the government will try
to intervene to correct market failure. In developing countries, the government might not have
the resources to intervene and reduce market failure. In such economies, the consequences of
market failure are:

 Retrenchment
 Unemployment
 Economic depression
 A rise in the levels of poverty
 A decline in the provisions of social welfare.

All the consequences are linked. Meaning the tend to happen one after the other.

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Retrenchment

Retrenchment occurs when workers lose their jobs due to the declining activity of a firm. If a
firm that is producing a negative externality is forced to reduce output or close down, then
workers will be retrenched.

When the firm produces less output, it will use less factor inputs (land, labor, capital and
entrepreneurship). If monopolies reduce economic activity due to government restrictions,
retrenchment will also occur.

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Unemployed

As workers are retrenched or laid off, they might be unable to find jobs; perhaps there are non-
available, or maybe their skills do not match the skills needed for the available jobs. They
become unemployed.

The unemployed refers to those persons who are actively seeking a job but are unable to find a
job. If markets fail to provide merit goods such as education, workers will be unable to
develop new skills. The poor will receive no education or training for jobs.

Lack of health care can result in more days lost by workers due to sickness. Absent workers lead
to fall in productivity. Employers, where they can, will substitute capital for labor, and
unemployment therefore grows.

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Economic Depression

Economic depression occurs when there is falling output in the economy and rising
unemployment. Market failure leads to economic depressions, as monopolies and firm
producing negative externalities reduce output.

These activities lead to unemployment. If a government does not take up the slack and provide
public goods and merit goods, there can be further unemployment.

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Increase in poverty

When people are out of jobs, and health and education services are produced in insufficient
quantities and at very high prices, this leads to an increase in poverty. The poor have no jobs.
They cannot afford education and training to make them employable.

The poor cannot also afford the expensive health care, and so might be sick and unable to work.
They might even be victims of firms creating negative externalities in the community. They have
to buy goods and services from firms selling at high monopoly prices.

They have no avenue to escape the poverty that is the result of market failure. Unless the
government intervenes to provide merit goods and public goods and to reduce negative
externalities, the poor will remain in their poverty.

There are two types of poverty:

 Absolute
 Relative

Absolute poverty is a condition where household income is below a necessary level to maintain
basic living standards (food, shelter, housing).

Relative poverty is A condition where household income is a certain percentage below median
income.

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Social Welfare

When there is market failure, governments have to intervene. The government has to use its
resources to provide public goods and merit goods. Firms producing positive externalities must
be given grants to increase output.

There are therefore, fewer resources available for governments to provide for the welfare of
citizens. Social welfare to the poor includes: education, health services, subsidized transport
and training programmes.

However, the provision of public goods and merit goods by the government forms part of its
welfare service to the citizens of the country.

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