2025 H2 Market Failure Notes ACJC

1 ©ACJC Econs Dept/2025/H2 Market Failure ANGLO-CHINESE JUNIOR COLLEGE JC1 Economics 2025 H2 MARKET FAILURE AND GOVERNMENT INTERVENTION Section Content Page 1 Efficiency in Markets 3 2 Market Failure and Government Intervention 5 2.1 Missing Markets: Public Goods 7 2.2 Externalities 11 2.2.1 Overview to Externalities 11 2.2.2 - 2.2.3 Negative Externalities 14 2.2.4 - 2.2.5 Positive Externalities 30 2.3 Information Failure 45 2.3.1 – 2.3.2 Insufficient and Inaccurate Information 45 2.3.3 Asymmetric Information 51 2.4 Factor Immobility 58 2.5 Market Dominance 63 3 Equity in Relation to Markets 66 3.1 Understanding the concept of Equity 66 3.2 Government Intervention to address Inequity 67 4 Decision-Making by Government 69 4.1 Summary of Government Policies 69 4.2 Government Failure 69 Learning Reflection and Annex 73

2 ©ACJC Econs Dept/2025/H2 Market Failure WHAT IS THIS TOPIC ABOUT? ● Due to the central economic problem of scarcity, resources need to be allocated in ways that bring about the most efficient outcome. ● In the free market, the price mechanism is the primary means by which resources are allocated and this would bring about efficiency in resource allocation. ● However, these conditions must be present for the price mechanism to bring about efficiency: o There are price signals to ‘direct’ resource allocation. o No third-party effects (externalities) in consumption or production o The market is perfectly competitive. o Perfect information in the market. o Perfect factor mobility. ● When any of these conditions are not met, resource allocation becomes inefficient (market failure). Markets may fail in term of: o Non provision of public goods o Under or over-consumption/production due to externalities. o Underproduction due to market dominance (H2 only). o Collapse of market or under/over consumption/production due to information failure. o Inefficiencies due to factor immobility. ● Due to these market failures as well as the issue of inequity, the government has to step in to correct them in order to achieve an efficient and equitable allocation of resources. However, due to various constraints, government intervention might fail, potentially leading to greater inefficiencies in resource allocation than those seen under free market forces. LEARNING OUTCOMES Enduring Understanding (students can explain and apply to real world): ● Price mechanism can fail to allocate resources efficiently and equitably. NOTE: Inequity is a distributional issue and not considered a source of market failure. ● Government has to make decisions on how to intervene in markets to correct market failure in order to achieve efficient and equitable allocation of resources. ● However, even with government intervention, the intended outcomes may not be achievable due to constraints in policy implementation, uncertainty of policy effects, and unintended consequences. Essential question: ● To what extent should governments intervene in the free market?

3 ©ACJC Econs Dept/2025/H2 Market Failure 1. EFFICIENCY IN MARKETS Governments mainly want to achieve resource allocation which meets the following microeconomic objectives: 1) EFFICIENT and 2) EQUITABLE allocation of resources (to be discussed in section 3) Understanding the concept of ‘efficiency’: There are 3 types of efficiency1 you will learn in economics: i. Productive efficiency This refers to a situation where goods are produced at the minimum average cost possible for the given output size, based on current technology. ii. Dynamic efficiency This refers to when firms invest in technology so that productivity and product quality will improve over time. iii. Allocative efficiency This refers to the situation where the current combination of goods produced and sold maximises society’s welfare. For this topic, we will be focusing on social optimum which refers to the level of output where society’s welfare is maximised i.e. the outcome is allocative efficient. In free markets, resource allocation takes place with the following characteristics: ● The economic agents (individuals and firms) base their decisions on the pursuit of self-interest (satisfaction, profits). ● Prices of goods and services (price signals) will direct the movement of resources and goods and services between markets. ● No government intervention in markets. 1 We will revisit these efficiency concepts when we learn about firms and decisions in Topic 4.

4 ©ACJC Econs Dept/2025/H2 Market Failure Figure 1: Diagrammatic representation of Social Optimum ▪ In Figure 1 above, social optimum is at market equilibrium point E. At this point, Triangle AEC is the total welfare to society (i.e. the sum of consumer and producer surplus). At the social optimum, social welfare is maximised. ▪ At Q1 (or any quantity below Q0): o Marginal social benefit (MSB) is greater than marginal social cost (MSC), so there will be net benefit added to society’s welfare if one more unit of the good is produced/consumed. o There is a loss of potential welfare when society consumes at Q 1. This loss of potential welfare is represented by the area of triangle BDE. ▪ At Q2 (or any quantity above Q0): o MSC is greater than MSB, so there will be a net cost to society’s welfare if one more unit of the good is produced/consumed. o A deadweight loss is incurred when society consumes at Q 2. This deadweight loss is represented by the area of triangle EFG. ▪ Therefore, social optimum will be attained at Q0 where: MSB = MSC. The attainment of social optimum in markets requires the fulfilment of these conditions: 1. There are price signals to enable consumption and production decisions through price mechanism. The market will fail to produce goods without price signals. o Thus, p ublic goods ( which are non-rival and non -excludable in consumption) leads to missing markets. 2. No third -party effects from the consumption/production of goods on others in the society (i.e. no externalities). o Firms and consumers base their decisions on the pursuit of self- interest. However, society’s valuation of costs and benefits is based on the maximisation of society’s welfare. o The presence of externalities means that the market-based valuation of costs and benefits will differ from that of society’s. Thus, the free market equilibrium will not maximise social welfare. These conditions will be explained further in the next section of this topic.

5 ©ACJC Econs Dept/2025/H2 Market Failure 3. Perfect information o This is where c onsumers are fully aware of the actual costs and benefits of consuming a good. o In addition, o ne party in the transaction (say firms) does not have more information than the other party (consumers). o Imperfect information will result in inefficiency. 4. Market is perfectly competitive o Firms do not have market power to influence the prices. o In the real world, markets are mostly imperfect → social optimum is not achievable. 5. Perfect mobility of resources o Resources can easily move from one use or industry to another. o If resources are immobile → leads to disequilibrium (shortage or surplus) which cannot be self-adjusted → social optimum not attained since the market is not able to adjust towards equilibrium. Key Learning Points in Section 1: ✓ Social optimum is attained when the output in a market is where MSB=MSC (total net benefit to society is maximised). ✓ Social optimum will not be attained when certain conditions are not fulfilled. 2. MARKET FAILURE AND GOVERNMENT INTERVENTION Recall that to achieve social optimum, the markets should satisfy certain conditions. However, in the real world, such conditions are not easily present, leading to market failure. Definition: Market failure occurs when