Economics Notes: Unit 2 - Why Markets Fail

Module 2881 Unit 2: The Market System - Why
Markets Can Fail

2-1. INTRODUCTION
As we learned it Unit 1, in a perfect world the price mechanism can give us a perfect
allocation of resources: what is demanded is produced, changes in demand lead to
changes in what is produced, and the workers move from a dying industry to a
growing one.
But the world is not perfect! Some things stop us getting to this beautiful market
solution. It only needs one of these particular elements to be operative, and we
will fail to reach the perfect market solution above!
And in fact most of them are frequently operative in the real world in which we live!
So we know that free markets do not give a perfect answer. However, we have yet to
find a better way to get what we want produced: running the whole economy by
central planning gives even worse results. So, poor as they may be, free markets are
still the best way we have found for organising the economy. So almost all countries
use the market system, then whenever as a society we do not like a particular result
that they give, the government can step in and change it.
Listing these 8 major factors:
o Monopoly elements or market dominance.

o Externalities.
o Public goods.
o Merit goods.
o De-merit goods.
o Information failures.
o Factor immobility.
o Undesirable income and wealth distribution.
Unit Two deals with such imperfections and reasons for market failure. We will go
through them in the order just listed.
Q. What can we do if some or all of these are operating and preventing a good market
result?
A. The government can intervene and put it right.
NB These Units are a way of organising the teaching and learning of economics. You can use
knowledge from one unit when answering a question in another unit – and you
should!
Copyright Kevin Bucknall 2-1

What does market failure mean?
It means that we do not have full efficiency; we could produce more with the
resources we have; and we could satisfy consumer demands better with the resources
we have. There is waste in the system.
Types of efficiency in economics:
A.) Allocative efficiency. This means good resource allocation, when we cannot
make any consumer better off without making some other consumer worse off.
This approach looks at the given resources and tries to get the most output from them
– and it also means that firms sell at a fair price to consumers that reflects the real
resource use.
B.) Productive efficiency. This means that production is done at the lowest possible
cost.
• We are at the bottom of the average cost curve (which is always U-shaped). In
that position we have what is called “X-efficiency”.
• And this means we are also on the production frontier, not somewhere inside
it.
A.) Allocative efficiency
Allocative efficiency occurs when the value the consumer puts on a good or services
is the same as the cost of the resources used in producing it. This occurs when price
= marginal cost! In this position, total economic welfare is maximised.
In the perfect competition diagram below, where MC = MR for the firm, we have
allocative efficiency because the firm’s price is the marginal revenue (it can sell any
amount at the unchanged price - each extra unit sold at that price provides the
marginal revenue), so MC = P. In fact, at that point we have more equalities MC = P
= MR = AR.
“AR” is merely another word for price – it is “average revenue” which we get by
dividing total revenue by quantity. We know that quantity multiplied by price gives
us total revenue, so it follows that price actually is average revenue.

Price, Costs
MC
AC
0 Ot Output
B.) Productive efficiency
This exists when we are actually on the production frontier. That means we are using
the least resources we can. In turn, it says that we are at minimum average costs = the
bottom of the AC curve.
Perfect competition is like this – so economists prefer this position and you will recall
that it is known as “X-efficiency” – it is where we are totally efficient.
Where market equilibrium is totally efficient, we cannot make someone better off
without making someone else worse off (this is sometimes called “the Pareto
optimum position”).
The production possibility curve:
When we are below the production possibility curve (e.g., at “X” in the diagram
below), we can move north-east and get onto the curve, thus making everyone better
off; only when we are on it do we have proper productive efficiency.
And only when we are on it does the concept of opportunity cost arise. If we are
below it, we do not have to give anything up to get more of the other thing; we can
have more of both simply by moving out to the curve.

Apples Apples
ppc1 X ppc1
0 Bananas 0 Bananas
Note: we can have allocative efficiency and productive efficiency but still have
inequity in the country, which can also stop us reaching “perfection”.
Example 1. If you personally have all the income in your suburb, the other residents
will be poor and might even starve, which does not sound at all like perfect! The
market system is amoral i.e., it is not concerned with good or bad. Economics is not
about ethics.
Example 2. Drug dealers could wait at the gates of primary schools, give away drugs
for free to six year old children and in this way build up a market as they become
addicted. This would create a demand, which the drug dealers could then supply later
– at a price. Most people would regard this situation as totally wrong, exploitative,
and immoral – but the market would be working - and possibly very “efficiently” too.
Social efficiency matter not just private!
We might produce too much or too little as a society, for our own good, even if have
perfect competition and an acceptable distribution of income and nothing illegal or
immoral is occurring. This can happen because of externalities. We move on to
consider these next.
NB The whole of Unit Two consists of two main components:
1. What is efficiency, why the market mechanism (price mechanism) provides the
best solution for allocating resources to meet consumer demand, (Unit 1 is how it
does this, with some overlap on why it is best). You need to be able to defend this
proposition.
2. What prevents the market mechanism from achieving this perfection, which is the
core of this whole unit. You also need to know and answer questions about how
this prevents the achievement of perfection – hence you need to understand what
efficiency is! We turn to consider in detail the things that stop the price
mechanism working perfectly next.

2-2. MONOPOLY ELEMENTS OR MARKET DOMINANCE = the first
reason for free markets not working perfectly
TR = total revenue.
TC = total costs.
MONOPOLY
What is a monopoly?
Definition: Technically a monopolist is a sole supplier, that is to say, one firm is the
industry.
But there are degrees of monopoly - if one firm supplies, say, eighty per cent of the
market, it is close to being a monopolist and will usually act like one.
If two (or more) firms supply most of the output, it pays them to work together, to act
like a monopoly, and to keep prices high (if there are two firms we call it “a
duopoly”).
Types of monopoly, (sometimes called “causes of monopoly”; "sources of

monopoly"; or "conditions for monopoly"
• Economies of scale, i.e. one firm grows large, its costs fall as a result and
become lower than the others, so it can reduce its price and sell more produce.
The others cannot compete because they are small and higher cost. The firm
grows to become the sole one, which then supplies the entire market. We
return to examine economies of scale in more detail later.
• The result of law – the government may restrict an industry to one huge
nationalised firm, e.g., British Steel in 1964 - or a trade union can have a
monopoly over the supply of one kind of labour – the British Medical
Association for instance is the trade union for doctors and can strongly
influence their supply.
• An agreement between firms, so that all act together as one monopolist - often
it is illegal but it happens. We call this a cartel. This can happen under
oligopoly conditions (which are covered later).
• Exclusive ownership of a unique resource: perhaps there is only one source of

supply of a raw material, e.g., all the known supply of iron ore in Australia
was once in the hands of a company called BHP, until new sources were
discovered. As another example, in South Africa, de Beers once owned
virtually all the diamond mining and it still has control over much of the
global diamond supply.

• Copyrights, patents and licences are particular forms of this exclusive
ownership.
• So-called natural monopoly. This is often the result of economies of scale -

e.g., electricity supply, telephone supply, or railways - because we do not want
twenty different sets of rail lines, all parallel, between London and
Birmingham!
Problems with monopoly (what is wrong with monopoly or "the welfare effects
of monopoly")
• It limits output and keeps price high - as just said. Really this means that a
monopolist misallocates (and misuses) resources.
• This behaviour of the monopolist redistributes income from all the consumers
of the product (they are paying more than they need) to one firm or person (the
monopolist). This is an equity issue.
• A monopolist may develop political and social power over others which
reduces the efficiency of democracy and the amount of equity. There is a
strong political danger from a very few rich and powerful people emerging
and changing the course of events. Conrad Black? Robert Maxwell? It seems
to be most serious in the media area, like newspapers or TV, as they can
influence the way people think or what they believe.
• A monopolist may behave badly in an anti-social way. For instance, he or she

may force out a potential rival firm by selling at give-away prices (well below
cost). After they have forced out the honest competitor, they will put the price
back up again.
• **5. Lack of competition tends to encourage inefficiency in the firm. The

monopolist tends to rest on his laurels, has no need to try hard, and lacks
dynamism – this is probably the main criticism - said Austin Robinson.
• As a result, we can get the emergence of lazy managers and owners.
• And it may mean that technical progress is slow, leading to slow growth of the
country as a whole, and a lower standard of living than we could enjoy.
• A monopoly breeds inefficiency which means that the cost curves will be
higher than they need be; this means that the intersection of MC and MR may
be higher.
• Resources are misallocated - too many are going to the monopolist who does
not fully use them. This is a waste for society. It really means that the price
mechanism is prevented from working efficiently.

• A monopoly may reduce consumer choice. He may ignore small market
demands as he cannot be bothered to meet them. As Henry Ford is reputed to
have said about his motor cars “You can have any colour you want, as long as
it’s black”.
Q Which of the following 10 main economic goals does monopoly hurt?
1. To maximise (raise) economic growth.

2. To minimise (reduce) unemployment.
3. To end (reduce) inflation.
4. To increase the standard of living.
5. To keep a satisfactory balance of payments.
6. To maintain a satisfactory international value of the currency (£).
7. To allocate resources in the best way (to meet the needs of society).
8. To obtain an acceptable distribution of income.
9. To look after the environment.
10. To avoid unwanted fluctuations in above items.
THINK FIRST; WRITE DOWN THE NUMBERS YOU THINK MONOPOLY

DAMAGES – THEN TURN TO THE NEXT PAGE!

Answers:
The long run damaging effects may include slower growth; a lower standard of living;
higher unemployment (because employ fewer); higher prices; a slightly poorer
balance of payments; less equal income distribution; and poor resource allocation.
That is to say, most of the goals! In the exam room, the inefficiency in resource
allocation, the higher costs, and the monopoly profit are usually worth stressing.
Benefits of Monopoly
There are few benefits really - economists are almost united in opposition to
monopolies, and many are against both public and private ones – those on the political
left wing tend to prefer public ones more than those on the right wing.
Economists usually favour reducing or ending monopolies and increasing

competition.
BUT some defence is possible!
• The monopoly profits can be used for research and development, leading to
product improvement, faster growth, and lower costs.
Joseph Schumpeter's argument on innovation - that big firms are the only ones
able to afford the necessary laboratories and research staff – may apply.
Against this, research shows that many breakthroughs come from smaller
firms, not the large ones. For instance, Apple computers began in a garage.
• A monopolist may reap economies of scale, e.g., the Royal Mail, telephone
lines, electricity supply, gas supply, or the railways. This means lower costs.
• A redistribution of income is not too bad perhaps:
It is always happening in a dynamic economy anyway.
If necessary, it can be corrected by government action.

OLIGOPOLY
Oligopoly is where there are only a few producers or sellers (between three and nine
maybe! The number is not fixed), so the actions of one can affect another - who may (or
may not) choose to react in some way. For example, if firm A reduces its selling price,
firm B may choose to reduce its selling price, or just leave it where it is and instead to
increase its advertising, expand its sales force, or take other measures. Because of the
inherent uncertainty of the reaction of rivals, rather than one model of oligopoly, we
have several types, which is to say there is no general theory of oligopoly!
Examples of oligopoly:
In Britain only three companies controlled all computer sales from shops in the high
street (the main shopping areas) in 1998; they operated under a variety of different
names, so the consumers thought there was a lot more competition than really existed.
In the same year, De Beers had a 70% share of the marketing of the world’s quality
diamonds.
The degree of oligopoly is measured by “the concentration ratio”
• This can be measured at the level of, say, three firms, or five firms or seven
firms.
• The concentration ratio measures their combined share of the total market.
• We can measure the share of employment or output in that particular industry
- or both.
An example of the UK in 1992: the 5-Firm concentration ratio:
• Iron & steel had 90.9% measured by employment and 95.3% by gross output.
• Wines, cider and perry: 97.7% by employment and 99.5% by gross output.
• Tobacco; 97.7% by employment and 99.5% by gross output.
What can increase the concentration ratio? (i.e., reduce competition)
• A merger within the industry (between a firm already in the top 3, or 5 etc. and a
much smaller one previously outside).
• When a large firm (in the top 5 etc.) takes customers away from a small one
outside the top few.
CARTELS
Cartels work like a monopoly. A cartel exists when several suppliers get together to
sell as a group, i.e., they reduce the competition and form a monopoly. The object is
to increase profits, usually by increasing the price jointly, to lower the risks, and to
keep out new entrants.
It is often found in the primary produce - usually they say they wish to stabilise the
price – but they actually try to increase it in many cases.

Cartels are common with oligopoly. Firms get together and transfer power to the
centre in order to act as one firm. In effect they behave like a single monopolist, thereby
obtaining monopoly profits. These will be higher than they can get by competing with
each other. This is called “collusion”.
Cartels are inherently unstable, because:
• It is always in the interests of one member to break the rules, and reduce its
price a bit, or sell more than it has agreed, so increasing its profits. Effectively,
the individual faces a more elastic demand curve than the cartel as a whole!
• The higher (monopoly-type) price attracts newcomers to the industry, who

eventually break the cartel by selling as much as they can at the (high) cartel-
established price.
The OPEC oil cartel lasted about a decade (a long time) because of several special
factors:
• There is a long lead time to find oil and develop new wells.
• There is an inelastic supply of oil.
• The market for oil was growing rapidly because of global economic expansion, so it
was easier to live with high prices.
• Oil is durable – it does not rot if left in the ground.
• Arab unity may have helped a bit – though they do not seem very unified usually!
If a cartel is fully successful - the diagram is simply that of a monopolist!
The Wastes of Oligopoly
• An oligopoly restricts output where it can, so less is produced than could be, and
at higher position on the cost curve.
• Price is higher than if the firms in the market were perfectly competitive.
• Collusion to try to establish a cartel and behave like a monopoly is likely; if

successful, we get all the problems of monopoly.
• Price wars may emerge, perhaps caused by new entrants, or the existing firms
reduce price because they fear the high price might attract entrants.
• There may be wastes (for society) of high advertising costs, or offers to

consumers of free trips or lotteries. These are not cheap to run and use real
resources.
• We may get bribery or other pressure on, government to keep or establish

Marketing Boards or other devices of restriction.

• There is a time and energy waste involved when firms are forced to watch
rivals, try to guess their likely innovations, or whether they will react to what the
first firm did.
• Industrial espionage and other illegal acts may be promoted. Some firms are
reputed to pay people to search the waste bins of their rivals!
• Employment is restricted, because an oligopoly keeps output down.

• Uncertainty levels are increased; this is generally felt to be bad thing.
The Benefits of Oligopoly
• Price does not change much (until we get a price war!).
• There is fierce competition to improve the product in order to increase the

demand for one’s own output - so we may see fast technical change, great
dynamism and much R & D effort.
• “Countervailing Power” - if a single monopoly is bad (as we feel), then a few

more competing firms can stand up against it, so the situation has to be better.
• The size of firms is usually larger – this means they can reap economies of scale
(unlike the tiny firms in perfect competition which will never be big enough).

IMPERFECT COMPETITION OR MONOPOLISTIC COMPETITION (the
terms are interchangeable)
Reminder: this is the bit in the middle!
Monopolistic competition
Perfect
Monopoly
Competition
Oligopoly
WHAT IS MONOPOLISTIC COMPETITION?
It is defined as:
• Many buyers and sellers of that type of good or service (= competition).

• Free entry and exit (= competition). But each firm has its own brand of the good
or service (= a monopoly on the brand name).
• So each faces a downward sloping demand curve for its own branded product (= a
monopoly effect).
i.e., we see elements of both monopoly and competition, hence the name.
The long run equilibrium position is where the demand curve is tangent to the average
cost curve.
The Long Run Equilibrium Condition
Price,
Costs
MC
AC
P1
D
0 Ot1 Output

Q. Why is long run equilibrium in this tangential position?
A. Because of the assumptions of strong competition and free entry/exit.
Let’s think about the short term.
If the firm suddenly improves its product, e.g. colours it fashionably, the demand for
the product will increase, this allows a price increase, and hence means higher profits
for the firm.
So the firm receives monopoly profits and in this short run position, the diagram is
identical with that for monopoly. It has a monopoly because the firm is the only one
with these new fashionable colours.
But what is going to happen? The higher profits and visible higher price draw the
attention of this firm’s existing competitors, and there may be new entrants. Both
groups can successfully compete by colouring their product also! They then earn
some monopoly profits. But the increase in total supply means that price starts to fall.
In addition to this, the demand curve of the original producer drifts back, as the firm
loses part of its market to these competitors.
Q. How far does it fall back?
A. Until the monopoly profits are eroded to zero – when we are again at the tangent
which is when competitors will stop coming in! There is no reason to enter once there
are no excess profits to be made.
So in the long run there are no monopoly profits – equilibrium is always tangential!!
The short run increase in demand:
If you draw the basic diagram for monopolistic competition in equilibrium and then
increase the demand for the product, you will see that it turns the diagram into the
monopoly one, with monopoly profits. This situation lasts until the attracted new
entrants cease – when we are back to the tangent as just described.
Problems with Monopolistic Competition
• Waste of time and effort – the firms have to worry about competitors’ actions.
• Waste of underused resources. In the tangential position, we are not at the bottom
of the AC curve – the firm could produce more, and more cheaply, but cannot do
it. This is to say that excess capacity exists.
• There may be too much differentiation – firms often pretend their product is
“better” but in fact it is merely different! As a consumer, you should be wary of
“miracle ingredient” claims, especially in the health and beauty area.

• Advertising wastes.
• Free gifts, free lottery tickets, 2-for-1 offers, competitions to get a free trip to
London, to the coast, to Paris etc. They all use up real resources to run them.
• We could have had better or cheaper products instead of all these offers!
Benefits of Monopolistic Competition
• The situation is very competitive – firms watch their competitors very closely.
• This strong competition drives the firms along:
• They strive to improve product quality and design, as well as (hopefully) to

lower the price.
• The firms engage in much research and development.
• Free entry and exit keeps competition fierce.
• Variety is great – there is more choice for purchasers and hence, we assume,
greater consumer satisfaction. Some observers now feel that too much choice
worries people and does not make them happier but the jury is still out on this one.
Some possible areas for data response questions
There may be a question about how insufficient competition prevents the market
solution from being optimal or the market working properly
You might get asked to explain why monopoly is undesirable generally – or you might
get a specific simple question, like working out what is the monopoly profit in a
diagram and/or figures.
You might get asked how much of a monopoly a company is (definitional); be asked to
work out a concentration ratio; or expected to mention cartels, or monopolistic
competition. Duopoly (= only two firms in the industry) is rare but if the examiners
find one in the real world to set a question about, you will be expected to use the term.
It could be teamed with the issue of privatisation, because natural monopolies were
often nationalised a long time ago, then privatised after Margaret Thatcher became
Prime Minister in 1979. “Efficiency” and “competition” are key words to use!
Monopoly is seen as essentially inefficient and bureaucratic with higher costs, as well
as taking monopoly profits, higher than they might be.

Privatisation is seen as an effort to increase competition and hence lower costs, to
allocate resources better, and to reduce the monopoly profit element.
We will look at these issues more closely later.

2-3. EXTERNALITIES, SOCIAL COST AND PRIVATE COSTS = the second
reason for markets being less than perfect.
EXTERNALITIES
Private costs are what they say – the costs incurred when producing something.
Social costs are greater than private costs. Social costs include things like pollution
and congestion that are suffered by society in general, not by any one producer.
These problems are called “externalities” i.e., they are external to the firm producing
them. They can be negative externalities (which harm society) or positive
externalities (which help).
Social cost = private cost + externality (if any).
Cost-benefit analysis tries to measure all the costs to society of a project.
A new tube line in London may never run at a private profit but still generate large
savings elsewhere. For example, the new line might reduce motorcar use, reduce
congestion, speed up traffic flow, and save people’s time. The Victoria line, built
1968-71, was established knowing it would lose money - but the social benefits were
so great.
We have a diagram for social costs:
Social Costs,
Price
Social costs
Pb Private costs
Pa
Demand
(Social Marginal Benefit)
Quantity
0 Qb Qa
Equilibrium will be where private costs cut the demand curve at Qa, as firms try to
maximise profits and charge price OPa for quantity OQa.

But because of negative externalities (pollution maybe), the socially optimum position
should be where social costs cut the demand curve. These would mean producing at
Qb, reading from the social costs curve, and selling at the higher price OPb to cover
these costs.
NEGATIVE EXTERNALITIES
Common types of negative externalities by producers:
• Air pollution, e.g., smoky factory chimneys.

• Soil pollution, especially by farm chemicals (closely related to the next type).
• Water pollution, e.g., rainwater run-off containing farming pesticides and
fertilisers.
• Noise pollution. Do you live near an airport or by a building site?
Some types of negative externalities by consumers:
• Pollution of air and water.

• Soil pollution, e.g., lead pollution in soils from motorcar exhaust emissions.
• Litter on streets; decomposing rubbish in land-fill sites.
• Noise pollution, e.g., motorcycle noise in urban areas, especially when the baffles
have been deliberately removed from the silencer.
• Vandalism; graffiti on walls.
• Smoking and alcohol abuse, causing NHS expenditures to rise.
We are unsure why the urban sparrow population has plummeted in recent decades
but it would seem to be the result of some externality.
POSITIVE EXTERNALITIES
When these exist, society would gain more than the producer – who therefore is
producing less than the optimal social amount.
Examples include:
• Labour training in firms; one firm may do little, as it knows that when a trained
worker leaves, someone else benefits - but the first firm paid for all the training!
• Education generally.
• Health generally, especially in poor Third World countries.
• The provision of playing fields at or near schools so that the health and sporting
skills of the children improves.
• Free museums and art galleries that can encourage the poor and uneducated to
widen their horizons, educate themselves, and generally improve.

To draw the diagram for positive externalities: just reverse the labelling of the curves
of social cost and private costs above. This is done in the diagram below where you
can see that we produce too little for society if firms profit maximise for themselves
(as they do). They choose to produce at OQa and sell for a price of OPa, but for the
greatest good of society they should be at OQb and selling at the lower price of OPb.
Social Costs,
Price
Private costs
Pa Social costs
Pb
Demand
Quantity
0 Qa Qb
Government intervention may be necessary to correct or offset market failure

caused by negative externalities – usually the government chooses to tax those
producing too much, or they may use the law to prosecute for water pollution or
whatever externality the government is tackling.
There are probably fewer cases of external benefits, but if we find any (such as private
firms training labour well) we can encourage this by tax breaks or subsidies.
Government action with external diseconomies
Government might try (and does):
1. Taxation.
2. Regulation.
3. Perhaps extending property rights.

Let’s think about polluters – what can the government do using the three points
above?
a) Taxing polluters
The need is to try to stop the problem being “external” and try to “internalise” it, i.e.,
to make the polluter pay for it via a tax. As economists, what we are really doing is
trying to get the firm to stop looking only at the private costs and benefits. In the
diagram below, we do this by putting a tax on, which shifts the supply curve up from
“S Private costs” to “Private costs + tax”. If we get it right, this moves the
equilibrium quantity produced from Qa to the smaller output Qb.
Social Costs,
Price
Social costs
S + tax
Pb S
Pa
Demand
Quantity
0 Qb Qa
In the UK, we now have a Landfill Tax (since October 1996) to encourage recycling.
Landfill operators have to pay a tax to the government. It was introduced at the rate
for inactive waste, which is easy to deal with, of £2 a ton and other waste at £10 per
ton. These amounts might increase shortly.
But there are problems with taxing polluters:
• When it works, output is reduced and prices are higher – but this can reduce the
consumer surplus, which some feel is not a good thing (Unit 4 looks at this
concept).
• It is often hard to identify the particular firms that are causing the pollution, and
then determine how much each is responsible for the total pollution.
• Poor legislation can hurt the innocent, e.g. households who wish to get rid of large
items of waste may not be allowed to take them to the dump.
• It is not easy to put a monetary figure on the damage pollution is causing.
• Producers can pass on much of the tax to consumers if demand is inelastic and not
pay it themselves.
• Taxes on demerit goods (to limit their consumption) can be regressive, i.e., hit
poor households the hardest. The tax on cigarettes does this because the poor are
statistically more likely to smoke than the wealthier.

In the UK, the government quite regularly increases duty on petrol, & tax on
cigarettes.
b) Regulating polluters approach (a second way that can be used in addition to

tax)
• Banning cigarette advertising at sporting events, or in places like cinemas.

• Making workplaces no-smoking areas.
• Increasing the penalties for firms that break the regulations.
c) Extending property rights (a third way that can be used)
If a lorry crashes into your garden and destroys the wall and all your trees you can get
compensation – but if a polluting factory puts out acid smoke and destroys the same
trees you cannot.
If we extend property rights so you could sue for compensation, it would make the
polluter think again and perhaps install anti-smoke devices on factory chimneys!
Benefits
• The property owner knows the value of the property better than the government
does, so the figures will probably be more accurate (but owners can, and perhaps
would, lie!).
• The polluter is forced to pay those suffering from his or her activities.
Disadvantages
• The damage may occur abroad, e.g., German acid rain destroys East European
forests – but it is next to impossible to enforce law across borders!
• Global interests and national interests may conflict. The UK cannot make Brazil
extend property rights over Brazilian trees which are being killed off at a rapid
rate, yet the world might feel the destruction of the Amazon rain forest is wrong.
Trading permits to pollute
Many believe that it is so difficult and expensive to stop companies polluting

(identifying who did it can be impossible e.g., with one stream and dozens of factories
discharging into it) that instead we should auction off the right to pollute. Only those
firms that pay a high price for the limited number of licences would be allowed to
pollute. The government could then use the large sum of money raised to tackle the
pollution itself. The end result could be much better than we currently have!

If we allow a firm to sell its right to pollute (it may have used only 80 per cent of what
it is permitted, for example) then those with the greatest demand for their product, and
hence the most profitable, can buy the remaining 20 per cent. It means the things we
most desire still get produced but the government has the resources to tackle the
resulting pollution.
Yet many think it is morally wrong to allow permits to pollute at all!
Singapore uses such permits for ozone-depleting substances.
The Kyoto Summit on Climate Change (Dec. 1997) saw a move towards such permits
as being an improvement at least! But the United States and Russia refuse to ratify
this. In September 2004, President Putin of Russia agreed to it, but it still has to go
before the Russian Parliament.
Coase’s Theorem
Ronald Coase established that there is no need to tax or regulate polluters at all! He
saw that if polluters compensated those suffering, the market would solve it properly,
with just enough “acceptable” pollution occurring and still no one suffers without
being compensated. He got the Nobel Prize in Economics 1991 for this! It is worth
trying to get the phrase “Coase’s Theorem” into an answer about how to deal with
pollution.

2-4. PUBLIC GOODS, MERIT GOODS, DEMERIT GOODS AND
INFORMATION FAILURES = the third to the sixth reasons why markets may
not give us a perfect solution.
Even when the market appears to be working perfectly, we can have a problem with
some goods. These are:
• public goods;
• merit goods; and
• demerit goods.
These may all be supplied in the “wrong” amounts, or even not supplied at all. When
this occurs, it renders the market system inefficient and it is failing in this area
Public Goods
These are collectively consumed and the market may simply not supply them; e.g.,
defence of the country (a police force and army), a fire brigade, street lighting, or
lighthouses. The market system does not work well in this area.
Some goods are “semi-public goods”, “quasi public goods” or “collective

consumption goods”, for instance roads. These are often supplied by the state, but in
principle they can be privately supplied, and sometimes are. Examples include the
British Toll Roads in the Nineteenth Century or the péage motorways in France today;
when you use them, you pay.
In some countries, such as Thailand when I lived there, the fire brigade falls in this
area. People insure with a private fire brigade and call them when the house is
burning. If you are not insured and you still call them, the market swings into action
and they negotiate a rate on the spot for putting out the fire – given the urgency of the
event, the demand by the burning house owner is highly inelastic and the price can be
very high indeed!
Public goods require
• The lack of ability to exclude (if I am defended, so are you, even if you do not
pay!)
• The consumption by one does not reduce the consumption available to the others
(if you walk down the street after dark you do not use up any of the street
lighting.)
These two requirements may be called the “non-rivalry” and “non-excludability”

features.
One of the jobs of government, both central and local, is to supply public goods or
services that are needed but otherwise would not be made available by the market.

Merit Goods
These are provided by the market - but in smaller amounts than are needed for the
good of the state. Health and education are the most obvious ones – there will be
some privately-supplied health and education but the state as a whole benefits if
everyone has access to them, not just a few. For instance, in the health area, the
National Health service and inoculations tend to reduce mass epidemics; the health
service also means that fewer people will be off work sick. We see a contemporary
example with the dispute over the MMR jab for young children. The fear that it may
be linked with autism in children prevents some parents from getting their child
injected and there is a fear that an epidemic of measles could emerge as a result. In
the case of education, society would not function as well if half the population could
not read the instructions on the label!
Private consumers individually value merit goods less than the state does. The market
system fails to provide enough merit goods which is why the state steps in to make
them more widely available. It does this by subsidising the production of some merit
goods or services.
Merit goods may be targetted at certain groups and rationed; for instance, we might
limit access to higher education to those passing A levels well! It is assumed that
such people are the most intelligent in society. Which of course you are!
In the diagram below, a subsidy equal to AB is applied by the government – this shifts
the supply curve downward and to the right. The equilibrium position then moves
from P1Q1 to P2Q2. The result is that more is then consumed at the lower price i.e.,
the demand for merit goods has extended. (I am stressing that the demand has not
increased; that would have meant a new demand curve!)
Price S1
B S2
P1
P2 A
0 Q1 Q2 Quantity

Demerit goods
Demerit goods are exactly the opposite of merit goods in that they are over-consumed
by individual people and this causes problems for the nation as a whole.
Cigarettes are a clear example: they cause unpleasant smoke which is dangerous to
people in the area who are forced to become passive smokers. They also cause cancer
and a whole range of nasty diseases, including emphysema. They inflate the national
health bill because both the smokers and the passive smokers get sick and visit the
doctor. But smokers will not stop, perhaps are unable to stop, because they are
addicted.
Too many demerit goods are demanded, so the government steps in and taxes
cigarettes highly in order to reduce consumption and to raise revenue which is needed
anyway to spend on treating smokers. The government also advertises heavily to try
to persuade people to stop smoking and the young not to start and is seriously
considering banning smoking in all public work places, as Ireland did in 2004. Some
individual doctors are also refusing to treat smokers for smoke-related diseases unless
they stop smoking which adds to the pressure.
The effect of the government taxation is in the diagram below. The indirect tax EB is
added vertically to the supply curve, which shifts upward and to the left from S1 to
S2.
This reduces the consumption from OQ1 down to OQ2, (a move from the equilibrium
point A to B) as price rises from P1 to P2 and consumers contract up the unchanged
demand curve.
Price S2
S1
B
P2
P1 C
A
0 Q2 Q1 Quantity
Rather than simply relying on tax to decrease the supply curve and force up the price,
the government may also try to tackle the demand side. It can do this in the ways
mentioned above and the diagram is reproduced below.

Price
S1
P1
P2
D1
D2
0 Q2 Q1 Quantity
You will observe that, if successful, the quantity smoked falls.
The government uses both methods, reducing demand and taxing heavily, to deal with
smoking as a demerit activity!
Information failures
Knowledge is never perfect!
Consumers lack information on things like:
• What goods are available and what new goods have recently come onto the
market.
• What the quality of the different models or makes available is like.
• How long an item will last before breaking down.
Information lack is particularly common in both the health service and in education
where consumers do not know much - although we now know more than a few years
ago.
This lack of perfect knowledge means that we may choose badly through ignorance.
The demand curves would be different, and better, if we did know everything. This
means of course that the existing demand curves do not give us a perfect market
solution.

Producers lack information on:
• What new demands are arising and how old ones are starting to change, so the
producers may produce more (or less) than they should.
• What their existing rivals, and any new ones about to emerge, are doing or might
do.
Which means that the producers may produce the wrong type of goods or the wrong
quantity of goods.
We know that in the world in which we live, new firms start up and many die away
within the first two years – they usually got it wrong on the demand for their service
or goods in that particular place, although sometimes they simply were not good
enough at the job. In the process of being born and dying, the firms used up resources
(including the labour of the would-be entrepreneur) in a less than fruitful way.
Workers lack information on:
• All the jobs available now. Many of these will be local but more particularly they
are usually ignorant of opportunities elsewhere in the country or in the EU for that
matter. So the workers may not move to where they are needed though simple
lack of knowledge.
• Which industries will grow and which will wither away in the future. This means
that workers may join a firm that will disappear in a few years time, throwing
them out of work but not for any fault of their own. Technical change can render
whole jobs out of date: the handloom weavers are a classic example of the late
18th and early 19th century; coal trimmers stacking the coal in the depth of ships
in the mid 20th century; and coal miners of the late 20th century. As a consequence
of workers not being able to predict future job needs, resources may be tied up in
dying industries too long.
- A real problem is that those leaving school or college may join an

industry and train in skills that will shortly be no longer needed.
So here again the market does not reach the “correct” or optimal solution.
The response to information failures
Private firms gather information and try to sell it.
For instance:
• Private job centres may open up to try to find a job for people. These are mostly
in large cities and for service workers, rather than for manufacturing. Such firms
are trying to improve the flow of information for profit.

• Magazines like “Which?” exist. They test and investigate the quality of goods
and services and publish the results.
• Specialist magazines are produced for things like hi-fi, TV, motorcars, or
computers – such magazines also test and report the results.
• In order to help producers, various trade associations and chambers of commerce
gather information and inform their members about what is happening. They also
organise conferences and set up fact-finding trips abroad and the like.
The state tries to provide information by:
• Establishing job centres.

• Providing advice to careers advisers in schools.
• Issuing pamphlets and working papers to try to improve peoples’ knowledge. The
newspapers pick up this information and may publicise it.
Overall, as information improves, consumers adjust their demand patterns to favour

what fits their needs best. Producers chose the most suitable and cheapest sources for
their inputs. This of course means the market mechanism then works better to supply
what people want and are willing to pay for.

2-5. FACTOR IMMOBILITY = the seventh reason for free markets not
providing a perfect solution.
The factors of production that we have are land, labour and capital plus a remainder
term (L, N, K, + R) – most economists and textbooks focus on labour immobility, but
this is not guaranteed for the exam!
We can also have land immobility
• Some land is good for growing one or two particular crops and not very good at
some other crops. It is not easy to change rice (which needs wet soils) to wheat
(which needs drier conditions).
• It is not possible to move land from where it is to somewhere else.
• Climate change may be occurring and farmers are often traditional, growing what
they or their family have done for years or even generations. They may be unaware
of, or refuse to try growing, a now more suitable crop.
• Economic Union subsidies keep many farmers’ attention on producing the crops
that are highly subsidised (as it gains them a higher income) rather than what might
be more suitable for their land or sell better. Quite often the EU gets it wrong, so
we ending up with a lot of produce that is hard to sell. Dumping it on international
markets annoys other countries that produce such goods efficiently as it reduces
their market. Dumping it into the sea causes criticisms of waste in a world of
poverty.
And capital immobility
• Some capital is specific e.g., it makes light bulbs, and it cannot be transferred to
another use, like producing ball point pens.
• Some capital is very big and heavy, e.g., a steel mill, and it is difficult or impossible
to move it to another geographic areas.
• Some old decaying industries may be subsidised by government and continue to
exist for years, well beyond their shelf life. This keeps the capital (and the
associated land and labour) where it is so that it is not released for use where it is
more wanted by society. That is to say, government subsidises prevent factors of
production moving to turn out what people now demand. The fact that the industry
is decaying shows that demand has changed and people no longer want that good or
service as much as they once did.
• Some (usually small) firms stay in business despite making poor profits because the
owner does not want to move or to cease production; or perhaps the owner is too
old to bother to make any major change.

Labour immobility (the really interesting one – we ourselves are people!)
Geographic immobility of labour
• People do not up and move easily from Leeds to Watford, just because they can
earn £20 a week more there. Even less do they move from Tours in France to Hull
in Yorkshire.
• People are usually happy where they are: they have got relatives and friends, they
know the town and area, and they are members of various clubs and other social
groupings. They do not wish to move.
• They may not know about the extra £20 they could get if they were to move
(“information failure”). Information failure actually costs money to overcome:
people must pay to use the Internet, or have to buy newspapers and magazines.
• Moving house costs money: there are estate agents’ fees, lawyers’ fees, a
government stamp duty and the cost of transporting furniture and all the other
household effects.
• Inertia: people often do not like a big move as they have a sort of fear about it, so
they just stay where they are.
Institutional immobility of labour
• Trade unions and government pass rules or laws that prevent people from entering a
new job easily.
• Pension schemes may tie people into a particular company – if a worker moves, he
or she will probably lose the amount paid in by the employer on their behalf (this
can amount to several thousand pounds).
• Council houses (state subsidised housing) are let below market rents and can
prevent people moving; if they move it means they must give up their cheap house
unless they are able to arrange for a house-exchange with another council tenant.
• Foreign-trained doctors may not be allowed to work in the UK unless they spend
several years retraining - and not always even then.
Sociological and economic differences causing immobility of labour
• Minority groups often get paid less. For instance, it may be harder for migrants
who do not naturally speak English to find work and to receive the same pay. If
they are not selected for a vacancy, it renders them less mobile. Even women,
hardly a minority, find it hard to get the same pay as men, despite the existence of
long-standing legislation.
• We can think of this as a lower demand curve for them, because employers do not
like hiring them as much.
• Married or very close couples: one may not be able to take a better paid job offered
elsewhere because it would render the other partner unemployed, so total family
income would fall if they moved.

• The skills a person has may not fit the new demand for workers, so he or she would
find it hard to get another job. As demands in society change (taste + higher
incomes + new goods + new technology + fashion and trends…) it means new skills
are needed and old ones become redundant. How many chariot wheel makers do
we now need?
• Age: once past fifty years, or even forty years of age, it is difficult to get a new job.
Employers often prefer younger people. If an applicant is old, the employer fears
that they will not learn new skills quickly; and if the applicant is older than the
employer, he or she may feel uncomfortable giving them orders and so simply
refuse to hire them in the first place; and old workers who join the firm will only
pay into pension scheme for, say, ten years until they retire, but will take out for
perhaps another thirty years until they die. An ageing population makes this
scenario more common.
Such factors mean that wage differences (and unemployment) can permanently exist
between industries and between regions. The market does not work well enough to
equalise wages and long term wage differences persist.
Diagram: the wage of labourers in London and Cornwall: London has a greater supply
but a much greater demand so the curves are further to the right. And of course in
London, the level of wages and the quantity of workers are higher.
Wages Wages
S lab
W1 S lab
W1
D lab
D lab
0 Ql 0 Ql
Quantity of labour Quantity of labour
London Cornwall

What can be done? Government intervention may help produce a better market
solution.
Government training and retraining for the new skills that society needs.
The government may improve or alter the educational system and encourage
academic courses to be more geared to the needs of a modern economy (although
some intellectuals disagree and think education should not do this).
We can retrain workers at government expense. The state can pay for retraining
courses and give generous tax breaks to those choosing to receive new skills.
The government may tackle the geographic problem
It may pay workers to move; or pay the costs of buying or selling the house; or end
(or reduce) the stamp duty for such people; or pay the unemployed to travel to look at
job opportunities in a new area.
It may subsidise firms to move to old decaying areas. This approach is generally
inefficient, as it means costs will be higher than they need be, as it is probably not a
good location for the firm (which we can assume or the firm would be there already or
willing to go without a subsidy). This would make the UK less competitive with
other countries.
The government may allow pension mobility, i.e. when a person leaves a firm he or
she can take their pension rights with them – the new stakeholder pensions do this.
The push for people to take out their own private pensions means that workers are
more mobile than they once were. There is a slight problem in that the rich who are
usually already mobile are taking out stakeholder pensions, but the poor, less mobile,
are tending to avoid them.
The government could change the laws as needed
Example 1. The government could make all company pension schemes pay out the
employer’s contribution when worker leaves.
Example 2. The government could make the British Medical Association (BMA)
allow foreign doctors in to work more easily. The BMA is rather restrictive and keeps
some well-trained foreign doctors from working in the UK unless they requalify or
take special tests. This reduction in supply means there is a permanent shortage of
doctors which helps the BMA to pressure the government for pay increases, better
conditions, or whatever it wants.
Example 3. The government could pass “non ageist” legislation to try to stop older
but good being refused jobs or even fired (government is planning to do this -
eventually).

Other areas of law no doubt could be similarly changed – watch the newspapers for
articles and examples that you could quote in the exam room.

2-6. THE DISTRIBUTION OF INCOME AND WEALTH = the eighth reason
why markets may not work perfectly.
The demand curves we see in the economy are for the given distribution of income
and wealth in that economy. If we were to change the distribution of income or
wealth, we could expect to see a different set of demand curves.
For example, if London were to suddenly gain all the income and wealth in the
country, everyone outside that city would reduce their consumption of almost
everything and do so quickly. They would have no income and have only limited
savings to draw on. So the demand curves for many goods and services would alter.
We can imagine that if all the income in the UK were to be redistributed so that
everyone had exactly the same income, it would be insufficient per person to buy
Porsche or Rolls Royce motor cars, or indeed many luxury goods and services. The
demand for these would diminish sharply or perhaps even cease to exist.
This means that unless we have a “good”, “proper”, “desirable” or “acceptable”

distribution of income and wealth, then the market will provide a less than satisfactory
result! It merely reflects the existing income distribution and not what would make
everyone better off. Only if we can all agree that the current income distribution is
“the best”, will the market distribute according to what people need rather than have
the money to buy (remember, demand means “effective demand”, that is, backed by
money, and it is not merely a need). Every time we change the distribution of
income, we change the pattern of demand.
Note that as time passes the economy grows, and some sectors and people do better
than others, so the pattern of demand is in fact constantly changing. Other factors that
can change demand include new technological goods (mobile phones, scanners…);
new goods generally; advertising; weather changes; and new tastes or fashion.
Measuring the distribution of income
The Lorenz curve
We can show the degree of inequality in income distribution in a diagram. If 10 per

cent of families have 10 per cent of the income, and 20 per cent have 20 per cent, and
so on, we have perfect equality.
The Lorenz curve shows the actual difference from the 45 degree line of perfect
equality. We can actually see the inequality gap in the diagram below!

100% 45 degrees
% of income
(cumulative)
Perfect equality
on 45 degrees
curve
50%
Inequality
gap
The Lorenz
25% Curve
0 50% 60% 100%

% of families (cumulative)
Here, we see that about 60% of the families have only 25% of the income.
The Gini Coefficient
The Gini Coefficient is a more accurate measure than the Lorenz curve - and frankly
it is much easier to compare numbers than pictures!
The Gini Coefficient measures the degree of inequality by using numbers – it is

calculated as:
Area between diagonal line and Lorenz curve

Triangular area under diagonal line
i.e., this is the inequality gap in the diagram above as a proportion of the whole
bottom triangle. The bigger the inequality gap, the closer it gets to the whole;
eventually it is the same as the whole and a number divided by the same number
always equals one. So the higher the Gini coefficient, the less equal is the distribution
of income.
Perfect equality = 0.0

Perfect inequality = 1.0

When the Gini Coefficient equals zero we have perfect equality
100%
% of income
(cumulative)
Perfect equality
on 45 degrees
curve
50%
45 degrees
0 50% 100%
% of familes (cumulative)
Some actual Gini Coefficient figures for three countries
1980 1994
UK 0.327 0.345
Spain 0.397 0.340
France 0.417 0.290
Using these figures, rather than trying to compare by eye some three separate
diagrams, we can now compare easily.
We can see that:
• In 1980, the income distribution in the UK is more equal than in Spain.

• The UK’s income distribution got less equal (under the Thatcher government).
• Spain’s income distribution got more equal over the period.
• By 1994, Spain had a more equal income distribution than the UK.
• And France, which in 1980 had less equality, is revealed to have a more equal
income distribution in 1994 than either of the other two countries!

This is the sort of thing that the Gini coefficient is used for.
Oh! One more thing! Latin America has the highest Gini coefficients of any of the
continents in the world (that is, it has the widest income disparities). That might be a
useful statement you could make.
The Gini Coefficient can easily be set in exams, either as an essay or as data
response.

2-7. ECONOMIES OF SCALE
What are they concerned with?
We look at what happens to costs as the size (the scale) of a firm increases; e.g., if a
firm grows by a given percentage, say 20 per cent, we examine what happens to the cost
structure.
There are three logical outcomes if firm grows by 20%:
• Output grows more than 20% = economies of scale or “increasing returns to

scale”.
• Output grows less than 20% = diseconomies of scale or “decreasing returns to

scale”.
• Output just grows 20% = “constant returns to scale”.
NOTE it does not have to be 20 per cent – it is what happens to costs when the firm
grows by any amount that interests us.
The Envelope Curve or Long Run Average Cost Curve
It often occurs that as a small firm grows, its average costs fall at first, then level out for
some time, then finally start to rise. If we join up the tangents we get the “envelope
curve” or the long run average cost curve (LRAC curve).
Average Costs
LRAC
AC AC
AC
0 Time
Copyright Kevin Bucknall 2-37 81

Digression: When drawing the envelope curve it is far easier to draw in the LRAC
curve first, then fit the small AC curves to it. This is the reverse of the way we actually
get the LRAC curve.
Remember that the average costs are always drawn U-shaped whatever the
competitive state of the firm we are considering (perfect competition, imperfect
competition, or monopoly). This helps you, because so you now know that you can
always start your diagrams in the same way in all theory of the firm questions.
How can we get economies of scale? (“increasing returns to scale”)
1. Technical: a new machine can be used that reduces costs as output increases :
• Such a process is often referred to as “mass production”.
2. Financial:
(a) Banking:
• A large company can borrow at cheaper rate than others, e.g., Shell pays lower
interest than I do to borrow money.
• When output is larger, it spreads the interest cost of borrowing over a greater
number of units, so the average cost per unit is lower.
(b) Insurance
• A larger output again spreads the cost over more units.
• A large company may be big enough to do its own insurance and not have to
pay premiums to others.
(c) Advertising
• Once more, the larger company spreads the advertising cost over more units.
(d) Purchasing
• Bulk buying is cheaper.
3. Managerial
• A large firm spreads the cost of management over more units.

• Management may be underused in small firm.
• In a large company the managers can specialise: there might be a marketing
manger, a transport manager, a production manager and so on - each does a
better job as a result of specialisation..

4. Risk spreading
• A large company can have a greater variety of produce - if the demand for one
product falls off, the demand for others will probably be still be good.
• A large company can sell in different markets, perhaps including several export
markets.
• The firm’s own insurance can be done (already mentioned).
Note: cost curve eventually turns up at the right hand end. This reflects
diseconomies of scale, or decreasing returns to scale
Q. Why does it turn up in this way or why do they occur?
A. There are three main reasons:
• Managerial limitations
• Financial factors.
• Quality deterioration.
1. Management. This is the most important reason usually.
Management becomes a fixed factor in a sense. The firm gets too complex for one
person to manage everything, mistakes are made, and decisions are slower causing costs
to increase.
A firm can increase the number of managers to offset this diseconomy and perhaps put
it off until a larger output is reached - but as managers increase in number we can
expect to see new problems arising.
• Red tape arises, that is to say, there is a slow and cumbersome bureaucracy.
• Meetings proliferate and a paper war starts.
• Factionalism arises, each department starts to try to score off others and do them
down. This is often an effort to advance one’s self in the promotion race but
some people simply develop a loyalty to their own division and start to dislike
other divisions.
• A new idea of safety and security arises. The new managers tend to be
administrators with less entrepreneurial skills, and they also try to protect their
backs rather than promote the interests of the company.
• A new breed of people, "corporation people" emerge – the firm is no longer
chasing profit and taking risks but coasting along.
• Communications falter, up and down as well as sideways. People do not all
know what is going on.

Some things may offset the managerial diseconomy:
• Computers and technological progress, e.g., photocopying machines speed up

the paper chain (although they increase its length!)
• Various incentive and bonus schemes are possible, including stock purchase
options (mostly for managers who can later buy shares in company at a price
agreed now. It means that if they work hard and the company makes profits, the
share price will rise, and they can buy cheaply - so they get rich).
• Bonus may be linked to growth in profit level, for workers or managers.
• No absenteeism or unauthorised sick leave by a worker for a defined period of
time may attract a bonus. British Airways were considering this in 2004.
• Possibly a person might receive a bonus if he or she is never late for work for a
defined period (this applies to lower grade workers more often).
• Suggestions boxes, meetings to invigorate staff, etc. might be used and can help
to some extent.
2. Financial diseconomies may arise:
As a firm grows, it increases its demand for everything, including perhaps some
particular factor of production, a needed raw material, or certain spare parts. As
demand increases it can turn the price up against itself (an increase in demand with
normal supply curve; we will look at the diagram again later on).
Price
S
P2
P1
D2
D1
0 Q1 Q2 Quantity
3. Quality diseconomies may occur:
When a firm starts up, it hires the best labour it can find, and buys from the best source
of materials available; but when it has taken all that is possible from these sources, to
grow further it may be forced to:
a) Hire lower quality labour, which will mean a lower productivity.

b) Take worse raw materials, or hire less suitable transport vehicles (say, not well
refrigerated) because the really good ones have already been taken and there are none of
comparable quality left available.
And both these actions will increase the firm’s costs of production.

2-8. PRICE FIXING BY GOVERNMENT OR ONE OF ITS BODIES
The government might decide that the prices determined by the market are too high or
too low and may wish to intervene and change them.
When some institution fixes a price other than at equilibrium, logically it must be either:
a) Maximum price fixing, or

b) Minimum price fixing.
a) Maximum price fixing
When fixing a maximum price, it is always set below the equilibrium level.
Q. Why?
A. There is no point setting a maximum of say £1 million for the price of a loaf of bread
– it would have no effect! It is always less than that anyway.
When someone sets an effective maximum price we always see the same result:
Demand will exceed supply at the set price. We did this in an earlier diagram but we
will do it again now.
Price
D S
P1
Set Price
Quantity
0 Qs Q1 Qd
With this maximum price fixing we have an excess demand of OQd – OQs (which is
the distance Qs to Qd).
Therefore we can expect to see:

• shortages.
• black markets emerging.

• possibly rationing will be introduced.
• corruption might arise.
In the rental housing market if there is “rent control”:

• “key money” might be demanded, a bribe in order to be able to rent the cheap
house; or
• a silly bet can be made which is deliberately lost, just to hand over money; or
• the person renting has to purchase the fixtures and fittings at an extremely high
price; or
• perhaps sexual favours will be demanded before the owner will rent to a person.
In other markets, such as for meat in war time, there will be shortages and queues (=
rationing by time) until a rationing system is introduced by government.
b) Minimum price fixing:
Minimum price fixing may occur with agricultural products in rich countries, where the
government tries to help its farmers by giving them a larger income.
It may also be encountered in primary produce in the third world, with marketing
schemes and buffer stocks.
The same results always emerge: the quantity demanded is less than the quantity
supplied at the prevailing price,
Price
D S
Set Price
P1
Quantity
0 Qd Q1 Qs
With this minimum price fixing at “Set Price”, above the equilibrium level of P1, we
see a surplus of OQs minus OQd, or the gap Qd to Qs.
And we can also expect to observe:

• storage problems and high storage costs (agricultural produce is like that!);
• the spoilage rate likely to be high (agricultural produce);
• there may be dumping of some of the produce in the sea; or
• selling part of it below cost to countries abroad.
The surplus will continue to grow each year as long as the minimum price persists
above the equilibrium one, so the problem (and storage costs) keep on increasing.
Primary produce marketing schemes
Primary produce is prone to large fluctuations in price, the result of both demand and
supply being relatively inelastic, so that a change in either alters price quite
considerably.
Supply is likely to alter sharply for all agricultural crops, as the harvest can be poor or a
bumper one, depending on the weather.
Demand is likely to alter sharply for things like rubber if there is a slump in the motor
vehicle industry so that fewer tyres are required.
So if we look at a diagram of inelastic supply and demand and alter either, price will
rise or fall substantially.
Remember to draw the curves very steeply – they are very inelastic and the steep slope
gives us the large price alterations.
Bumper harvest, Maybe a new diet fad,

supply increase demand increase
Price S1 S2 Price D2 S
D D1
P1 P2
P1
P2
0 Q1Q2 0 Q1Q2
Quantity Quantity
Copyright Kevin Bucknall 2-44 88

As a result of the wide price fluctuations, it is tempting to set up a marketing scheme,
which can buy when prices are low and sell when prices are high, thus stabilising the
price. A “buying price” and “selling price” are set by the marketing board and all
should be well. This is how it looks (the curves would be much steeper; I have drawn
them flatter so you can see what is happening more easily):
Price
D S
Selling price
P1
Buying price
0 Q1 Quantity
However, there is a major problem! Unless the board guesses the long term price it will
set the buying and selling prices incorrectly. If the board buys at a relatively high price,
it will run out of money rapidly. If it sells at a relatively high price, it will end up with
stocks of the produce that cannot be sold.
In the worst scenario it would look something like this in the diagram below:
Price
D S
Selling price
P1 Buying price
0 Q1 Quantity
You can see that the excess supply is great at the selling price, but there is little excess
demand at the lower buying price. So stocks must build up as supply permanently
exceeds demand.
Typically this happens, for the board normally also wishes to increase the incomes of
the farmers a bit so that when setting the prices it tends to err on the generous side.

Does this sort of thing occur in the real world? Yes it does! Cocoa, coffee, rubber,
sugar and tin have all had such boards and suffered problems with them, including
attempts by the boards to raise the long term price by restricting supply.
NOTE: all price fixing brings problems in its wake, even if the intentions are good!
Economists generally favour free markets for this reason. If there are particular
problems, like pockets of poverty, it is usually better to tackle them directly rather than
try to fix the price of the product for all – which includes the rich and the poor.
Price fixing can also be found in labour markets where the government tries to
help the lowly paid by setting a minimum wage.
As economic analysis predicts, problems will emerge. In the case of labour, we would
see unemployment at the prevailing wage rate. There might also be kickbacks and
bribes by workers to get one of the few jobs available. Marlon Brando in the movie “On
the Waterfront” was involved in such a process – it’s an old film but worth seeing!
That is not to say that we should never have a minimum wage and the benefits (a
minimum income, preventing the exploitation of the poor and needy by unscrupulous
employers, and generally feeling that a wealthy society can afford to be slightly
generous to those at the bottom) may be worth the problems.
What are the problems of setting a minimum wage?
When the government legislates for a national minimum wage, it does not affect all
industries and firms. Many are already paying well above the minimum, in order to
attract the right kind and quantity of workers. So minimum wage legislation only
impinges on lowly paid jobs in some industries, as in firm C in the diagram below.
Firm A Firm B Firm C

No effect No effect Min wage works
W W W
Slab Slab
W
W
Dlab Slab
Min Wage
W Min Wage
Dlab
Dlab
Q1 Q1 Q2 Q1 Q3
0 Labour 0 Labour 0 Labour

Firms A and B might be city banks, and C might be a small local café for example.
Where minimum wage legislation is effective, as in firm C, we see that after the
imposition of a minimum wage, fewer people will be employed. The numbers fall
from OQ1 to OQ2, a reduction of Q1-Q2. We will also observe unemployment in
such firms, as the number offering themselves for work is OQ3, reading off the supply
curve, but the number that are employed is only OQ2. Unemployment is represented
by the distance Q2-Q3 in the above diagram. Those who find a job in such firms now
enjoy a higher income, but fewer can actually find a job than earlier and conspicuous
unemployment emerges. It is the usual problem of excess supply at the higher
minimum price or wage.
We return to look at the demand and supply of labour and other labour issues in Unit
5.
If you are finding these free notes useful and feel that you might need
a bit of help in writing essays, getting better marks in exams, and
learning more quickly and easily, take a look at a book I have written to
help you do better - Going to University: the Secrets of Success: Kewei
Press, Second Revised and Expanded Edition, August 2009, paperback,
204 pages, ISBN 978-0956182319.
It can be obtained directly from the publisher www.keweipress.com for

£9.95 (including postage within the UK) in which case you get a free
bonus CD with 19 articles covering things such as how to study more
easily and get better results as well as more economics-related items.
Alternatively, Going to University: the Secrets of Success can be
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Economics Notes: Unit 2 - Why Markets Fail

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Economics Notes: Unit 2 - Why Markets Fail

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Module 2881 Unit 2: The Market System - Why

Markets Can Fail

Listing these 8 major factors:

o Monopoly elements or market dominance.

A. The government can intervene and put it right.

Copyright Kevin Bucknall 2-1

Types of efficiency in economics:

A.) Allocative efficiency

Copyright Kevin Bucknall 2-2

B.) Productive efficiency

The production possibility curve:

Copyright Kevin Bucknall 2-3

Social efficiency matter not just private!

NB The whole of Unit Two consists of two main components:

Copyright Kevin Bucknall 2-4

Types of monopoly, (sometimes called “causes of monopoly”; "sources of

• Exclusive ownership of a unique resource: perhaps there is only one source of

Copyright Kevin Bucknall 2-5

• So-called natural monopoly. This is often the result of economies of scale -

• A monopolist may behave badly in an anti-social way. For instance, he or she

• **5. Lack of competition tends to encourage inefficiency in the firm. The

• As a result, we can get the emergence of lazy managers and owners.

Copyright Kevin Bucknall 2-6

Q Which of the following 10 main economic goals does monopoly hurt?

1. To maximise (raise) economic growth.

THINK FIRST; WRITE DOWN THE NUMBERS YOU THINK MONOPOLY

Copyright Kevin Bucknall 2-7

Economists usually favour reducing or ending monopolies and increasing

BUT some defence is possible!

• A redistribution of income is not too bad perhaps:

It is always happening in a dynamic economy anyway.

If necessary, it can be corrected by government action.

Copyright Kevin Bucknall 2-8

The degree of oligopoly is measured by “the concentration ratio”

An example of the UK in 1992: the 5-Firm concentration ratio:

What can increase the concentration ratio? (i.e., reduce competition)

Copyright Kevin Bucknall 2-9

Cartels are inherently unstable, because:

• The higher (monopoly-type) price attracts newcomers to the industry, who

If a cartel is fully successful - the diagram is simply that of a monopolist!

The Wastes of Oligopoly

• Collusion to try to establish a cartel and behave like a monopoly is likely; if

• There may be wastes (for society) of high advertising costs, or offers to

• We may get bribery or other pressure on, government to keep or establish

Copyright Kevin Bucknall 2-10

• Employment is restricted, because an oligopoly keeps output down.

The Benefits of Oligopoly

• Price does not change much (until we get a price war!).

• There is fierce competition to improve the product in order to increase the

• “Countervailing Power” - if a single monopoly is bad (as we feel), then a few

Copyright Kevin Bucknall 2-11

Reminder: this is the bit in the middle!

WHAT IS MONOPOLISTIC COMPETITION?

• Many buyers and sellers of that type of good or service (= competition).

The Long Run Equilibrium Condition

Copyright Kevin Bucknall 2-12

A. Because of the assumptions of strong competition and free entry/exit.

Let’s think about the short term.

Q. How far does it fall back?

The short run increase in demand:

Problems with Monopolistic Competition

Copyright Kevin Bucknall 2-13

Benefits of Monopolistic Competition