market failure essay memorandum

Market Failure

Definition of Market Failure – This occurs when there is an inefficient allocation of resources in a free market. Market failure can occur due to a variety of reasons, such as monopoly (higher prices and less output), negative externalities (over-consumed and costs to third party) and public goods (usually not provided in a free market)

Types of market failure

• Positive externalities – Goods/services which give benefit to a third party, e.g. less congestion from cycling.
• Negative externalities – Goods/services which impose a cost on a third party, e.g. cancer from passive smoking.
• Merit goods – People underestimate the benefit of good, e.g. education. It may also have positive externalities
• Demerit goods – People underestimate the costs of a good, e.g. smoking. It may also have negative externalities.
• Public Goods – Goods which are non-rival and non-excludable – e.g. police, national defence. Public goods are often not provided in a free market.
• Monopoly Power – when a firm controls the market (with high market share) and can set higher prices.
• Inequality – unfair distribution of resources in free market, e.g. some experiencing poverty and homelessness
• Factor Immobility – E.g. geographical / occupational immobility. For example, when there are pockets of high unemployment, but it is difficult for the unemployed to move and get a job.
• Agriculture – Agriculture is often subject to market failure – due to volatile prices, fluctuating weather and externalities.
• Information failure – where there is a lack of information to make an informed choice.
• Principal-agent problem – Two agents with different objectives and information asymmetries. For example, adverse selection where a buyer has less information than the seller.
• Moral hazard . When individuals have incentive to change their behaviour when others take the risk. For example, when banks are insured by the government, bankers take risky decisions which can cause bank losses.
• Macroeconomic instability – When an economy enters into prolonged recession and high unemployment – or inflationary boom which is unstable.

A way to remember several types of market failure

Key Terms in Market Failure

• Externalities :  These occur when a third party is affected by the decisions and actions of others.
• Social benefit :  the total benefit to society = Private Marginal Benefit (PMB) + External Marginal  Benefit (XMB)
• Social Cost : is the total cost to society = Private Marginal Cost (PMC) + External Marginal Cost (XMC
• Social Efficiency : This occurs when resources are utilised in the most efficient way. This will occur at an output where social marginal cost (SMC) = Social Marginal Benefit. (SMB)

Overcoming Market Failure

• Tax on Negative Externalities – e.g. Petrol tax
• Carbon Tax e.g. tax on CO2 emissions
• Subsidy on positive externalities – why the government may subsidies public transport
• Laws and regulations – Simple and effective ways to regulate demerit goods, like a ban on smoking advertising.
• Buffer stocks – aim to stabilise prices
• Government failure – why government intervention may not always improve the situation

Market failure and behavioural economics

Behavioural economics examines how individuals often act in a non-rational manner – contrary to the expectation of conventional economic models. These types of ‘irrational behaviour’ can lead to a type of market failure where people make poor choices. For example.

• Irrational exuberance – people getting carried away by good news leading to boom and bust.

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6.3 Market Failure

Learning objectives.

• Explain what is meant by market failure and the conditions that may lead to it.
• Distinguish between private goods and public goods and relate them to the free rider problem and the role of government.
• Explain the concepts of external costs and benefits and the role of government intervention when they are present.
• Explain why a common property resource is unlikely to be allocated efficiently in the marketplace.

Private decisions in the marketplace may not be consistent with the maximization of the net benefit of a particular activity. The failure of private decisions in the marketplace to achieve an efficient allocation of scarce resources is called market failure . Markets will not generate an efficient allocation of resources if they are not competitive or if property rights are not well defined and fully transferable. Either condition will mean that decision makers are not faced with the marginal benefits and costs of their choices.

Think about the drive that we had you take at the beginning of this chapter. You faced some, but not all, of the opportunity costs involved in that choice. In particular, your choice to go for a drive would increase air pollution and might increase traffic congestion. That means that, in weighing the marginal benefits and marginal costs of going for a drive, not all of the costs would be counted. As a result, the net benefit of the allocation of resources such as the air might not be maximized.

Noncompetitive Markets

The model of demand and supply assumes that markets are competitive. No one in these markets has any power over the equilibrium price; each consumer and producer takes the market price as given and responds to it. Under such conditions, price is determined by the intersection of demand and supply.

In some markets, however, individual buyers or sellers are powerful enough to influence the market price. In subsequent chapters, we will study cases in which producers or consumers are in a position to affect the prices they charge or must pay, respectively. We shall find that when individual firms or groups of firms have market power, which is the ability to change the market price, the price will be distorted—it will not equal marginal cost.

Public Goods

Some goods are unlikely to be produced and exchanged in a market because of special characteristics of the goods themselves. The benefits of these goods are such that exclusion is not feasible. Once they are produced, anyone can enjoy them; there is no practical way to exclude people who have not paid for them from consuming them. Furthermore, the marginal cost of adding one more consumer is zero. A good for which the cost of exclusion is prohibitive and for which the marginal cost of an additional user is zero is a public good . A good for which exclusion is possible and for which the marginal cost of another user is positive is a private good .

National defense is a public good. Once defense is provided, it is not possible to exclude people who have not paid for it from its consumption. Further, the cost of an additional user is zero—an army does not cost any more if there is one more person to be protected. Other examples of public goods include law enforcement, fire protection, and efforts to preserve species threatened with extinction.

Free Riders

Suppose a private firm, Terror Alert, Inc., develops a completely reliable system to identify and intercept 98% of any would-be terrorists that might attempt to enter the United States from anywhere in the world. This service is a public good. Once it is provided, no one can be excluded from the system’s protection on grounds that he or she has not paid for it, and the cost of adding one more person to the group protected is zero. Suppose that the system, by eliminating a potential threat to U.S. security, makes the average person in the United States better off; the benefit to each household from the added security is worth $40 per month (about the same as an earthquake insurance premium). There are roughly 113 million households in the United States, so the total benefit of the system is $4.5 billion per month. Assume that it will cost Terror Alert, Inc., $1 billion per month to operate. The benefits of the system far outweigh the cost.

Suppose that Terror Alert installs its system and sends a bill to each household for $20 for the first month of service—an amount equal to half of each household’s benefit. If each household pays its bill, Terror Alert will enjoy a tidy profit; it will receive revenues of more than $2.25 billion per month.

But will each household pay? Once the system is in place, each household would recognize that it will benefit from the security provided by Terror Alert whether it pays its bill or not. Although some households will voluntarily pay their bills, it seems unlikely that very many will. Recognizing the opportunity to consume the good without paying for it, most would be free riders. Free riders are people or firms that consume a public good without paying for it. Even though the total benefit of the system is $4.5 billion, Terror Alert will not be faced by the marketplace with a signal that suggests that the system is worthwhile. It is unlikely that it will recover its cost of $1 billion per month. Terror Alert is not likely to get off the ground.

The bill for $20 from Terror Alert sends the wrong signal, too. An efficient market requires a price equal to marginal cost. But the marginal cost of protecting one more household is zero; adding one more household adds nothing to the cost of the system. A household that decides not to pay Terror Alert anything for its service is paying a price equal to its marginal cost. But doing that, being a free rider, is precisely what prevents Terror Alert from operating.

Because no household can be excluded and because the cost of an extra household is zero, the efficiency condition will not be met in a private market. What is true of Terror Alert, Inc., is true of public goods in general: they simply do not lend themselves to private market provision.

Public Goods and the Government

Because many individuals who benefit from public goods will not pay for them, private firms will produce a smaller quantity of public goods than is efficient, if they produce them at all. In such cases, it may be desirable for government agencies to step in. Government can supply a greater quantity of the good by direct provision, by purchasing the public good from a private agency, or by subsidizing consumption. In any case, the cost is financed through taxation and thus avoids the free-rider problem.

Most public goods are provided directly by government agencies. Governments produce national defense and law enforcement, for example. Private firms under contract with government agencies produce some public goods. Park maintenance and fire services are public goods that are sometimes produced by private firms. In other cases, the government promotes the private consumption or production of public goods by subsidizing them. Private charitable contributions often support activities that are public goods; federal and state governments subsidize these by allowing taxpayers to reduce their tax payments by a fraction of the amount they contribute.

Figure 6.15 Public Goods and Market Failure

Because free riders will prevent firms from being able to require consumers to pay for the benefits received from consuming a public good, output will be less than the efficient level. In the case shown here, private donations achieved a level of the public good of Q 1 per period. The efficient level is Q *. The deadweight loss is shown by the triangle ABC.

While the market will produce some level of public goods in the absence of government intervention, we do not expect that it will produce the quantity that maximizes net benefit. Figure 6.15 “Public Goods and Market Failure” illustrates the problem. Suppose that provision of a public good such as national defense is left entirely to private firms. It is likely that some defense services would be produced; suppose that equals Q 1 units per period. This level of national defense might be achieved through individual contributions. But it is very unlikely that contributions would achieve the correct level of defense services. The efficient quantity occurs where the demand, or marginal benefit, curve intersects the marginal cost curve, at Q *. The deadweight loss is the shaded area ABC; we can think of this as the net benefit of government intervention to increase the production of national defense from Q 1 up to the efficient quantity, Q *.

Note that the definitions of public and private goods are based on characteristics of the goods themselves, not on whether they are provided by the public or the private sector. Postal services are a private good provided by the public sector. The fact that these goods are produced by a government agency does not make them a public good.

External Costs and Benefits

Suppose that in the course of production, the firms in a particular industry generate air pollution. These firms thus impose costs on others, but they do so outside the context of any market exchange—no agreement has been made between the firms and the people affected by the pollution. The firms thus will not be faced with the costs of their action. A cost imposed on others outside of any market exchange is an external cost .

We saw an example of an external cost in our imaginary decision to go for a drive. Here is another: violence on television, in the movies, and in video games. Many critics argue that the violence that pervades these media fosters greater violence in the real world. By the time a child who spends the average amount of time watching television finishes elementary school, he or she will have seen 100,000 acts of violence, including 8,000 murders, according to the American Psychological Association. Thousands of studies of the relationship between violence in the media and behavior have concluded that there is a link between watching violence and violent behaviors. Video games are a major element of the problem, as young children now spend hours each week playing them. Fifty percent of fourth-grade graders say that their favorite video games are the “first person shooter” type 1 .

Any tendency of increased violence resulting from increased violence in the media constitutes an external cost of such media. The American Academy of Pediatrics reported in 2001 that homicides were the fourth leading cause of death among children between the ages of 10 and 14 and the second leading cause of death for people aged 15 to 24 and has recommended a reduction in exposure to media violence (Rosenberg, M., 2003). It seems reasonable to assume that at least some of these acts of violence can be considered an external cost of violence in the media.

An action taken by a person or firm can also create benefits for others, again in the absence of any market agreement; such a benefit is called an external benefit . A firm that builds a beautiful building generates benefits to everyone who admires it; such benefits are external.

External Costs and Efficiency

Figure 6.16 External Costs

When firms in an industry generate external costs, the supply curve S 1 reflects only their private marginal costs, MC P . Forcing firms to pay the external costs they impose shifts the supply curve to S 2 , which reflects the full marginal cost of the firms’ production, MC e . Output is reduced and price goes up. The deadweight loss that occurs when firms are not faced with the full costs of their decisions is shown by the shaded area in the graph.

The case of the polluting firms is illustrated in Figure 6.16 “External Costs” . The industry supply curve S 1 reflects private marginal costs, MC p . The market price is P p for a quantity Q p . This is the solution that would occur if firms generating external costs were not forced to pay those costs. If the external costs generated by the pollution were added, the new supply curve S 2 would reflect higher marginal costs, MC e . Faced with those costs, the market would generate a lower equilibrium quantity, Q e . That quantity would command a higher price, P e . The failure to confront producers with the cost of their pollution means that consumers do not pay the full cost of the good they are purchasing. The level of output and the level of pollution are therefore higher than would be economically efficient. If a way could be found to confront producers with the full cost of their choices, then consumers would be faced with a higher cost as well. Figure 6.16 “External Costs” shows that consumption would be reduced to the efficient level, Q e , at which demand and the full marginal cost curve ( MC e ) intersect. The deadweight loss generated by allowing the external cost to be generated with an output of Q p is given as the shaded region in the graph.

External Costs and Government Intervention

If an activity generates external costs, the decision makers generating the activity will not be faced with its full costs. Agents who impose these costs will carry out their activities beyond the efficient level; those who consume them, facing too low a price, will consume too much. As a result, producers and consumers will carry out an excessive quantity of the activity. In such cases, government may try to intervene to reduce the level of the activity toward the efficient quantity. In the case shown in Figure 6.16 “External Costs” , for example, firms generating an external cost have a supply curve S 1 that reflects their private marginal costs, MC p . A per-unit pollution fee imposed on the firms would increase their marginal costs to MC e , thus shifting the supply curve to S 2 , and the efficient level of production would emerge. Taxes or other restrictions may be imposed on the activity that generates the external cost in an effort to confront decision makers with the costs that they are imposing. In many areas, firms and consumers that pollute rivers and lakes are required to pay fees based on the amount they pollute. Firms in many areas are required to purchase permits in order to pollute the air; the requirement that permits be purchased serves to confront the firms with the costs of their choices.

Another approach to dealing with problems of external costs is direct regulation. For example, a firm may be ordered to reduce its pollution. A person who turns his or her front yard into a garbage dump may be ordered to clean it up. Participants at a raucous party may be told to be quiet. Alternative ways of dealing with external costs are discussed later in the text.

Common Property Resources

Common property resources are resources for which no property rights have been defined. The difficulty with common property resources is that individuals may not have adequate incentives to engage in efforts to preserve or protect them. Consider, for example, the relative fates of cattle and buffalo in the United States in the nineteenth century. Cattle populations increased throughout the century, while the buffalo nearly became extinct. The chief difference between the two animals was that exclusive property rights existed for cattle but not for buffalo.

Owners of cattle had an incentive to maintain herd sizes. A cattle owner who slaughtered all of his or her cattle without providing for replacement of the herd would not have a source of future income. Cattle owners not only maintained their herds but also engaged in extensive efforts to breed high-quality livestock. They invested time and effort in the efficient management of the resource on which their livelihoods depended.

Buffalo hunters surely had similar concerns about the maintenance of buffalo herds, but they had no individual stake in doing anything about them—the animals were a common property resource. Thousands of individuals hunted buffalo for a living. Anyone who cut back on hunting in order to help to preserve the herd would lose income—and face the likelihood that other hunters would go on hunting at the same rate as before.

Today, exclusive rights to buffalo have been widely established. The demand for buffalo meat, which is lower in fat than beef, has been increasing, but the number of buffalo in the United States is rising rapidly. If buffalo were still a common property resource, that increased demand, in the absence of other restrictions on hunting of the animals, would surely result in the elimination of the animal. Because there are exclusive, transferable property rights in buffalo and because a competitive market brings buyers and sellers of buffalo and buffalo products together, we can be reasonably confident in the efficient management of the animal.

When a species is threatened with extinction, it is likely that no one has exclusive property rights to it. Whales, condors, grizzly bears, elephants in Central Africa—whatever the animal that is threatened—are common property resources. In such cases a government agency may impose limits on the killing of the animal or destruction of its habitat. Such limits can prevent the excessive private use of a common property resource. Alternatively, as was done in the case of the buffalo, private rights can be established, giving resource owners the task of preservation.

Key Takeaways

• Public sector intervention to increase the level of provision of public goods may improve the efficiency of resource allocation by overcoming the problem of free riders.
• Activities that generate external costs are likely to be carried out at levels that exceed those that would be efficient; the public sector may seek to intervene to confront decision makers with the full costs of their choices.
• Some private activities generate external benefits.
• A common property resource is unlikely to be allocated efficiently in the marketplace.

The manufacture of memory chips for computers generates pollutants that generally enter rivers and streams. Use the model of demand and supply to show the equilibrium price and output of chips. Assuming chip manufacturers do not have to pay the costs these pollutants impose, what can you say about the efficiency of the quantity of chips produced? Show the area of deadweight loss imposed by this external cost. Show how a requirement that firms pay these costs as they produce the chips would affect the equilibrium price and output of chips. Would such a requirement help to satisfy the efficiency condition? Explain.

Case in Point: Externalities and Smoking

Figure 6.17

Russellstreet – Smoker – CC BY-SA 2.0.

Smokers impose tremendous costs on themselves. Based solely on the degree to which smoking shortens their life expectancy, which is by about six years, the cost per pack is $35.64. That cost, of course, is a private cost. In addition to that private cost, smokers impose costs on others. Those external costs come in three ways. First, they increase health-care costs and thus increase health insurance premiums. Second, smoking causes fires that destroy more than $300 million worth of property each year. Third, more than 2,000 people die each year as a result of “secondhand” smoke. A 1989 study by the RAND Corporation estimated these costs at $0.53 per pack.

In an important way, however, smokers also generate external benefits. They contribute to retirement programs and to Social Security, then die sooner than nonsmokers. They thus subsidize the retirement programs of the rest of the population. According to the RAND study, that produces an external benefit of $0.24 per pack, leaving a net external cost of $0.29 per pack. Given that state and federal excise taxes averaged $0.37 in 1989, the RAND researchers concluded that smokers more than paid their own way.

Economists Jonathan Gruber of the Massachusetts Institute of Technology and Botond Koszegi of the University of California at Berkeley have suggested that, in the case of people who consume “addictive bads” such as cigarettes, an excise tax on cigarettes of as much as $4.76 per pack may improve the welfare of smokers.

They base their argument on the concept of “time inconsistency,” which is the theory that smokers seek the immediate gratification of a cigarette and then regret their decision later. Professors Gruber and Koszegi argue that higher taxes would serve to reduce the quantity of cigarettes demanded and thus reduce behavior that smokers would otherwise regret. Their argument is that smokers impose “internalities” on themselves and that higher taxes would reduce this.

Where does this lead us? If smokers are “rationally addicted” to smoking, i.e., they have weighed the benefits and costs of smoking and have chosen to smoke, then the only problem for public policy is to assure that smokers are confronted with the external costs they impose. In that case, the problem is solved: through excise taxes, smokers more than pay their own way. But, if the decision to smoke is an irrational one, it may be improved through higher excise taxes on smoking.

Sources: Jonathan Gruber and Botond Koszegi, “A Theory of Government Regulation of Addictive Bads: Optimal Tax Levels and Tax Incidence for Cigarette Excise Taxation,” NBER Working Paper 8777, February 2002; Willard G. Manning et al., “The Taxes of Sin: Do Smokers and Drinkers Pay Their Way?” Journal of the American Medical Association , 261 (March 17, 1989): 1604–1609.

Answer to Try It! Problem

Figure 6.18

In the absence of any regulation, chip producers are not faced with the costs of the pollution their operations generate. The market price is thus P 1 and the quantity Q 1 . The efficiency condition is not met; the price is lower and the quantity greater than would be efficient. If producers were forced to face the cost of their pollution as well as other production costs, the supply curve would shift to S 2 , the price would rise to P 2 , and the quantity would fall to Q 2 . The new solution satisfies the efficiency condition.

1 See Report of the Committee on Commerce, Science, and Transportation, Children’s Protection From Violent Programming Act , Senate Report 106–509 (October 26, 2000), Washington, D.C.: U.S. Government Printing Office, 2000, and Michael Rich, “Violent Video Games Testimony,” Chicago City Council, October 30, 2000, at http://www.aap.org/advocacy/rich-videogameviolence.pdf .

2 Common property resources are sometimes referred to as open access resources.

Rosenberg, M., “Successful State Strategies,” Adolescent Health Leadership Forum, December 6, 2003, at http://www.aap.org/advocacy/ahproject/AHLSuccessful StateStrategiesMRosenberg.pps .

Principles of Economics Copyright © 2016 by University of Minnesota is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License , except where otherwise noted.

Market Failure: A Critical Analysis Essay

Introduction, understanding market failure, causes of market failure, government’s intervention strategies, reference list.

The collapse of the global financial system in 2008 and the subsequent recession through 2009 defied the reputation of the free market economy in the public imagination and discourse in a way that it had not been defied since the Great Depression.

The intellectual consensus after this particular recession was that free-market economies are not only unstable and exploitive (Boettke 2010), but contribute to market failure, thus the need for government’s intervention on a multiplicity of fronts to neutralize these objectionable characteristics (Devlin 2010).

Academics and economic commentators are still critically analyzing what could have gone wrong to occasion such an unprecedented financial crisis on the global front, but one of the possible reasons that continue to elicit increased attention is market failure (Dorn 2010). The present paper aims to shed more light into the concept of market failure, its causes, and the various interventions that government can adopt to correct this undesirable market outcome.

In precise terms, market failure is “…an economic term that encompasses a situation where, in any given market, the quantity of a product demanded by consumers does not equate to the quantity supplied by suppliers” (Investopedia 2012, para. 1).

This scenario is thought to arise due to the absence of certain economically ideal factors, which not only prevent the achievement of market equilibrium but also occasion negative ramifications on the economy due to fact that optimal allocation of resources is not realized (Investopedia 2012; Wetherly & Otter 2011).

In other words, market failure occurs when the allotment of commodities and services by a free market fails to meet the efficiency requirements, in large part due to the pursuit of pure self-interest and imperfections in the market mechanism (Palmer & Hartley 2006). Market failure is caused by a multiplicity of factors, discussed as follows:

Academics and economic experts are of the opinion that market failure may be caused either by non-disclosure of critical information among private sector players, or by inadequacy of information in the market (Devlin 2010). This view is reinforced by Basu (2009), who acknowledges that market failure is caused by incomplete information, as well as imperfect or asymmetric information.

According to this author, “…asymmetric information refers to the problem which principally arises from the non-disclosure of information; this means information is there but one agent does not disclose all the relevant parts of it, specially his/her true intention to his/her opposite agent” (p. 488).

On the other hand, incomplete information implies that all the relevant information that is essential for private sector actors to make informed investment decisions is not currently available, either due to the fact that it was not being collected and stored by relevant market agencies or because it has yet to emerge in a particular market (Wetherly & Otter 2011; Dorn 2010).

Borooah (2003) acknowledges that market failure may arise due to unfair competition practices perpetuated by monopolies. In the economic arena, agents perpetuate unfair competition practices with the view to serve their own best interests while relying on imperfect knowledge, leading to market failure (Booth 2008).

Still, extant research demonstrates that market failure can be triggered by externalities, which may come into play when the action of one agent inevitably influences the welfare of another agent in a market setting (Borooah 2003; Wetherly & Otter 2011; Palmer & Hartley 2006), or when skill formation may bear broader benefits or spillages that agents financing the formation may be unable to fully capture for themselves and which those making investments will not have any incentive to consider in making their decisions (Keep 2006).

Moving on, economic theory has proved that market failure can be triggered by risk and uncertainty, and by social welfare and inequality (Borooah 2003; Wetherly & Otter 2011). The challenge of risk and uncertainty, according to these authors, crops up when products and services are differentiated by ‘time of consumption’, and by position or level of contingency.

In terms of social welfare and inequality, it is felt that market failure may arise in any given market because disparity in the distribution of products and services between consumers may indicate that the social welfare linked to a stated level of production is actually sub-optimal (Borooah 2003).

A strand of economic literature (e.g., Basu 2009; Wetherly & Otter 2011; Keep 2006) demonstrates that in many situations government intervention in a free-market economy materializes from the failure of the private sector to streamline the markets, and from government urge to protect investors and the public.

The 2008 financial recession certainly taught analysts and industry that assumptions of an efficient market are misplaced where systemic risk and uncertainty permeate various private sector actors, and where the collapse of one key player triggers the collapse of other players, not only in terms of domestic scope but also globally (Devlin 2010; Palmer & Hartley 2006).

This particular recession demonstrated to the world that government intervention in free market economy is indeed a necessity, and that incompetent support for the free market is, to say the least, dogmatic.

Market failure, along with its well known antecedents and systemic events, such as conflict of interests, insider trading, and fraud, continue to trigger a plethora of regulatory reform proposals, particularly from government and other stakeholders (Dorn 2010). As noted by this author, government- initiated reforms and proposals “…are directed at reducing systemic risks, within which context regulators are more actively targeting a range of so-called ‘market failures’, including non-compliance and crime” (p. 49).

To effectively correct market failures, therefore, government needs to develop and implement regulations that can guard against dubious and shady practices perpetrated by market insiders in the corporate world, and also lay down frameworks for addressing conflict of interest among free market actors (Dorn 2010; Devlin 2010).

Moving on, some analysts argue that government can correct market failure by changing the context within which markets operate, with a view to redistribute resources and alter the initial endowments in order to avoid grossly inequitable consequences (Borooah 2003; Wetherly & Otter 2011).

This view is supported by Basu (2010), who acknowledges that government has a role to intervene in free-market economies to ensure the benefits accruing from the market ‘trickle down’ to the population. However, government’s “…role would be limited by the injunction that, in the pursuit of redistributive objectives, [it] should not, by distorting incentives, prevent the free functioning of markets” (Borooah 2003, p. 2).

Another strand of literature demonstrates that government could attempt to correct market failure by privatizing public institutions, which continue to absorb much of the blame for entrenching monopolies and thus creating market imperfections (Dorn 2010; Wetherly & Otter 2011). This preposition, as noted by Borooah (2003), implies that government could attempt to correct the undesirable outcomes occasioned by market failure by abdicating its productive responsibilities in support of the public sector.

Such abdication, according to this author, would lead to the removal of imperfections, which are known to prevent markets from functioning properly as they are linked to a lack “…of competition (for example, through the existence of monopolies) or with the presence of barriers to price flexibility (for example, through price-support mechanisms like minimum wage legislation)” (p. 3).

Consequently, the task of government in such a scenario would be limited to taking obligatory steps to guarantee that all hurdles to the proper functioning of markets are eliminated.

To curtail externalities and inequities in the market, which leads to market failure, government could engage in the provision of public goods and restriction of public undesirables through increased taxes, public purchases and grants (Dolfsma 2011).

Critics, however, extrapolate that this kind of interference may actually lead to disturbance of market equilibrium, triggering more challenges particularly on the supply side (Booth 2008). For example, an electronic company accused of disturbing the market of a local economy by selling counterfeit products may relocate to another country instead of paying high taxes in penalties.

Such relocation, if done by half of the companies operating in a given market, will ultimately lead to low supplies and consequent market failure. This observation leads Boettke (2010) to argue that government must be extremely cautious when making decisions to intervene in a free market economy as such intervention, if not properly formulated and implemented, may imply doom to the market dynamics.

The above notwithstanding, it is well known that government must undertake the responsibility to formulate and maintain rules in the economy (Dolfsma 2011), and that rules set out by government not only profoundly influence the economic discourse but also affect the overall levels of income or income distribution (Palmer & Hartley 2006; Basu 2009).

This view is supported by Basu (2009), who suggests that it is the function of governments across the world to formulate rules for the better functioning of society. Consequently, it can be suggested that government may use this prerogative of being the ‘principal rule formulator and implementer’ to correct existing market failures.

From the above discussion, it is evident that there exists an obvious economic case for government’s intervention in markets where some form of market failure is unfolding due to the fact it must always act to safeguard the interests of the public.

Of course the role of the government in attempting to correct market failure is perceived by many economists as an issue of ideological discussion that transcends individuals and economies (Dolfsma 2011), but the issues discussed in this paper demonstrate that the state should be concerned with the appropriate functioning of the entire market system if desirable economic outcomes are to be achieved.

It cannot be rightly guessed that government will automatically succeed where free market forces have failed, and that all cases of market failure could be amenable to correction through government intervention; however, the government remains an indispensable player in streamlining market activities and processes.

Basu, S. 2009, ‘Government success, failure of the market: A case study of rural India’, International Review of Applied Economics , vol. 23 no. 4, pp. 485-501.

Boettke, P. J. 2010, ‘What happened to efficient markets?’ Independent Review , vol. 14 no. 3, pp. 363-375.

Booth, P. 2008, ‘Market failure: A failed paradigm’, Economic Affairs , vol. 28 no. 4, pp. 72-74.

Borooah, V. K. 2003. Market failure: An economic analysis of its causes and consequences . Web.

Devlin, A. 2010, ‘Antitrust in an era of market failure’, Harvard Journal of Law & Public Policy , vol. 33 no. 2, pp. 557-606.

Dolfsma, W. 2011. ‘Government failure – four types’, Journal of Economic Issues, vol. 45 no. 3, pp. 593-604.

Dorn, N. 2010, ‘Regulatory conceptions of unacceptable market practices under three policy scenarios’, Journal of Banking Regulation , vol. 12 no. 1, pp. 48-68.

Investopedia 2012. Market failure . Web.

Keep, E. 2006, ‘Market failure and public policy on training: Some reasons for caution’, Development and Learning in Organizations , vol. 20 no. 6, pp. 7-9.

Palmer, A. & Hartley, B. 2006. The business environment , 5th ed, Berkshire, McGraw Hill.

Wetherly, P., & Otter, D. 2011, The business environment: Themes and issues , 2nd ed, Oxford, Oxford University Press.

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Gr. 12 Economics Lesson W3 T3: Market Failures

Grade 12 Economics Lesson Week 3, Term 3: Market Failures

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Resources for cie economics (9708), cie economics a2 essay guide – efficiency and market failure.

I firmly believe that best way to prepare for essays is through highly focused, exam-oriented preparation. And the most exam-oriented preparation you get is past year papers. However, randomly doing past papers is highly ineffective; your practice needs to be structured to allow you to gain as much as possible. This requires a tightly-woven strategy and military-grade planning (hehe).

This guide does just that – it packages the model essays on ‘Efficiency and Market Failure’ in a way that’s designed to optimise your mastery of the material, and allow you to tackle any exam question on the topic!

Let’s begin!

The first thing you’ll need to know is how to describe efficiency and market failure in detail, and precisely. This essay deals with that, and will provide you with a very standard ‘template’ which can be modified and used across almost any essay within this topic:

Next, you’ll need to understand  why  you’re learning all this stuff about efficiency and market failure. The reason is that economic theory says that the way to maximise welfare is to allocate resources efficiently! Therefore, we need to know what efficiency is, so we know how to maximise welfare for the people of a country. This essay deals with that:

Now, let’s deal with two classic questions that come up all the time! The first is whether a free market can work to allocate resources efficiently. I cover that with this sample:

Here’s another permutation of that essay, which asks whether or not privatisation and competition will help or hinder efficiency.

The second is whether or not government intervention will help achieve efficiency. Part (b) of this essay deals with that, and as an added bonus, also provides an excellent example of how to deal with questions asking about ‘necessary and sufficient conditions’. I’ve included a page of notes at the end explaining exactly what it means!

Part (a) of the essay above is something that’s already been covered in definitions of efficiency – how to use PPCs to demonstrate efficiency. However, the essay here deals with it in a little more depth, so it’s definitely worth checking out!

Finally, here’s what I call a ‘random question’. One of those things you can’t really study for or predict, because the exam could throw anything at you. However, knowing all the material above will  definitely allow you to write a top-quality essay with just a little bit of thinking and modification of material you already know.

This particular one asks whether the reason for free market failure is the ‘complex modern economy’. Note that it’s just a variation on ‘Is the free market efficient?’, which we’ve covered above! You just have to add in a little bit of analysis to consider whether or not the failure is due to the ‘complex modern economy’ (it’s not).

So, after following this guide all the way through, here’s what you’ve mastered:

• How to describe efficiency and market failure (applicable to all essays on the topic).
• Why you’re learning this (to learn how to maximise welfare).
• Whether the free market allocates resources efficiently.
• Whether government intervention can achieve efficiency.
• A sample of how to adapt your knowledge to a small twist CIE throws in!

Voila. You’re ready.

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In our house, English is not English. Not in the phonetic sense, like short a is for apple , but rather in the pronunciation – in our house, snake is snack . Words do not roll off our tongues correctly – yet I, who was pulled out of class to meet with language specialists, and my mother from Malaysia, who pronounces film as flim , understand each other perfectly.

In our house, there is no difference between cast and cash , which was why at a church retreat, people made fun of me for “ cashing out demons.” I did not realize the glaring difference between the two Englishes until my teacher corrected my pronunciations of hammock , ladle , and siphon . Classmates laughed because I pronounce accept as except , success as sussess . I was in the Creative Writing conservatory, and yet words failed me when I needed them most.

Suddenly, understanding flower is flour wasn’t enough. I rejected the English that had never seemed broken before, a language that had raised me and taught me everything I knew. Everybody else’s parents spoke with accents smarting of Ph.D.s and university teaching positions. So why couldn’t mine?

My mother spread her sunbaked hands and said, “This is where I came from,” spinning a tale with the English she had taught herself.

When my mother moved from her village to a town in Malaysia, she had to learn a brand new language in middle school: English. In a time when humiliation was encouraged, my mother was defenseless against the cruel words spewing from the teacher, who criticized her paper in front of the class. When she began to cry, the class president stood up and said, “That’s enough.”

“Be like that class president,” my mother said with tears in her eyes. The class president took her under her wing and patiently mended my mother’s strands of language. “She stood up for the weak and used her words to fight back.”

We were both crying now. My mother asked me to teach her proper English so old white ladies at Target wouldn’t laugh at her pronunciation. It has not been easy. There is a measure of guilt when I sew her letters together. Long vowels, double consonants — I am still learning myself. Sometimes I let the brokenness slide to spare her pride but perhaps I have hurt her more to spare mine.

As my mother’s vocabulary began to grow, I mended my own English. Through performing poetry in front of 3000 at my school’s Season Finale event, interviewing people from all walks of life, and writing stories for the stage, I stand against ignorance and become a voice for the homeless, the refugees, the ignored. With my words I fight against jeers pelted at an old Asian street performer on a New York subway. My mother’s eyes are reflected in underprivileged ESL children who have so many stories to tell but do not know how. I fill them with words as they take needle and thread to make a tapestry.

In our house, there is beauty in the way we speak to each other. In our house, language is not broken but rather bursting with emotion. We have built a house out of words. There are friendly snakes in the cupboard and snacks in the tank. It is a crooked house. It is a little messy. But this is where we have made our home.

Our mock interview sessions made me more confident to voice and articulate my thoughts during the actual interview. The sessions also emotionally prepared me for the interview. As a result, I was a lot less nervous and was able to think on my feet during the actual interview. Besides prepping for the interview, we also explored economic concepts and topics that I was interested in- the sessions were not limited to preparing me for a single interview but served as a learning opportunity to expand my knowledge.

Thevesh is a brilliant teacher, he has a way of explaining things that makes convoluted concepts easier to grasp. When I was having difficulties, he went the extra mile by offering me different explanations to aid in my understanding. He was always patient and understanding, tireless in answering my questions and clearing my doubts.

Thank you, Thevesh, for your unparalleled guidance and support.

Inspiring, dedicated and personalised. Thevesh not only strikes as an inspiring and extremely impressive individual at first glance but also willing to go the extra mile to provide personalised guidance as you get to know him better as a university application mentor. If you’re looking to read how amazing his personal statement critiques are, feel free to read a testimony by any one of the brilliant young minds he’s helped. I will also not focus on his achievements and credentials as an economist and tutor as I believe those speak for themselves. Instead, I hope that, at the end of reading this review, you will, at the very least, be curious enough to want to start a conversation with Thevesh.

Throughout the year leading up to submitting my UCAS application, Thevesh helped shape me intellectually, playing multiple roles including friend, debate coach, maths tutor and mentor. I believe what sets him apart is that he is not just a senior who will comment on your personal statements and walk you through their application experience. He is always prepared and excited to share with you things that he thinks you would benefit from. Even a long way before the actual application, Thevesh helped me explicitly by initiating deeply thought-provoking conversations about anything from ethics to the global economy as well as implicitly through the countless articles and discussions he shared with me. As a world-class debater, he helped me become a more articulate and structured speaker, which, by making me a more confident presenter and interviewee, has undoubtedly helped me in the admissions process. More importantly, skills and habits Thevesh has induced in me such as keeping up with the news and questioning the mathematics behind Economics are transferable to the next stage of my education.

Specific to Economics at Cambridge, I think a good yardstick to deduce your suitability for such a demanding course is whether you enjoy talking to Thevesh. I can’t say for certain, but listening to him explain Hotelling’s Law during a mock interview sounded awfully representative of a supervision at university. Thevesh is on a constant quest to satisfy his thirst for knowledge and his desire to educate; tagging along on this journey will open your eyes to an abundance of knowledge.

If you’re looking to grow as an economist, the quality of his detailed explanations of A Level multiple choice questions is proof of his ability to dissect and break down information into easily digestable chunks. If you’re looking to maximise your chances of being admitted into a top university, his wealth of experience easily matches professionals (if he saw me say this he would immediately lay a disclaimer that you should always defer to the experts). If you’re looking to grow intellectually as a person, just having a conversation with Thevesh will leave questions demanding to be answered.

What to do next:

Step 1: Go to the Contact page of this website Step 2: Pick a mode of contact (email/mobile number) Step 3: Say Hi to Thevesh Step 4 (automatic): You’ll have found a new friend and reliable mentor who will try his best for you.

Thevesh also pushed me to expand my reading, which in turn provided me with some great content for my personal statement. It was a really fun and interesting experience to learn economic concepts not found in the syllabus from him, as he has the knack of explaining things accurately, simply and effectively.

With all the help I was receiving, I didn’t just feel like a better applicant, I felt like I was growing into the shoes of a better economist. Because he’s studying an economics degree himself, his well-rounded knowledge of the subject gave me an amazing insight into economics on a different level.

He was very patient in guiding me throughout my application, and was never tired in answering my questions or any doubts I had. And if it happened to be that he didn’t know the answer to my question, he’d do his research and have a full discussion with me about it. He provided me with emotional support too, as university application is a stressful matter for most students, and I came out of the whole process feeling much more confident of myself and my application choices.

Thevesh also provided me with extensive reading material. The books provided me with great insights on how economics was applied in reality and it was fun to read and learn concepts and ideas that lie outside the sphere of academic syllabus. This in turn allowed me to have a better understanding on economic concepts and some of it turned out to be great content to be included in the PS.

During the interview session, Thevesh maintained a very professional setting that resembled how actual interviews are. He was warm, welcoming and friendly. The methods he employed in interviewing were similar to the actual ones and by the end of the interview, he gives honest and critical evaluations about our performances. One of the things that I liked about him is his ability to identify key areas that needs to be worked on. His criticisms are constructive in nature and they are specific which then allows me to quickly fix or improve in that particular area.

I honestly feel like I improved both as an applicant because Thevesh made me think like an economist. He would often do the role playing method to get me thinking on how an economist would solve problems. If I appeared to be struggling, he would subtly push me in a way that would allow me to link my thoughts and be able to come up with the solutions. To me, that is important. As an economist, your knowledge is your tool box and you have to use what is inside and apply them to solve the problems and those are the things you can expect to learn from Thevesh.

All in all, I truly admire the work and effort that Thevesh put in to help me with my application. The sincerity and the work rate that he invested in me in turn created a cycle within me of wanting to do better myself. That chain reaction is something truly remarkable. Thevesh has a real charm when it comes to his ability to motivate and inspire people and that is not a skill that can trained but rather a product of honesty, hard work and humility. I am truly thankful for all the help I received from Thevesh. He has been an excellent UK application tutor.

One thing that I am truly grateful to Thevesh for, is for never giving up on me. He pushed me academically, but was also there emotionally whenever I needed a morale boost, regardless of what time of the day it was. I think that this combination makes him an excellent guidance counsellor for whoever applying, because the whole process is rigorous and emotional draining. He truly gives his all to each student who is applying, and I believe that his help was part of the reason that I obtained my offer. Thank you Thevesh!

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Market Failure in the Marketplace of Ideas: Commercial Speech and the Problem that Won't Go Away

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THE DYNAMICS OF IMPERFECT MARKETS GRADE 12 NOTES - ECONOMICS STUDY GUIDES

• Key concepts
• Output profit and loss
• Oligopolies
• Monopolistic competition
• Summary of market structures

There are a number of different types of imperfect markets, e.g. monopolies, oligopolies and monopolistic competition. An imperfect market is characterised by imperfect competition. Some participants have earlier or exclusive access to information that benefits them in the marketplace at the expense of their competitors. Certain participants will be able to access the market more easily than other participants, i.e. the supply of and demand for products will not be equal, and the matching of buyers to sellers will not be immediate. Overview

7.1 Key concepts

These definitions will help you understand the meaning of key Economics concepts that are used in this study guide. Understand these concepts well.

Use mobile notes to help you learn these key concepts. See page xiv in the introduction for more.

7.2 Monopolies

A monopoly exists when there is one seller of a good or service for which there is no close substitute. 7.2.1 Characterictics of monopolies

• There is only one seller of the product
• There are barriers to entry. These are caused by patents and other forms of intellectual property rights, control over resources, government regulations and decreasing costs.
• The monopolist is regarded as a price maker since it is able to influence the market price through changing the quantity it supplies to the market.
• The are no close substitutes. The product cannot be easily replaced. Consumers have no choice in price and quality of the product.
• There is no competition. One business in the market will control the supply of goods and services.
• Products are differentiated and unique. Monopolies manufacture a variety of products which are difficult for other companies to copy.
• Large amounts of starting capital are required. Large industries like Eskom and SASOL require millions of starting capital.
• Monopolies have legal considerations. New inventions are protected by patent rights. Services, like the Post Office are protected by law and other businesses are prohibited from entering the market.
• It is also possible for the monopolist to make an economic profit in the long run. This is because it faces no competition from new entrants as a result of the barriers to entry.

Monopolies can be classified as two main groups due to barriers that exist Natural monopolies: High development costs prevent others from entering the market and therefore the government supplies the product. E.g. Electricity in South Africa is provided by the government enterprise, Eskom. It costs billions of rands to build and maintain power stations and therefore there are no other suppliers. Artificial monopolies : Here the barriers to entry are not economic in nature. An example of a barrier is a patent. A patent is a legal and exclusive right to manufacture a product, e.g. Denel Land Systems manufacturing Casspirs. 7.2.2 The demand curve of the monopolist

• Under perfect competition the individual producer faces a horizontal demand curve where D = MR = AR, since it is a price taker.
• By contrast, the monopolist faces a normal market demand curve which slopes downwards from left to right. Here D = AR.
• It is also the market (or industry’s) demand curve, since the monopolist is responsible for the entire output of the industry.

7.2.3 The marginal revenue curve of a monopolist

• Since a monopolist faces a downward sloping demand curve, its marginal revenue curve and its demand curve are not the same curve as is the case with an individual producer under perfect competition.
• Under perfect competition, the individual producer is a price taker and can sell any quantity at the market price and therefore faces a horizontal demand curve, which is also its marginal revenue curve.
• The demand curve for a monopolist, which is downward sloping, implies that, if it wishes to increase its sales by an additional unit, it must decrease the price of the product.
• The lower price applies to all its customers. Its marginal revenue - that is the amount by which total revenue increases if it sells an additional unit – will therefore be less than the price.
• The marginal revenue curve and the demand curve are therefore not the same curve. The Marginal revenue curve will be lower than the demand curve.

Activity 1 Use the table below of a typical monopolist and plot the revenue curves on the same set of axes. Notice the position of the Marginal revenue curve in relation to the Demand curve.

7.3 Output profit and loss

7.3.1 Revenue

• The demand curve for a monopolist is the market demand curve and slopes downwards from left to right (DD/AR). See the top graph in Figure 7.1.
• Any point on the curve is an indication of the quantity of the product to be sold and the price at which trade takes place.
• Any price-quantity combination on the demand curve is also its average revenue (AR) curve.
• The average revenue from each product is calculated by dividing the total revenue by the quantity = the price. See the bottom graph in Figure 7.1 (left).
• The marginal revenue (MR) curve runs below the demand curve (AR) – it always intersects the horizontal axis at a point halfway between the origin and the point of intersection of the demand curve (AR).
• The cost structure of the monopoly is the same as that of competitive businesses.
• Determine the point where MC = MR, the point where the production cost of the last unit is equal to the revenue it earns (point e) – profitmaximising production quantity of Q1 on the horizontal axis.
• To determine the price at which Q1 is sold, move vertically upwards from e to L on the demand curve. The market price is therefore determined at P.
• Total revenue is greater than the short-term total costs. The monopolist makes a profit (due to demand and cost of production).

7.3.3 Economic loss in the short term When you draw the economic loss for the monopolist, the graph stays the same, EXCEPT the AC curve moves to the right - up, and totally misses the AR (demand) curve (see Figure 7.7).

• The monopoly suffers short-term losses when the AC curve lies above the demand curve (DD).
• Equilibrium is reached where MR = MC (a loss-minimising situation).
• The monopoly will produce a quantity Q and sell at price P. The total costs are the area OCLQ; the total revenue is the area OPNQ. The loss will be that part that is shaded (the area PCLN).

7.3.4 Comparison of a monopoly and a perfect market 

Loss Some people argue that a monopolist always makes an economic profit. This is not the case. Profitability of a monopolist depends on the demand for the product as well as the cost of production.

7.4 Oligopolies

An oligopoly exists when a small number of large companies are able to influence the supply of a product or service to a market. By controlling the supply of the product or service on the market, oligopolies aim to keep its prices and profits high. Oil companies are one of the best examples of an oligopoly. A special type of this market form is a duopoly – an industry with only two producers. 7.4.1 Characteristics of oligopolies

• There is limited competition. Only a few suppliers manufacture the same product.
• Products may be homogenous or differentiated.
• This market is characterised by mutual dependence. The decision of one company will influence and will be influenced by the decisions of the other companies.
• Oligopolies can frequently change their prices in order to increase their market share. However this can result in a price war.
• Extensive use is made non-price measures to increase market share e.g. advertising, efficient service or product differentiation.
• Producers have considerable control over the price of their products although not as much as in a monopoly.
• If oligopolies operate as a cartel, firms have an absolute cost advantage over the rest of the competitors in the industry. Abnormal high profits may be a result of joint decisions in an oligopoly.
• Entry is not easy in an oligopolistic market. This is due to brand loyalty and it also requires a large capital outlay.

7.4.2 Kinked demand curve for the oligopolist

• One theory devised by an American economist, Paul Sweezy, can be used to determine the oligopolist’s demand curve.
• An oligopolist faces a kinked demand curve. This demand curve consists of two sections.
• The top section, the section that relates to high prices is a very elastic slope (i.e. demand is very sensitive to a price change.)
• The bottom section, the section that relates to lower prices is very inelastic (i.e. demand is not sensitive to a price change).
• Suppose the oligopolist is selling at the original/present price of R10 and 9 units of output are sold. Total revenue is R10 × 9 = R90
• If the firm tries to increase profit by increasing the price by R2 to R12, quantity demanded would fall to 2 units and total revenue would decrease to R24 (R12 × 2).
• If the firm tries to increase profit by reducing the price by R2 to R8 and increasing its total sales, total revenue would be R80.
• The oligopolist is therefore faced with a difficult decision because in both instances it will not benefit.
• Increasing the price of goods or reducing the price to increase sales will not lead to greater revenue earned.

7.4.3 Non-price competition

• Oligopoly firms are reluctant to change prices because a price war will drive prices down and profits will be eliminated.
• They make use of non-price measures to attract customers and increase their market share.
• An important aspect of non-price competition is to build brand loyalty, product recognition and product differentiation.
• This is done by means of advertising and marketing. As a result, oligopoly firms tend to spend a substantial amount of money on this.

Other forms of non-price competition include:

• extended shopping and business hours
• doing business over the internet
• after-sales services
• offering additional services
• loyalty rewards for customers
• door-to-door deliveries

Examples of firms that use kinds of non-price strategies are those in petrol retailing such as Shell, BP and Caltex and in the banking sector such as ABSA, FNB etc. 7.4.4 Collusion Collusion takes place when rival firms cooperate by raising prices and by restricting production in order to maximise their profits. When there is a formal agreement between firms to collude it is called a cartel. A cartel is a group of producers whose goal is to form a collective monopoly in order to fix prices and limit supply and competition. In general, cartels are economically unstable because there is a great incentive for members not to stick to the agreement, to cheat by cutting prices illegally and to sell more than the quotas set by the cartel. Although there is an incentive to collude there is also an incentive to compete. This has caused many cartels to be unsuccessful in the long term. Some well known cartels are the Organisation of Petroleum Exporting Countries(OPEC) and De Beers diamonds in South Africa. Overt/Formal collusion e.g. cartels are generally forbidden by law in most countries. However, they continue to exist nationally and internationally. Sometimes in an oligopoly market, a dominant firm will increase the price of a product in the hope that its rivals will see this as a signal to do the same. This is referred to as price leadership and is an example of a tacit collusion.

7.5 Monopolistic competition

7.5.1 Characteristics of monopolistic competition

• The products are differentiated. Products are similar but not identical. The are similar in that they satisfy the same need of the consumer. There may be differences in packaging but the product is the same. e.g. sugar and salt.
• Differentiated products create opportunities for non-price competition e.g. advertising.
• Monopolistic competition displays a hybrid structure. It is a combination of competition and a monopoly.
• There are many sellers.This indicates the element of competition.
• Entry into the market is easy.
• Businesses have little control over the price of the product. Each business sells at its own price since a single price cannot be determined for the differentiated product because a range of prices could apply.
• Information for buyers and sellers is incomplete.
• Collusion is not possible under monopolistic competition.
• Restaurants, plumbers, lawyers, insurance brokers, hairdressers, funeral parlours and estate agents are all examples of monopolistic competitors.

See nonprice competition for oligopolies on page 109. Some forms are similar for monopolistic competition. Make sure you can draw the graphs for the monopolistic competitor. 7.5.2 Non-price competition

• Differentiated products create opportunities for non-price competition i.e. competition is not based on prices but rather on factors relating to the product’s uniqueness.
• Advertising campaigns and further product differentiation are powerful forms of non-price competition.
• The greater the product differentiation the less price elastic the demand for the product will be.
• Large sums of money are spent on research, development and advertising to build a loyal consumer group.
• Therefore brands play a significant role in determining customer loyalty where a consumer may choose one producer over another. Large chain stores e.g. Checkers, Spar etc. have their own brands for some products. Most of these products are exactly the same as known brands.

7.5.3 Prices and production levels in the short-term and long-term

• The demand curve for a monopolistic competitor is similar that of a monopolist.
• Short term equilibrium (economic profit and economic loss) corresponds with a monopoly, but the demand curve is more price elastic (flatter) due to good substitutes.
• Long-term equilibrium is characterised by normal profit, due to the ease of entry and exit into the market (similar to a perfect market). The economic profit made in the short-term attracts more businesses to enter the market.

7.5.4 Comparison of monopolistic competition with perfect competition

• Both firms make normal profit in the long run. Therefore there is no difference in the long-run between the perfect market and the monopolistic market as far as profit is concerned.
• The equilibrium price is higher than in a perfect market. The consumer therefore pays less in the perfect market and more in the monopolistic market.
• The monopolistic competitor does not produce at the minimum of the LAC whereas the perfect competitor does. He is less efficient.
• The perfect competitor produces more at a lower price while the monopolistic competitor produces less at a higher price.

7.6 Summary of market structures

Activity 2 Complete the following table by filling in the missing information:

[20] Answer to activity 2

[20] Activity 3 Study the following graph and answer the questions that follow:

• Define the term imperfect market. (2)
• Motivate why the above graph indicates short-term equilibrium. (4)
• Which point on the graph indicates profit maximisation? (2)
• Calculate the economic profit. (6) [14]

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