Question

Discuss the situations under which private markets fail to achieve the highest level of social welfare. Include in your answer how the different situations effect WTP/MB and WTA/MC. In addition, discuss the role of government when markets fail to achieve the socially optimal level of output.

Answer 1

Private markets fail to achieve highest level of social welfare when goods are not allocated at the optimal price. When there is monopoly, in the case of a sole firm selling the product in the market and when there is underproduction of merit goods which benefits the society such as education, healthcare, this leads to increase in the cost of availing such services, thereby reducing social welfare. When there is overproduction of goods which are harmful to the consumer.

When there is monopoly, the monopolist can charge a consumer based on his willingness to pay as he will charge a rich consumer a higher value and the lowest possible value to a person who has less ability to pay. The marginal benefit is the price the consumers are willing to pay, thus higher the MB, higher the price they are willing to pay, higher the profitability of the firm. Willingness to accept is the minimum amount of money which the monopolist will charge a consumer in order to cover his marginal cost of production. Otherwise he won't sell the good.

In the case of underproduction in merit good, this does not effect the WTP as the consumer has to consume this product regardless of whether he is willing to pay or not. But the willingness to pay will reduce if the costs go on increasing, which will reduce the marginal benefit, leading to higher WTA for the firm who is providing the merit good and higher marginal cost for the consumer.

In the case of overproduction of demerit goods, the WTP increases as consumers want to increase as much marginal benefit as possible, thereby increasing WTA and reducing the Marginal cost of the producer as he achieves economies of scale because of overproduction.

Government intervenes by way of increasing taxes of demerit goods producers, providing incentives to setup merit goods and increasing competition in the economy by removing barriers to entry, thus creating a price competitive world where consumers are not exploited.