This graph shows why the free market system fails when it allocates resources to industries which product de-merit goods.
The three lines on the graph all stand for different things and by looking at all of them together we can see why the market fails to provide these goods. To put the graph in context let us say that this graph shows the benefit and cost curves for chemicals that are harmful to the environment but useful to the individual. The red line on the curve shows the marginal benefit to the individual for every extra unit of the chemicals bought.This benefit is reflected in how much the people will be willing to pay for the good.
(This is why the y-axis is labelled cost/benefit as one can be used as a synonym for the other. ) This line is much like the demand curve on a supply and demand graph. The blue line is the private costs to a company of producing every extra good. The slope of this curve has been greatly exaggerated so that that this explanation is made slightly easier.
The line in actual fact would probably be closer to a horizontal line.Since the companies costs to product the third barrel of chemicals would probably be the same as the companies costs to produce the forth. This curve only shows the costs that the firm pays to make the chemical. The raw materials, profit margin, labour etc.
It does not include any of the costs that are imposed on society from the chemical being made or being used. (Remember that if no one used the chemical then nobody would make it). These costs are shown by the yellow line. This shows the social cost of each extra unit made.
It would also usually be shown as a flat line but again I have exaggerated the curve to make the graph slightly easier to explain. The line is parallel to the private costs curve. This is because it includes all the costs that the company pays and also includes all of the costs that society pays. For example the chemicals could be contaminating a nearby river.
Water companies then have to clean the water before selling it to customers. The cost of cleaning out the pollution is the social cost of producing the chemicals. There are also costs which are harder to give a financial value to.For example how much of a cost is the lost of habitat for animals that live along the side of the river.
The social cost curve tries to take all of these into account. Driven by the free market system the companies will make and sell chemicals up to a point where the cost they pay for each unit is equal to what people will pay for them. As you can see on this graph when roughly 8 units are produced the cost of each additional unit is equal to the amount that a person will pay for an additional unit of the chemical. This means that the user is getting the amount of benefit they want.
The company is getting the amount of money they want and every body is happy. This point is easily seen as the point where the private costs and benefit curves cross. The problem with this is that the costs on society are not included. We can see that if the social costs are included then the perfect amount to supply would be closer to 7.
Since a free market system is run on the principle that every body should look after their own self-interest, more would be supplied than what is beneficial to society. The good is “OVER-SUPPLIED”.If social costs were taken into account the amount would be at the point where the social costs curve and the private benefit curve crossed. This would mean that the benefit to society (remember the people buying the product are society) would equal the cost to society.
This would mean that the resources in the country were correctly allocated to the chemical industry. The triangle that is shown on the graph shows the extra cost that society pays for the good. Or to look at it another way it shows the welfare that is lost from the good being over supplied.The area of the triangle shows the overall amount of welfare to society that is lost.
This is the case with all de-merit goods. Market Failure With Merit Goods The second graph shows how the free market system also fails to provide the correct amount of merit goods. Again we have three lines. Two of these are the same as in the last graph.
There is the yellow line to show the benefit to the individual of buying or using a good. There is the blue line to show private cost to a company of producing a good, which is also the same as in the last graph.However the third line on this graph is not the extra cost to society of an individually using an additional unit of the good but the extra benefit. The example that I am going to use to put this graph into context is TB jabs.
When you get a TB jab there is benefit to you; you don’t catch the TB virus. However there is also a benefit to those around you who don’t catch the virus from you. The benefit to these people is included in the social benefit curve as well as the benefit to the individual. If it were left to the free market, companies would only supply jabs up to a point where private costs equalled private benefit.
This would mean that about 8 TB jabs would be produced. However society would benefit most if 9 TB jabs produced. If any more than 9 were produced then the cost to the society (In this case the cost to the individual and the cost to society are the same and are therefore shown with the same curve. ) Would be more than the benefit that was received.
We can see that once again the free market system has failed to supply the correct amount of a good for the maximum society benefit. If left to the free market system there would not be enough TB jabs produced.
