1.3 Flashcards
The main role of the price mechanism in a free-market economy
to allocate scarce resources efficiently.
Complete market failure happens when
market does not supply products at all
Partial market failure happens when
market functions, but it supplies either the wrong quantity of a product or at the wrong price
For markets to operate efficiently
property rights must be protected – perhaps through state regulation
Failure to protect property rights may lead to what is known as the Tragedy of the Commons
overuse of common land and the long-term decline of fish stocks caused by over-fishing which leads to a long-term permanent damage to the stock of natural resources.
Externalities are defined as
spill-over effects from production and/or consumption for which no appropriate compensation is paid to one or more third parties affected.
- can be negative or positive
Externalities cause market failure if
The price mechanism does not take account of the social costs and benefits of production and consumption
Private costs are the costs faced by
producer or consumer directly involved in a transaction.
When negative externalities exist then social costs exceed
Private cost
External costs occur when the activity of one agent has a
Negative effect on the well-being of a third party
key aspect of all externalities is the difficulty of assigning values:
- Shadow pricing: e.g. the external cost of road congestion can be calculated by multiplying the number of hours lost by the average wage e.g. 1m lost working hours x £12 average hourly wage = £12m
- Compensation estimate the cost of putting right an externality e.g. includes the cost of installing double-glazing in houses affected by increased road noise from a new motorway. If 200 houses are affected each with £5,000 double glazing cost, increased road noise is estimated at £1m
- Revealed preference- how much people are willing to pay to avoid an externality
Marginal private cost (MPC)
o Cost to the producing firm of producing an additional unit of output or costs to an individual of any
economic action. Private costs are internal costs.
demand curve represents private benefits, supply curve represents private costs
Marginal external cost (MEC)
Cost to third parties from the production/consumption of an additional unit of output
Marginal social cost (MSC)
- total cost to society of producing an extra unit of output
- MSC = MPC + MEC
Marginal external benefit (MEB)
o The benefit to a third party from the production/consumption of an additional unit of something
Marginal social benefit (MSB)
o Total benefit to society from consuming an extra unit.
o MSB = MPB + Marginal External Benefit (MEB)
Examples of negative externalities from production
- air pollution from factories
- pollution from fertilisers
- industrial waste
- noise pollution
- collapsing fish stocks
- methane emissions
If MSC pivots away from MPC, then
Marginal external cost of extra output is increasing
When equilibrium is at MSC
price goes up as market has recognised and accommodated for negative externalities such as pollution
social welfare loss is when market output (q1)
is higher than the optimum social position (q2)
Negative externalities from consumption
- noise pollution from neighbours
- air pollution from smokers
- vehicle pollution
- litter from tourists
- spillover costs from rising levels of obesity
Positive externalities exist when third parties
benefit from the spill-over effects of production/consumption e.g. the social returns from investment in training or the positive benefits from health care/medical research.
If there are negative externalities, then we must add the external costs to the firm’s
supply curve to find the marginal social cost curve (MSC).
If there are positive externalities, then we must add the external benefits to the demand curve
demand curve (i.e. the marginal private benefit (MPB) curve) to find the marginal social benefit curve (MSB).
if market ignores positive externalities,
then there’ll be underconsumption, leading to a misallocation of resources
Marginal private benefit (MPB):
benefit to the consumer of consuming an additional unit of output
Marginal external benefit (MEB)
benefit to third parties from the consumption of an additional unit of output
Marginal social benefit (MSB)
total benefit to society of consuming an extra unit of output. MSB = MPB + MEB
With positive (consumption) externalities, marginal social benefit is
higher than marginal private benefit
Examples of positive consumption externalities
- health programmes
- bike schemes
- free school meals
social optimum is where msb =
msc
negative externalities means MSC has
higher gradient
A private good or service has three main characteristics:
Excludable
Rival in consumption
Rejectable
excludable?
excludability gives seller the chance to make a profit, buyers can be excluded if they are not willing and able to pay for it
Rival in consumption?
one person’s consumption of a product reduces the amount left for others to consume and benefit from
eg, eaten pizza is no longer available or road space
Non-rejectable?
The consumer can reject private goods and services if their needs and preferences or their budget changes.
What are the key features of pure public goods?
- non excludability - no price will be charged (could cause a free rider problem)
- non-rival consumption -Consumption by one consumer does not restrict consumption by other consumers
- non rejectable (eg, nuclear defence system)
It is up to the government to decide what, and how?
output of public goods is appropriate for society.
Estimate the net social benefits from making public goods available.
do governments have to provide public goods?
NO, They might finance them but leave delivery to the private sector.
Pure public goods are not normally provided by the private sector because
free rider problem, so no revenue for firms
A quasi-public good is a
near-public good
features of quasi public goods
- Semi-non-rival, ie it is public up to a point
- Semi-non-excludable, ie it is possible but difficult or costly to exclude non-paying consumers
The Free-Rider Problem
The free rider problem leads to non-provision of a pure public good and thus causes pure market failure.
For markets to work, there needs to be symmetric information
i.e. consumers & producers have the same knowledge about products, they know everything there is to know about the effects of consuming them
Asymmetric information is when information does exist but
there is an imbalance in information between buyer and seller which can distort their choices
chain of reasoning if car sellers know more than buyers
- sellers know more about quality
- buyers can’t tell quality
- buyers will offer average price for all cars
- typically lower than sellers perceived value
- sellers may remove good vehicles from sale
- average quality of cars drop
- buyers no longer buy at previous prices = higher risk of market disappearing
Moral hazard occurs when
insured consumers are likely to take greater risks, knowing that a claim will be paid for by their cover.
if consumers had better/fuller information on the benefits to themselves of consuming a good
marginalprivate benefit curve would shift lower leading to a smaller equilibrium quantity.
= possible market failure
three main types of market failure:
- externalities
- under-provision of public goods
- information gaps
externalities
an externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism. (define) spill over leads to over/under production of goods, meaning resources aren’t allocated efficiently
under provision of public goods
public goods are non-rivalry and non-excludable, meaning they are underprovided by the private sector due to the free rider problem.
market is unable to ensure enough of these goods are provided, eg streetlights
information gaps
homo economicus assumed to have perfect info, just like firms, so are assumed to make completely rational decisions. BUT, agents do not always make rational decisions and so resources are not allocated to maximise welfare. eg, 2nd hand goods
when there are asymmetric markets
government provides information to allow people to make informed decisons, like smoking and drinking
a demerit good is
good with external costs, where the cost to society is greater than the cost to the individual, tend to be overprovided by free market
economy should produce at
MSB=MSC, the social optimum position at Q2P2,
difference between MSC and MPC increases at output grows, because external costs grow the more that people do something (think driving)
positive externalities of consumption occur when
when social benefits are greater than social costs
if market considers all benefits
will produce at MSB=MSC at Q2P2, failure of market to consider external benefits has led to the misallocation of resources so there is an underproduction of Q1-Q2, leads to a welfare loss in the shaded area. gap grows as output grows, eg vaccination
difficult to work out size of
externality as it tends to be placed on value judgements, since it is difficult to monetise external costs, lots of externalities involved with information gaps, as people are unaware of full implications of their decisions
government intervention
indirect taxes and subsidies tradable pollution permits provision of the good provision of information regulation
indirect taxes and subsidies
- taxes can be put on goods with negative externalities and subsidies on goods with positive externalities
tradable pollution permits
these allow firms to produce up to a certain amount of pollution, and can be traded amongst firms to give them a choice whilst reducing level of pollution
provision of the good
when social benefit is very high, gov may decide to provide the good through taxation, eg, healthcare/education
provision of information
since some externalities are associated with information gaps, gov can provide info to help people make informed decisions and acknowledge external costs
regulation
this could limit consumption of goods with negative externalities, eg banning smoking ads
public goods are non-rivalry + non-excludable
NR - which means that one persons use of the good doesn’t stop someone else from using
NE - meaning you can’t stop someone from accessing the good and someone can not choose to not access the good
eg, streetlights, roads are quasi
free rider problem
- can’t charge an individual a price for the provision of a non-excludable good because someone else will gain the benefit from it without paying anything
- private sector producers will not provide public good to people because the cannot be sure of making profit, due to non-excludability of public goods, therefore if proven was left to market mechanism, market would fail
symmetric information
when buyers and sellers have potential access to same info, but many decisions are based on imperfect info and so economic agents are unable to make informed decisions (suffer from information gaps)
asymmetric information
when one party has superior knowledge compared to another. usually, the seller has more info than the buyer and this means they can take advantage of the other parts lack of knowledge, by charging them a higher price
problems with advertising
leads to info gaps because it is designed to change attitudes of the consumers to encourage them to buy the good, could cause them to think benefits are greater than they are
- improvements in technology mean info gap are on the decline
info gaps lead to
market failure as there is a misallocation of resources, because people do not buy things that maximise their welfare
- means consumer demand/ prod supply too high/low so price and quantity not at social optimum position
