1.3-1.4 (Market Failure and Government Intervention) Flashcards
Allocative Efficiency
Definition: Allocative efficiency is achieved when society is producing an appropriate bundle of goods relative to consumer preferences
Private Costs (PC) = Producer’s costs of production
Social Costs (SC) = Private Costs (PC) + External Costs (EC)
Private Benefits (PB) = Individual consumer benefit upon consumption
Social Benefits (SB) = Private Benefits (PB) + External Benefits (EB)
MPC = Marginal Private Costs
MSC = Marginal Social Costs
MPB= Marginal Private Benefits
MSB = Marginal Social Benefits
MPB=MSB is the Private Optimum
MPC=MSC is the Social Optimum
MPC=MSC is upward-sloping due to the law of diminishing marginal returns, because if the marginal cost of producing each unit increases (i.e. it costs more to produce an additional unit than the last), suppliers would want a higher price each time to produce the units to cover their costs for producing additional units (this is the same reason why the Supply Curve is upward-sloping).
MPB=MSB is downward-sloping due to the law of diminishing marginal utility, meaning that for every additional unit consumed, the benefit/satisfaction given to the consumer by that additional unit decreases with every additional unit consumed (this is the same reason why the Demand Curve is downward-sloping).
In a free market that is allocatively efficient, we assume that there are no external costs or benefits at all, hence the reason for MPC being equal to MSC, and MPB being equal to MSB.
If Allocative Efficiency is occurring, then the following points will take place:
- Allocative Efficiency is the maximisation of society surplus (the sum of consumer surplus (CS) and producer surplus (PS)). This idea is built on the basic economics problem of how to allocate scarce resources given unlimited wants. Consumers have wants and producers produce the output to satisfy those wants, if both of these economic agents are fully satisfied, then resources cannot be allocated any better, which is allocative efficiency. This occurs where Demand = Supply i.e. at equilibrium. If the there were to be a shift along either the demand or supply curves, the size of the society surplus (the larger triangle made up of both the consumer and producer surplus triangles) would become smaller.
- Allocative Efficiency is the maximisation of net social benefit. This occurs where MSB=MSC and in a free market that occurs at equilibrium. This works under the assumption that MSC=MPC and MSB=MPB, i.e. there are no external costs or benefits. With Qd movement to the right, there would be a loss of net social benefit as social costs would be higher than social benefits, and with a Qd movement to the right, there would be a loss of potential social benefit by not producing those units.
- Allocative Efficiency is where resources perfectly follow consumer demand, i.e. there are no surpluses, excess supply, excess demand or shortages. This occurs at the market equilibrium where Demand = Supply.
However, allocative efficiency works under the following assumptions:
- There are many buyers and sellers in the market
- There is perfect information for both producers and consumers in the market
- There are no barriers to enter the market, so any firms can enter and compete in the market at will
- There are no barriers to exit the market
- That producers are aiming to maximise profit
- That consumers are aiming to maximise utility
If any of these assumptions were to break down, there is a chance that the private optimum would be different to the social optimum.
Negative Externalities of Production
Definition: Negative Externalities of Production are the costs to third parties as a result of the actions of producers
> A Negative Externality of Production occurs when there are negative external costs (EC) as a result of production e.g. air pollution from producing textiles causes the local community to develop respiratory issues
Other examples: resource degradation, leaching/eutrophication, resource depletion, deforestation
On a diagram,
MSC>MPC (SC = PC + EC)
As the market is allocating resources at the wrong level (where MPB=MSB and MPC meet), there is a welfare loss as the market is not operating at allocative efficiency (where MPB=MSB and MSC meet).
The welfare loss is always the triangle that points towards the social optimum (MSC).
The bottom of the triangle (where MPB=MSB and MPC meet) is social benefit, and the top of the triangle (where Q1 and MPC meet) is social cost. Therefore, social cost>social benefit, hence, welfare loss.
As firms are operating in their own self-interest to maximise profit, over-consumption and over-production and over-consumption occur (shown on the diagram as Q1 is to the right of allocative efficiency where MPB=MPB and MSC meet), also leading to a lowering of the price, creating a misallocation of resources which ultimately culminates to a welfare loss.
Negative Externalities of Consumption
Definition: Negative Externalities of Consumption are the costs to third parties as a result of the actions of consumers
> A Negative Externality of Consumption occurs when there are negative external costs (EC) as a result of consumption e.g. people smoking causes a strain on healthcare as people develop respiratory issues, the secondary smoke inhaled by people surrounded by smokers can also cause people to develop healthcare issues and employers may lose out on productivity due to use of sick days
Other examples: Excessive alcohol, Excessive sugary drinks/snacks/fast food, non-recyclable plastics
On a diagram,
MSB<MPB (SB = PB + EB)
The market will allocate scare resources at the private optimum (where MPC=MSC and MPB meet), and create a welfare loss as it is not operating at the social optimum/allocative efficiency (where MPC=MSC and MSB meet).
The welfare loss is always the triangle that points towards the social optimum (MSB). All of the units being produced beyond the social optimum at Q1 are producing a higher social cost than social benefit, hence, a higher cost to society.
As consumers are operating in their own self-interest, there is an over-production and over-consumption of these goods/services, and as a result there is a misallocation of resources and a welfare loss to society as the market is operating beyond the allocative efficiency.
Positive Externalities of Production
Definition: Positive Externalities of Production are the benefits to third parties as a result of the actions of producers
> A Positive Externality of Production occurs when there are positive external benefits (EB) as a result of production e.g. in-work training schemes that would allow other firms to poach workers without having to offer and pay for in-work training schemes themselves, and leads to more competitiveness in the job market and higher wages, which can ultimately lead to more taxes being paid and government spending on things like infrastructure and education.
Other Examples: Research and Development
On a diagram,
MSC<MPC (SC = PC +EC)
The market allocates scare resources at the private optimum (where MPB=MSC and MPC meet), whereas society would like the market to allocate at the social optimum/allocative efficiency (where MPB=MSC and MSC meet), therefore, resulting in a welfare loss. The welfare loss is always the triangle that points towards the social optimum (MSC). As less units are being produced at Q1 than at the social optimum, social cost>social benefit, hence, welfare loss.
As producers are operating in their own self-interest and only considering their private costs (PC) rather than social costs (SC) they ignore any external benefits to society, the market allocates resources at the private optimum leading to an under-consumption and under-production of these goods/services, this results in a misallocation of resources and welfare loss as too few resources are allocated to the market in comparison to the social optimum/allocative efficiency.
Positive Externalities of Consumption
Definition: Positive Externalities of Consumption are the benefits to third parties as a result of the actions of consumers
> A Positive Externality of Consumption occurs when there are positive external benefits (EB) as a result of consumption e.g. vaccinations reduce the chances of someone contracting a virus and their ability to pass that virus onto others and reduces the impact the virus has on the person and others they might pass that virus onto, this can also lead to an increase in productivity as people are less likely to take sick days and are able to function without hindrance and ultimately would then pay more tax to the government, which could lead to an improvement in schools and infrastructure, etc.
Other examples: Healthcare, Education, Exercise, Healthy Eating
On a diagram,
MSB>MPB (SB = PB + EB)
The free market will allocate scarce resources at the private optimum (where MSC=MPC and MPB meet), and not at the social optimum/allocative efficiency (where MSC=MPC and MSB meet), leading to a welfare loss. The welfare loss is always the triangle that points towards the social optimum (MSB). As less units are being produced at Q1 than at the social optimum, social cost>social benefit, hence, welfare loss.
As consumers are operating in their own self interest and are ignoring the benefits to society, the market allocates resources at the private optimum leading to an under-consumption and under-production of these goods/services, this results in a misallocation of resources and welfare loss as too few resources are allocated to the market in comparison to the social optimum/allocative efficiency.
Merit Goods
Merit Goods Definition: Goods that are deemed to be more beneficial to consumers than they realise
De-Merit Goods Definition: Goods that are deemed to be more harmful to consumers than they realise
(Normative considerations decided by politicians)
Imperfect Information -
Information Failure when the information is not present at all, when the information is not clear, and/or when consumers choose to ignore the information.
Asymmetric Information where the information does exist but is not shared equally between the two parties.
An example of merit goods is that education may be under-consumed as consumers cannot recognise or do not understand the long-term benefits, such as not knowing just how much extra income they could earn with a university degree. This could lead to irrational decision-making and the subsequent underconsumption or underproduction of education or other merit goods as they often generate a positive externality of consumption when consumed.
Other Examples: Healthcare, renewable energy and exercise.
On the other hand, for de-merit goods, irrational decision-making as a result of information failure leads to the overconsumption and overproduction of de-merit goods as they often generate a negative externality of consumption when consumed.
Examples include: Cigarettes, Alcohol and Gambling
Public Goods
Characteristics of Public Goods:
Non-Excludable - No price can be charged for the good
This is because:
- The benefits of consuming the good cannot be confined to the individual that has paid
- There is no cost-efficient way to price e.g. building a wall around a beach to make it private
Non-Rivalrous - The quantity of the good doesn’t diminish upon consumption
Examples: Flood Defences, Road Signs, Street Lights, Roads, Beaches, Lighthouses
Issues:
- Free Rider Problem
- Missing Market: no supply by private firms despite the huge demand for these goods to issue with profitability and the free rider problem, therefore, cannot be supplied by the free market mechanism
Evaluation:
- Quasi Public Good: Can show the characteristics of both public and private goods, e.g. toll roads or hotels owning a beach or the fact that one person using a beach reduces the space available on the beach and over-crowding on the beach reduces the quality of the experience
Common Access Resources - Tragedy of the Commons
Definition: Natural resources over which no private ownership has been established
Lack of private ownership leads to the Tragedy of the Commons. Private producers act according to their self-interest and unsustainably exploit common access resources, eventually leading to the depletion of those resources
Private producers will continue to deplete these common access resources as a means to boost profits. However, if an individual producer chooses to scale back in an effort to stop the depletion of these resources, other firms will continue to deplete resources, leading to a loss solely for the individual producer who scaled back.
Examples of common access resources: Air, seafood, timber and minerals
Indirect Taxation and Market Failure
Definition: An indirect tax increases a firm’s costs of production but can be transferred onto the consumer in the form of price hikes.
On a negative externality of production diagram, MPC can shift to the left when an indirect tax is added, setting MSC=MPC + tax
The indirect tax:
> Increases the costs of production for the firm
> Internalises the Externality (as the private costs are now equal to the social costs when tax is added) so the polluter pays
> Solves issues of overconsumption and overproduction as the market equilibrium is now at the social optimum
> Promotes allocative efficiency whilst generating government revenue (represented by a box on the diagram) creating a welfare gain in the market
Key phrase when talking about government revenue would be to say that the tax is a hypothecated tax i.e. the revenue is ringfenced to solve market failure.
The revenue could be used:
> to educate or advertise
> to fund alternative policies or policies that work in conjunction with the tax
> to subsidise alternatives if it is a demerit good
> to fund rehabilitation schemes
Assumptions made when drawing diagrams and analysing the benefits of the tax:
> Must be price elastic so that there is responsiveness to an increase in price
> That the government has perfect information so that they can set the tax at the right level to meet the social optimum.
> Overtaxing could lead to black markets which would lead to lost tax revenue and higher government spending on policing
> Overtaxing could cause (smaller) firms to shut down leading to unemployment and a lack of competitiveness in the market
> Overtaxing could be seen as a regressive policy, often having a significantly higher impact on the poorer members of society
Furthermore, the implementation of an indirect tax is ultimately the decision of the government and it could be argued that the policy is an infringement on people’s rights and their freedom to choose
Subsidy and Market Failure
Definition: A subsidy is a money grant given to producers by the government to lower the costs of production and encourage an increase in output
On a negative externality of production diagram, MPC can shift to the right when a subsidy is added, setting MSC=MPC + subsidy
The subsidy:
> Lowers the costs of production
> Reduces the price whilst increasing the quantity
> Solves issues of underconsumption and underproduction
> Promotes allocative efficiency and creates a welfare gain
Assumptions made when drawing diagrams and analysing the benefits of a subsidy:
> The cost of the subsidy to the government (represented by a box on the diagram) could in the future cause spending cuts or tax rises that disproportionately impact the poorer members of society. The opportunity cost of spending the money on a subsidy rather than other things such as infrastructure must also be considered and the interest paid if the money is borrowed.
> That the government has perfect information so that they can set the subsidy at the right level to meet the social optimum.
> That firms will pass on the lower costs of production onto the consumer reflected in a lower price
> That firms do not become dependent on subsidies in the long-run
> That there is price elastic demand so that there is a responsiveness in the market to a decrease in price
Regulation and Market Failure
Definition: Regulation is a rule or law enacted by the government that must be followed by economic agents to encourage a change in behaviour.
Non-Market Based Approach but a Command/Control Approach
Command Approach can use:
> Bans
> Limits
> Caps
> Compulsory
> Innovative Regulations
Control Approach can use:
> Enforcement
> Punishment
Acts as an incentive to change behaviour to restore the market quantity to socially optimum levels. Solving issues in the free market without working through the free market to achieve allocative efficiency and welfare gain.
However:
> Regulation is extremely costly due to administration and enforcement costs
> Works under the assumption that the regulation is set at the right level of strictness, has the potential to significantly increase costs and force firms to leave the country, causing a loss of tax revenue for the government and unemployment
> Can encourage the emergence of black markets that pose a threat to consumers and a loss of tax revenue for the government and increased costs for policing required
> Encourages firms to break regulations if enforcement or punishment is not effectively distributed or attempts to find loopholes
Tradable Pollution Permits and Market Failure
Governments set a cap on the number of pollution permits at Q-star/the socially optimum level
Permits issued to firms across the economy to match the cap
Firms make decisions based on the options involving the lowest costs:
> Investing in Green Technology
> Buys Spare Permits
Government enforces permits
Pollution comes down to the socially optimum level to achieve allocative efficiency
Scheme designed to promote long-run incentives to invest in green technology:
> Increases Profits
> Not burdened when prices increase as number of permits decreases
However:
> Heavily reliant on enforcement, developing countries may not have the means to properly enforce or implement permit scheme + reliance on technology to have the ability to accurately measure CO2 emissions
> Assumption that government has perfect information and can or are willing to allocate the number of permits at the socially optimum level
> Unintended consequences such as firms shutting down or leaving the country to places with more relaxed pollution laws
> Chance of firms passing on the costs or acquiring additional permits onto consumers
> Reliant on international cooperation as climate change is not a market failure limited to a single country
State Provision and Market Failure
Definition: State provision is the direct provision of goods and services by the government free at the point of consumption.
Can solve the issue of merit goods being under-consumed and under-produced, but only when there is inequity in the free market for key merit goods such as education and healthcare.
Can also solve the market failure for public goods due to missing markets in the free market.
Government considers the social costs and social benefits and allocates at the socially optimum level
Free at the Point of Consumption
Solves the under-consumption and under-production of these goods as well as inequity
Solves missing market issues
Achieves allocative efficiency and a maximisation of welfare
Issues:
> Excess demand due to the price being 0
> Extreme costs and issues with long-run funding, opportunity cost of not allocating scarce resources elsewhere
> Assumption that governments have perfect information to allocate supply at the socially optimum level
> Inefficiency of state-run organisations due to lack of profit motivation, can cause people to turn to the private sector
Price Controls and Market Failure
Minimum Price:
At the current market equilibrium, P1 and Q1 are to the right of the socially optimum level. By imposing a minimum price higher than the current market equilibrium, the price increases and subsequently, the demand drops and allocative efficiency is achieved.
However:
> If there is price inelastic demand, demand will reduce disproportionately to price and may not reach the socially optimum level for Qd
> A minimum price is regressive and could widen income inequality in society by disproportionately affecting poorer people, especially if the good is price inelastic
> Could encourage the emergence of black markets and smuggling, posing a risk to consumers and decreasing tax revenue
> Assumes that the government has perfect information and that they can set the minimum price at the right price to meet the social optimum
> Could have an impact on producers as the demand for their products decreases
Maximum Price:
At the current market equilibrium, P1 and Q1 are to the right of the socially optimum level. By imposing a maximum price lower than the current market equilibrium, the price decreases and subsequently, the supply drops and allocative efficiency is achieved.
However:
> There may be shortages as suppliers become less willing and able to supply at the maximum price and the Qd at that price increases
Could encourage the emergence of black market due to shortages as consumers are willing and able to pay higher prices to guarantee the good/service
Reliant on the government enforcing the maximum price
Assumes that the government has perfect information and that they can set the maximum price at the right price to meet the social optimum
Cost to the government to increase the supply available to meet Qd, possibly in the form of subsidies or other incentives
Information Provision and Market Failure
Definition: Information Provision is government-funded information in the form of provision/education/advertising to encourage or discourage consumption.
Demand Shift
Consumers make rational decisions as they know the true Marginal Private Benefit
Solves over/under-consumption
Achieves Allocative Efficiency
But:
> High cost to operate, opportunity cost of not utilising scarce resources elsewhere
> No Guarantee of Success
> Focused on the LR rather than the SR
> Assumes that the government themselves have perfect information
