1.3 Market Failure Flashcards
What is market failure?
The inefficient allocation of resources in the free market which leads to a loss of social welfare
What are the 3 types of market failure?
- Information gaps
- Under-provision of public goods
- Externalities
What is an externality?
A spillover effect from consumption or production on a third party (can be positive or negative)
What is a marginal private cost (MPC)?
The cost incurred by an individual (producer/firm) as part of the production of a good
What is a marginal private benefit (MPB)?
The extra satisfaction gained by an individual for consuming a good
What is MSB = MSC?
The social optimum level of production
What is a negative production externality?
When the production of a good/service has a harmful external impact on a third party (social costs are greater than private costs)
What is deadweight welfare loss?
A cost to society due to a reduction in economic efficiency when market is not in equilibrium (loss of consumer or producer surplus)
What are merit goods?
Goods/services which have positive consumption externalities but are often underproduced by the free market
What are demerit goods?
Goods/services with negative externalities that are often overproduced by the free market and consumed to a greater extent than considered socially desirable
What are indirect taxes?
A tax imposed by the government that increases the supply cost of producers, aims to decrease the supply of a good or service
How does an indirect tax solve externalities?
The cost of the externality is internalised, moving production closer to the social optimum
What are 3 drawbacks of indirect tax to solve externalities?
- Difficult to measure externality
- Regressive
- Opportunity/enforcement costs
What is cap and trade?
A market based policy in which the government sets a ‘cap’ on carbon emissions and firms are given permits to pollute which can be traded or sold to other firms
Why is the supply of carbon permits inelastic and what is the effect?
Government increases the scarcity of permits resulting in an increase in price. This makes it more expensive for firms to gain permits, discouraging them from polluting
What are 2 advantages of cap and trade?
- Encourages investment in green technology
- Does not deter future investment: it is a gradual reduction
What are 2 disadvantages of cap and trade?
- Political favouritism: governments likely to distribute more permits to companies with national significance
- Setting correct cap is complex: too high=limited effect on pollutants, too low=permits expensive for smaller businesses
What is regulation?
A set of rules, normally imposed by government that firms must follow in order to modify their behaviour
What are 2 advantages of regulation?
- Can be gradually toughened/implemented over time
- Theoretically ‘cheaper and simpler’ to implement
What are 3 disadvantages of regulation?
- High enforcement and opportunity costs
- Unintended consequences e.g black markets, smuggling
- Deters future investment
What is nationalisation?
The transfer of an industry from private to public ownership and the government begins to provide the good/service
What are 2 benefits of nationalisation?
- Better coordination with the central plan or strategy
- State can monitor externalities easily: can reduce negative externalities and increase positive externalies
What are the alternative interventions to increase the production/consumption of merit goods?
- Legislation
- Advertising/Information
- Direct Provisioning
What is good information?
When the buyer and seller both have full knowledge of the price, benefits and costs of a good
What is symmetric information?
When both parties in a transaction have access to the same, complete and accurate information
What are information gaps?
When the buyer or the seller does not have access to the information to make a fully-informed decision
What is asymmetric information?
When one party has superior information compared to another
What are 4 causes of information gaps?
- Addiction/Habits
- Asymmetry
- Poor knowledge of long-term impacts
- Framing (decisions based on the way information presented rather than facts)
What is the result of poor information?
Leads to poor decisions and therefore consumer demand or producer supply of the good/service being too high (thus price and quantity are not at social optimum)
What is moral hazard?
When a party with superior information alters their behaviour to benefit themselves while imposing costs on others e.g doctors/dentists, insurance
What is information provisioning?
Directly supplying information to consumers or requiring producers to do so e.g nutrition labels, cigarette packaging
What are 2 problems with information provisioning?
- Issues when provided by government: from what sources?, opportunity cost of collecting and publishing
- Issues when provided by firms: may provide information that is difficult to understand e.g chemical instead of common names
What are 2 ways to solve information failure?
- Regulation: require sellers of goods/services to meet certain safety or quality standards
- Licensing: schemes to ensure trained professionals act according to standard
What are 2 problems with licensing?
- Limits the supply of workers
- Controls competence not morality
Draw:
Negative production externality
Draw:
Positive consumption externality
Draw:
Negative production externality + tax
Describe the free rider problem
- Consumers realise they can access goods without paying (non-excludable)
- Individuals who benefit from a public good/service without contributing to the cost of providing it
- Private firms will will not produce good as there is no profit incentive (under-provision)
- The good/service will be provided by government
What are public goods?
Goods that are beneficial to society but are under provided in the free market
What are 2 features of public goods?
- Non-rivalry: goods that can be consumed by multiple people without reducing the amount available for others
- Non-excludable: goods that cannot exclude a certain person or group of persons from using them
What are private goods?
Goods that firms are able to provide to generate profits (excludable and rivalrous)
What makes a good excludable?
- The price mechanism, as some customers cannot afford to buy the good/service
What makes a good rivalrous?
Consumers compete for goods which are limited in supply (this rivalry helps to generate profits for firms)
How does imperfect market information may lead to a misallocation of resources
- Consumers do not buy things that maximise their welfare
- Demand for a good/supply of a good may be too high or too low
- Price and quantity are not at the social optimum position
