1.4 - Market failure Flashcards
Define: market failure
The failure of the market to allocate resources efficiently. Resulting in allocative inefficiency and welfare losses.
Where is the most desirable point to be in a market? (for society)
At MSC=MSB
This is called the socially optimum point
Define: externality
When the actions of consumers or producers give rise to negative or positive side-effects on third parties.
Define: positive externality
When the actions of individuals benefit third parties.
Define: negative externality
When the actions of individuals harm third parties
Define: MPC
Marginal Private Costs
Costs to producers of producing one more unit of a good
Define: MSC
Marginal Social Costs
The cost to society of producing one more unit of a good.
Define: MPB
Marginal Private Benefit
The benefits to consumers of consuming one more unit of a good.
Define: MSB
Marginal Social Benefits
The benefits to society of consuming one more unit of a good.
Define: Negative externalities of production.
Examples?
The external costs to society created by producers of a good.
E.g. a cement factory emitting smoke into the air and dumping waste into the ocean
How can you represent a negative externality of production diagrammatically?
MPC further right than MSC
How could you determine the welfare loss created by a negative externality of production?
The triangle above demand, between MSC and MPC.
On a negative externality of production diagram, compare:
- Market equilibrium consumer, producer and social surplus.
- Social equilibrium consumer, producer and social surplus.
Market equilibrium:
CS: a + b + c + d | PS: f + g + h | SS: a + b + c + d +f + g + h - e
Social equilibrium:
CS: a | PS: b + f | SS: a + b + f
What are two general ways of dealing with externalities?
- Government regulation (‘command’ approach)
- Market-based policies
How can the government use regulation limit the external costs created by a negative externality of production?
- Limit the emission of pollutants - a legal maximum.
- Limit the quantity of output by the polluting firm.
- Require polluting firms to install technologies to reduce emissions.
How could the government use market-based policies to correct a negative externality of production?
Diagrams?
- Impose a tax on the firm
- Impose a tax on the pollutants produced
- Set up a cap and trade system
Why might a government use regulation to correct negative externalities?
—
Why shouldn’t they?
+ If the social costs are direct and serious, e.g. radioactive waste
+ Easier to implement and are fixed
+ Are almost certain to have the overall desired effect
—
- They do not allow for the externality to be internalised
- They do not provide incentives to change production practices, only quantity output.
Why might a government use market-based solutions to deal with a negative externality?
+ Internalises the cost
+ Encourages changes in practices, decreasing the aspect that creates the external cost
—
- Rule-breakers may go unnoticed, or hard to detect
- Political decisions on what is the right amount of intervention
- May not have the desired effect or no effect at all.
Define: Negative externality of consumption
Examples?
The external cost to third parties created by consumers consuming a particular good.
E.g. partying with loud music through the night - disturbing neighbours. Consuming fossil fuels for petrol cars - causing pollution.
How can you represent a negative externality of consumption diagrammatically?
MPB above/further right than MSB
On a negative externality of consumption diagram, compare:
- Market equilibrium consumer, producer and social surplus.
- Social equilibrium consumer, producer and social surplus.
Market equilibrium:
CS: a + b | PS: c + d + f | SS: a + b + c + d + f - e
Social equilibrium:
CS: b + c | PS: f | SS: b + c + f
Define: demerit goods
Demerit goods are goods that are considered to be undesirable for consumers but are overprovided by the market.
How can a government deal with a negative externality of consumption?
Diagrams?
- Government regulation on consumption
- Advertisement and awareness campaigns
- Market-based policies (tax on producers or tax on consumers)
Define: Positive externalities of production
Examples?
The external benefits to third parties created by producers.
E.g. a pharmaceutical company develops a new drug that benefits not only its users but those around them with improved life expectancy and quality of life.
How can a positive externality of production be shown diagrammatically?
MPC further left to MSC
On a positive externality of production diagram, compare:
- Market equilibrium consumer, producer and social surplus.
- Social equilibrium consumer, producer and social surplus.
Market equilibrium:
CS: a | PS: b + e | SS: a + b + e - d - g
Social equilibrium:
CS: a + b + c + d | PS: e + f + g | SS: a + b + c + d + e + f + g
How might a government correct a positive externality of production?
Diagrams?
- Direct government provision
- Granting subsidies
Define: positive externality of consumption
Examples?
The external benefits to third parties created by consumers.
E.g. consumption of healthcare
How can a positive externality of consumption be shown diagrammatically?
MPB further left than MSB
On a positive externality of consumption diagram, compare:
- Market equilibrium consumer, producer and social surplus.
- Social equilibrium consumer, producer and social surplus.
Market equilibrium:
CS: b + d | PS: g | SS: b + d + g - c - f
Social equilibrium:
CS: a + b + c | PS: d + e + f + g | SS: a + b + c + d + e + f + g
Define: merit goods
Goods that are held to be desirable for consumers, but which are underprovided by the market.
Why might a merit good be underprovided?
(3)
- The good may have positive externalities
- Low levels of income and poverty
- Consumer ignorance.
How might a government correct a positive externality of consumption?
Diagrams?
- Legislation e.g. school leaving age
- Advertising
- Direct government provision
- Subsidies
What is a private good?
Goods that are rivalrous and excludable
What is a public good?
Goods that are non-rivalrous and non-excludable
What does rivalrous mean?
What does excludable mean?
Rivalrous: Its consumption by one person reduces its availability for someone else
Excludable: It is possible to exclude people from the good such as through price
What are examples of pure public goods?
- A lighthouse
- A police force
- National defence
- Flood control
- Non-toll roads
- Fire protection
- Basic research
- Anti-poverty programmes
How do public goods illustrate the free-rider problem?
As they are non-excludable, people can enjoy the good without paying for it.
What are quasi-public goods?
Examples?
Goods that are non-rivalrous (like public goods) but are excludable (like private goods).
E.g. Entrance fees to public museums, toll roads.
What are common access resources?
Examples?
Resources that are not owned by anyone, do not have a price and are available for everyone to use. They are rivalrous but non-excludable.
E.g. clean air, lakes, open seas, the stable climate
What is sustainability?
Maintaining the ability od the environment and the economy to continue to produce and satisfy needs and wants into the future.
How can a government respond to threats to sustainability?
- Legislation
- Carbon taxes
- Research and promotion of green energy
Why might carbon taxes be better than cap and trade schemes?
- Carbons taxes make energy prices more predictable.
- Carbon taxes are easier to design and implement.
- Carbon taxes can be applied to all users of fossil fuels.
- Carbon taxes do not offer opportunities for manipulation by governments or interest groups.
- Carbon taxes do not require as much monitoring for enforcement.
- Cap and trade face political pressures to set an appropriate cap
- Carbon taxes can restrict competition between firms.
Why might cap and trade schemes be better than carbon taxes?
- Carbon taxes may be too low
- Carbon taxes cannot target a particular level of carbon reduction
- Carbon taxes are regressive
- Carbon taxes must be adjusted for inflation
What steps can governments take for climate change mitigation?
- Encouragement and investment into green R&D
- International cooperation
- Adopting Green GDP
What is asymmetric information?
What are information gaps?
Asymmetric information: A situation where buyers and sellers do not have equal access to information
Information gaps: When neither the buyers nor sellers have information.
What are possible government responses to asymmetric information?
- Regulation
- Licensure
- Provision of information
What is moral hazard?
A situation where one party takes risks but does not face the full costs of those risks.
What is monopoly power/market power?
The ability of a firm or group of firms to control the price of the product they sell.
Can occur in monopolies and oligopolies.
What steps can a government take against monopoly power?
- Anti-monopoly legislation
- Regulation
- Nationalisation
- Trade liberalisation
What are all 10 market failures?
What misallocation do they correspond to?
- Negative production externality (overallocation)
- Negative consumption externality (overallocation)
- Positive production externality (underallocation)
- Positive consumption externality (underallocation)
- Merit goods (underallocation)
- Demerit goods (overallocation)
- Public goods (underallocation)
- Overuse of common access resources (overallocation)
- Asymmetric information (underallocation)
- Monopoly power (underallocation)
What are all 7 government failures?
- Political self-interest
- Poor value for money - inefficient
- Policy short-termism
- Regulatory capture
- Conflicting objectives
- Bureaucracy and red tape
- Unintended consequences
What is regulatory capture?
When a government agency operates in favour of producers.
E.g. Lobbying
