2: Market Failure Flashcards
Market failure
When the price mechanism leads to a misallocation of resources
Complete market failure
Happens where unless the good or service is provided outside the price mechansim there wouldn’t be a market for it i.e. the military
Partial market failure
Happens when the private sector may partially provide it but at the wrong price or quantity i.e. private health care vs NHS
What are the benefits of a good seperated into?
Private and external benefits
What are the costs of a good seperated into?
Private and external costs
What is a source of market failure due to costs and benefits of goods?
Some are over/under consumed
Social benefit =
External + private benefits. Socially optimal level is where it is allocatively efficient to produce and consume -> a different quantity to what is observed in the free market
What is the difference between the social benefit and the private benefit?
The external benefit
When is the external benefit constant?
When social + private curves are parallel
When is the external benefit greater as output increases?
When social + private curves diverge
Causes of market failure
Externalities
Lack of public goods
Infomation gaps
Externalities
Effects of producing/consuming a good on a 3rd party
Positive consumption externalities
‘Good’ externalitie created in consumption of a good
MSB is more than MPB
Consumers won’t account for the benefit of the externality and this good will be underconsumed i.e. education
Negative consumption externalities
‘Bad’ externality created in consumption of goods/services
MSB is less than the MPB and the good will be overconsumed i.e. cigarettes
Positive production externalities
‘Good’ externality incurred when producing good/service
MSC is less than the MPC and the good will be underproduced
Negative production externailities
‘Bad’ externality incurred when producing good/service
MSC is greater than the MPC and the good will be overproduced (Vs socially optimal level) i.e. factory noise + air pollution
Private cost/benefit
Benefit/cost to an individual in the market
External cost/benefit
Cost/benefit a 3rd party receives due to a positive/negative externality
Social cost/benefit
Cost/benefit to society due to a positive/negative externality
What do firms only account for when producing goods?
MPC
What do consumers only account for when consuming goods?
MPB
Deadweight welfare loss
Loss to society when overproducing something that has a negative externality
Characteristics of a public good
Non-rivalrous (more than one person can consume)
Non-excludable (not paying can still consume)
Characteristics of a private good
Rivalrous
Excludable
Why do the private sector rarely produce public goods?
No incentive
What does the government do to produce public goods?
Intervenes and decides suitable amount of public goods for society. Has to guess the MSB which can be inaccurate
Free-rider problem
Can’t exclude someone from public goods who can’t pay for it, so everyone gets the same benefit -> disincentives people from producing a good in the free market which is a form of market failure
What else disincentives production of a public good in the free market?
It is hard to price. Producers may overvalue, consumers may undervalue
Asymmetric infomation
Both parties in a transaction have unequal amounts of infomation. Can cause a decline in price or quantity of products solds. i.e. producer may know a product is faulty and consumer doesn’t -> misallocation of resources + limits ability to make rational choices and pay appropriate price for a product
Thin market
Buyers + sellers discouraged from participating in a market, fewer active in said market
Thick market
Lots of buyers and sellers
What do buyers with imperfect infomation believe?
Price = Quality i.e. Michelin Star > Mcdonalds. Leads to markets struggling to reach an equilibrium price and quantity
Demerit goods
Negative effects of a good i.e. smoking
Merit goods
Positive effects of a good i.e. education
What can solve overconsumption of a demerit good?
Taxes/bans -> correct market failure
What can encourage consumption of merit goods?
Subsidies -> correct market failure
Advantages of a subsidy
Reduce cost of product and allow firms to exploit economies of scale -> will improve long run efficiency + competitveness abroad
Consumer preference may change
Disadvantages of a subsidy
Encourages laziness from producers as don’t need to be efficient
Elasticity of demand determines how effective a subsidy is
May be of a lower standard than the good they are replacing
Max price
Used to increase consumption of a good
If max price above equilibrium not effective, if below it there will be more demand. Shortage of supply leads to excess demand however -> lead to a good being sold in the black market as less people have it
Pros of max price
Protects consumers from exploitation
Makes firms more efficient as pay attention to costs
Cons of max price
Deters firms from entering a market
Limited investment into a market due to limited profit
Firms could cut costs too aggressively to boost profit leading to a poor quality good
Min price
Corrects market failures in monoplies
If below equilibrium no change, if above there will be less demand but increased supply leading to excess supply
Min price pros
Suppliers get reasonable price for goods
Min price cons
Consumers pay more for goods
Resources wasted when excess goods are destroyed
Resources allocated inefficently (excess supply)
Opportunity cost
Tradeable pollution permits
Allocated to businesses to control pollution levels
Tradeable pollution permits pros
Put cap on pollution
Lower pollution for a firm, more they can benefit -> incentive to lower pollution levels
Government makes revenue
Tradeable pollution permits cons
Costs
Deciding on pollution level is difficult
Market for permits is subject to failure
What does the European Union emissions trading system (ETS) do to incentives less pollution?
Cut members of permits, forcing firms who don’t comply to buy more permits
Regulation pros
Correct market failures that arise from externalities i.e. limit pollution a firm makes
Can control monoplies and stop them taking advantage of customers and reducing welfare
Legislation provides a means of punishing firms for their anti-competitive behaviour
Protects environment
Regulation cons
Hard to know what industries to regulate and how to regulate them -> needs value judgement i.e. what level to set for pollution
Expensive to monitor firms and opportunity cost
Expensive to follow regulations -> firms may close down or relocate due to high costs
Deregulation pros
Allocation of resources will improve due to less governmet intervention
By reducing the bureaucracy associated with legislation, efficiency will improve
Deregulation cons
Customers no longer protected from the anti-competitive behaviour from firms and may lose out
Some market failures can’t fix themselves i.e. externalities -> deregulation of industries may lead to an increase in pollution due to tragedy of the commons
Some natural monoplies need regulation i.e. sewage services
Renewable obligation certificates (ROCS)
Set regulations to try to promote the use of renewable energy sources. Suppliers that don’t comply with purchasing energy from accredited electricity generators will be fined -> money is shared between suppliers that do
State-provision
When states provide good/services to consumers. Either provided by government themselves (education) or purchased via private sector so public use for free (NHS) -> paid for by tax revenue
State provision pros
Reduce inequality by distributing money from wealthy to poor
Provides services that my not be profitable (some train routes)
Value judgements decide what state can and can’t provide well
State provision cons
Less incentive to make a service as efficient as possible if it isn’t profitable -> economics incentives for efficiency may be eroded
Opportunity cost
Asymmertic infomation may lead to government failure
When have the government spread infomation to overcome market failures?
Diptheria vacccine - 1942 advertised by govt as people though it was more common during war
Polio vaccine - 1956 campaign to vaccinate everyone under 40. Eradicated by 1980
Lifestyle campaigns - 2004, DrinkAware, Change4Life
Government failure
The unintended worsening allocation of resources as a consequence of a policy the government has implemented to correct market failure. Produces net welfare loss i.e. Council charging for forms of waste disposal may increase fly-tipping
Administrative costs
Resources needed to implement government intervention. If costs too high, intervention not worthwhile. Governments may underestimate costs of their projects
Bureaccuracy
Individuals working for the government don’t see benefits directly
Governments also very large and may suffer from material diseconomies of scale
Imperfect infomation
Limits governments ability to critically assess market failures and possible solutions -> right decision may not be made and government failure may arise
What can government failure lead to?
Conflicting polivy objectives - trying to satisfy one objective may be compromised or politicians may be influenced by what’s politcally acceptable or not i.e. can’t ban cars as people rely on them or macro economic policies clash with environmental ones
Market distortions - can affect the way price mechanism works i.e. income taxes give less incentive to work -> reduces efficiency, subsidies allow firms to make profits without being efficient, min and max price can distort price signals (overproduction as firms can gurantee a min price)
