2.8-2.9 market failure Flashcards
the free market is failing
essay prompt: analyse demerit goods as a market failure
how to answer this essay?
- define “demerit goods”, “market failure” & “negative consumption externality”
- why MPB > MSB
- explain with hypothetical example
- e.g. impact to society bc of drinking
- ignorance
- explain with hypothetical example
- explain overallocation of resources
- Qm > Qopt
- Pm > Popt
- explain deadweight loss
- at Qm (MSC > MSB)
what as the assumptions of allocative efficiency? [3]
- markets are free
- without market failure
- perfectly competitive
6 causes of market failure
and brief reasons for why they occur
- negative externalities (self-interest)
- positive externalities (self-interest)
- demerit goods (information failure)
- merit goods (information failure)
- public goods (free rider & non-profitable)
- common pool resources (self-interest → tragedy of the commons)
market failure definiton
failure of the market to allocate resources efficiently
underallocation of resources
not enough resources allocated to production of a good
overallocation of resources
too many resources allocated to production of a good
externalities
action of consumers or producers give rise to negative or positive side-effects on those not part of the transaction (third-party)
what does market failure evaluate? ____ vs ______
expectation from society vs desire from market
Private Benefits (PB) =
Consumer’s benefits upon consumption
Social Benefits (SB)
PB + External Benefits
Private Costs (PC) =
Producer’s costs of production
Social Costs (SC) =
PC + External Costs
what are positive external costs?
e.g. pollution
things that BRING UP the cost
what are negative external costs?
things that are GOOD FOR SOCIETY
e.g. recycling
What is the private benefit of taking medication / vaccination?
make you healthy, give you immunity
Is there going to be an positive / negative external benefit from taking medication?
other people won’t get sick
PB > / < SB for medication?
SB > PB, ignore external benefit
What is the private cost of producing beef?
- food for the cows
- rent for the land
Is there going to be positive / negative external cost from producing meat?
- NEGATIVE
- methane from cows
- global warming
Cows for meat production
PC > / < SC
SC > PC, ignore external cost
Marginal private benefits (MPB)
benefits to consumers of consuming one more unit
Marginal social benefit (MSB)
benefits to society of consuming one more unit
Marginal private costs (MPC)
costs to producers of consuming one more unit
MPC = MPB –> ?
market equilibrium
assumptions in a free and competitive market for marginal + surplus + Q
In a free and competitive market:
- It is assumed that there will be no external costs and benefits, (MPC = MSC & MPB = MSB)
- Social welfare is at its maximum level, (CS + PS)
- At market price, Qd= Qs, no surplus / shortage)
Marginal social costs (MSC)
costs to society of consuming one more unit
Market failure will happen if ___?
there is a difference between the social and market expectation
MSC = MSB –> ?
social optimum = allocative efficiency
for negative production externalities, is MSC or MPC higher?
MSC
MSC > MPC
describe negative production externalities in terms of MSC/MSB/MPC/MPB
- Social optimal outcome is MSB = MSC
- Free market outcome is MPB = MPC
- Divergence between Private Costs and Social Costs (MSC > MPC)
in negative production externality, due to self interest, do you think the producer would produce more / less quantity of cars than the society wanted?
MORE
when does welfare loss occur?
when MSC>MSB or MSC<MSB
what happens to the allocation of resources when there is a negative production externality
overallocation of resources
what are the market based policies to correct negative production externalities
Pigouvian taxes (indirect taxes)
tradable permits
what are Pigouvian taxes?
indirect taxes to correct negative externality
what are the 3 common methods to correct negative production externalities
market based interventions: pigouvian taxes, tradable permits
government regulations
education
how would you tax the air pollution by car factories?
tax on emission level
why would taxing production output of car factories not be effective?
- would not be incentivised to become cleaner in production → will be taxed either way
- tax on the emission level
explain the short run and long run impacts of carbon tax
- SHORT RUN
- cost of production increase (MPC will shift left)
- LONG RUN
- incentives for producers to use less polluting or non-polluting energy sources
- incentives for producers to be more efficient and invest in cleaner technologies
explain how tradable permits work
- government gives firms “permits to pollute”
- permits can be traded on the free market
- can sell permit to others / can buy permit from others to pollute more
explain how tradable permits are effective
- supply of permits is fixed (perfectly inelastic)
- if firms need to increase the output level, the demand for permits will increase
- price of buying permits increases
- what happens to factory A and B when the price of permits increases → increase in cost of production
explain the short run and long run impacts of tradable permits
SHORT RUN
- the higher cost from trade permits will increase the MPC
LONG RUN
- it gives incentives to producers to switch to less polluting resources → MSC decreased
- why such incentives?
- no need to buy excessive permits
- able to sell the remaining permits for higher profit
- why such incentives?
advantages of using market based policies to solve the negative production externalities?
- External costs can be internalised (more taxes have to be paid by producers & consumers if output increases) → burden goes back to transaction parties
- Taxes on pollutants emitted provide incentives to firms for using less pollution production
disadvantages of using taxes (market based policies) to solve the negative production externalities?
Taxes
- Technical difficulties
- what production methods produce pollutants?
- what pollutants are harmful?
- what is the value of the harm (externalities)?
- how much should be charged on the tax?
- Some firms with high cost of reducing production may not try to reduce emission but pay the tax
disadvantages of using tradable permits (market based policies) to solve the negative production externalities?
All technical difficulties faced by designing taxes
- The amount of maximum acceptable level for pollutants
- How to distribute the permits to polluting firms in a fair way
give examples of how legislation and regulation can be used to correct negative production externalities
- Require firms to install technologies reducing emissions
- Setting maximum level of pollutants permitted
- Limiting the output by the polluting firms
advantages of government regulation
- It can be implemented easily compared to market-based policies
- Regulations force polluting firms to comply and reduce pollution levels (taxes may not)
- The practical difficulties are too great to implement market-based solutions
disadvantages of government regulation
- No incentive for firms to use less polluting resources (Unable to lower the size of the externality)
- Problems with enforcement (costs?)
- It may suffer from similar limitations (e.g technical difficulties) as the market-based policies
– What pollutants should be regulated
– Amount of the pollutants should be regulated
advantages of using education to correct negative production externalities
Producers’ production and revenue are based on the consumer demand and preferences
disadvantages of using education to correct negative production externalities
- Opportunity costs
- It may take a long time to achieve the effect
- People may not be responsive (no one cares) to problems of a general nature (e.g. green house gas emission)
define demerit goods
goods which create a negative consumption externality, and are overprovided in the market
for MSC/MSB/MPC/MPB, which of these does negative consumption externalities affect?
MPB > MSB
what is negative consumption externality?
-ve External benefit created by consumers (when consuming a good)
examples of demerit goods
gambling, cigarettes, drugs, alcohol
why might demerit goods be overprovided? why do consumers still demand demerit goods?
- Consumer ignorance about its negative effects
- Consumers may not be aware / care about the harmful effects upon others from their actions
the welfare loss for negative consumption externalities is when….?
MSB < MSC
what are the types of government intervention for negative consumption externalities?
- government regulation
- advertising and education
- market based policies (e.g. indirect (excise) tax)
advantages of government intervention in correcting negative consumption externalities
Indirect tax
- Internalise the externality
- Incentives for consumers to change their consumption patterns
Advertising and Education
- Much simpler
Regulation
- Direct enforcement
disadvantages of government intervention in correcting negative consumption externalities
Indirect tax
- Design of tax
- Who and what is affected
- Value of the external costs
- How much should be taxed
- Some of the goods may have an inelastic demand
Advertising and Education
- Opportunity costs
- They may not be effective in reducing the negative externality
- It may only be effective in the long-run
Regulation
- Difficult for enforcement
does positive consumption externality affect Marginal Costs or Marginal Benefits?
marginal benefits
in positive consumption externality, is MSB larger or MPB larger
MSB > MPB
examples of merit goods
education, insurance, healthcare service, recreational service
define merit goods
goods/services which benefit consumers & society, but are underprovided by the market
Why might vaccines be under-consumed in the market?
- positive externalities
- consumer ignorance of the benefits
- unable to realise the greater benefits to the society- Low levels of income and poverty (unable to afford them)
what are the types of intervention to correct positive consumption externality?
- Legislation
- Advertising
- Direct Government Provision
- Subsidy on the edu. providers
evaluate government intervention for positive consumption externality
Government provision and subsidies
- opportunity cost
- size of external benefit
- difficult to achieve social optimum level
- not effective on its own
Legislation and advertising
- difficult to achieve social optimum level
- not effective on its own
- what will happen if government regulates schooling up to a minimum age without subsidies / direct provision or the other way around?
- combine policies (e.g. direct provision + legislation)
- may raise the price of goods
what is positive production externality
positive benefits (external cost decrease) to third parties created by producers
give examples of positive production externality
- Polio vaccine (by Jonas Salk)
- R&D into new technology: Atlas
- robot, by Boston Dynamics
→ worker training
what are the features of public goods?
non-rival & non-excludable
MUST have BOTH
give examples of public goods
- national defence
- parks
- statues/landmarks
- public toilet
- public libraries
- roads/bridge → infrastructure
- free TV channel
- fire services
- trash bins
Types of intervention to correct positive production externality
Direct Government Provision
- R&D
- Government provided training
Subsidies
- Lower the costs of production (increase supply)
explain the features of public goods
Non-rival
- consumption by one person does not reduce consumption by someone else
- rival e.g. 1 pair of jeans and 2 people
- non rival e.g. music performance/busking on the street
Non-excludable
- impossible to prevent people who have not paid for the good from having access to it
- excludable e.g. iphone bc you have to pay for it
- non-excludable e.g. fireworks
the nature of public goods leads to what problem?
“free-rider problem” → the good will not be provided at all in the free market
what is rival but non-excludable
free food for the homeless/in need, fishing
what is excludable but non-rival
cable tv (you need to pay for the channels)
How does the government correct the problem of public goods?
Government provision
-Opportunity cost (which good/service to provide? In what quantity?)
-Even more difficult to estimate MSB (no market price) than providing / subsidising on private goods.
-How can governments try to estimate?
define common pool resources
resources not owned by anyone (as they are non-excludable), and therefore there is no price for use
define tragedy of the commons
definition: common pool resources over-used by private individuals who enjoy the short term benefits, but ignore the long-term depletion of the resource
why are common pool resources market failure?
When we overuse the air / river / sea / land / etc. for production without “paying” for them
consequences: Ozone depletion, destroying marine ecosystem, global climate change, excessive grazing, soil erosion
define sustainable development
development that meets the needs of the present without compromising the ability of future generations to meet their own needs (pursue economic growth that does not deplete or degrade natural resources)
explain tragedy of the commons using a diagram
- The price at P1 is too low which encourages more consumption and thus more production
easier to explain with production side → negative production externality
- e.g. overfishing, deforestation, exploiting fossil fuels
what leads to tragedy of the commons?
- Lack of private ownership leads to the tragedy of the commons
- self interest → resource depletion
define sustainability
ability of the environment and economy to be maintained or preserved over time
what are the 2 components of sustainability?
1) Environment: environmental preservation (less environmental destruction)
2) Economy: preservation of humankind’s ability to provide goods and services to satisfy needs and wants into the future
explain how collective self governance can be used to solve tragedy of the commons
Collective self governance to solve tragedy of the commons (Elinor Ostrom)
- People do have the self-control to better use the common pool resources
- government direct intervention may not be needed
- within boundaries of areas (communities)
- good communication with each other to establish norms e.g.
- rules of using the resources
- sanctions on violation
- monitoring
video notes
- state control and privatisation is not the only way → self governance
- design of rules determines the success of the commons → design principles
- success of rules is context dependent
explain how international agreements can be used to solve tragedy of the commons & give examples
- consequences from tragedy of the commons (e.g. global climate & ozone layer) always affect not only a single country
- cooperation among different countries is crucial to control and prevent the problems from happening and worsening
- Montreal Protocol
- Kyoto Protocol
- Paris Agreement
- Convention on international trade in endangered species of wild fauna and flora
- the protocol on water and health
other than government intervention, what can be used to solve tragedy of the commons?
collective self governance
international agreements
