4.1.8 The market mechanism, market failure and government intervention in markets Flashcards
Explain the function of the Price Mechanism.
The function of the price mechanism is to allocate resources.
This can be done in 3 ways:
* rationing
* incentive
* signalling
Explain the roles of the different Economic Incentives.
- Economic incentives provide the reasons for economic agents to provide goods + services.
- Based on the price mechanism; method by which prices for goods + services are achieved.
- Rationing function: occurs because increase demand/reduced supply of a product will lead to a price rise, due to scarcity of the product (more scarce a product,higher the price). Leads to reduction in QD- rationing of product as its use is restricted. Movement along D curve showing a decrease in QD + in P.
- Signalling function occurs: because changing prices give a signal to consumers + producers as to whether to leave or enter a market, e.g. higher P suggests consumers should reduce D, increase in P gives indication to producers that she should decrease S.
- Incentive function: occurs because a consumer/producer is motivated to a course of action, e.g. higher prices incentivise a producer to supply more of a good/service; due to greater contribution per unit (difference between the selling price of a product + the VC). As prices rise so does revenue + profit- there’ll be a movement along the S curve showing an increase in QS + a decrease in P
Explain the effectiveness of markets. in Allocating Resources.
- Allocative efficiency is difficult to identify, as we need to match consumer preferences to producer output, i.e. need to match D + S
- Markets don’t always operate at the market clearing price due to: excess demand (D > S) or excess supply (S > D)
- Market forces do push prices towards equilibrium where QD will equal QS.
- Therefore, likely that competitive markets help in achieving allocative efficiency.
State + explain what firms compete on, other than price.
- Customisation: customers increasingly wish to purchase products modified to their preferences.
- Advertising: increasing brand recognition + brand loyalty
- New products: anticipating trends in markets by developing new products
- Location/Convenience: for some services, being in the right location is the most important.
- Online reviews: firms may seek to gain better online reviews.
- Pay for best workers: firms may want to employ top chef, best footballers, e.t.c.
Define Market Failure.
- Market Failure: when the free market fails to allocate scarce resources at the socially optimum level of output.
State + explain some of the different types of Market Failure.
• Negative/Positive Externalities: negative/positive impacts on 3rd parties, as a result of production or consumption. Not accounted for in the free market mechanism- as firms are profit maximisers, only consider their private costs, + consumers are utility maximisers + only consider their private benefits. Thus, the consumers + producers are self-interested.
• Merit + De-Merit Goods: Imperfect information/information failure, therefore consumers may make irrational decisions when they consume. Could lead to the allocation of scarce resources being too high or too low.
• Public Goods: Free rider problem + the notion that firms are profit maximisers, thus there’ll be no supply of public goods in the end.
• Common Access Resources: often over-consumed + over-produced, due to negative externalities in production. Private producers ignore external costs when it comes to producing- self-interest.
• Income Inequality: inequity- when income inequality becomes so high that it’s deemed to be unfair, it can be argued to be a source of market failure.
• Monopoly Power: one dominant seller + high barriers to entry- give rise to monopoly power, consumers are exploited with high prices (higher than socially optimum) and lower than socially optimum quantities.
Define a Public Good.
• Public Good: one where its use by an individual doesn’t stop others from using it whilst its consumption doesn’t reduce the amount available for consumption by others.
State + explain the characteristics of a Public Good.
• Non-Excludable: no price can be charged for the good (this is because the benefits of consuming the good can’t be confined to the individual whom paid, + maybe no price can be charged as there’s not an efficient way to price the good).
• Non-Rival: quantity available of good doesn’t diminish upon consumption
Give an example of a Public Good.
- Street Lights: as soon as someone’s paid, the benefits can’t be confined to that person everybody else can also consume that streetlight, non-rival as when they are consumed the quantity available doesn’t diminish for everybody else
Define a Pure Public Good.
• Pure Public Good: it’s impossible to exclude someone from consuming it if they are unwilling to pay for its use
* Example: the air we breathe
Define + explain the Free-Rider Problem.
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Free-Rider Problem: where individuals have the incentive not to contribute anything at all to the provision of the public good, as they’ll wait for others to contribute, then free-ride of their contributions.
• Individuals can ‘free-ride’ as they know the benefits can’t be confined to the person who paid, they also know that if the person whom paid consumed, the same amount would be available for them to consume as well.
• If everybody has this incentive, no body will pay towards the provision of public goods-no contributions, therefore no private motive to supply them. Thus, no supply in the free-market, therefore there’ll be a missing market- complete market failure.
Define a Private Good.
• Private Good: where its use by an individual stops others from using it whilst its consumption reduces the amount available for consumption by others.
* Examples: clothing, cars
State + explain the characteristics of a Private Good.
• Rival Goods: consumption of good reduces amount available for consumption by others.
• Excludable Goods: where, once provided, possible to stop other individuals from using them.
* Can have either positive or negative externalities.
Define a Quasi-Public Good.
- Quasi-Public Goods: a private good that is similar to a pure public good but there’s an ability to stop non-paying consumers from using it.
- Consumers can be stopped from using a product that is normally free.
- Example: Roads (can be excludable through toll roads, also can be rival during peak times where road space does diminish upon consumption)
Explain how Technological Change leads to markets providing Private Goods.
- Technological Change: Process of innovation, invention + the widespread use of technology in society.
- Tech change can lead to markets efficiently producing goods previously regarded as non-excludable + non-rival.
- Therefore public goods can become private goods over time.
This can be achieved by: - Intellectual Property Rights (IPR): granting patents, copyright, e.t.c. Becomes protected/excludable.
- Monitoring + Control Systems: restricting use of good by monitoring usage (e.g. congestion charging)
- Technology tends to be non-rival but can be excludable.
- Its use can create tangible goods, generally recognised to be rival + therefore excludable.
- Thus, tech change can lead to public goods becoming private goods.
Define Positive Externalities.
- Positive Externalities: Benefits to a third party that aren’t included in the price of the economic activity.
Define Private Benefits + Social Benefits.
• Private Benefits: benefits of consuming/producing goods/services that are received by an economic agent (i.e. individual or firm). These benefits are paid for by the economic agent.
• Social Benefits: benefits of consuming/producing goods/services that are received by society. Social benefits include private benefits, but the difference between them is unpaid for, creating the free-rider problem.
* When Social Benefits (SB) > Private Benefits (PB) we have positive externalities.
Analyse Positive Externalities in Consumption.
MSB > MPB
* Self-Interest: individual consumers are ignoring the full SB of their actions, only considering their own PB.
* Under-Consumption/Under-Production
* Misallocation of Resources: too few resources being allocated to this market. Thus, there’s a welfare loss.
State an example of Positive Externalities in Consumption.
- Healthcare: being vaccinated against the flu- other people in society benefit as there’s less chance of them contracting the flu.
- Education: rest of society benefits if individuals are well educated, as they’re more productive, earn higher incomes, pay greater taxes to gov- used to provide socially desirable things, e.g. infrastructure
Analyse Positive Externalities in Production.
MSC < MPC
* Self-Interest: firms only consider their PB, don’t consider any SB- therefore they ignore any external benefits to external firms. Thus, resources are allocated at their private optimum (P1,Q1), rather than their social optimum (P,Q)
* Under-Consumption/Production taking place
* Misallocation of Resources: allocative inefficiency + a welfare loss.
State an example of Positive Externalities in Production.
- Producers may offer high quality in-work training schemes: 3rd party that’ll benefit is other firms who are able to poach workers whom have benefited from the training schemes, without having to pay to train them themselves- lower CoPs.
Define Negative Externalities.
• Negative Externalities: Costs to a third party that aren’t included in the price of the economic activity.
Define Private Costs + Social Costs.
• Private Costs: those costs of consuming/producing goods/service that have to be paid for by the parties to the transaction (e.g. individual or firm)
• Social Costs: those costs of consuming/producing goods/services that are paid for by society (e.g. social Costs include Private Costs)
• When Social Costs (SC) > Private Costs (PC) we have negative externalities
Analyse Negative Externalities in Production.
MSC > MPC
* Self-Interest: firms are ignoring full SC due to self-interest, only consider their PC
* Over-Production/Consumption
* Price too low: as it’s at P1 not P*- only accounting for the PC, not the full SC.
* Misallocation of Resources: allocative inefficiency + welfare loss.
State examples of Negative Externalities in Production.
- Air Pollution: firms producing metals, chemicals which produce air pollution. 3rd party could be local residents- suffer from respiratory problems, greater risk of lung cancer.
- Deforestation: 3rd party: villagers whom live near the forest, use it for food sources, water sources, e.t.c
Analyse Negative Externalities in Consumption.
MSB < MPB
* Self-Interest: consumers ignore full SB of their actions, only consider their PB.
* Over-Consumption + Over-Production
* Misallocation of Resources: too many resources allocated to this market, than are socially desirable- resulting in allocative efficiency + welfare loss to society.
State examples of Negative Externalities in Consumption.
- Smoking: bi-standers who inhale the smoke- greater risk of luck cancer + respiratory issues
- Those who consume excess alcohol: 3rd parties: health-services- deal with treating them, + police services- deal with crime associated.
Define Merit Goods.
- Merit Goods: goods for which social benefits on consumption > private benefits (i.e. good has positive externalities)
- Deemed to be more beneficial to consumers than they realise.
- There’s a value judgement when deciding if a good is a merit good.
- Examples: health care, education, museums.
State + explain the characteristics of Merit Goods.
- Deemed to be socially desirable- good for society
- Have positive externalities in consumption
- Have information failures associated with consumption
- Would be under-consumed if left to the free market; therefore, gov intervenes in the arrest + attempts to increase/encourage greater consumption.
Explain Information Failures, with regard to Merit Goods.
- Information Failures where Merit Goods are concerned: consumer will consumer too little of a merit good compared to what they would consume if they fully understood the benefits to themselves + to society.
- In these circumstances, consumers themselves lose out on the benefits, as well as society missing out on the benefits.
Information Failures can occur: - Information can be too little, too much, inaccurate, too complex.
- Present Bias: occurs when individuals place greater value on goods/income achieved in the present moment- rather than receiving the same goods/income in the future. (Present bias suggests that given a choice between a pay-off today + a pay-off in the future,we will choose today, also suggests people can be time-inconsistent- they may make decisions their future self may regret)
Define Demerit Goods.
- Demerit Goods: goods for which the private benefits of consumption > social benefits
- Deemed to be more harmful to consumers than they realise.
- There’s a value judgement when deciding if a good/service is a demerit good
- Good must have negative impacts that go to a wider society (i.e. negative externalities)
State + explain the characteristics of a Demerit Good.
- Deemed to be socially undesirable- bad for society
- Have negative externalities in consumption
- Have information failures associated with consumption
- Demerit Goods will be over-consumer if left to the free market; therefore, govs will intervene in market + attempt to decrease/discourage consumption.
Explain Information Failures, with regards to Demerit Goods.
- Consumer will consume too much of a demerit good compared to what they’d consume if they fully understood the full cost of consuming good.
Information Failures can occur: - Information too little/too much/inaccurate/too complex.
- Present Bias.
- Asymmetric Information:** producers may have information but are deciding not to share it perfectly with consumers.
- Can also be addictive/ influence by social norms leading to overconsumption.
Define Symmetric Information.
• Consumers + producers have perfect market information to make their decisions.
• Leads to an efficient allocation of resources.
Explain what Asymmetric Information is.
• Unequal knowledge between consumers + producers; leads to market failure.
• Example: car dealer might know about a fault with the car that the consumer is unaware of.
• Could also lead to a misallocation of resources.
• Consumers can also know more information than the producer (e.g. when purchasing insurance policies)
• Could also be imperfect information, where information is missing, so an informed decision can’t be made- leads to a misallocation of resources.
• Consumers may pay too much/too little, + firms might produce the incorrect amount (e.g. monopolies might exploit the consumer by charging them more than consumers really need to pay)
• Asymmetric information can be linked with the principal-agent problem- when the agent makes decision for the principal, but the agent is inclined to act in their own interests, rather than those of the principal.
• Information could be made more widely available through advertising or government intervention (e.g. harmful effects of smoking could be made public through adverts + messages on cigarette boxes)
Explain why the Immobility of FoPs can lead to Market Failure.
- Mobility of labour is the ability of workers to change between jobs.
- Unemployment is evidence that labour markets don’t work efficiently.
- Geographical immobility: refers to the obstacles which prevent the FoPs moving between areas (e.g. labour might find it hard to find work due to family + social ties, the financial costs involved with moving, imperfect market knowledge on work, e.t.c.)
- Occupational immobility: refers to the obstacles which prevent the FoPs changing their use (e.g. labour might find it difficult to change occupation- occurred in the UK with the collapse of mining industry, when workers didn’t have transferable skills to find other work- causes of this include insufficient education, training + skills.)
Explain why the existence of Monopoly + Monopoly Power can lead to Market Failure.
- Basic model of monopoly suggests higher prices, profits + inefficiency may result in a misallocation of resources compared to the outcome in a competitive market.
- Monopolies could exploit consumers by charging them higher prices- means the good is under-consumed, so consumer needs + wants aren’t fully met- this loss of allocative efficiency is a form of market failure.
- Monopolies have no incentive to become more efficient, as they have few/no competitors, so production costs are higher.
- There’s a loss of consumer surplus + gain of producer surplus
Explain how inequitable distribution of income + wealth can lead to a Market Failure.
- In absence of gov intervention, the market mechanism is likely to result in a very unequal + inequitable distribution of income + wealth.
- In market economies, an individual’s ability to consumer goods depends upon their income, inequitable distribution of income likely leads to misallocation of resources, hence market failure.
Define Government Intervention.
- Government Intervention: when the state (gov) intervenes in a market, to change the behaviour of those in the market + to change the market outcomes.
- In Neo-Classical (Free Market) economics there’s said to be a case for gov intervention in a market when the market fails to achieve an efficient/equitable allocation of resources
State + explain the reasons for Government Intervention in Markets.
1) To correct market failures + improve the allocation of resources
Why?
* To provide public goods that wouldn’t be provided at all, or would be underprovided by the market
* Reduce negative externalities +/or maximise positive externalities
* Increase consumption of merit goods +/or reduce the consumption of demerit goods
* Correct/reduce market imperfections (e.g. information failures, monopoly power, factor immobility)
* Change the distribution of income/reduce inequality
Other reasons for Gov Intervention:
2) Achieive macroeconomic objectives + improve economic performance
3) Economic growth
4) Low unemployment
5) Low + Stable inflation (2% target)
6) Satisfactory current account of the BoPs
7) Equity (fairness)- achieve a fairer outcome for citizens, reduce poverty + its impact
8) Improve economic well-being of citizens
State + explain the ways in which the Government Intervenes to correct Market Failure.
- Indirect Taxation: specific duties, VAT
- Subsidies: provision of payments to suppliers
- Price Controls: minimum price (price floor), maximum price (price ceiling)
- Direct Provision: provision of goods + services (e.g. education so they are free at the point of consumption)
- Regulation: rules/laws to restrict behaviour of firms/consumers + encourage competition
- Provision of Information: reduce information failures
State + explain how Indirect Taxation is used to correct Market Failures.
- Internalise the Externality (polluter pays principle): if tax can be set at value of negative externality, effectively makes producers + consumers pay for the negative externality (full social cost). However, very difficult to estimate actual value of externality- so as long as it moves the market closer to the socially optimal level of output, likely to be seen as beneficial.
- Creates Revenue for Gov: revenue can be used for clearing up the externality, provision of services, enforcement costs, e.t.c.
- Impact of Tax depends on PED: if tax is used to reduce consumption of a good with a negative externality such as a demerit good- less effective if demand is price inelastic.
-
Indirect Taxes often Regressive: regressive tax is a tax which takes a higher % of tax revenue from those on low incomes. As income increases, proportion of your income paid in tax falls.
Example: if there’s a council tax of £2,000, a household earning £20,000 is paying 10% of their income in tax, a household earning £40,000 is paying 5% of their income in tax, + a household earning £100,000 would pay just 2% of their income in tax.
State + explain how Indirect Taxation is used to correct Market Failures.
- Internalise the Externality (polluter pays principle): if tax can be set at value of negative externality, effectively makes producers + consumers pay for the negative externality (full social cost). However, very difficult to estimate actual value of externality- so as long as it moves the market closer to the socially optimal level of output, likely to be seen as beneficial.
- Creates Revenue for Gov: revenue can be used for clearing up the externality, provision of services, enforcement costs, e.t.c.
- Impact of Tax depends on PED: if tax is used to reduce consumption of a good with a negative externality such as a demerit good- less effective if demand is price inelastic.
-
Indirect Taxes often Regressive: regressive tax is a tax which takes a higher % of tax revenue from those on low incomes. As income increases, proportion of your income paid in tax falls.
Example: if there’s a council tax of £2,000, a household earning £20,000 is paying 10% of their income in tax, a household earning £40,000 is paying 5% of their income in tax, + a household earning £100,000 would pay just 2% of their income in tax.
State + explain how Subsidies are used to correct Market Failures.
- Subsidies:Any form of gov support- financial or otherwise- offered to producers + (occasionally) consumers.
- Subsidies to producers reduce the marginal cost (MC) of supply (i.e. the subsidy has the effect of reducing the costs of production)
- Subsidy usually leads to an increase in the output sold of a good/service at a lower market price.
- The subsidy reduces the costs of production, consequently there’s the potential for additional profit for the firms- thus creating the incentive for firm to increase supply- shifts S right- leads to an increase in QS + a decrease in P, causing a movement along the demand curve + a new equilibrium quantity + price.
State examples of Subsidies for Consumers.
- Subsidies for people buying electric cars
- Food + energy subsides- often used in emerging/developing countries
- Free television listeners for the over 75s
- Scotland- new legal duty in 2021 on local authorities to ensure that free items such as sanity products are available to ‘anyone who needs them’
Explain when Subsidies may be justified as a method by which the government intervenes in a market.
- Helping poorer families with food + childcare costs particularly during an economic crisis
- Encourage output + investment in fledgling sectors, e.g. life science + renewable energy
- Protect jobs in loss-making industries hit by recession + by external economic shocks
- Improve housing + transport affordability to improve geographical mobility of labour
- Reduce the cost of training + employing workers.
Explain the Disadvantages of using Subsidies in attempt of correcting a Market Failure.
- Producers can become ‘subsidy dependent’
- Subsidies can lead to excess production/surpluses
- Subsidies can distort resource allocation
- Environmental risks from extensive production
- Subsidies can be very expensive- taxpayers bear the costs
State + explain how State Provision is used to correct Market Failures.
- State Provision: Direct provision of goods/services by the gov free at the point of consumption.
- Merit goods (under-consumed/production inequity)- state provision for healthcare/education
- Public goods: state provision solves free rider problem
How state provision works: - Gov considers full SC + SB, allocating resources at Q*
- Free at point of consumption
- Solve UC/UP + inequity issues
- Solve missing market issues
- Allocative efficiency + Welfare max.
State + explain the Issues when using State Provision, in an attempt to correct Market Failures.
- Long-run excess demand: Q* not at Q1- in a private market, excess demand is likely to be an issue.
- Cost of state provision: taking over whole market- greatly expensive
- Gov doesn’t have perfect information: Q isn’t going to be at Q*- gov failure risks
- State run organisations tend to be highly inefficient due to lacking a profit motive
Define a Price Control.
Price Control: when the gov sets a legal maximum or minimum price for a good/service.
Define a Minimum Price (Price Floor)
A fixed price (price floor) enacted by the gov usually set above the equilibrium market price.
* Gov is saying the equilibrium market price is simply too low, + it needs to be rise by implementing a minimum price.
* Legally prices cannot fall below this level
Explain why the government may implement a Minimum Price.
- Protect producers from price volatility: in particular farmers, or producers of primary commodities, as these goods are highly volatile. Minimum price protects producers from price falls in particular + keeps an industry going- by providing producers with a guaranteed income.
- Solve Market Failure: raising price to discourage consumption + production of goods/services which do a lot of harm to society (e.g. minimum price on alcohol).
Explain the effects using a Price Floor, in an attempt to correct a Market Failure.
- The imposition of a minimum price means prices can’t legally go below this set price floor.
- If minimum price is set at Pmin (i.e. above the equilibrium), this leads to higher prices for producers selling the good.
- Demand contracts along the D curve so that quantity sold is now at QD
- However, at the new higher price, there’ll be excess supply of QDQS, as firms will wish to supply more at a higher price.
Define a Maximum Price (Price Ceiling).
A fixed price (price ceiling) enacted by the gov usually set below the equilibrium market price.
* Gov is saying the equilibrium market price is too high, needs to be lowered
* Legally prices can’t be set any higher.
Explain why the government may implement a Maximum Price.
- To increase affordability of necessity goods + services: allow more consumers to access the market. (e.g. renting accommodation market- renting controls).
Explain the effects of using a Maximum Price, in an attempt to correct a Market Failure.
- Imposition of a max price at Pmax, below the market price, restricts prices charged by producers to Pmax.
- Reduces supply; there’s a contraction down the supply curve.
- Also leads to excess demand of Q2Q3, as consumers wish to demand more at a lower price.
- Gov may wish to impose a max price to prevent the consumer from being exploited
Explain how Regulations are used to correct Market Failures.
- Regulation is undertaken by gov to tackle market failures, + improve efficiency + competitiveness in markets.
- Very wide range of regulations in UK economy that affect activities of firms + consumers. Significant regulations on industries such as telecoms, water + energy.
- Regulations can often be seen as restricting firms’ activities in the free market (e.g. rules on quality standards or employee rights)
- However, many regulations are designed to improve the operation of the market by increasing competing such as regulations on predatory pricing + collusion.
- If a regulation’s effective, it should: prevent consumers being exploited, improve efficiency in the market, lead to greater choice + lower prices for consumers.
Define common access resources.
Common Access Resources: natural resources over which no private ownership is established (i.e. no private producer owns resources).
• Forests: provides natural resources like timber + pulp to make paper.
• Seas: provides natural resources like seafood + minerals
• Air: provides air.
Explain the tragedy of the commons + the issues with common access resources.
• Lack Of Private Ownership Leads To Tragedy Of The Commons: private producers act according to their own self-interest + unsustainably keep exploiting common access resources - eventually leading to depletion of that resource.
• Self Interest: profit motive - private producers keep exploiting common access resources - if resources they get can be used to increase profits. Even if individual producers stop because they’re concerned about resource depletion overtime , over producers will come in + take resources, then there’ll be nothing left for individual who stopped - only person who’ll lose it.
• Resource Depletion: overproducing leads to resource depletion - massive impact on future generations - lost incomes, goods + services made with CAS wont be available for consumption. Current generations can suffer if resources have depleted so fast - income goes down, consumption benefits lost. Significant negative externalities - due to overproduction + clear misallocation of resources.
Define government failure.
- When costs of intervention outweigh benefits of intervention.
- Leads to worsening of allocation of scarce resources - harming social welfare.
State + explain the causes of government failure.
- Information Failure: gov wont have full information to make effective policy decisions - particularly when valuing externalities - perfect policy would be to internalise externalities / make sure they’re accounted for in P / make sure Q is at socially optimum level. However, if externalities can’t be measured properly - can lead to strict / relaxed information - leads to government failure - policy may be ineffective with sufficient costs outweighing benefits.
- Admin + Enforcement Costs Very High: costs of regulation (if gov cant enforce regulation - costs outweighs benefits), subsidies (huge costs), state provision (huge costs), price controls (huge costs with enforcement + in sorting out problems price controls cause).
- Unintended Consequences: gov can overlook issues if policy isn’t thought about effectively. Such as: black markets (seen in UK with cigarettes + alcohol), impact on poor (regressive taxes, min P), impact on firms (overstrict regulation, taxation), unemployment.
- Regulatory Capture: when regulating monopoly power - occurs when interests of society are overlooked for interests of CEO’s + managers of firms in industry - happens when managers influence regulators to reduce extent of regulation - in interest of firm + not in interest of society - leading to gov failure.
Define regulation.
Rule / law enacted by gov that must be followed by economic agents to encourage change in behaviour.
Explain how regulation can be used to solve market failure.
• Non-market based approach to solving market failure - doesn’t work through price mechanism - doesn’t have some issues as indirect taxes / subsidies - dependence on P elasticity.
• Don’t draw diagram.
• Command / Control Approach: Command aspect: bans (public smoking ban), limits (age limits on buying cigarettes + alcohol), caps (emission caps), compulsory regulations (compulsory graphic imagery on cigarette packaging), innovative regulations (deposit recycling scheme) Control: strong enforcement, effective punishment (e.g. fines, bad publicity, e.t.c.) - ensure there’s incentive to follow it.
• If command / control is strong - incentive to change behaviour (produce / consume less / more) - to move Q to socially optimum level - solving issues in FM - without working through FM.
• Allocative efficiency + welfare gain.
State + explain the issues with using regulation to solve market failure.
- Cost: regulation is costly - administration cost + cost of enforcing regulation (i.e. needs policing + monitoring) - if C cant be afforded by gov - regulation will be poor - enforcement wont exist.
- Setting The Right Regulation: is command going to be set at right level / strictness to incentivise changes in behaviour? If too strict - many unintended consequences - burdening firms, increasing C significantly, reduces profitability so much that firms leave country to operate in countries where regulation isn’t as strict, reduces production - leads to unemployment. If regulations strict on consumers - may look for alternative modes of S (i.e. black market) - dangerous - loss of tax rev, more policing - increases C for gov. If regulation too lax - no incentive to follow it - doesn’t change behaviour enough to solve market failure.
- Black Markets + Unintended Consequences: even if regulation isn’t set too strict - strong likelihood of consumers finding alternative modes of S. Businesses may find regulation too strict - leave country, produce less, shut down, e.t.c.
- Equity: pollution caps in particular - unfair on some firms - may not be their fault that it’s diff to reduce pollution - unfair to impose such a cap on them. Maybe tradeable pollution permit scheme more appropriate - so firms have greater choice + so there’s more equity.
- Paternalistic: regulation dominated by gov - most forceful type of policy - lacks freedom, choice, + liberty - takes away massive benefit. of market. Particularly relevant if market failure isn’t that prevalent - other policies may be more beneficial.
Define indirect tax.
Increases firm’s CoPs but can be transferred to consumer via higher P.
• Increasing indirect tax can be used to solve overconsumption + / or overproduction.
State + explain the issues with using indirect tax to solve market failure.
• Price Inelastic Demand: for indirect tax to work in reducing Q to socially optimum, D needs to be more P elastic - responsiveness to increases in P. If inelastic, Q decreases proportionately less than P - not enough to solve market failure.
• Setting Tax At Right Level: assumption that gov has perfect information to internalise externality - unrealistic assumption - gov doesn’t have perfect information over value of NE - likely to set level of tax wrong - may overtax (can lead to black markets, burden firms, regressive) / undertax.
• Regressive: indirect tax can be regressive - takes greater income of poor then it will of rich - lose macroeconomic objective of redistributing income - bad for society - undesirable.
• Black Markets: increasing P signicantly for goods / services people want, they’ll find S - danger of black market- quality may be poorer than if bought legally - worsens market failure. Gov looses tax rev. Pure gov failure.
• Paternalistic: gov forces firms / individuals to do what they want - saying there’s a problem + then that firms / individuals have to pay higher P + suffer cost - paternalistic idea - infringes on individual freedom, liberty, + choice. Argument whereby market failure isn’t that significant.
Define state provision.
State Provision: direct provision of goods / services by gov, free at point of consumption.
• Gov takes over market completely.
Explain how state provision can be used to solve market failure.
• Merit Goods: state provision can be used to solve merit good market failure - under consumed / underproduced - state provision can fix that, in theory, given that gov will account for all externalities - more likely to hit socially optimum. But there needs to be more than just underconsumption / underproduction taking place - needs to be that left to FM there’s inequity when it comes to key merit goods (e.g. healthcare, education) - no body should be excluded.
• Public Goods: left to FM, wouldn’t be market for public goods - no provision in FM, due to free-rider problem - state provision is a way to completely fix issue.
* Assume gov knows full SC + SB - know all externalities present + know what socially optimal level of output - allocating resources at Q*.
* Free at point of consumption (P0 charged)
* Solves underconsumption / underproduction + inequity issues - given there’s universal access.
* Solve missing market - public good - issues.
* Allocative efficiency + welfare max.
State + explain the issues with using state provision to solve market failure.
• Excess Demand: occurs at P0 - when goods are free at consumption. Left to FM, wouldn’t be LR issue - P would rise to reduce excess D - can’t happen with state provision - idea of universal access. Could be argued that there’s role for private sector - if there was functioning private sector - those who can afford it, will go to private sector instead - alleviates some pressure on state provided goods / services.
• Cost: gov taking over whole market - huge sums of money going into state provision - tax payers money - LR funding issues - higher taxes, cuts to other areas of G, debt interest that needs to be paid - opportunity cost arguments valid.
• **Imperfect Information: **gov doesn’t have perfect information - we assume they know SB, SC, can value externalities, that they know socially optimum level of output. In reality, Q wont be at Q* - could be higher - pure gov failure arguments, overdoing allocation of resources, or could be lower - worsening excess D - gov failure risks both ways.
• Inefficiency Of State Organisations: lack profit motive - costs tend to be much higher - is it really most effective use of public money? Big risks of gov failure as a result.
Explain how minimum prices can be used to solve market failure.
• Used to discourage consumption of demerit goods, where there’s negative externalities in consumption (e.g. alcoholic drinks - Scotland impose min P on alcohol - in FM overconsumption/ overproduction of alcoholic drinks - by imposing min P above equilibrium - contracts D - consumption in market discouraged - Q in market falls to Q* - socially optimum level of output - NE externality internalised, allocative efficiency + welfare max.
State + explain the issues with using a minimum price to solve market failure.
- Price Inelastic Demand: when P goes up, fall in QD will be proportionally less than increase in P - may not see fall in Q enough to fully solve market failure.
- Regressive: burdens poor - widens income inequality in society - gov loses key macro objective - takes greater proportion of income of poor.
- Black Markets: consumers could find alternatives S in black market - concerns surrounding quality of good. Could make market failure wish. Tax rev could be lost - if consumer buy from illegal sources - gov loses out.
- Set At Right Level? Not internalising externality - going further - negative impact on firms - may suffer, may leave country, may shut down, may be unemployment caused - unintended consequences linking to gov failure. However, if P is inelastic producers will see increases in revenue - wont be punished, will actually gain.
Define information provision.
Information Provision: gov funded information provision / advertising / education to encourage / discourage consumption.
* Advertising could include billboard advertising, print advertising, radio / TV advertising.
* Education reforms - gov funded changes to curriculum to make children aware of how good / bad something is to consume.
* Solves merit + demerit goods market failure.
* Market friendly policy - not very interventionist or paternalistic.
State + explain the issues with using information provision to solve market failure.
- Cost: gov funded.
- No Guarantee Of Success: no guarantee that information provision will encourage consumption of merit goods / discourage consumption of demerit goods - especially if policy is poorly targeted + of poor quality - targeting wrong consumers / consumers ignoring it. Then policy deemed ineffective.
- Long-Run Not Short-Run: takes time before information is absorbed by consumers - for them to then change their consumption habits + takes time for consumers to repetitively see adverts + change consumption.
Define tradeable pollution permits.
- Innovative policy that aims at battling pollution based market-failure.
• Market friendly approach to bringing down pollution.
Explain how tradable pollution permits work to solve market failure.
- Cap Set At Q:** gov sets pollution cap (amount of CO2 emissions economy’s allowed to emit in a year). Assume gov knows externalities of pollution + can value them accurately - thus know socially optimum level - therefore, ceteris paribus, pollution level set at Q.
- Permits Issued To Match Cap: thus market for permits created - S perfectly P inelastic (S1) - amount of permits is fixed to match cap (can’t rise / fall).
- Firms Make Decisions Based On Lowest Cost: can I in green tech - find ways of producing that’s more climate friendly - if cheap enough firms will do this. If too costly, firms will buy up spare permits in market - decide on whatever’s cheaper. Externality internalised - polluter pays in most efficient way.
- Enforcement: with strict enforcement will come down to socially optimum level.
- Pollution Falls To Socially Optimum Level: allocative efficiency occurs - max welfare in economy. Promotes LR incentives for firms to I in green tech - what society would like firms to do. Due to firms profiting from sales of spare permits + firms I in green tech will never be burdened when permit P rise.
State + explain the issues with using tradable pollution permits to solve market failure.
- Enforcement: can enforcment be afforded? - particularly in developing countries. If can’t be afforded, can’t be enforced - policy won’t work.
- Imperfect Information For Gov: assume they have perfect information + value externality at socially optimum level - but in reality they don’t, likely cap will be set too strict - unintended consequences, or too lax - risk of gov failure.
- Unintended Consequences: regardless of choices firms make, policy will increase CoPs for firms - if caps really strict + drastically increases CoPs - firms could shut down, leave country to continue polluting where policies aren’t as strict / don’t exist - leads to carbon leakages - emissions move from one place to another place in the world. Firms may pass higher CoPs onto consumers - inflationary risks.
- Need For International Cooperation: many countries need to partake in scheme - global market failure - not limited to one country. Getting international cooperation - extremely difficult - especially for developing countries - where increases in CoPs burden firms - don’t think it’s fair. Other countries can free-ride of contributions of countries that do sign up + reduce emissions.
Explain how property rights work to solve market failure.
- Incentive To Not Exploit Common Access Resources: if producer did - impact would be on that individual producer - only they suffer - lost income in future - for other private producers - won’t suffer no NE.
- Negative Externalities Internalised: only private producer suffers - incentive for private producer to look after the CAR.
- If Enforced Will Reduced Quantity To Socially Optimum Level: producer can protect CAR - leads to Q at socially optimum level - won’t see depletion of these resources - hit allocative efficiency in market, thus, welfare max.
State + explain the issues with using property rights to solve market failure.
- Can Property Rights Be Efficiently Distributed? some CAR can’t be divided + given to producers - largest issue.
- Enforcement Needed: very costly - what if gov can’t afford to police it?
- Equity: whoever gets rights is in dominating position.
State who enacts competition policy.
Competition + Markets Authority (CMA) - main regulator.
Regulatory Bodies: work beneath CMA + report to them.
* ORR: rail regulator in UK.
* CAA: civil aviation authority - airlines.
* OFCOM: communications regulator
* OFWAT: water regulator.
* OFGEM: gas + electricity regulator.
* European Competition Commission: UK must still ensure Eu competition regulations are followed.
State + explain the aims of competition policy.
To ensure public interest - if public interest being exploited - arguments for completion policy to be enacted.
* Prevent Excessive Pricing: oligopoly / monopoly charging way beyond MC - rationale for competitor policy to intervene.
* Promote Competition: any highly concentrated markets - competition policy may be enacted - to liberalise those markets - through deregulation, privatisation- to promote competition + competitive outcomes.
* Ensure Quality, Standards, + Choice: if monopoly’s are existing .
* Regulate Natural Monopolies: unregulated natural monopolies in markerts where central public service is being offered - monopoly outcomes will be poor - rationale for competition. If natural monopoly is being privatised to ensure privatisation is successful - role for competition policy.
* Promote Technological Innovation: ensure monopoly profits are being reinvested into innovative new products, new tech, better production processes, e.t.c. To ensure supernormal profits are being used in public interest.
State + explain when competition policy will be enacted.
- Antitrust + Cartel Arguments: if collusive agreements - rationale for competition policy. If there are cartels - rationale for intervention (oligopoly markets - whereby monopoly outcomes could be the end result - public interest would be harmed).
- Investigate Mergers: in UK, if any mergers create market share greater than 25% - often see investigation by competition authority - to make sure merger doesn’t act against public interest.
- Liberalise Concentrated Markets.
- Monitor State Aid Control: within EU, there’s heavy subsidies (particularly in agriculture sector) - if there are excessive subsidies given in 1 country - needs to be ensured this doesn’t distort competition / trade in another country.
Explain price regulation as a form of competition policy.
- P not allowed to be increased the next year beyond RPI (rate of inflation) - fairly restricts P increases for firms. If C are increasing by RPI - everybody increases P by RPI, for firm to also increase P by RPI - fair thing to do - covering C.
- RPI - X regulation: stricter (e.g. airport charges) - restricts level by which firms can increase P below RPI - X represents %. Promotes incentives of efficiency saving.
- RPI + / - K: whereby K represents % - enough profits can be made to allow for capital I (e.g. if K needs to be greater than RPI, % which is positive, RPI + K, or where K is negative, P don’t need to rise above RPI, can rise below RPI - giving firms enough profits to make capital I)
State + explain the issues with price regulation as a form of competition policy.
- Information Issues: how is level of X / level of K going to be generated - assumed gov / regulatory bodies have perfect information + appropriately decide on level. However, in reality, there isn’t perfect information - if level of X set too high - may lead to firms shutting down / not making enough profits to sustain operations. If set too low - then may not get competitive outcomes.
- Cost: for regulatory bodies to investigate firms its very costly + time consuming - tax payer has to bear cost - significant opportunity cost, especially where level of K + X are set wrong.
- Incentive to Keep Reducing X: if regulatory body is setting RPI - X as regulation + firms are successful at finding efficiency S + cutting C - then incentive for regulatory body is always to keep reducing X - not fair on firms.
- Risk Of Regulatory Capture: best regulators will be those who have worked in industry in question - have good contacts of managers / owners who are still in industry- therefore incentive is for those owners / managers to get in touch with regulators to reduce extent of regulation - therefore regulations won’t promote competitive outcomes + monopoly outcomes may still persist.
Explain quantity regulation as a form of competition policy.
• Examples: Trains - number of delays trains are allowed to have. Gas / electricity markets - if OAPS get into financial trouble in the winter + can’t pay gas / electricity - companies aren’t allowed to cut gas / electricity supply.
State + explain the issues with using quantity regulation as a form of competition policy.
• Disintended Consquences: NHS performance targets - GPs seeing set number of patients per hour- may lead to GPs not diagnosing properly.
• ‘Game The System’: train companies - if only allowed certain amount of delays per day - may extend journey times - to prevent delays occurring.
Explain profit regulation as a form of competition policy.
- Using equation where C are going to be covered , but also adding % rate of return on capital employed - risky thing to do, high C in short-term - but in LR creates productivity + greater profit.
- Thus regulatory authorities may say that if firms employ capital, they’ll give them rate of return on capital to reflect greater profits that machine will give you in future.
State + explain the issues with profit regulation as a form of competition policy.
• Asymmetric Information: if monopolist - over report capital employed + over report C - to make sure level of regulated reported profit is going to be higher - gives firms higher level of profit.
• Incentive To Increase Costs: (for monopolies) - as C will always be covered.
• Incentive To Over-Employ Capital: to keep I + buying in new capital machinery - each machinery increase rate of return equation - thus raises amount of profit they make.
Define windfall taxes on profit.
Taxing monopoly profit.
State + explain the issues with windfall taxes as a form of competition policy.
• Worsens Monopoly Outcomes: pushes up P + reduces Q.
• Promotes Tax Evasion / Avoidance.
• Under-Reporting Level Of Profit: to avoid paying taxes.
• Risk Of Less Innovation / Dynamic Efficiency: if monopoly is acting in public interest with profit (i.e. reinvesting profit) good thing - by taxing monopolists - takes this away.
Explain merger policy as a form of competition policy.
- Where mergers lead to market share creation of >25%.
- Competition authorities investigate - can break up merger or if monopoly outcomes are apparent in certain locations - can be made to sell stores in locations to competitions - to promote more competitive outcomes.
Evaluate the use of competition policy.
• Level Of Information: that regulatory bodies have - level of information may not be perfect in reality - no guarantee that regulators have correct information. Thus, policies may be too strict - unintended consequences of firms shutting down. Or too lax - still have monopoly outcomes - gov failure.
• Costs Vs Benefits: significant C of regulations - admin costs - tax payer pays. Not necessarily high benefits if policies too strict / too lax - costs may exceed benefits - leads to gov failure.
• Regulatory Capture: leads to gov failure.
• Benefits Of Monopoly: if regulate monopolies too harshly, may lose benefits (e.g. dynamic efficiency, natural monopoly - leads to allocative inefficiency).
Define privatisation.
Privatisation: when state run organisations / activities are sold off to private sector.
* Idea being that when private sector is in charge of organisations - will run organisations much more efficiently, due to profit motive.
* Allows for more competition, reduced C - leading to increased efficiency.
* Intention Of Privatisation: make markets more competitive + efficient.
State + explain the advantages of privatisation.
- Increased Allocative Efficiency: more competition - greater drive for efficiency - firms strive to produce goods / services that consumers want + that are very high quality - consumer satisfaction maximised + allocative efficiency increases.
- Reduction In X-Inefficiency (waste): due to firms driving down C to maximise profits.
- Efficiency Intentive Which Drives Dynamic Efficiency: to gain advantage firms may need to become dynamically efficient + reinvest - good for consumers - leads to lower P overtime.
State + explain the disadvantages of privatisation.
- Limited Competition: no guarantee of competition. productive (firms not operating at minimum point at AC - if competition limited - need not drive down C as much) + allocative inefficiency (if limited competition - why do firms need to strive to hit highest quality?)
- Loss Making Services Cut Even If Socially Desirable: firms wont want to provide loss-making services, even if desirable for society - negatively impacts consumers.
- Loss Of Natural Monopoly + Loss Of EoS Benefits: leads to productive inefficiency - AC can’t be minimised - each individual firm can’t produce as much - wont be able to exploit all potential EoS.
Define deregulation.
Deregulation: where gov reduces legal barriers to entry in given industries - incentives more firms to enter market - promotes competition + efficiencies.
State + explain the advantages of deregulation.
- More Firms Will Increase Consumer Choice: satisfying needs + wants of consumers - striving for allocative efficiency - huge incentive for firms to S where P = MC - to satisfy consumers + make sure they’re ahead of consumers.
- Increase Productive Efficiency + X - Efficiency: great incentive for firms to minimise costs + max profits - to stay ahead of competitions - desirable to produce at minimum point on AC curve + reduce any waste.
- Increase In Dynamic Efficiency: even though markets competitive - profits made can be re-invested again + again - any chance to get ahead will be taken
State + explain the disadvantages of deregulation.
- Loss Of Natural Monopoly: if previously there was natural monopoly - by deregulating market + allowing new firms to enter - see loss of natural monopoly - leads to increase in AC - reduction in productive efficiency (due to EoS benefits not being seen anymore, due to greater competition) - wasteful duplication of resources - allowing more firms to duplicate resources - leads to allocative inefficiency.
- Formation Of Oligopolies + Local Monopolies: could abuse power - lead to higher P + lower Q - allocative + productive inefficiency.
State + explain what the impact of deregulation depends on.
- Short Run Vs. Long-Run: if see oligopolies + local monopolies forming - contestability falls - idea is that markets will be more contestable - however if oligopolies formed - wont be contestable (maybe in SR but not LR) - policy failure.
- Height Of Other Barriers To Entry: no guarantee that just by reducing legal barriers, new firms can enter market + will become more contestable (e.g. technical barriers to entry, strategic barriers, e.t.c.) - disincentives new firms entering market - limits competition.
- Level Of Government Regulation: if there’s oligopolies + monopolies - strong regulation still needed - not in legal form, but to regulate against anticompetitive behaviour.
State + explain what the impact of privatisation depends on.
- Level Of Competition: post privatisation - higher level of competition - more effective will be.
- Level Of Government Regulation: if there is low level of competition - might see local monopolies / oligopolies existing - if regulation’s tight more likely to see competitive outcomes.
Define nationalisation.
Nationalisation: process of taking an industry into public ownership - gov is buying assets from private sector + running services / industries themselves.
State + explain the arguments in favour of nationalisation.
- Greater Economies Of Scale: leads to productive efficiency gains - lower AC + lower P potentially.
- More Focus On Service Provision: assumption that gov will always look to max social welfare + fulfil needs + wants of society - allocatively efficient. Likely to be at a low P - max CS.
- Less Likely To Be Market Failures Arising From Externalities: due to gov intending to max social welfare - thus consider full SC + SB when it comes to producing - as a result, Q levels are more likely to resemble socially optimum level of production - where by society is getting the Q they exactly want - minimising overproduction / overconsumption that would occur in private sector - due to self-interest of priv firms.
- Public Sector Can Be A Vehicle For Macro-Economic Control: more public sector companies operating - gov can manipulate W to keep inflation under control. Can also control employment issues (i.e. if in recession stage of economic cycle - public sector can look to employ more workers to keep unemployment rate low in period of recession).
State + explain the arguments against nationalisation.
• Diseconomies Of Scale: if there’s state-run monopoly - company could be huge - risk of diseconomies of scale is large (e.g. coordination, communication, motivation issues, e.t.c.) - leads to increasing AC, loss of productive efficiency gains + lead to higher P for consumers.
• Lack Of Incentive To Minimise Costs: (same as point 3).
• Complacency + Wasteful Production: leads to X-inefficiency - due to lacking incentive to reduce C. Leads to higher P for consumers.
• Lack Of Supernormal Profits: in comparison to privatised industry - dynamic inefficiency is end result - don’t see tech gains, innovation benefits, + R&D benefits that we see when supernormal profits are reinvested - bad for consumer in LR.
• Highly Expensive + Burden On Tax Payer: maintaining industry, paying W, buying assets from priv sector - tax payer shoulders burden. In period of austerity / when budget deficits / national debt is high - issue of whether gov can actually afford to nationalise industries. Opportunity cost argument - could there have been better benefits of using tax payers money in other areas - could there have been better rate of return in using money in diff areas in comparison to nationalising given industry.
• Higher Prices Due To Low Competition: higher P, lower Q - may see monopoly outcomes that are trying to be prevented - due to lack of competitive drive that keeps company under control + maintains efficiency - leads to allocative inefficiency.
• Greater Risk Of Moral Hazard: individuals that take risk don’t bear costs of risk if goes wrong - costs are borne by 3rd party (e.g. politicians make risky decisions - if goes wrong - tax payer bears cost)
• Political Priorities Override Commercial Issues: politicians who need to engage in I decisions for state-run monopoly - decide not to due to risk involved - even though I is necessary. Due to there being an election coming up, for instance.
Evaluate the use of nationalisation.
- Funding Vs. Delivery Of Key Public Services: although it has huge C - that tax payers money has to burden the C of, but if end result is that society gets better delivery of key services than in private sector - then may be worth it.
- Are PPs (public private partnerships) Better? Maybe private sector pays for construction / maintenance of project, whereas public sector prays private sector to rent it + use it. Public private sector partnerships thus may be argued to bet better - private sector + efficiency gains that come with that (minimisation of C), as well as nationalisation benefits - maintaining of public services to make sure service quality / Q / choice is high.
- Role Of Regulation: if there’s strong regulation of private sector industries - full nationalisation may not be necessary.
- Competition In Private Sector: high competition in private sector - industry need not be nationalised - just ensure there’s regulation.
- Size + Objective Of Private Sector Firms: if private sector firms are large + are benefiting from huge EoS - benefit that is worthwhile keeping, rather than nationalisation where firms may become too big + diseconomies of scale start to creep in. Not all private sector firms are profit maximising - may be striving for allocative efficiency - not a concern - no guarantee that private sector firms are always going to be profit maximising + trying to exploit consumers + harm public interest. Need to look at objective of firms prior to implementing nationalisation.
Explain the impact of technological change on costs of production.
Tech reduces CoP for businesses - S curve shifts right.
* Reduces CoP overtime - LRAC therefore decreases.
* If there’s better tech - specialist capital / machinery can be brought on - achieving technical EoS.
* Tech change allows specialisation - production processes broken down to production lines - improving productivity + efficiency (technical EoS).
* MES now takes place at greater level of output - due to greater exploitation of EoS.
Explain the impact of technological change on efficiency.
- Productive Efficiency: increases as CoP are now lower + MES is now at greater level of output.
- Allocative Efficiency: whether it occurs depends on whether lower C are passed onto consumers via lower P.
- Dynamic Efficiency: tech improvements leads to innovation, new services ,e.t.c.
State + explain the impact of technological change on market structures.
- Barriers To Entry: significantly reduced in many different industries - less need for physical premises (e.g. online retail) - start up C reduces, sunk C reduced significantly. Much easier to meet certain regulations + due to not employing as many workers because there’s no physical premises - easier to meet employment laws - legal barriers to entry lower / easier to meet. Advertising much easier with greater role of internet - reduces brand loyalty aspect of barriers to entry - break into markets much easier. In some industries, have actually increased, if firms are able to access greater copyrights / patents - restricts competition in certain industries.
- Number Of Firms: Depends heavily on barriers to entry - if reduced, see more firms in market with more competitive outcomes, vice versa.
- Product Homogeneity: with tech change - greater variety of goods + services.
- Knowledge: tech change - improves knowledge - role of internet improves P information for consumers + benefits producers - if see company using new tech for given product - other companies can take that + copy technologies. Consumers + businesses have better knowledge of market conditions. However, could be argued market has become more imperfect - due to patents, copyrights, licenses, e.t.c. - + one firm has control over given market.
