8. Market failure Flashcards
market failure
suboptimal allocation of resources, when CS isn’t maximized, when provision is greater or less than social optimum
externality
when the consumption or production of goods and services imposes costs or benefits on third parties (INDIRECT)
negative externality
when production or consumption leads to a cost (harmful)
positive externality
when the produciton or consumption leads to a benefit ( beneficial)
demand curve is now
benefit
supply curve is now
cost
MSC
cost society pays when producing one further quantity of a good, MPC+MEC
MPC
cost a firm pays when producing one further quantity of a good
when is MSC=MPC
no externality in the production process, MEC=0
MSB
demand curve, MPB + MEB
MPC
represent people selling the good (supply)
MPB
represent people who are buying the good (demand)
when is MSB=MPB
no externality in the consumption process, MEB=0
when is MSC=MSB
market is working at a social optimum, resources used as efficiently as possible
positive externality of consumption
a third party benefits from the consumption of a good, MSB>MPB
vaccine example for PEC
less risk of contracting a disease, better health closer to herd immunity
Q* on a graph
social optimum
potential welfare gain
getting PC or CS back by eliminating/reducing externality, distance between Q^x and Q*
welfare loss
“loss of consumer / producer surplus when less/more than the socially optimal output is produced / consumed (externality)
“
merit good
beneficial to consumers but are underconsumed because potential benefits are ignored or underestimates, usually brings great social benefits
merit good example of university education
a more educated population –> important technological innovations and productive society
merit good example of public sports facilities
better health, good hobby–> fitter population–> more productive society + live longer
how can the govy increase welfare related to PECs and underconsumptions of MerGs?
LIS
- Legislation: pass law to make consumption mandatory
- Improve information about benefit of product through increasing public awareness 3. Subsidy or direct provision by the gov
subsidy to “solve” PECs and increase welfare
shift MSC downwards the size of the externality –> new social level of consumption to be reached at Q^1
increasing public awareness to “solve” PECs and increase welfare
shift MPB to the right towards MSB –> increase welfare
problem with using subsidies to promote PECs
- creates opportunity cost - govs have limited resources and have to reallocate budget
- different political parties might prioritize differently
- takes long time to make and change a gov policy
problem with using public awareness campaigns to promote PECs
high cost to provide positive advertising, long time to take effect = minimal short term Bs
problem with government legislation to promote PECs
people could percieve as infringement of civil liberties and autonomy
positive externality of production
production of a good creates externals benefits favorable for third parties
when MPC > MSC
between Q* and Q^1 there is potential welfare gain
eg. a firm provides high quality training, people leave to other firms which now dont have to pay for extra training
how can the govy increase welfare related to PEPs
- subsidy 2. direct provision
subsidy to “solve” PEPs and increase welfare
MPC shift downwards by the subsidy to reach MPC = MSC and social optimum A (Q*)
direct provision to “solve” PEPs and increase welfare
provide vocational training although high costs and dissuade firms from offering training
negative externality of consumption
when MSB < MPB
private utility is diminshed by negative utility suffered by third parties
smoking as a NEC
eg. cigarettes –> second hand smoking + cancer, asthma
people will maximize private utility + ignore negative externality = consume where MSC=MPB
–> overconsumption at Q1,P1
there is welfare loss in society too many resources are allocated and overproduced
need to reach optimal at Q*
demerit good
goods that are harmful to consumers but people who consume are
- unaware or
- ignore possible risks - imperfect information about MSC
demand is higher than society’s socially optimum
demerit good example of alcohol
creates health consequences eg. hangovers, liver disease -
-> binge drinking can exacerbate aggresive behavior, drunk driving, domestic violence and increase medical costs
demerit good example of unhealthy food
leads to high blood pressure etc. + increase medical costs
how can the govy reduce welfare loss related to NECs and overconsumptions of DemGs?
- indirect tax
2. legislation/regulation:
indirect tax to “solve” NECs and reduce welfare loss
shift MSC upward to MSC + tax
reduce consumption to social optimum at Q*
but P to consumers is P2–> gov will gain revenue which can be used to correct NEs
legislation/regulation to “solve” NECs and reduce welfare loss
shift MPB leftward closer to MSB
eg. age restrictions, bans in public places, negative advertising
problem with pigouvian tax
- some demerit goods might have inelastic demand so taxes might not reduce Qd that much - gov R may be raised but Qd doesn’t fall to Q*
2. people might look for other supply sources where the good is cheaper - thus consumption isn’t reduced and gov doesn’t gain R
pigouvian tax
indirect tax imposed on a market with a negative externality
problem with legislation/regulation
- argue that it takes away rights of customers to choose
- creates negative effect on producers - less R –> potential lobbying
- difficult to enforce, need to allocate resources to ensure stakeholders comply
education/awareness campaigns to “solve” NECs and reduce welfare loss
govs can increase info evailable through education (long term) or funding public awareness campaigns –> shifting MPB to the left
problem with education/awareness to “solve” NECs and reduce welfare loss
some people dont care - irrational behavior
consumer nudges to “solve” NECs and reduce welfare loss
encourage people to reduce consumption voluntarily eg. putting graphic images and using plain colors on cigs –> nudge not to smoke
negative externality of production
production of a good creates external costs damaging to third parties - often are environmental issues related to sustainability
when MSC>MPC
firm only cares abt PCs and produces at Q1 not Q*
–> misallocation of resources +welfare loss because of extra units from Q1 and Q* making MSC > MSB
why might NEPs occur
- profit maximization: only take account of PCs and not SCs now and in the future - sustainability
CARs common access resources
natural resources that are difficult to exclude people from using them eg. forests, fishing grounds, pastures
characteristics of CARs
non excludable + rivalrous = without management –> inevitable overconsumption, degradation and depletion = not sustainable
non excludable
no one can be excluded from using them either physically impossible or PC > SB
imperfect information
where buyers and/or sellers do not have all of the necessary information to make an informed decision about the price or quality of a product
asymmetric information
when one party in a transaction is in possession of more information than the other
public good
would not be provided at all in a free market because theyre non excludable and non rivalrous
anyone can use them dont need to pay, no decreased supply
why arent public goods provided in free market
difficulty or expensive to charge people for their use eg. public park, street lights
non rivalrous
one person consuming doesn’t exclude someone from doing so
problem with non excludable goods
free rider problem:someone who wants others to pay for a public good but plans to use the good themselves
if many people act as free riders, the public good may never be provided
best way to pay for public goods
find a way of ensuring that everyone will make a contribution, thus preventing free riders eg. taxes
problem with non rivalrous goods
PB small compared to PC but SB > SC
productive efficiency
production is at lowest possible average cost, no waste in production
social efficiency
taking into account all EC+Bs as well as PC+Bs
social welfare is maximized when MSB=MSC
allocative efficiency
supply = demand, cost = benefit
limited resources are allocated to produce according to consumer reference reflected in the market
tradable permits
give the holder the right to pollute a certain amount, to buy permits if emissions increase, and to sell permits if emissions decrease
undersupply of MerGs as MF
when there is divergence between MPB AND MSB
consumption of MerGs creates PECs that society benefits from that the individual does not
MPB is lower and less than MSB because people are unaware of the higher social benefit –>
underconsumption creates potential welfare gain triangle
NEED to shift MPC/Supply to the right
oversupply of DemGs
when there is divergence between MPB and MSB
consumption of DemGs creates NECs because MPB is more and higher than MSB
people don’t realize the effects on third parties creating welfare loss
need to eliminate externality/welfare loss, shift MPB leftward
how can the govy increase consumption of MerGs?
- provide them directly-gov provision
2. subsidy
how can the govy decrease consumption of DemGs? reduce supply/demand
REMT
1. make illegal (but can create black market)
- tax (depending on elasticity)
- regulate
- education campaigns
deadweight loss
The loss of the trades not made due to government intervention. (taxes)
Allocative Efficiency Loss
When inefficient trades are made due to government intervention (subsidy)
Types of Market Failure
LEIOU
Lack of Public Goods
Existence of externalities
Imperfect Competition - Short Termism - Inequality Over-supply of demerit goods Under-supply of merit goods
other causes of market failure
3Is
- Immobility of production factors
- problems of Information
- Inequality
immobility of PFs as MF
resources are assumed to be reallocated based on higher profit incentives but this isn’t always the case
problems may be geographcial or occupational (lack of skills)
info problems as MF
When buyers and sellers don’t have all the correct information they may buy or sell a product at a higher or lower price than what would be reflective of its true benefit or cost
short termism as MF
decisions are made that have severe future implications such as unsustainable resource use
inequality as MF
income equalities makes it so only the products that create profits are supplied which can exclude people from a market because they cannot afford it
–> unequal allocation of resources
inequality as MF
income equalities makes it so only the products that create profits are supplied which can exclude people from a market because they cannot afford it
–> unequal allocation of resources
sustainability
use of resources that satisfies present needs without comprimising future generations especially non renewable resources
lack of public goods as market failure
- create market failures if a section of the population that consumes the goods fails to pay but continues using the good as actual payers
- its charact. makes it impossible to collect (enough) revenue to pay for private costs –> no incentive to provide
why CARs is a market failure/tragedy of the commons
non excludable but rivalrous –> becomes exploited + overconsumed because producers are acting rationally - maximize self interest => externalities
importance of international cooperation for sustainability
threats to sustainability are global (interdependence between ecosystems and countries)-
CARs are degraded everywhere which requires cooperation
LEDCs need to be supported through financial-tech support, some countries value economic growth unaware of long term effects
overfishing as an example of TOFTC
lake = CAR - non excludable + difficult to restrict access (size, location, cost)
–> ppl fish without paying license/fee – little incentive to limit consumption
–> maximize self interest and fish faster than fish can reproduce
atmosphere as a CAR
degradation - what is put into CARs eg. waste, pollution
how can international agreemenets reduce NEPs
economic activity = human impact -> need global agreements to protect
–> threats to world’s CARs because the earth only has limited stock
to comply to agreements countries need to work tgt to meet targets
how can tradable permits reduce NEPs
if countries don’t use up their permit - allowed to sell to countries over target = market for emissions
–> incentivize producers to use cleaner tech so they dont buy carbon credits
how can carbon taxes reduce NEPs
internalize NEPs through polluter paying
–> producer can choose whether to reduce emissions or pollute and pay, start lower so producers can change production/consumption patterns.
Tax –> COPs rise from MPC to MPC + carbon tax –>
p1- p2 –>consumption fall to Q2 moving closer to Q* (smaller WL)
how can legislations and regulations reduce NEPs
- to meet standards firms have to increase PCs = MPC + increased costs
- incentivize producers to find alternative production methods
command and control
strictly regulate producer behavior through legislations to ban or reduce ouput
concerns abt command and control
- so much info to process - impossible to gather
- need to consider unique differences of industries and ecosystems - could lead to over or underregulation
- raise product Ps –> less competitive in foreign market
- have to be closely monitored - compliance is expensive and time consuming
- environmental R concerning new tech discourage development
- govs are slow and resistant to change
- lobbying from stakeholders –> regulatory capture
how can subsidies reduce NEPs
through subsidizing alternative energy sources to make them more accessible and reduce COPs –> to meet increasing energy demand
subsidy
direct payment by the government to a firm per unit of output
tax
an additional charge on production or consumption in addition to the selling price, money to be used by the government for public infrastructure or goods
how can collective self governance help manage CARs
individuals and communities work tgt to develop rules/institutions to manage their shared R use
how can the govy reduce MF to increase supply of PubGs
- direct provision
2. public-private partnership - gov provide financing - private producer run it
why is asymmetric information a MF
there is allocative efficiency if people are aware of product availability and price ranges - they cant make informed decisions with imperfect info- AS and MH
adverse selection (AS)
when one party in an economic transaction has better info than the other
moral hazard (MH)
when ppl have incentive to change behavior and take more risk when they know others will absorb the risk
solutions to “solve” adverse selection
screening - when less informed party gets other party to reveal info
example of screening (market for lemons)
used car market: people cant tell between good car and lemon
– average P is charged so good car consumers make a loss –>
no market for a good car (MF) = bad drives out good
community surplus
the sum of consumer and producer surplus at a given price and quantity in a market - maximized at equilibrium - price = marginal cost
consumer surplus
when the price that consumers pay for a product or service is less than the price they’re willing to pay - additional benefit
producer surplus
difference between the amount producers get for selling a good and the amount they want to accept for that good -
excess benefit from selling at a price higher
list gov solutions to reduce MF
Provision Education Tax Regulate Ban Subsidy PETR BS
list gov solutions to reduce S/D for DemGs
make illegal, tax, regulation, education
existence of externalities as a MF
external costs and benefits of production/consumption of a good is not represented in its price
- damage not internalized because self interest wants to be maximized
subsidy as a solution for PEPs
increase positive externality (shift MPC to the right) - MPC + Subsidy = MSC - potential welfare gain
providing benefits as a solution for PEPs
reduce costs of production and encourage supply (usually for merit goods) eg. employee training
problem with firm subsidies (PEPs)
- difficult to estimate level of subsidy
2. opportunity cost of subsidy
problem with benefits (PEPs)
- cost to provide freely or low price is high
2. government trainers dont work for the firm so might not have their best interest
free rider problem
where individuals are able to consume a good without paying.
This creates a situation where there is little incentive to pay for the good – instead, we hope that others pay for it and we can get the good and save our money
–> this is why its underprovided and consumed
