Chapter 11: Market Failure Flashcards
What is Market failure
price mechanism allocates scarce resources inefficiently-> Loss in economic welfare.
Outcomes of market failure?
Under/over provision of certain products
Under/over consumption of certain products
Why does MF occur?
divergence between private costs and benefits, as well as social costs and benefits of production/consumption
External benefits/positive externalities
Advantages/gains of production/consumption to a third party (not involved in economic transaction)
External Costs/negative externalities
Disadvantages incurred by a third party in an economic transaction, compensation not paid
(spillover effects).
Private benefits
Advantages/gains of production/consumption enjoyed by an individual firm/person.
Private costs
PC of production/consumption are actual expenses incurred by a individual firm/person.
Social benefits
True benefits of consumption/production, sum of private and external benefits.
Social benefits = private benefits + positive externalities.
When does socially optimum output occur?
When marginal social benefit = marginal social cost (MSB = MSC output level)
Marginal Private benefit
Additional value enjoyed by stakeholders from consumption/production of an extra unit of particular product
Marginal private cost
Additional Expense of production for firms/extra charge paid by consumers for output/consumption of extra unit of product.
Marginal social benefit
total gain to society from extra unit of production/consumption (sum of benefits)
Marginal social cost
total expenses to society from an extra unit of particular product (cons/prod)
Allocative Efficiency
When social surplus is maximized.
socially optimum level of output MSB = MSC
not possible to reallocate resources to make one party better off without making others worse.
Social Surplus
Sum of CS and PS at a given market price. Net benefit available to society from economic transaction.
When is social surplus maximized?
Maximised when market is cleared by PM. No shortages/surpluses. Maximising social welfare
Negative Externalities/spillover effects
are the external costs of an economic transaction, causing the
market to fail to achieve the social optimum level of production or consumption
Positive externalities
benefits enjoyed by third party not directly involved.
Merit Goods
products that create positive externalities when produced/consumed. MSB > MPB (prod/cons)
deemed of value due to spill over effects on third parties, impacting social welfare. improves SOL in economy.
Characteristics of merit good
Rivalrous
Excludable
Tend to be underconsumed+produced in FM conditions.
what does rivalrous mean
consumption reduces amount available to others at that point in time
excludable
possible to prevent non-payers benefitting from merit good
Draw a graph of positive externalities of consumption (of merit goods)
- MSB > MPB
- positive consumption externalities exist at all levels up to socially optimal level of output as a result
- MF (at FM equilibrium) underconsumption of merit good
- MSB = MSC socially desirable level
Draw a graph of positive externalities of production (of merit goods)
MPC > MSC
- true for all levels of production, till (MSC = MPB)
- vert distance MPC and MSC shows existence of positive externalities
- hence MF at equilibrium
- underconsumption of merit good
intervention needed to lower price to encourage consumption
Demerit good
- products that create negative spillover effects
to third parties not directly involved. - can be damaging, production/consumption = MSC > MPC
- overproduced/consumed
Graph of negative externalities of production (Of demerit goods)
MSC>MPC (due to harmful effect when producing)
without intervention, output Qe (MPC = MPB of production)
socially opt is qopt
society deems there is overproduction welfare loss
benefits if output reduced, eliminate externalities
Graph of negative externalities of consumption (Of demerit goods)
MSB < MPB (due to harmful effect when consuming)
Without intervention, Qe, exceeds qopt (at MSC = MSB of consumption)
society deems overconsumption + welfare loss
society benefits if consumption reduced to qopt (eliminates externalities)
What are common pool/access resources?
Non-excludable but rivalrous in consumption and create tragedy of the commons, they result in negative externalities and unsustainable production. (pastures, rivers, atmosphere)
Non excludability in terms of CPRs
CPRs are freely available - tends to be overconsumed.
Difficult to sustain, hence require intervention to prevent depletion
Rivalrous in terms of CPRs
usage reduces amount available for others to consume.
consumption diminishes quantitiy and possibly quality of remaining resources for current and future generations
generations may be deprived
Tragedy of the commons
Degradation, depletion of a common pool resource caused by problems of rivalry and overuse.
exploitation of CPRs leads to unsustainable production and negative externalities.
Different methods to intervene in response to externalities and common pool resources (PIGLETS CC)
Pigouvian taxes
International agreements
Government provision
Legislation and regulation
Education (awareness creation)
Tradable permits
Subsidies
carbon taxes
collective self governance.
Pigouvian taxes
corrective measure “internalize” negative externalities. reduce/eliminate
pay true costs of their actions (buyer/seller)
without intervention no incentive for concern for external costs.
Draw a graph of a Pigouvian tax being implemented on a firm
-firm causes divergence between MPC and MSC
- Pigouvian tax objective, make price equal to D MSB. create more socially efficient allocation of resources.
- raises cost to producer, S = MPC curve shift leftwards towards S2 = MSC
- price -> Popt
- Qd -> Qopt
- A = free market equilibrium
- B socially optimal lvl output
Advantages of imposition of Pigouvian tax on production/consumption of products with negative externalities
- increases price so should decrease qd
- creates tax revenue for gov, can be used to raise public funds to deal with externalities or other measures.
Disadvantages of imposition of Pigouvian tax on production/consumption of products with negative externalities
- demand for such products is inelastic, little impact on level of consumption
- tax on these products is regressive, > impact on low income
- can encourage unofficial market activities (parallel market, smuggling)
Carbon taxes
tax on greenhouse gas emissions/carbon content of fossil fuels to reduce pollution from particular industries by internalizing negative externalities of production
- creates incentive to reduce pollution
- without tax, Mf exists as firms are not accurately charged for fossil fuel use.
Diagram of Carbon tax on polluting firms
Factory polluting creates divergence between MPC and MSC of production
- effectm of per unit carbon tax (Popt - P0) is fall of production to Qopt
and a higher price
tax rev earned shown by green area
Advantages of carbon tax
- impose additional costs to users of carbon fuels, pay for damage caused by their economic activities
- an effective carbon tax makes it more economically rewarding to switch to alternative fuels
Disadvantages of carbon tax
- correct tax rate is key to effectiveness
- too low, continue to pollute
- too high, escalated costs negatively affect profits, employment and consumers.
- effectiveness depends on ability to pass on higher energy costs to consumers
- inelastic? consumers bear greater proportion
- regressive, account for larger proportion of income of poorer households.
- higher income households, switch to energy efficient.
Legislation
Laws stipulated by government on the use of scarce resources
Regulation
Act of monitoring and controlling activity of firms, management of complex rules, laws policies.
How can laws be used in the case of merit goods/demerit goods
Can be used to encourage consumption of merit goods or reduce consumption/production of demerit.
Draw a diagram for Legislation and Regulation of Negative consumption externalities
- demand curve for demerit good shifts from MPB to MSB, due to reduced benefits of consumption
- consumption -> Q1 to Qopt
- reducing/eliminating negative externalities associated
- illegal markets can develop + people may choose to break rules/regulations
Limitations of Legislation and Regulation
- parallel markets develop, where demerit product is purchased, high price
- unless penalties are high +enforced, consumers may choose to break rules.
Education - awareness creation
Educating public, costs of consuming demerit goods/benefits of consuming merit goods to correct MF.
- more socially desirable outcomes
Diagram for education - awareness creation (vegetables and fruits e.g) positive consumption externaliites
-outward shift , MPB to MSB, consumption, Qm to qopt
- healthier people, fewer absences, benefits society
- costs for funding education, does not translate to CS/PS + administrative costs, DWL.
Advantages of education (awareness creatrtion) to combat problems of market failure
- behaviour/consumption patterns may change, rise in consumption of merit, fall in demerit
- successful advertising can lead to cultural change in behaviour, e.g healthier diets.
Disadvantages of education (awareness creation) to combat problems of market failure
- not all campaigns are effective, does not necessarily work
- time lags in educating, and to be acted upon
- opportunity cost of government expenditure. Could be spent on something more beneficial to society
Tradable permits (Cap and trade schemes)
government regulated emissions trading schemes, limit pollution in industry to more socially efficient level.
can sell any excess permits.
- incentive to change to cleaner technologies.
advantages of tradable permits (cap and trade schemes)
- can raise a significant amount of revenue for the government.
- due to economic growth, demand for pollution permits increase, but cap on pollution creates higher prices for tradable permits.
diagram of tradable permits when demand for them increases
Increased demand for permit, shifts market price
supply capped by gov, no change
polluters pay for external costs
rev goes from 0,P1,A,Qe to 0,P2,B,Qe (increased)
Effect of tradable permits on large polluters
- largest polluters need more permits
- increased costs, less competitive + profitable
Effect of tradable permits on environmentally friendly producers
- gain extra rev from selling permits (surplus)
- making them more competitive+profitable
Effects of a government over time choosing to reduce number of pollution permits
gov may chose to reduce, shift to left (supply)
- raises price
- greater incentive to be more efficient (clean tech)
Critiques of CATS
Argued it is anti competitive (smaller firms) = job losses (higher costs)
MNCs shift production elsewhere
argued higher prices of permits are ineffective to stop global warning (demand is highly price inelastic)
cap is deemed too high
International Agreements
governments can create international agreements in response to negative externalities
- most are legally binding (treaties) ->makes countries accountable
Bilateral agreements/multilateral
Agreements between two countries/more
Effects Of international agreements:
Implementation recognises countries that are higher income have more responsibility in playing a role to combat negative externalities (e.g global warming)
Critiques of International agreements
Require full commitment from all countries. Unwillingness undermines international agreements purpose.
High income countries/MNCs exploit low income countries, despite agreements
e.g deforestation
Collective Self Governance (local communities allocate use of resources)
Voluntary communal actions to tackle negative externalities and problems associated with exploitation of CARs
Why the need for collective self governance?
-Local communities make more informed decisions.
-Knowledge about local culture
-directly affected
-often reliant, taxation+education.
- creates socio-economic benefits for communities. employment + higher income
Subsidies
Financial assistance, gov to local firms, lower costs of production to help compete against foreign imports.
- encourage output, lower price, lower cost of living for citizens.
Diagram of Subsidies
- shown by vert distance, represents value of +ve ext
- reduced production costs, (s) shifts outwards to MSC
- consumers gain lower prices (Pm to Popt)
- producers keep remainder (lower prod costs, P0 to Pm)
- incentive to consume good (quantity)
- amoutn spent, shaded area
Welfare analysis of Subsidies graph
- administrative costs of provision + funding for subsidies do not equate to additional CS/PS
- Price was Pe, CS was A+B (Prior)
- PS was E + I
- After Price falls to Pc, CS increases to ABEFG
- producers, receive price of Pp, Ps is B+C+E+I
- total amount spent shown by shaded yellow area
- D + H = DWL
Limitations of Subsidies to correct MF
- difficult to set precise subsidy, for optimal allocation of resources
- social return for merit goods is difficult to measure
- if PED of product is inelastic, lower price, little impact
- always opportunity cost, could’ve spent on projects reaping greater social gains.
Government provision
Direct provision of products, final gov response to MF, ensures optimal level of output achieved
- market fails to provide adequate supply of merit/public goods
Advantages of Government provision
merit/public goods accessible to everyone regardless of status
- improves wellbeing of society
Limitations of Government Provision
- may encourage consumption beyond socially optimum level, likely to overuse.
- entails an opportunity cost, money could be spent paying off debt etc.
- difficult to decide who can take advantage of subsidized product (when there is excess demand)
What are the challenges involved in measurement of externalities?
- what is the value of an externality, can they be measured precisely?
- challenges in measuring impact of an externality does not mean government can ignore it.
What is the degree of effectiveness of government intervention?
- not always clear if intervention clears MF effectively.
- many factors affect consumption of merit/demerit goods. cannot use ceteris paribus
- policies limited by time lags and costs of enforcement/cost of government provision
- value judgements influence use of certain policies to deal with Mf
- disagreements will occur between policymakers, economists from diff schools of thoughts, poltiicians
What are the consequences for stakeholders (MNCs and Lower income firms) affected by government intervention
- MNCs relocate to low income countries, limits are not imposed/controlled, same extent
- legislation/regulation favour MNCs that have financial resources to comply, smaller firms, higher cost of compliance, struggle
- Pigouvian taxes, regressive, impactful on low income earners/smaller firms. Minimal impact on spending behaviour
Importance of International Cooperation
vital due to demand for scarce resources
- requires consideration, global nature of sustainability issues
- challenges faced in international cooperation
- need for monitoring and enforcement.
Global nature of sustainability issues
- governments need to consider ecological/social sustainability than just economic
- SDGs (UN) widely used framework
- address global challenges to sustainability, caused by MF
- debate on how much needed to achieve 17 goals.
Challenges faced in International Cooperation
- cultural differences, contexts, challenges.
- laws differ in countries (alcohol/cigarette age)
- may generate huge tax revenues in countries, e.g China, Russia
- reluctant to comply with ban
- debate, how much should countries contribute to tackling problems.
Monitoring and Enforcement
Enforcing policies used to correct MF
Monitoring and Enforcement examples
- regulate where to drive, cycle gamble
- smoking being illegal
- eat/talk on phone while driving
- passengers, seatbelts.
Limitations of Monitoring and Enforcement
- Financial+opportunity costs
- no control over quality of products in parallel markets
- can be dangerous
- may still break rules, fines not high enough to discourage, laws not enforced
