Chapter 3 Flashcards
The roles of the government
GADS
Growth function: promoting sustainable economic growth
Allocative function: Correcting allocative inefficiency
Distributive function: Correcting inequity
Stabilisation function: Correcting economic instability
Sources of market failure
- Public goods and benefits
2.Externalities - Imperfect info on costs
Public goods
Goods or services that have the features of non-rivalry and non excludability and as a result would not be provided by the free market
aka goods that are essential/beneficial socially but private enterprises cannot finance so the govt provides/finances them. They provide directly or pay private firms to provide them
Non excludability
not possible to provide the good/service to only one person without it thereby being available for others to enjoy
goods are collectively consumed
Non rivalry
The consumption of the good or service by an individual does not deplete the benefits available to others to enjoy
MC=0
Free-rider problem arising from the consumption of non excludable goods
Situation in which an individual is able to enjoy benefits from consumption of a good or service without having a pay for the consumption of the good or service
non-rejectability
individuals are able to choose forego consumption or prevent themselves from benefitting from the good once it is provided
private goods are rejectable
public goods are not rejectable
P=MC
price = marginal cost in a free market assuming that,
market is perfectly competitive
No externalities
No imperfect info
Exit and entry into market easy
Not a public good
No govt intervention
Externalities
Negative
Positive
occurs when some of the costs and benefits associated with the production or consumption of a good ‘spills over onto third parties-to parties other than immediate seller or buyer for which no compensation is paid
Negative externalities
When external costs are imposed on society from production/consumption of a good or service by producers/consumers
NE graph
The 7 steps
WEEEWSE
1.When left to free market, private producers/consumers produce/consume at MPB=MPC
2. Explain MPB and MPC in context
3.Explain MEC in context
4.Explain the divergence between MPC and MSC due to the presence of MEC , assuming no positive externalities MSB=MPB
5.When left to free market, private producers/consumers produce/consume at Qp where MPB=MSB. But socially optimal output level is at Qs where MSC=MSB. Producers/consumers fail to internalise external costs
6.Since Qp>Qs there is overproduction/overconsumption leading to allocative inefficiency lead to market failure
7. resultant deadweight loss (mark area)
Positive externalities
Occurs when society or third party benefit from the consumption/production of a good or service by consumers/producers
In the absence of externalities
MPC=MSC private optimal quantity=socially optimal quantity
The reason for why externalities arise
When producing firms only consider marginal private cost and marginal private benefit hence the produce at price level at market output
consumers consume goods based on marginal private cost and marginal benefit as well
hence loss of welfare
MPC
costs incurred by those who directly produce/consume a good
MEC
costs associated with production/consumption of good which spill over onto third parties
MSC
opportunity cost to society consisting of both private and external costs
MSC= MPC+MEC
MPB
Satisfaction individual/firm able to obtain from direct consumption/production of good
MEB
Benefits associated with production or consumption of a good which spills over onto third parties
MSB
total gain in welfare by the whole of society from consumption/production of a certain good/service by individual/firm MSB= MPB+MEB
For allocative efficiency
MSB=MSC that means the absence of externalities
NE concept
When negative externalities generated in production of goods
MPC=MSB (private optimal quantity) at output level is more than socially optimal output MSC=MSB/MPB leading to over production
When negative externalities generated in consumption of goods MPC=MSB at private optimal quantity is more than social optimal output MSC=MSB/MPB leading to over consumption
The over production and over consumption lead to over allocation of resources and hence overallocation (allocative inefficiency occurs ) and hence welfare loss to society(deadweight loss)
Govt intervention for NE
- Market based solutions
- Taxation
-Tradable permits
-Quotas - Non market based
-Legislation or govt regulation
-Education/campaigns/ads
PE graph
7 steps
- When left to free market private consumers consume at MPB=MPC
- Explain MPB and MPC in context of the qn
3.Explain MEB in context - Explain the divergence between MPB and MSB due to the presence of MEB. Assume no negative externality MPC=MSC
5.When left to the free market private consumers consume at Qp where MPB=MSC . But the socially optimum output is at Qs where MSB=MSC
6.Since Qp market failure
7.Explain area of DWL
Govt intervention for PE
1.Direct Subsidies
2.Indirect Subsidies
the govt will be able to stimulate either MPC or MPB respectively such that efficiently is achieved
3.Legislation/Govt reg
4.Direct Provision
5.Joint Provision
6. Education/Campaigns/ads
Direct Subsidies
draw graph
amount that is equal to the MEB at the socially optimal level is given to consumers to encourage consumption. Allocative efficiency is attained with direct subsidy causing MPB to shift upwards to new MSB=MPB + subsidy to equate with the MSC at socially optimal output of OQs
Indirect Subsidies
draw graph
lowered MPC and stimulate prod
MPC shifts downwards to MPC+subsidy will lower the price of the good thus helping to increase consumption by QpQs
Legislation/ Govt reg
Laws
Making certain goods compulsory
Advantages
-Easy to implement
-Simple to understand
Disadvantages
-Difficult and expensive to enforce
- Govt must accurately estimate the impact of legislation in order to achieve socially optimal level of consumption/production
Direct provision
Govt directly provides the good to increase the prod to the socially optimal level
Advantages
-The govt can increase the output immediately to the socially optimum level
-govt can control the quality
-Addresses equity as the govt may provide good for free/low priced
so it is accessible for everyone
Disadvantages
-May lead to greater inefficiency due to lack of competitive pressure and profit motive
-Funding through increased taxes and borrowing
-High opp cost due to large sum required
Joint provision
Where govt employs private firms to carry out parts of the provision of the goods with positive externalities while it remains as the sole provider
AKA Private public partnership
Advantages
Govt can increase output to the socially optimum level
Private firms have more incentive to be efficient due to competitive pressure and private firms’ profit motive
Disadvantages
Difficulty in monitoring and enforcing the quality standards
Funding through increased taxes and borrowing
High opp cost due to large sum required
Education/Campaigns/Ads
Advantages
motivates people to consume more of the good which has positive externalities as it presents full benefits of doing so and
helps to address root cause
Reduces ignorance
Limitations
Effectiveness depends on people’s receptiveness to it (difficult to change people’s mindset
Cost of implementation
Takes time
imperfect info on costs of consumption of a good
Individuals lack information of full costs of consumption hence they over consume (Qa-Qp) the demerit good because of imperfect info
graph
e.g. cigarettes
consumers do not full access to actual, full MPC and underestimate the chance of being affected by that good
additional cost to society for over consuming the good outweighs the additional benefits. Allocative inefficiency due to imperfect info resulting in deadweight loss to society
imperfect info on benefits of consumption of a good
only applicable to consumers
MPC actual
MPC perceived graph
e.g. immunisation
Due to imperfect info, there is underconsumption (Qp-Qa) of merit goods
Due to imperfect info consumers unaware of full benefits and underestimate the true value of MPB. If consumers can appreciate actual benefit of consuming the good quantity demanded of goods shifts from Qp to Qa
welfare loss to society as increased consumption with perfect info outweighs additional cost to society with underconsumption due to imperfect info results in allocative inefficiency hence deadweight loss
Govt intervention for imperfect info
- Public education/campaigns/ads
2.Regulation (command and control measure)
Public education/ads/campaigns
Reducing imperfect info by providing consumers with info about true MPC/MPB derived from consuming good
Addresses root cause of info failure
Distorts price signals to a smaller extent
Limitations
Difficult to influence people’s mindsets and beliefs
know how to draw graph
Regulation (Command and control measure)
Govt could directly influence consumption pattern by making the consumption of certain goods compulsory and imposing restrictions on consumption of goods that are bad (smoking)
Regulation can also be used to improve flow of info so that consumers are fully aware of true MPB of good so to make rational decision
Limitations:
High Admin/enforcement cost
(hiring extra staff to enforce, prosecuting offenders)
Over correction
Over correction of market failure results in larger deadweight loss
5.Shifts in govt policy creating uncertainties in the market
if govt intervention changes too frequently, difficult for firms to plan if cannot predict tax rates/subsidies/price controls
Market failure
new deadweight loss > old deadweight loss
allocative inefficiency
welfare loss
Taxation
draw graph
govt can levy specific tax at socially optimal output level .
Taxes enacted to correct the NE by allowing firms to internalise external costs
Advantages
Internalisation of external costs acts as incentive to do R&D to reduce MEC
Generates Tax rev to fund measures to reduce NE (e.g.: pollution levels)
Disadvantages
Govt does not have full info to implement the right amt of tax resulting in either overtax or under tax (draw diagram) leading to more welfare loss
Admin cost of collecting tax
Tradable permits
Each firm is given a permit to produce a given level of pollution. If firm produces lesser than legal permission they r given credit which can be sold to other firms allowing them to exceed original limit (draw diagram)
Advantages
Internalisation of external cost which is an incentive for firms to decrease MEC
Govt does not need to know individual firms’ level of pollution
Free market will allocate the ‘right’ no.of permit to each firm
Disadvantages
If cost to reduce pollution is high then firms will rather pay for permit from other firms hence no incentive to reduce pollution Assuming price of permit decreases
