Chapter 7 Flashcards
Define equity and explain how this applies to economics.
A fair distribution of resources. The free market fails to lead to a fair distribution of resources if it results in some people living in great affluence while others live in dire poverty.
Define social efficiency.
Production and consumption at the point where marginal social benefits equal marginal social costs. Thus: MSB > MSC = produce more; MSC > MSB = produce less; MSB = MSC = keep production at its current level.
Social efficiency is an example of “allocative efficiency” i.e., the best allocation of resources between alternative uses.
Define the general equilibrium.
Markets are in a constant state of flux; changes in demand and supply cause markets to adjust to a new equilibrium. Thus, it is useful to look at the overall equilibrium to which markets are heading: the general equilibrium.
What makes an economy where all markets are perfectly competitive and there are no externalities socially efficient when there is a state of general equilibrium?
In the absence of externalities, benefits from consumption are confined to consumers. I.e., as members of society their benefit is the whole social benefit. P = MU = MSB. Likewise, the costs of production are confined to the producers: there are no costs imposed on other members of society P = MC = MSC.
What are externalities and how do they contribute to market failure?
Externalities are the side effects, or “third-party” effects, of production or consumption. i.e., the actions of producers or consumers that affect people other than themselves. They can be positive or negative. If other people are affected beneficially, there are said to be external benefits (vs external costs).
Thus, the full cost to society (the social cost) of the production of any good or service is the private cost faced by firms plus an externalities of production (positive or negative). Likewise, the full benefit to society (the social benefit) from the consumption of any good is the private benefit enjoyed by consumers plus any externalities of consumption (positive or negative). There are 4 main types of externality.
Define the external costs of production (MSC > MC)
Most common and important form of externality. E.g., when waste is dumped into a river, the community bears costs additional to those borne by the firm. The marginal social cost (MSC) of chemical production exceeds the marginal private cost (MC). The MSC curve is above the MC curve. This problem occurs in a free-market economy because no one has legal ownership of air/rivers, and no-one cause prevent or charge for their use. Thus control must be left to the government.
Define the external benefits of production (MSC < MC)
If a timber company plants new woodlands, there is a benefit not only to the company itself but also to the world. Thus the marginal social cost of providing timber is less than the marginal private cost to the company. The MSC curve is below the MC curve.
Define the external costs of consumption (MSB < MB)
When people use their cars, other people suffer from the exhaust fumes, congestion, noise, etc. These negative externalities make the marginal social benefit of using cars less than the marginal private benefit for the motorist. Thus, the MSB curve is below the MB curve. When there are negative externalities in consumption, the actual level of consumption is too great from society’s point of view.
Define the external benefits of consumption (MSB > MB)
When people travel by train, etc other people benefit by there being less congestion/accidents/exhaust. Thus, the marginal social benefit of rail travel is greater than the marginal private benefit to the rail passenger. There are external benefits from rail travel. The MSB curve is above the private MB curve.
To summarise: whenever there are external benefits, there will be too little produced or consumed. Whenever there are external costs, there will be too much produced or consumed. The market will not equate MSB and MSC.
What are public goods and how do they contribute to market failure?
A category of goods where the positive externalities are so great that the free market would not produce them at all (e.g., street light and public services such as police).
What 2 characteristics do public goods have?
- Non-rivalry. Where the consumption of a good or service by one person will not prevent others from enjoying it. This makes them socially desirable, but privately unprofitable (e.g., footpath; no single individual would pay to have this built along their street as the private benefit is too small relative to the cost).
- Non-excludability. Where it is not possible to provide a good or service to one person without it thereby being available to others to enjoy. Others would get the benefits for free and have no incentive to pay themselves. This is known as the free-rider problem (where it is not possible to exclude other people from consuming a good that someone has bought).
How does monopoly power contribute to market failure?
Whenever markets are imperfect the market will fail to equate MSB and MC even if there are no externalities. A monopoly will produce less than the socially efficient output.
What is deadweight loss under monopoly?
Consumer and producer surplus. Consumer surplus is the excess of consumers’ total benefit (or utility) from consuming a good over their total expenditure on it. Producer surplus is another name for profit. Monopoly profits are larger than profits under perfect competition. Consumer surplus, however, will be much smaller. The net loss of total surplus is known as the deadweight welfare loss of monopoly.
How does ignorance and poor decision making contribute to market failure?
There is often a great deal of ignorance and uncertainty from consumers and producers. Some goods are only purchased a few times in a lifetime. Consumers may not be aware of quality until after they purchase these goods. Advertising can contribute to ignorance by misleading people.
Firms are often ignorant of ways to be more efficient, prices, costs, etc. Thus, the government may feel the need to protect people from poor economic decisions on their own behalf. It may feel people will consume too many harmful things (taxes to discourage smoking). It may feel that people consume too little of things that are good for them (i.e., merit goods). Thus, it may subsidise these or provide them for free (e.g., healthcare).
How can people lose from poor decision made by others acting on their behalf?
Principal-agent problem. Inherent danger for the principal: there is asymmetric information. The agent knows more about the situation than the principal. The agent may not act in the principal’s best interests and may get away with it because of the principal’s imperfect knowledge.
How can principal’s tackle the problem?
- Have some way of monitoring the performance of their agents
- Must be incentives for agents to behave in the principals’ interests.
How can the government correct externalities?
Use taxes and subsidies. Tax goods/activities where the market produces too much and subsidise those where the market produces too little. The government should impose a tax equal to the marginal external cost (or grant a subsidy equal to the marginal external benefit).
What are the benefits of the government using taxes and subsidies?
It still allows the market to operate. It forces firms to take on board the full social cost and benefits of their actions. i.e., it “internalises” the externality. It also has the flexibility of being adjustable according to the magnitude of the problem. When firms are taxed for bad practices they are encouraged to find socially better ways of producing. Likewise, when good practices are subsidised, firms are given the incentive to adopt more good practices.
What are the disadvantages of taxes and subsidies?
- Unfeasibility of using different tax and subsidy rates. It would be administratively very difficult and expensive, if not impossible, to charge every offending firm its own particular tax rate (or grant every relevant firm its own particular rate of subsidy).
- Lack of knowledge. It is not possible to measure marginal external costs and apportion blame. (however, it is possible to charge firms by the amount of a particular emission).
How can the government determine which public goods should be provided?
With a pure public good, once it is provided the marginal cost of supplying one more consumer is zero. (e.g., lighthouse, there is no extra cost of providing the service to additional passing ships). In order to determine if the construction of a new public good should go ahead cost benefit analysis is used.
How does the government regulate monopolies and restrictive practices?
In Australia it is the ACCC. They prohibit various forms of anti-competitive practices, including:
* Price fixing and market sharing
* Elimination of a competitor through predatory pricing
* Resale price maintenance, which involves a supplier specifying minimum prices at which a good may be resold.
Proposed mergers involving assets greater than specified amounts have to be referred to the ACCC for approval.
How does the government manage ignorance and poor decision making?
Provides the direct provision of information (e.g., info on jobs provided by the job network, or the effects of smoking or eating certain foods. As people may undervalue and thus under consume merit goods the government may provide these for free or subsidise them.
What are 4 reasons that the government provides/subsidises merit goods?
- Social justice. Society may feel that these things should not be provided according to ability to pay. Rather they should be provided as an equal right based on need.
- Large positive externalities. People other than the consumer may benefit substantially. E.g., if a person is treated for an infectious disease other people benefit by not being infected.
- Dependants. E.g., if education were not free and parents chose to invest in it, the quality of children’s education would depend not only on parents’ income but also how much they cared.
- Ignorance. Consumers may not realise how much they will benefit (e.g., with healthcare).
What is the environmental problem?
Resources become scarcer; their prices rise. This encourages people to use less of them, either by more efficient technology or by switching to renewable alternatives. Public opinion can put pressure on governments and firms. Part of the problem is the expanding world population, but a major cause is the failure of the market system.
What are 4 ways market failures do not provide adequate protection for the environment?
- The environment as a common resource. Nobody owns the environment; it has the characteristic of “non-excludability”. Most environmental resources are scarce, there is “rivalry” in their use. One person’s use of a common resource diminishes the amount or quality available for others. At a zero price, these resources will be overused. This is known as the “tragedy of the commons”.
- Externalities. When people pollute the environment, the costs are borne mainly by others. Because no one owns the environment, there is no one to enforce property rights over it.
- Ignorance. Many people have caused environmental damage without realising, especially when the effects build up over a long time. So even if people want to be more environmentally friendly, they might not have the knowledge required to do this.
- Intergenerational problems. The harmful effects of many activities are long term, whereas the benefits are immediate. Thus, consumers and firms may be prepared to continue with certain practices and leave future generations to worry about the environmental consequences.
What are environmental charges?
Where the government imposes environmental charges on consumers or firms for using natural resources. Emission charges could be levied on firms discharging waste.
What are environmental (green) taxes and subsidies?
Rather than charging for environmental use, a tax could be imposed on the output (or consumption) of a good wherever external environment costs are generated. These are known as green taxes. The rate of tax should be equal to the marginal external control cost. The alternative is to subsidise activities that reduce pollution (e.g., the installation of roof insulation).
How do laws and regulations tackle pollution?
Traditional way has been to set maximum permitted levels of emission or resource use, or minimum acceptable levels of environmental quality, and then to fine firms contravening these limits. There have to be enough inspectors to monitor the amount of pollution and the fines have to be large enough to deter firms from exceeding the limit.
Given uncertainty around environmental impacts, it is better to set tough emissions standards. These can be relaxed later, but it is not possible to reverse damage later. Regulations are more straightforward to devise, easier to understand by firms, and easier to implement than taxes.
How do tradeable permits tackle pollution?
Each firm is given a permit to produce a given level of pollution. If less than the permitted amount is produced the firm is given a credit. This can then be sold to another firm, allowing it to exceed the original limit.
What are 2 advantages of tradeable permits?
- They combine the simplicity of regulations with the benefits of achieving pollution reduction in the most efficient way.
- Firms have a financial incentive to cut pollution. This might make it easier for governments to set tougher standards (i.e., set lower permitted levels of emission).
What are 4 disadvantages of tradeable permits?
- Difficult to distribute the permissions in a way that all firms regard as fair.
- Trade may lead to pollution being concentrated in certain geographical areas
- It may reduce the pressure on dirtier factories or countries to cut their emissions.
- Once the system is in place, the government might feel the pressure is off to reduce permitted levels.
How does education tackle pollution?
If people were more aware of environmental issues and the consequences of these, consumption habits could change and more pressure would be put on firms to improve their “green credentials”.
