E: Market Failure Flashcards
What price function does this describe: as prices rise, excess demand is removed and only consumers with the ability to pay are able to purchase the good
The rationing function
What price function does this describe: Prices provide important signals to market participants
The signalling function
What price function does this describe: increased prices strengthen incentives to firms to produce more in order to make a profit
The incentive function
What does the allocative function do?
Acts to divert resources to where they can maximise their returns and away from uses where they do not
What is the role of the government in a free market economy?
The government limits itself to protecting property rights of people and businesses using LEGAL system and protecting the value of money or the value of a currency
What is the idea of consumer sovereignty?
Consumer sovereignty is the idea that it is consumers who influence production decisions. The spending power of consumers means effectively they ‘vote’ for goods. Firms will respond to consumer preferences and produce the goods demanded by consumers. It is a manifestation of the ‘invisible hand’
How can we link allocative efficiency and consumer sovereignty?
As advantages of the free market. It enables an efficient allocation of scarce resources so factor inputs go where expected profit is highest which in turn represents the goods/services most desired by consumers (allocative efficiency + consumer sovereignty)
How does the free market benefit the consumer?
Competition and Profit motive:
* Drives innovation, higher profits so better products
* Trade competition reduces domestic monopoly power
* Competitive prices as firms want to up market share
* Stimulates investment - economies of scale - lower prices
Failures of a free market economy
- Public goods not provided
- Demerit goods over produced
- Merit goods underproduced, even education + healthcare
- Those unable to work will live in poverty - inequality
- Monopolies
- Exploited labour and environmental damage
Define market failure
Misallocation of resources
What makes partial market failure different from complete market failure?
The market exists (so it is not a missing market) , but it is consumed or produced in quantities that do not maximise economic welfare.
Why is a lighthouse a public good and not a private good?
It is non-excludable and **non-rival **
What problem can be associated with non-excludability
free-rider problem
What is the marginal cost of supplying a public good to an extra person?
ZERO
Explain how a beach is a quasi-public good
It is semi non-rival because consumption by one consumer does not restrict consumption for another until the beach becomes crowded. It is semi non-excludable because it is difficult or costly to exclude non-paying people. E.g fencin a beach and charging an entrance fee
Why should the government provide public goods?
- Solve the market failure
- Under provision or consumption is prevented so social welfare improves
- Helps affordabilty and access to important services for lower income households
Why should the government NOT provide public goods?
If it becomes a monopoly power, inefficiencies arise from lack of competition. There could be a signigicant opportunity cost
What is the underlying issue behind Tragedy of the commons?
The lack of property rights (confer legal control or ownership). For markets to operate efficiently, property rights must be protected (perhaps by regulation). An un-owned asset carries no incentive for protection. E.g. long-term decline of fish stocks. Individual users aim to maximise their own utility and in doing so, reduce the benefits for everyone and ultimately themselves because it’s overused.
What are externalities?
Externalities are impacts on third parties as a result of a market transaction
essay repeatable, think exchange
Why aren’t externalities reflected in the market price?
Because they lie outside the initial market transaction
multiple choice questions like this one
Social cost = ?
Social costs = private + external costs
specification wording
Externalities occur when…
There is a divergence between private and social costs and benefits
evaluation
How can we use externalities to argue that government interventions may be ineffective?
It is virtually impossible to value an external cost. If the government used a tax to reduce production to the S.O.L this required an indirect tax EQUAL to the value of the external cost
What should we remember when drawing the deadweight welfare loss trianlge
- The traingle forms an arrow that points to the socially optimal outcome
What analysis do we say when explaining negative production externalities
- In the free market, the individual firm will only consider their private costs and benefits and not those of wider society so they will produce at the free market equilibrium Q1P1
- MSC > MPC
- The socially optimal level occurs where MSB=MSC at Q2P2 so there is over production by Q1-Q2 leading to …
- An overall welfare loss equal to the triangle enclosed by the letters AEF
What analysis do we say when explaining negative consumption externalities?
- In the free market, Consumers only consider the private benefits to themselves and not those of wider society
- MPB>MSB
- The socially optimal level occurs where MSB=MSC at Q2P2 so there is overconsumption by Q2-Q1
- This leaves an overall welfare loss equal to the triangle enclosed by the letters FEA
What analysis do we say when explaining positive consumption externalities
- MSB>MPB
- The socially optimal level is where MSB=MSC and at Q2P2 so there is underconsumption by Q1-Q2
- This leaves an overall welfare loss equal to the triangle enlosed by AEF
What analysis do we say when explaining positive production externalities?
- MPC>MSC
- The socially optimal level is where MSB=MSC at Q2P2 so there is underproduction by Q1-Q2
- This leaves an overall welfare loss equal to the triangle enclosed by FEA
just a tip for externalities essays
Carefully consider the 3rd party being affected. If a production process is creating atmospheric pollution; don’t just write “pollution is a negative externality” but write “people living close to the factory may be inhaling air containing particles that are likely to make them ill which may result in them taking time off work and losing income as a result”
The classification of a merit or demerit good depends on ___
A value judgement
Normative
Merit good definition
A good underconsumed in the free market because consumers are unaware of the potential (long term) benefits of consumption and do not take the external benefits into account
Demerit good definition
A good overconsumed in the free market because consumers are unaware of the long term damage from consumption and do not take the external costs in to account
What behavioural economics concepts apply to merit and demerit goods?
- Information failure
- Present value bias
How does Asymmmetric information lead to market failure?
Where there is an imbalance of information between buyer and seller choices can be distorted
Insurance markets are plagued by two important aspects of asymmetric information. What are they?
- Moral hazard - insured consumers are likely to take greater risks knowing that a claim will be paid for by their cover. The consumer knows more about their intended actions than the insurer
- Adverse selection - those most likely to need e.g. health insurance are those most likely to purchase it. Since the insurance company knows this, they raise the avg. price of the cover, potentially pricing out some healthy low risk consumers out of the market
monopoly - only one firm supplying (or largest market share)
Low price elasticity of demand means profits can be increased by restricting output and elevating price when there is a monopoly. What are the issues with this?
- A monopoly producer has no incentive to be economically efficient so consumers will not benefit form the lowest prices or have a choice of products
- The market failure leads to productive inefficiency
- Allocative inefficiency
- Reduced choice for consumers - an equity issue
A mismatch between skills on offer and those required
Give an example of occupational immobility
A former steel worker may not find it easy to switch to working as an IT consultant as they may lack the specific skills required.
Link to structural unemployment
Define geographical immobility
a source of factor immobility that means workers have difficulty moving to locations where jobs are available for reasons such as a lack of affordable housing or family commitments
What is equity
the notion of fairness in the allocation of economic resources
What are the opposite sides of the coin when it comes to views on inequality?
- free market capitalists would argue inequality creates useful incentives among economic agents that positively influence overall national income and can ‘trickle down’ to poorer members of society, raising overall living standards
- critics say inequality creates social tensiosn between the relatively rich and poor, leading to reduced living standards
