Economics 2.7 - Role of gov in microeconomics

Question 1

Market failure

Answer 1

The failure of markets to achieve allocative efficiency. Markets fail to produce the output at which MSB = MSC; social or community surplus (consumer surplus + producer surplus) is NOT maximised. Free market fails when there is a surplus/shortage.

Question 2

Price controls

Answer 2

Prices imposed by an authority, set above or below the equilibrium market price.

They refer to the setting of minimum or maximum prices by the government (or private organisations) so that prices are unable to adjust to their equilibrium level determined by demand and supply. Price controls result in market disequilibrium, and therefore in shortages (excess demand) or surpluses (excess supply)

Question 3

Price ceiling (max. price)

Answer 3

A price imposed by an authority and set below the equilibrium price. Prices cannot rise above this price.

Often results in a shortage (excess demand). Placed to make a good/service more affordable (esp low-income individuals/households)

Question 4

Price floor (min. price)

Answer 4

A price imposed by an authority and set above the equilibrium price. Prices cannot fall below this price.

Often results in a surplus (excess supply). Placed to provide more income/wages to workers (esp low-income + low-skilled workers)

Question 5

Why do gov intervene?

Answer 5

1. Earn gov. revenue
2. Support firms
3. Support households on low incomes
4. Influence production levels
5. Influence consumption levels
6. Correct market failure
7. Promote equity

Question 6

What are the main forms of gov intervention in markets?

Answer 6

1. Price controls
2. Indirect taxes + Subsidies
3. Direct provision of services
4. Command + Control regulation and legislation

Question 7

MSC

Answer 7

It is the marginal social cost and is the additional cost incurred by society when producing an additional unit of output

Question 8

MPC

Answer 8

It is the marginal private cost and is the additional cost incurred by producers when producing an additional unit of output

Question 9

MSB

Answer 9

Marginal social benefit is the additional benefit gained by society when consuming an additional unit of output

Question 10

MPB

Answer 10

It is the marginal private benefit and is the additional benefit gained by consumers when consuming an additional unit of output

Question 11

Types of market failure

Answer 11

1. Negative externalities (of production and consumption)
2. Positive externalities (of production and consumption)
3. Lack of public goods
4. Common access to resources and threat to sustainability
5. Asymmetric information
6. Abuse of monopoly power

Question 12

What is an externality

Answer 12

A transaction where someone other than the buyer or seller (a third party), experiences a benefit or loss as a result of the transaction

‘spillover’

-

When there are externalities:

Social benefits = private benefit + external benefit
Social costs = private cost + external costs

Where no externalities exist:

Social benefits = private benefits
Social costs = private costs

Question 13

Negative consumption externalities

Answer 13

SEEN ON MARGINAL BENEFIT CURVE

MSB < MPB

MPB is greater than MSB, reflecting the greater benefit enjoyed by private car users

Question 14

Negative production externalities

Answer 14

eg. Oil production/Coal production

Question 15

Taxing profits of firms that produce negative externalities

Answer 15

Advantages

1. Reduces the size of the externality (shaded triangle box)
2. Internalizes the externality - by compelling producers and consumers to pay the costs of their transaction
3. Brings output down towards the optimal level

Disadvantages

1. Assessing the magnitude of the externality is extremely difficult; governments and firms normally hire cost-benefit analysts to determine this
2. Determining the appropriate tax amount is a challenge
3. Taxing the good may not deter pollution, only reduce it

Question 16

Consequence of PRICE CEILINGS on market

Answer 16

1. Shortages (Qd > Qs)
2. Non-price rationing (first come first serve, favouritism, coupon distribution)
3. Underground/parallel markets
4. Underallocation of resources/allocative INEFFICIENCY
5. Negative welfare impacts

Question 17

Consequence of PRICE CEILINGS on stakeholders

Answer 17

Consumers: partly gain & lose - those who are able to get commodity at a lower price benefit, but due to shortage, some consumers may not be able to buy the good at all

Producers: worse off - they sell less of a good, that too at a lower price –> revenue drops

Government: no gains or losses, but they may become more popular due to people who benefit

Workers: likely to lose, as they may be laid off/fired

Question 18

What are examples of rent controls ?

Answer 18

Consist of a maximum legal rent on housing, which is below the market determined level of rent (the price of rental housing). It is undertaken by governments in some cities around the world to make housing more affordable to low income earners.

Consequences of rent controls include:
1. Housing more affordable for low-income earners
2. A shortage of housing, as Qd of housing at legally maximum rent > Qs (quantity available)
3. Long waiting lists of interested tenants
4. A market for rented units were tenants sublet their apartments at rents above alegal maximum (underground market)
5. Run-down and poorly maintained rental housing because it is unprofitable for landlords to maintain or renovate their rental units since low rents result in low revenues.

Question 19

Examples of food price controls ?

Answer 19

FOOD PRICE CONTROLS:

Method to make food more affordable to low-income earners
When food prices fall then Qd rises → results in shortage of food

1. Non-price rationing methods (such as queues) deal with the shortages
2. Development of underground markets
3. Falling farmer incomes due to lower revenues
4. More unemployment in the agricultural sector
5. Misallocation of resources
6. Possible greater popularity for the government among consumers who benefit

Question 20

Welfare loss

Answer 20

Also known as deadweight loss, it represents social surplus or welfare benefits that are lost to society because resources are not allocated efficiently

A price ceiling creates a welfare loss, indicating that the price ceiling introduces allocative inefficiency due to an underallocation of resources to the production of the good. This is shown by Qs < Qe. Also MB > MC, indicating that society is not getting enough of the good

Question 21

What are the consequences of price floors on the market

Answer 21

1. Surpluses
2. Government measures to dispose of surpluses
3. Firm inefficiency
4. Overallocation of resources to the production & allocative INEFFICIENCY
5. Negative welfare impacts
6. Reduced market size
7. Informal markets

> > > A PRICE FLOOR CREATES WELFARE LOSS, INDICATING THAT THE PRICE FLOOR INTRODUCES ALLOCATIVE INEFFICIENCY DUE TO AN OVERALLOCATION OF RESOURCES TO THE PRODUCTION OF THE GOOD, SHOWN BY QS > QE. ALSO MB < MC, INDICATING THAT SOCIETY IS GETTING TOO MUCH OF THE GOOD.

Question 22

What are the consequences of price floors on stakeholders

Answer 22

Consumers: worse off – must now pay a higher price of the good, while the buy a smaller quantity of it

Producers: gain – they receive a higher price and produce a larger quantity. Since the government buys up the surplus, they increase their revenues. This is the rationale of agricultural price floors. Producers also become protected against low-cost competition and do not face as strong incentives to become efficient producers; they are therefore less likely to go out of business if they are producing inefficiently (higher costs)

Workers: gain – employment increases on account of greater production of the good

Government: lose – when the government buys excess supply, it is a burden on its budget, resulting in less government funds to spend on other desirable activities in the economy. The costs to the government are paid out of taxes (therefore, taxpayers) and there are further costs of storing the surplus of subsidising it for export (sale to other countries).

Stakeholders in other countries: Surpluses are sometimes exported, leading to lower world prices due to large supply. Countries that do not have price support are forced to sell their agricultural products at low world prices. The low prices in these countries signal to local farmers that they should cut back on their production, resulting in an underallocation of resources to these products/ These events often work against the interests of less developed countries. Overall, a global misallocation of resources, as price floors cause high-cost producers to produce more and low-cost producers to produce less than the social optimum