Market Failure Flashcards
Define market failure
where the free market mechanism fails to achieve economic efficiency
Define externality
where third parties affected y the production or consumption of a good/service
Define negative externality of production
Production of a good/service has a negative impact on a third party
Define negative externality of consumption
consumption of a good/service has a negative impact on a third party
Define positive externality of production
production of a good/service has a positive impact on a third party
Define positive externality of consumption
consumption of a good/service has a positive impact on a third party
Define information failure
not all the participants in an economic exchange have perfect knowledge about the details of that exchange
Define asymmetric information
where information is not equally shared between two parties
Define moral hazard
the risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information
Define merit goods
Good/service that brings more benefits to consumers than they expect. government thinks they are under-consumed
Define demerit goods
Good/service that brings less benefits to consumers than they expect. government thinks they are over-consumed
Define public goods
goods/services provided without profit to all members of society
Define quasi-public goods
have characteristics of both private and public goods
define free ride
someone who receives the benefit but allows others to pay for it
define non-excludable products
once a good/service is provided no person can be excluded from benefiting
define non-rival products
when consumption of a good/service by one person does not reduce the amount available for the other
what are private costs
costs incurred by individuals or firms by producing/consuming the good
what are external costs
costs incurred by a third party as a result of producing the good
what are external benefits
benefits gained by the third party
what are social benefits
private benefit + eternal benefit. Total benefit to society.
what is an incomplete market
when the total supply is insufficient to meet the needs of consumers
what is a missing market
services where it is not viable for the private sector to provide
what are private benefits
gains to individuals/firms from consuming/producing an item
what are social costs
private costs + external costs
what is a cost benefit analysis
technique for assessing the monetary social costs and benefits of a capital investment project over a given time period
in market failure only what is equal to demand
marginal private benefit
in market failure only what is equal to supply
marginal private cost
what is welfare loss
what society is losing out on
example of negative externality of production
factory pollution causing ill health in the local community
example of positive externality of production
companies providing first aid classes for their workers so they can save lives in the community
example of negative externality of consumption
traffic congestion/noise pollution/passive smoking
example of positive externality of consumption
education like becoming a doctor
What is MSC
cost to society of producing an extra unit of a good
What is MSB
additional benefit that society gains from consuming an extra unit of a good
What can cause allocative inefficiency
when there are costs and benefits not included by the price mechanism so resources can not be allocated efficiently. Society is worse off
Explain negative externalities of consumption diagram
In the free market only private costs are considered so equilibrium is MPC=MPB. However, socially optimum level of output is where MSC=MSB. MPB>MSC (consumers behavior negatively impacts others). Shown by MSB left of MPB. Good is over consumed and there is a welfare loss.
Explain the diagram for positive externalities of consumption
Optimum level of output for society is MSC=MSB. Consumers only consider MPB so are willing to pay a lower price and consume less. Under consumed. MSB>MPB. By consuming Q1 at P1 society is better off than under free market by the welfare gain.
Explain the diagram for negative externalities of production
Socially optimum level is MSC=MSB. MPB=MSB (no externalities of consumption). MPC>MSC (behavior negatively impacting third party). Overproduced as producers only have to pay lower private costs. Welfare loss shows allocative inefficiency causng the divergence of MSB and MSC.
Explain the diagram for positive externalities of production
Optimum level of output is MSC=MSB. In a free market only MPC is considered so lower quantity and price. Underproduced for what is best to society. For each unit consumed between Q0 and Q1. MSC>MPC. Q1/P1 is better than under free market by welfare gain shown. Allocative inefficiency.
What is adverse selection
A situation in which a person at risk is more likely to take out insurance
What is symmetric information
Perfect information is known by both buyers and sellers. (full knowledge of: price, costs, availability, benefits, substitute goods)
What does asymmetric information cause
Buyers and sellers can’t make decisions that best reflect their preferences without perfect information causing allocative inefficiency.
What is welfare gain
extra producer and consumer surplus that could be otherwise gained by society, shows there is a misallocation of resources (allocative efficiency)
Characteristics of a merit good
positive externalities of consumption/production, underconsumed/underproduced, governments decide to intervene by providing them or funding them. Normative judgement of what is and isn’t a merit good.
What can government intervention of a merit good lead to
Can help overcome information failure and provide merit good at low/no cost, society can capture available welfare gain and consume more allocative efficient level of production
Deciding whether a good is a merit good
normative based on opinions and beliefs, positive externalities don’t always mean merit good, opportunity cost of the intervention/
Characteristics of demerit good
negative externalities of consumption/production, overocnumed/overproduced, government has decided to intervene in the market. Goods are usually sold by the private sector and there may be imperfect information. Normative judgement
Government intervention for a demerit good
helps overcome information failure and reduce consumption by raising the price and reducing availability/banning their consumption. Reduces welfare loss of MSC>MPC and consume more allocatively efficient.
Deciding whether a good is a demerit good
normative, negative externalities don’t always mean demerit good, opportunity cost (larger the externality more important to intervene)
Characteristics of public goods
non-excludable and non-rivalry (leads to 0 MC)
What does the existence of free riders lead to
price mechanism can not work properly to find a free market equilibrium, allocatively inefficient
Analysis of public goods
Non-excludable characteristic means it will not be provided by the private sector (free riders), so less revenue. Causing market to be allocatively inefficient. To maximise social utility and become allocatively efficient the government must legally enforce payment or provide the good themselves.
Advantages of a public good
increases equality, economies of scale (single provider so gain bigger economies of scale)
Disadvantages of public good
expensive for government (high opportunity cost), no market disciplining producers (missing markets/producers have higher costs), reduces innovation (free market adapts faster to meet needs)
What is an indirect tax
Tax levied on expenditure of goods or services
What is a direct tax
tax charged directly to an individual based on a component of income
Incidence of a tax
the way in which the burden of paying a sales tax is divided between buyers and sellers
What is an ad valorem tax
Tax levied on a commodity set as a percentage of the selling price
Excess burden of a sales tax
the deadweight loss to society following the imposition of a sales tax
What is hypothecation
spending tax revenue in the same area in which the revenue was generated e.g. tax on tobacco, revenue spent on reducing the harm to third parties by the consumption
Explain the diagram showing the effect of a tax
MSC(S1) is left to MPC(S0) so supply is reduced as producers costs are higher. Size of tax is P1-P2. Shaded area is tax revenue. Tax causes market clearing prices to rise from P0-P1 and there is a contraction in demand. If it was a demerit good, now closer to the social optimum where MSC=MSB and so more allocatively efficient and reduces market failure. Consumer burden of tax is Q0(P1-P0). Producer burden Q0(P0-P2)
What does the tax revenue from a good depend on
PED -inelastic (relative to PES) leads to smaller fall Qd (heavy tax to reduce Qd)
What does the amount of tax passed onto the consumer depend on
PED - more elastic the more responsive the consumer is to price, the less taxpassed down to consumer
What does the effect of a tax depend on
the size (the larger the tax, the larger the fall in Qd), PED (inelastic, less effective)
Advantages of a tax
market based solution (external cost included in price of the good, reducing negative externalities), raises revenue (can be hypothecated)
Disadvantages of a tax
hard to value negative externalities (difficult to measure external cost, and base the tax on this), redistribution effects (indirect taxes are regressive), collection issues tax avoidance/expensive to collect)
Judging taxation
indirect taxes are less effective for good with inelastic ped. size of tax determines effectiveness.
What is a subsidy
grant given by the government to producers to encourage production of a good or service
Effect of a subsidy on a good
merit goods tend to be subsidised. Lowers the price as i is extra money the producer receives. Substitution effect leads to consumers buying less goods that cause negative externalities.
Explain the subsidy diagram
Supply shifts right as producers costs are reduced. Subsidy is equal to P1-P2 per unit. Shaded area is total cost to government. Price falls from P0-P2. Extension in demand - new market equilibrium at P2Q1. If good is underproduced it is closer to the new equilibrium (where MSC=MSB), increasing allocative efficiency. Causes a welfare gain to society.
When do subsidies work well
if demand is price elastic, a small subsidy will lead to a bigger increase in production, and output closer to social optimum/allocative efficiency.
Advantages to a subsidy
market based solution (aligns incentives of producers and consumers to be allocative efficient), better if PED is elastic
Disadvantages to a subsidy
expensive for government (high opportunity cost), benefits may mainly benefit producers (depends on PED/PES), effectiveness depends upon level of competition (lower comp, less incentive to pass subsidy to consumers)
Why a subsidy compares favorably to a tax
encourage consumption of a merit good, tax can fund the subsidy (more effective if used together)
Why a subsidy compares unfavorably to a tax
costs money rather than raising money (government has limited funds), may undermine government objectives
What does state provision mean
the funding comes from the government and the good/service is provided by the government or private companies
Why does the government provide state provision
increase consumption of merit goods, ensure that public goods are produced, reduce inequality and redistribute income
Analysis of merit good diagram
state provision acts as a signal, changing consumer taste shifting MPB right to MSB. Increases quantity consumed, as price falls, when left to the free market. Government want quantity consumed to increase welfare gain to society. If government ensure high quantity and low price there socially optimum level of consumption may be achieved (allocative efficiency), or closer to optimum.
Advantages of state provision
Reduces inequality (access to the same regardless of income), may support macro objectives (merit/public good have supply side effects)
Disadvantages of state provision
expensive for government (high opportunity cost), missing markets (higher producer costs), encourages dependence (rely on state), reduces innovation (free market adapts more quickly to innovation)
Why state provision compares favorably to a subsidy
subsidy cannot lead to provision of public good whereas state provision can, state provision increases equality more than a subsidy
Why state provision compares unfavorably to subsidy
state provision is more expensive as consumer contributes nothing, non-market solution may encourage lack of discipline along providers
What are buffer stocks
A scheme intended to stabalise the price of a commodity by buying excess supply in periods when supply is high, and selling when supply is low
Explain the buffer stocks diagram
with no intervention price fluctuates between PI and P2 creating uncertainty for producers. High level of uncertainty disincentivizes producers from investing further exacerbating future supply an price volatility. Government buffer stock buys Q3-Q1 produce when the price falls below Pmin, increasing price and certainty. . Sold (Q2-Q4) when shortage causes price to rise above Pmax.
In the buffer stocks diagram why is supply inelastic
because supply can only be increased in the long term. Market failure caused by imperfect future information is corrected, to some extent from buffer stocks. quantity consumed increases from Q2 to Q4, closer to allocative efficient level. High consumer utility, reduces inequity caused by differences in wealth.
Advantages of buffer stocks
market based solution (incentivises producers to continue investment), may be self-funding (profits from shortage years can pay for produce bought in glut years)
Disadvantages of buffer stocks
limited deployability (limited to commodities that can be stored for years), may be expensive
Why a buffer stock compares favorably to a subsidy
operating a buffer stock may be cheaper if it is self-funding, as a market based solution producers are disciplined by competition instead of becoming dependent on subsidies
Why a buffer stock compares unfavorably to a subsidy
if surplus is large cost of purchasing may be unaffordable, in a surplus year buffer stock increases prices instead of lowering them like a subsidy
What does putting a maximum price on a good do
increases consumption and therefore consumer utility and make a good more affordable. However if it is set at above equilibrium price it will have no impact. If it is set below it leads to excess demand and a shortage
What effect does a minimum price have
increases production, the price producer receives and therefore producer profit. If it is set below equilibrium price it will have no impact, if it is set above the free market equilibrium it leads to excess supply and a surplus
Analysis of the minimum price diagram
minimum price P1 is set above market clearing price P0. Incentivizes producers to increase production to Q2. However fewer consumers can buy the good so only Q1 is consumed. Leading to surplus of Q1-Q2. Government pay maximum price to produce not sold leading to government expenditure of P1(Q2-Q1)
When may a minimum price be imposed
a good that causes negative externalities of consumption, imposes external cost on third parties which is not taken into account and is over consumed. Reduces consumption to MPC=MSC improving allocative efficiency
Analysis of maximum price diagram
maximum price is set at P1 below the market clearing price of P0. Disincentivizes producers and production falls to Q1. More consumers can afford it so consumer demand is Q2 leading to shortage of Q2-Q1. Lower income groups can afford the product improving equality.
Advantages of maximum price
cheap to impose as a method to improve equality, reduces monopoly’s power to profit maximise and exploit customers.
Disadvantages of maximum prices
shortage created (some consumers who are willing to pay more can not purchase reducing utility), may need to allocate rations, may lead to black markets forming
Advantages to minimum price
minimum income that producers receive incentivizes them to invest, stockpiles can mitigate the impact of severe weather
Disadvantages to minimum price
lowers utility (high price so less consumed), opportunity cost of paying minimum price is lower than spending on healthcare, allocative inefficiency
Why a maximum price compares unfavorably to a subsidy
fail to increase consumption as production is reduced, may be necessary to subsidize production alongside a maximum price.
Why a minimum price compares unfavorably to a tax
both reduce consumption and sometimes negative externalities but tax raises revenue. To improve allocative efficiency impose a tax alongside minimum price and hypothecate revenue to mitigate the impact of negative externalities
What is prohibition
Attempt to prevent consumption of a demerit good by declaring it illegal
How can regulations effect the sale of goods
Can restrict or ban the sale of demerit goods, are backed up by legislation that threaten fines and imprisonment against producers. Offer producer and consumer protection from asymmetric information
Analysis of legislation and regulation diagram
effect of prohibition is to threaten legal consequences leading to most suppliers ceasing production shifting supply from S0 to S1=D1. Leading to lower consumption of Q0 to Q1 at a higher price of P0 to p1.
Effect of prohibition
regulates demerit goods (social costs higher than private costs. Consumers may be unaware of consequences). So reduces inequity by protecting poorest from them selves Exists when allocatively efficient level of output is 0 (no circumstances where society is better off by consumption)
Advantages to legislation/regulation
cheap to create (exsisting infrastructure enforce regulations), self funding (fines pay to enforce rules)
Disadvantages to legislation/regulation
difficult to set, can increase firms cost, expensive to enforce, may require international agreement
Why regulation compares favorably to a tax
allocative efficient level of consumption is 0, so more effective to prohibit that set a tax. Behavior government wants to discourage does not have a price on it, a tax cannot change behavior.
Why regulation compares unfavorably to a tax
tax raises more revenue than fines and is cheaper to enforce. Costs imposed upon a business of a tax are easier to measure whereas costs of a regulation are more difficult to predict
What is information provision
when the government educates the public to help consumers make better choices
What effect does information provision have
firms and households make better decisions, closer to symmetric information which is needed for allocatively efficiency and improves equality as it prevents buyers and sellers from being exploited. Reduces market failure (e.g. with negative externalities)
Advantages to information provision
cheap, firms can be forces to provide information on their packaging which the consumer can not avoid seeing
Disadvantages to information provision
ineffective against irrationality (e.g. addicts), limited impact (may be needed alongside other forms of market intervention)
Why information provision compares favorably to legislation
imposed more quickly at lower opportunity cost, and more effectively without legislation by threatening legislation if it fails to self-regulate
Why information provision compares unfavorably to legislation
the size of market failure that can be tackled by information provision is smaller than legislation. If negative externalities are large information provision may fail.
What could government failure be caused by
political self interest, regulatory capture, disincentive effects, government intervention and evasion, policy decisions based on imperfect information, unintended consequences
How can political self interest cause government failure
pressure is exerted by special interest groups leading to inappropriate spending and tax decisions. Decisions may not have the normal cost benefit analysis to determine social costs and benefits
How can policy myopia cause government failure
a quick fix solution may cause conflicts between policies e.g. building more roads or widening them may encourage more car use and lead to increased CO2 emissions exacerbating that market failure
How can regulatory capture cause government failure
Industries under the control of a regulatory body appear to operate in favor of the vested interest of producers rather than consumers. Perhaps the regulator is preventing the ability of the market to operate freely
How can disincentive effects cause government failure
taxes and legislation that reduce income and wealth inequalities can worsen incentives and productivity e.g. national minimum wage may raise wages above free market level increasing unemployment
How can government intervention and evasion cause government failure
A decision by the government to raise taxes on de merit goods such as cigarettes might lead to an increase in attempted tax avoidance (tax evasion) smuggling and the development of grey markets where trade takes place without tax
How can policy decisions based on imperfect information cause government failure
may underestimate cost of large infrastructure projects such as creating a central NHS IT system for patient records. May go ahead with a project without full amount of information required for a proper cost benefit analysis
How can bureaucracy and red tape cause government failure
can prove costly to administer and enforce. Estimated social benefits of a particular policy might be lower than administrative cots of introducing it. Furthermore there may be increased costs to business adding to an external cost of government failure.
Analysis of government failure
caused by under or over intervention in a market. An impact may be to cause misallocation of scarce resources. If too many or too few are used allocative efficiency has not been achieved because MSC does not equal MSB due to government intervention
Consequences of government intervention are less severe than market failure
known issue(potential downsides of solution are unlikely to be worse than the issue), smaller welfare loss (fewer misallocated resources)
Consequences of government intervention are more severe than market failure
larger welfare loss (over correction leads to more misallocated scarce resources so less allocatively efficient), spills over in different field (ore cause issues in an area of more significance than original market failure that was being addressed)
