Market Failure Flashcards
What are the 4 functions of price?
Rationing
Signalling
Incentives
Allocates
What is market failure?
Market Failure - Where the market fails to allocate resources at the socially optimal level of output.
What are public goods?
Non excludable - No one can be stopped from using the good, meaning no price can be charged
Non rival - The quantity of the good doesn’t diminish upon consumption, meaning an individual’s consumption will not affect another’s.
What is the Free Rider Problem?
Individuals have the incentive to not contribute anything to the provision of the public good, rather waiting for someone else to do so and free-ride off their contributions. They know they can do this due to the characteristics of public goods, with them not being excludable nor rival. If everyone were to do this, the good will not be provided, resulting in a missing market and huge market failure.
Quasi-public goods are a mix between a public and private good. This can help avoid market failure and the free-rider problem. For example, roads can be made excludable through tolls and could be rival in times of high traffic.
What are common resources and how can they lead to the tragedy of the commons?
Common resources are those which no private ownership has been established. For example: forests, seas and air. The lack of private ownership can lead to the tragedy of the commons. This is where private businesses act in their own self-interest and unsustainable keep exploiting common resources (through overconsumption or under-maintenance), eventually depleting this resource.
What is government failure?
Government failure is the idea that the costs of intervention outweigh the benefits. The end result is a worsening of the allocation of scarce resources, harming social welfare and worsening market failure.
- Information failure - e.g. lacking the knowledge of how much tax to place on tobacco
- High admin and enforcement costs
- Regulatory capture - When CEOs and managers of a monopoly can influence the regulator, altering the regulation.
- Unintended consequences
What are merit goods?
Merit goods are those that are more beneficial to consumers than they realise. There is clearly imperfect information about the benefits of such goods, either information failure (no info at all) or asymmetric information. There are also positive externalities in consumption of merit goods, showing how they are under consumed.
What are demerit goods?
Demerit goods are those that are overconsumed and deemed more harmful to consumers than they realise. There is also imperfect information and negative externalities in consumption, resulting in overconsumption.
What are indirect taxes?
Indirect taxes are those that increase a firm’s costs of production but can be transferred to consumers via higher prices. This increase in costs of production will lead to higher prices and lower quantity. This lower quantity will internalise the externality, solving the overconsumption/production. Thus, this will promote allocative efficiency. As well as this, the indirect tax will generate government revenue, which can then be used to subsidise alternatives.
But the tax may be unsuccessful if:
-There is price inelastic demand - This can lead to little change in quantity, rather only leading to a rise in prices.
-Hard to set taxes at the correct level - government do not have perfect information
-Tax could be very regressive, due to it constituting a greater proportion of the income of the poor.
-Black Markets could be created if the government over-tax, creating uncertainty over the quality of the goods.
What are subsidies?
Subsidies are payments given to firms in order to lower costs of production and encourage an increase in output. They are used to solve positive externalities whereby there is underconsumption or underproduction. By lowering costs of production, there will be a clear fall in price and increase in quantity, resulting in allocative efficiency.
But the subsidy may be unsuccessful if:
-There is a high cost of a subsidy - Opportunity cost of government spending.
-Hard to set the subsidy at the right level - Imperfect information
-Firms may not use the subsidy as desired - May just take the subsidy and ‘sit on it’
-Price inelastic demand
What is regulation?
Regulations are rules or laws, enacted by the government, that must be followed by economic agents to encourage a change in behaviour. They create an incentive to change behaviour, punishing firms that do not abide by the regulations. This change in behaviour will aim to move output to socially optimal levels, resulting in allocative efficiency and welfare gain.
However, the are significant issues with regulation, such as:
-High Cost - Both an administrative cost and enforcement costs
-Difficult to set the right regulation - Will it change behaviour?
-Could lead to black markets or firms moving abroad if not
-Risk of government failure
-Equity - Might be unfair on some firms to impose certain regulations
What is state provision?
State Provision - Where the government decides to provide all goods and services in a market. For public goods and merit goods this is desirable due to firms having no incentives to provide public goods and the sheer benefit of merit goods. Also, the good being provided by the state must lead to inequity if left to the free market. For example, both healthcare and education are underconsumed and underproduced but it would also be inequitable for them to be provided to some, but not all, consumers, with it only being fair for everyone to receive healthcare and education. It is assumed that the government is aware of all externalities and the socially optimal level of output, meaning that they can set output at the socially optimal level. The good will be free at the point of consumption, solving market failure and missing markets.
However, there will be excess demand (shown on diagram), leading to negative consequences. Also, there is a high upfront cost in order to take over the entire market, putting a burden on the taxpayer and a high opportunity cost. Furthermore, there is imperfect information and the government does not perfectly know what level to set output. Finally, the state run organisation tends to be highly inefficient, due to the lack of competition and profit incentive.
What are tradable pollution permits?
Tradable pollution permits are a form of regulation to tackle harmful emissions. Firstly, there will be a cap set on the amount of pollution allowed by a permit. Then these permits will be issued in order to match this cap. This allows a firm to make a decision, either aim to pollute less and invest in ‘green’ technologies or buy up the spare permits and continue production as before. No matter how firms decide to act, due to the fixed amount of permits, the externality is always internalised, reducing pollution to socially optimal levels and allocative efficiency. Also, there is a clear LR incentive to invest in ‘green’ technologies, due to the profits from selling spare permits, as well as them not being burdened from reduced amounts of permits.
But pollution permits may not work because:
-They can be very hard to enforce. This is due to pollution emissions being difficult to measure.
-The government has imperfect information, resulting in the amount of permits being set at the incorrect level.
-Need for international cooperation - Firms may be able to move production abroad and continue pollution whilst avoiding extra costs.
Minimum Prices
Minimum Prices are used to discourage the consumption of demerit goods.
- The increased price will contract demand and quantity will fall closer to the socially optimal level of output, internalising the externality.
- If there is inelastic demand there will be little fall in quantity demanded
- Minimum prices are regressive and burden the poor more.
- Could lead to black markets, creating dangerous goods - government failure
- The minimum price is difficult to set at the right level - imperfect information
Maximum Prices
Maximum Prices are used to incentivise demand and consumption of merit goods.
- Could lead to a shortage, with excess demand being created
- Could result in black markets
- Hard to enforce
- Difficult to set at the right level
- High costs - Governments may try to subsidise in order to deal with the excess demand.
