Market Failure Flashcards
What are the two microeconomic problems that require government intervention?
- Inefficiency in resource allocation: due to allocative and productive inefficiency, governments need to get markets to produce at the social optimum level.
- Inequitable distribution of income: distribution of output may not be equitable or fair.
What is market failure?
The failure of the free market to achieve an efficient allocation of resources that maximises the society’s welfare.
Allocative efficiency:
- Society producing and consuming a combination of goods and services that maximises its welfare, when goods and services are produced in the right quantities.
- 1 point on PPC curve
- Consumer and producer surplus is maximised
- Price = Marginal benefit
- Marginal social benefit = Marginal social cost
Productive efficiency:
- All resources fully and efficiently utilised and the cost of producing any given level of output is minimised.
- Any point on the PPC
- Any point on LRAC (firm’s POV)
- Produce at MES (society’s POV)
What are the reasons for market failure?
- Externalities
- Information failure
- Zero provision of public goods
- Market dominance
- Immobility of factors of production
What are externalities?
Some costs or benefits associated with the production or consumption of a good spills over to third parties (parties other than the immediate seller and buyer).
Terminologies for externalities:
MPC: costs to producers of producing one more unit of a good
MEC: costs on third parties when one more unit of good is produced
MSC: costs to society of producing one more unit of a good (MPC+MEC)
MPB: benefits to consumers of producing one more unit of a good
MEB: benefits on third parties when one more unit of a good is produced
MSB: benefits to society when one more unit of a good is produced (MPB+MEB)
What are the types of externalities?
- Negative externalities from production
- Negative externalities from consumption
- Positive externalities from production
- Positive externalities from consumption
What are negative externalities from production?
External costs imposed on third parties from the production of a good or service.
Explain negative externalities from production:
Sellers, in pursuit of self interest, will only consider their own private costs of production, ignoring the external costs. When MEC>0, there is a divergence between MPC and MSC, as MSC>MPC. Free market equilibrium output is where MPC=MPB, however, at this output level, MSC>MSB since MSB=MPB. Welfare would increase if fewer goods are produced, meaning free market equilibrium output is allocatively inefficient and results in overproduction, resulting in deadweight loss.
What are negative externalities from consumption?
External costs imposed on third parties from the consumption of a good or service.
Explain negative externalities from consumption:
Buyers, in pursuit of self interest, will only consider their own private costs of consumption, ignoring the external costs. When MEB<0, there is a divergence between MPB and MSB, as MPB>MSB. Free market equilibrium output is where MPC=MPB, however, at this output level, MSC>MSB since MSB=MPB. Welfare would increase if fewer goods are produced, meaning free market equilibrium output is allocatively inefficient and results in overproduction, resulting in deadweight loss.
What are positive externalities from production?
External benefits enjoyed by third parties from the production of a good or service
Explain positive externalities of production:
Sellers, in pursuit of self interest, will only consider their own private costs of production, ignoring the external benefits. When MEC<0, there is a divergence between MPC and MSC, as MPC>MSC. Free market equilibrium output is where MPC=MPB, however, at this output level, MSB>MSC since MSB=MPB. Welfare would increase if more goods are produced, meaning free market equilibrium output is allocatively inefficient and results in underproduction, resulting in deadweight loss.
What are positive externalities of consumption?
External benefits enjoyed by third parties from the consumption of a good or service.
Explain positive externalities of consumption:
Buyers, in pursuit of self interest, will only consider their own private costs of consumption, ignoring the external benefits. When MEB>0, there is a divergence between MPB and MSB, as MSB>MPB. Free market equilibrium output is where MPC=MPB, however, at this output level, MSB>MSC since MSB=MPB. Welfare would increase if more goods are produced, meaning free market equilibrium output is allocatively inefficient and results in underproduction, resulting in deadweight loss.
What is information failure?
People having inaccurate, incomplete, uncertain or misunderstood data and hence make potentially suboptimal choices about their behaviour, resulting in over or underconsumption of a good or service.
What are the types of information failure?
- Imperfect information
2. Asymmetric information
What is imperfect information?
Individuals not knowing the full private costs or benefits of consuming a good.
How does imperfect information result in over-allocation of resources?
Imperfect information results in people being unaware if the true private costs arising from consuming a good, thus overestimating their own private benefits and over-value the good. Demand for the good under imperfect information is higher than that under perfect information. Good will be over-consumed and the market fails to achieve allocative efficiency as too many resources are diverted to the production and consumption, which will result in a welfare loss.
Supplier induced demand through advertisements can increase demand through influencing tastes and preferences.
How does imperfect information result in under-allocation of resources?
Imperfect information results in people being unaware of the true private benefits arising from consuming a good, thus undervaluing their own private benefits and under-value the good. Demand for the good under imperfect information is lower than that under perfect information. Good will be under-consumed and the market fails to achieve allocative efficiency as too few resources are diverted to the production and consumption, which will result in a welfare loss.
What is asymmetric information?
One party involved in a trade having more or better information compared to another when making decisions and transactions.
What are the consequences of asymmetric information?
- Adverse selection
2. Moral hazard
How does asymmetric information result in adverse selection?
When seller knows more about the good than consumer, they will try to conceal information in pursuit of profits. Buyer’s will hence offer a lower price as they cannot tell good quality goods from bad quality ones. This low price discourages sellers of peaches to offer their goods for sale, giving rise to a market for lemons. The market ends up adversely selecting against the peaches.
When buyers’ know more about themselves than sellers, they conceal information in pursuit of utility. Sellers hence charge higher prices, discouraging individuals who don’t need the good as much from buying the good. The sellers are left with an adverse pool of buyers.
Good products and consumers are under-represented while bad products and consumers are over-represented and could even lead to a missing market.
What is moral hazard?
A situation in which economic agents take greater risks than they normally would, because the costs that result from their riskier behaviours would not be solely borne by themselves.
How does asymmetric information result in moral hazard?
Insurance companies lack information about whether and how the insured would change their behaviour when they are protected by the insurance. The insured will have the tendency to take less care to prevent that loss when they are protected from the harmful consequences through the insurance. The riskier behaviour increases the social cost and use of scarce resources, leading to misallocation of resources.
What are the defining features of public goods?
- Non-rivalry in consumption: consumption of the good by one person does not reduce the amount or benefits available to others.
- Non-excludability: impossible or very costly to exclude non-payers from consuming the good once it is provided.
- Non-rejectability: good cannot be rejected by beneficiaries once the good is provided.
Why are public goods not provided by the free market?
Good is non-excludable, thus no one has the incentive to pay for it resulting in the free-rider problem. Revenue cannot be generated. Additionally, to achieve an allocatively efficient provision of a public good, price should equal to MC, but since MC of providing good is zero, price should be zero. Profit maximising firms will never provide a good for free.
How does market dominance lead to allocative inefficiency?
Allocatively efficient output level is where P=MC, however when firms have market dominance, they have price-setting ability, and hence set the price where MC=MR to maximise profit. P>MC, there is underproduction and consumption of the good, sum of consumer and producer surplus falls, no allocative efficiency.
How does market dominance lead to productive inefficiency?
With market dominance, firms can retain supernormal profits, thus can be X-inefficient due to complacency. They do not incur lowest LRAC possible, resulting in wastage of resources and productive inefficiency.
How does market dominance lead to dynamic inefficiency?
Due to high barriers to entry, firms may not have the incentive to engage in R&D, product quality falls over time, resulting in dynamic inefficiency.
What are the two types of immobility of factors of production?
- Occupational immobility
2. Geographical immobility
What is occupational immobility?
Barriers to moving factors of production between different sectors of the economy, resulting in some factors being unemployed. For example, labour often experiences occupational immobility because occupation-specific skills may not be easily transferrable, resulting in unemployment or underemployment, wasting resources. Demand for goods in certain industries may fall, resources may be unutilised or underutilised, wasting resources.
How does occupational immobility lead to market failure?
Labour often experiences occupational immobility because occupation-specific skills may not be easily transferable, resulting in unemployment or underemployment, wasting resources. Demand for goods in certain industries may fall, resources may be unutilised or underutilised, wasting resources.
What is geographical immobility?
Barriers to labour moving from one area to another to find work, due to family and social ties, financial costs involved in moving, huge regional differences in house prices and differences i the general cost of living between different regions.
How does geographical immobility lead to market failure?
Discourage labour from moving into area with shortage of labour, while perpetuating high unemployment rates in other areas. Actual output is less than potential output. The longer people are unemployed, the less likely they retain their skills. Unemployment represents a waste of resources.
What is inequity?
Unfair distribution of essential goods and services.
What are the causes of inequitable distribution?
- Excessive income inequality
2. High prices of essential goods and services in the free market
How does excessive income inequality lead to inequity?
Causes market to channel more resources to providing normal and luxurious goods due to high effective demand from higher income groups and produce fewer essential goods due to lower effective demand by lower income groups.
How do high prices of essential goods and services lead to inequity?
Lower income groups are unable to afford and gain excess to these goods and services.
How can inequality be represented?
- Lorenz curve: 45 degree line is the line of perfect equality. The further a line deviates from it, the greater the income inequality.
- Gini coefficient: ratio of area of deviation over area under the line of perfect equality. Greater deviation of Lorenz curve, larger Gini coefficient, higher income inequality. Range is from 0 to 1.
What causes wage inequality?
Demand for labour service being high relative to supply.
Workers being more productive and generating higher returns, more educated and skilful and possess some innate talent have more limited supply and hence earn higher wages.
What are the causes of income inequality?
Presence of unequal factor endowment means free market mechanism can yield large non-wage incomes for those who possess valuable financial assets and physical assets. They receive high non-wage income due to luck. Those with low wages have little ability to save and hence cannot accumulate financial and physical assets to earn non-wage incomes.
What are the effects of income inequality and inequity?
- Inequitable distribution of resources: poor are unable to afford essential goods or services
- Unequal access to opportunities: rich people have better connections, better education which could mean better job security and higher income. Inequality causes lack of social mobility, income inequality persists, unequal access to opportunities persist.
- Others: political and social instability, poor prosperity of country, bad health and mental wellbeing, reduced social cohesion.
Rational decision making by a government:
Objective: maximise society’s welfare
Constraints: budget, scarce resources
Information: need both quantitative and qualitative information about potential costs and benefits
Perspectives: needs to consider the impact and reaction of households and firms and other stakeholders
Benefits: monetary vs non-monetary, short run vs long run social benefits, externalities
Costs: opportunity costs, short run vs long run social costs, externalities
Decision making: MSB=MSC or total social benefits against total social costs
Intended consequences
Unintended consequences: aris due to imperfect information and changing economic conditions
Changes: evaluate outcome and decide whether to continue or change decision
What are the measures used by governments to address externalities?
- Taxes and subsidies
- Legislation and regulation
- Direct provision of goods that are under-consumed/produced
Taxes on negative production externalities:
Government can levy a per unit production tax equivalent to the MEC at the socially optimal output level. MPC curve will shift up to be the same as MSC curve. Market price increases, Qdd decreases. Effective price for suppliers decreases, Qss decreases. New equilibrium quantity where MSB=MSC reached.
