Market Failure Flashcards
Technical Efficiency
When firms pursue the least cost method of production, where firms produce at minimum average cost
Allocative Efficiency
When resources are allocated to its best use
Define “pareto optimality”
When market is in equilibrium, with no external influences
Define “market failure”
A situation when the free market under or over allocate good or services, causing over- or under-consumption and production.
Demerit goods
Private goods that has negative externalities associated with its consumption
e.g. smoking, porn, drugs, prostitution, alcohol
Merit goods
Private goods that has positive externalities associated with its consumption
e.g. education, medical care
How does government response to fix market failure?
- Direct provision
- Taxation
- Subsidizing
- Negative and positive advertising
- Extending property rights
- Legislation
Market failure can arise with…
- lack of public goods to benefit society
- inequality of wealth/income
- people make decisions based on imcomplete information
- people make decisions without considering long term
- under supply of merit goods
- over supply of demerit goods
- abuse of monopoly power (firms)
- externalities (4 types)
Public Goods Characteristics
Non-rivalrous – jointly consumed by people without reducing the amount available to others
Non-exclusive – good or service can be used by people who do not pay for them
Thereby consumers have no incentive to pay for the good – leads to the “free-rider” problem
Private goods characteristics
rivalrous and exclusive
What can a government do to intervene in response to a need for public goods?
- Direct provision
- Contracting out to the private sector
Common Access Resources (Common Pool)
The ‘gifts of nature’ over which there is no private ownership and therefore no effective means of regulating use of the resource
Possible solutions for Common Access Resources Issues
- Privatization
- Tradeable permits
Privatization
- assigning private ownership of a resource
- creates incentives for owners to protect and manage it sustainably
Tradeable permits
- issuing permits to private users to allow limited amount of extraction in a period of time
- limit exploitation and maintain sustainable usage
(Asymmetric) Information - HL ONLY
Decisions are based on incomplete information – either the buyer or the seller (usually the seller) has more information than the other party
Government solution for asymmetric information
- Legislation
- Regulation
- Provision of information
Opportunistic Behaviour
- This is when one party takes advantage of the fact the other party lacks information
- Results in adverse selection or moral hazard
Adverse selection
- Results of decisions when buyers and sellers have access to different information
- Distorts price and quantity
Moral hazard
Protected party takes more risks because they have more information, passing costs onto others or society
Government solution to income inequality
- Taxation system
- Transfer payments
Taxation system
- Progressive Tax - rate of tax increases the higher the income
- Proportionate Tax - rate of tax is proportionate to income
- Regressive Tax - rate of tax decreases the higher the income
Transfer payment
When government transfers income from one group of the population to another through taxation and benefits
Externality
A spillover in production or consumption that results in social costs or benefits from an economic activity
Negative Externality of Production (NEOP)
A spillover in production that arises in social costs when a firm undertakes an economic activity
Government Solutions for NEOP
- Taxation
- Fines
- Legislation/Government regulations
- Tradeable permits (Allocating Property Rights)
Taxation Evaluation for NEOP
Effective:
- preferred by governments
- generate extra revenue
- cost of collecting it is relatively small
Not Effective:
- should consider the elasticity of good
- inelastic - burden fall on consumer = not good
- burden should fall on producer
Fine
A payment per unit of production to the government
Fine Evalution for NEOP
Effective:
- encourages firms to cut back on production without any pressure on output
Not Effective:
- costly to the government to monitor
- fine needs to be the right amount
- too little = cheaper for firms to pay fine and keep producing
- too much = drive firms out of business = unemployment
Legislation
Laws that are passed to reduce production/consumption
Legislation Evalutation for NEOP
Effective:
- when law is specific and easy to enforce
Not Effective:
- difficult for govenment to balance costs and benefits
- legislation too tough = too restrictive on firms output since theres no point in producing
- legislation too loose = no incentive for firms to cut back
Allocating Property Rights
- using market forces to solve the externality
- transfers ownership of a good or resource from the public to a private firm
Allocating Property Rights Evalution for NEOP
(e.g. forest)
- No property rights = everyone chop down any tree they see
- With property rights = each person has their piece of land, has to cut back production or else no more tree left = young trees could be protected, reseeding
(e.g. oysters) - oyster farm
- An incentive to maintain clean water
- Farmers may sue firms that polute the water to protect river
- Private sector responsible for monitoring, enforcing and clean up
Positive Externality of Production
A spillover in production that arises in social benefits when a firm undertakes an economic activity
Government Solutions for PEOP
- Subsidies or Vocational Training
- Legislation or Government Funding or Decrease Tax
- Advertising to influence behaviour
- Direct provision of goods and services
Subsidy
payment per unit to produce
Legislation for PEOP
- requires firm to produce extra
- similar effect to subsidy
- production cost would come from firm, not government
Government Funding or Decrease Tax
- exempt tax for producers = decrease cost of production
- decrease tax paid for the good for consumers
- same effect as subsidy
Negative Externality of Consumption
A spillover in consumption that arises in social costs when an individual undertakes an economic activity
Government Solutions for NEOC
- Taxation
- Advertising
- Government regulations/legislation
- Nudges (HL)
Taxation Evaluation for NEOC
- ineffective for inelastic goods (e.g. cigarettes)
- people would buy regardless the price (addictive)
- cigarette price increase = more expensive, greater % of income = harms low incomers
- good to generate extra revenue (government)
Advertising Evaluation for NEOC
Effective:
- when cost to individuals > additional benefit to society
Not Effective:
- target wrong audience
- cheap black market goods available
Legislation for NEOC
- government either restrict the consumption of good (18+ for alcohol)
- criminalizes the good (e.g. heroin)
- fines for certain behavior (chewing gum, Singapore)
- advertising in a particular way could also be legislation (health warnings on cigarette packet)
Advertisement for NEOC
- negative advertising to inform the costs to consumers
- in order to decrease consumption
Legislation Evaluation for NEOC
effective when social costs of consuming > cost of putting legislation
e.g. heroin - high social cost
Positive Externality of Consumption
A spillover in consumption that arises in social benefits when an individual undertakes an economic activity.
Government Solutions for PEOC
- Subsidies
- Legislation
- Advertising to influence behaviour
- Direct provision of goods and services
- Nudges (HL)
Examples of Positive externalities of consumption and Merit goods
Examples of Negative Externalities of Consumption and Demerit goods
Subsidy Evaluation for PEOC
Effective:
- size of subsidy = externality
- if subsidy outweighs the opportunity cost of alternative uses of government funds
Government provision Evaluation for PEOC
- if additional benefit to consume the good is high, government might supply good for free
e.g. compulsory vaccines are often free because of high benefit to society
Cost
everything sacrificed or given up when a policy is implemented or a choice is made
Marginal Cost
The additional costs associated with a decision to do a little more or a little less of something
Benefit
things gained when a policy is implemented or a choice is made
Marginal benefit
the additional benefit associated with a decision to do a little more or a little less of something
