Market Failure Flashcards
[policy] Explain how indirect subsidies work to correct market failure
Faced with positive externalities, the government could provide a subsidy that is equivalent to the marginal external benefit at Qs, given by the divergence between MPB and MSB at Qs.
Subsidy - ab per unit output
The benefit that was previously external to the economic agent is now captured in the form of cost savings from the subsidy. Referring to the diagram, the subsidy lowers the MPC from MPC0 to MPC1. The new private equilibrium output is now Qp1, where MPB = MPC1, up from the original equilibrium output Qp. The new private equilibrium output also coincides with the socially optimal output Qs, where MSB = MPB, thus achieving a socially efficient allocation of resources
[policy] Explain with 2 diagrams the possible effects of full subsidy on economic welfare/ alloc efficiency
By making the good free to all consumers who desire it, the government is in fact providing a 100% subsidy.
With a 100% subsidy, MPC=0. The private optimum level of output now occurs at MPC=MPB=0
Referring to the first diagram, the private optimum level of output increases to coincide with the socially optimal level Qs, where MSB = MSC.
Referring to the second diagram, the private optimum level of output increases past Qs to Q1. Where the private optimum level of output is in excess of the socially optimal output, Qs, it creates a deadweight loss of area cde, the excess of MSC over MSB for QSQ1 units. The overall effect on economic welfare depends on which results in a greater deadweight loss: the underconsumption of QpQs units when left to the free market, or the overconsumption of QsQ1 units when the government provides a full subsidy. Where area abc> cde, there is a net improvement in society’s welfare when the good is made free. Where area abc<cde, the policy leads to a larger loss of economic welfare than if the government had not intervened. The latter case is known as government failure.
[mkt failure policy] Explain how imperfect information is a limitation of indirect subsidies, with a diagram drawn
If you use this limitation, how to eval??
A key difficulty in employing indirect subsidies is the determination of the exact monetary value of the marginal external benefit at the socially optimal level. It is difficult to determine with reasonable accuracy the amount of subsidy as the necessary info is simply too vast and the value of externalities are hard to quantify, with externalities being the un-priced effects in the first place.
Given such challenges faced by policymakers, the govt may end up subsidising too much or too little, causing the economy to move from one inefficient resource allocation to another, without necessarily improving economic welfare.
[mkt failure policy] How can subsidies work in the long run, while ensuring fiscal sustainability? EDIT THIS
Subsidies to support the production/consumption of a good would be fiscally unsustainable in the long run, however, subsidies CAN have the effect of supporting an industry’s long run development.
(Keep in mind that For production externalities, subsidies are meant to lower firm’s MPC—ie cost of production + opp
cost)
While the firm may have to rely on subsidies to keep costs down in the initial stage of development, over time, as the scale of the industry (and the firms within the industry) grow, firms are able to enjoy economies of scale (both internal + external). The mass production techniques which they are now able to employ raises productivity, lowering the average and marginal costs of a firm. Eventually, costs fall sufficiently for the firm to be able to compete effectively against substitutes in similar product markets, even without govt subsidies. At this pt, the govt can withdraw the subsidy
What does the effectiveness of indirect subsidies depend on? List with brief explanation. How do we increase effectiveness of subsidies? (2 ways)
Ways to increase effectiveness:
1. Leverage on cognitive biases (loss aversion)
Idea that losses tend to have bigger impact on consumers’ decision making as compared to gains
(WRT EVs)
Gains: stream of cost savings from using energy efficient vehicles
Losses: higher upfront cost
Reduce losses: tax rebate by govt (EV Early Adoption Incentive)
- Increase PED/PES of the good (Ultimate goal to increase consumption/production of the good)
Need to complement with policies that can achieve this
Eg, range anxiety faced by consumers —> install more charging points around the country
What is an example of a subsidy on electric vehicles?
Tax rebates on EVs in Singapore. The government has introduced the EV Early Adoption Incentive (EEAI). From 1 Jan 2021 to 31 Dec 2023, anyone who register fully electric cars will receive a rebate of 45% off the Additional Registration Fee (capped at 20000 dollars). This reduces the upfront cost of purchasing EVs, lowering MPC.
Why would a government choose to impose a ban? (2 scenarios, just state the choices they can make and the graphical analysis of deadweight loss)
Case 1: MEC is so large such that MSC>MSB for all units of output. Where this occurs, additional units of output beyond zero adds more to society’s cost than to society’s benefit, creating deadweight loss. A ban may be imposed on all production/consumption
Case 2: MEC is not as large, socially optimal output occurs at some positive level. The government has the choice of imposing taxes or bans. Sometimes, the administrative costs of collecting taxes incurred by the govt is high due to the complexities in its administration. In these cases, the govt may prefer a total ban.
Effect of ban: (will reduce deadweight loss)
Ban reduces quantity consumed to zero. The underconsumption of OQs units will create a deadweight loss cef, the excess of MSB over MSC for OQs units that are not consumed. Comparing the size of deadweight loss before and after the ban, area cef< area abc, size of deadweight loss decreases, resulting in a net improvement in economic welfare. Where cef>abc, the ban results in a larger deadweight loss than the original and Govt should consider moving away from an outright ban to alternative measures.
Can you write the graphical analysis for bans, and in what instance might it not be suitable as a policy measure?
With a total ban, quantity consumed falls to zero. The underconsumption of OQs units will create a deadweight loss cef, the excess of MSB over MSC for OQs units that are not consumed. Where cef< area abc, the original deadweight loss, the ban will reduce size of deadweight loss, resulting in a net improvement in economic welfare. Where cef>abc, the ban has the effect of creating an even larger loss in economic welfare. Govt should consider moving away from an outright ban to alternative measures.
What are Command and control measures?
Government regulations which aim to control consumption and production via administrative rules and laws
What is an example of a govt regulation to reduce negative externality of cigarettes?
(Hint: location control)
To reduce the harmful effects of smoking on non smokers, such as second hand tobacco smoke, the government has introduced the Smoking (Prohibition in Certain Places) Regulations, which is a ban on smoking in public areas such as indoor public spaces (restaurants, malls, offices) , public transport facilities (MRT stations) and some outdoor spaces (parks and playgrounds). In some locations, designated smoking areas are set up outside building entrances where people are allowed to smoke.
What is compulsory consumption and why is it carried out?
The government may deem the magnitude of the external benefits to be so large that it decides to make consumption of the good compulsory by law. However, it must be recognised that not everyone has the means to pay the market price of the good. Hence, compulsory consumption HAS to be complemented with subsidised/free provision for the policy to be effective.
State what is the Compulsory Education Act and what it entails
The Compulsory Education Act is a law which mandates compulsory primary education for all singaporean children. . All Singaporean children are to attend and complete 6 years of primary education in national schools or schools which offer a curriculum approved by MOE.
Free provision: Primary Education is provided free of charge in Singapore. Additional subsidies such as the Financial Assistance Scheme aim to further support low income households by subsidising or waiving Miscalleneous fees, and the costs of transportation and school supplies —> ensuring all children have access to basic education, regardless of family’s financial situation.
How to talk about quotas for goods that produce negative externality?
It’s often a hybrid measure used along with tradable permits. Not much to say about the determination of the maximum permissible pollution level, which is based on the socially optimum level of production Qs.
What is an example of a quota in Singapore?
In Singapore, the NEA sets a limit on smoke from vehicles that is based on the socially optimum level of production/consumption Qs. A penalty is imposed against vehicles that emit excessive smoke.
State how tradable permits as a hybrid measure works: (market based aspect got two ways of allocating/distributing permits).
The govt will set a limit on the amount of emissions permitted in society at what it deems to be the socially optimal level.
The govt can either:
1. Allocate permits to individual firms. Companies are allowed to trade permits. And if the firm produces less emission than what they are LEGALLY PERMITTED to produce, they receive credits which they can sell to other firms, allowing the other firm to exceed its original limit.
- Alternatively, govt can put up permits in the market for sale through a system of auction
External costs are internalised in the form of the price paid for the permit
Give an example of hybrid measures in Singapore —(hint: COE)
Singapore employs the vehicle quota system to control the number of cars on the road to manage congestion. The LTA determines the number of vehicles available for registration and releases the number of COEs correspondingly. Via a bidding system, the price of COEs are determined.
Is the VQS in Singapore considered tradable permits/cap and trade?
NOO
Describe the negative effect of cognitive biases on the VQS’s effectiveness. (Hint: sunk cost fallacy)
Sunk cost fallacy arises when a person’s decision making is affected by fixed costs rather than marginal costs. There is a tendency for people to continue in an activity once an investment of time, effort or money has been made.
[sunk cost fallacy]
To rationalise high sunk cost paid for the COEs, car owners drive cars more
Additionally, the high COE prices also lowers price sensitivity of road pricing. Drivers less responsive to a rise in ERP rates, undermining effectiveness of ERP in controlling traffic.
Limitations of hybrid measures such as tradable permits/ VQS (permits are sold in the market through a system of auctions)
Effect of distributing permits through a system of auctions /allocating permits based on market forces on equity
[VQS]—> In a bidding system, the allocation of COEs relies on the market forces of demand and supply, ie, allocated based on consumers’ ability to pay. This is considered “unfair” as higher income households are able to outbid the lower-income households, leading to an inequitable outcome. Some families may own multiple cars while others own none, despite needing the car more (eg, having family members who are not physically mobile to take public transport)
Why does the existence of public goods result in market failure?
2 ways to explain: 1) the free rider problem and 2) why charging anything but $0 is allocative inefficient.
The free rider problem: public goods have the characteristics of being non-excludable and non-rivalrous.
Non-excludability of public goods means that non-payers are still able to enjoy the benefits of this good that payers have paid for. Non-rivalrous nature of the good means that non-payers can continue to free ride on payers as the quantity of the good doesn’t diminish.
When consumers know that they are able to free ride on another consumer, everyone will wait for another person to pay —> no expression of demand via price signals (as nobody is willing to pay for a good they can enjoy for free). Without demand, firms won’t even enter market to supply the good, resulting in a missing market.
Link to market failure: market has failed because zero resources are allocated to the production of the good despite it yielding valuable benefits to society —> society welfare not maximised.
Given the non-rivalrous nature of public goods in consumption, the consumption of the good by one person does not reduce the quantity available for another person to consume. In the provision of national defence, once it has been provided, every person in the country can enjoy the same level of national defence, and the amount of security will not diminish with the addition of another person. There is no additional cost incurred to provide security to another user. Hence, the marginal cost of supplying the good to another user is zero. The good should then be made available to anyone who derives positive marginal benefit from consumption as it can only increase societal welfare. The allocatively efficient price to charge, P=MC, is thus zero. As no profit maximising firm will provide the good at P=0, it is not possible for the free market to supply the good while also achieving allocative efficiency
Explain what is direct provision (with analysis of max welfare at Qs, no diagram)
A common solution to the problem of public goods is for the govt to be directly involved in the provision of these goods. By making decisions on behalf of society as a whole, the government can decide to produce these goods. Government can use tax revenue collected from taxpayers to pay for and bring into existence the public goods which everyone enjoys but no one is willing to pay for
How it works:
Government makes an estimate of the social cost and social benefit of producing the public good —EXEMPLIFY!!!
In the case of street lighting,the social benefits include: increased sense of safety and security, attracting investment—> boosted GDP growth). Social costs include ___(explicit and implicit costs)___
Government then provides an amount equivalent to the socially optimal level (MSB=MSC)
At this level of output, the last unit of output produced adds as much to society’s cost as it does to society’s benefit. Society’s welfare cannot be increased further by adjusting output. In other words, society’s welfare is maximised at Qs.
Explain how the lemon law works (can give some background info of the info asymmetry where sellers have more info about quality of product)
Typically (without lemon law):
- Sellers have more information than buyers regarding the quality of the goods sold.
- Sellers will try to downplay/hide defects of goods, misleading consumers to pay a higher price than the marginal utility derived from the good.
- Buyers tend to lower the price that they are willing to pay for the good as they are aware of this fact.
Intervention: Under the Lemon Law, consumers have the right to request repair, replacement, reduction of price (or refund) for goods that are of unsatisfactory quality or performance standards at the time of delivery
Effect:
reduce incentive for sellers to sell defective goods in the market/hide defects to sell the good at a higher price because they would have to replace them anyway
With less sellers in the market hiding information about true quality of good, consumers are able to accurately determine a fair price which they are willing n able to pay for the given quality of the good.
Explain how adverse selection in the market for USED cars (seller know more) leads to market failure
Adverse selection arises when products of different quality are sold at the same price, because buyers OR sellers are not sufficiently informed to determine the true quality of the product at the time of purchase.
In the market for used cars, used car sellers know more about the condition of the car than buyers. Used car sellers may try to hide the condition of the car from potential buyers so as to sell poorer quality cars at a higher price.
Buyers, aware that they are unable to determine the condition of the used car accurately, will offer an average price that is in between what they are willing to pay for a lemon and a plum. At this lower price, sellers of high quality used cars are unwilling to provide the good for sale, and will thus begin to leave the market. As more sellers of high quality used cars leave the market, the market for used cars become increasingly dominated by lemons (poorer quality cars). The market thus adversely selects against high quality cars in favour of lower quality cars, leaving unrealised the potentially Pareto improving exchanges.
In an extreme situation, all sellers of high quality cars leave the market, leading to a missing market for high quality cars. The potential benefits from having some high quality cars exchanged and consumed is lost, and society welfare is not maximised. Hence, allocative inefficiency arises
Explain how adverse selection in the market for insurance can lead to market failure
In market for insurance, buyers of health insurance know more about their health condition than sellers.
An individual w poor health is more likely to want insurance than healthy individuals, and thus the proportion of poor health individuals in the pool of insured ppl will rise—> claims rise, firm exp rise in cost of production, raise price to protect profits. Facing an increase in MC of consuming insurance, only individuals w sufficiently high marginal benefit from the consumption of the good will continue to consume the good—individuals w poor health. Healthy individuals, aware of their low risks, will choose not to be insured. Number of ppl w poor health in the pool of insured ppl increases further , pushing up prices of insurance again
Results in a situation where high risk poor health individuals buy v ex insurance, and low risk healthy ppl are unable to consume at reasonable rates. Market adversely selects against good quality buyers in favour of poor quality buyers —> leaving unrealised the potentially Pareto improving exchanges.
Describe how moral hazard leads to market failure
Moral hazard describes the tendency to change behaviour when the cost of the behaviour is fully borne by other parties.
When an individual is fully insured and cannot be accurately monitored by an insurance company with limited information, the insured party may take on activities which increase the likelihood of injury/accident.
When insurance companies cannot accurately monitor the behaviour of their customers, individuals assume that any additional costs that they incur will be spread out over a large group of people, with only a negligible portion accruing to each of them individually. The increased willingness of insured parties to take on higher risk activities will increase the likelihood of insurance payout. As number of claims rise, insurance companies face an increase in costs,and will charge higher premiums to protect their profits. The moral hazard in this case imposes an external cost on potential buyers of insurance, who now pay higher premiums. In an extreme situation, costs incurred by the insurance company rise to the point where they no longer make profits. In this case, insurance companies will be unwilling\ to supply the good as there is insufficient profits to offer it for sale —> missing market for insurance.
Explain why something can be considered a public good (tip: try to contextualise as much as possible)
Non rivalrous: one person’s benefit from the good does not reduce another person’s ability to benefit from the good. Benefit does not diminish with the number of people consuming the good
(Definition: a person’s consumption of the good does not reduce the quantity available for others to consume/benefit from)
Non-excludable: It is not feasible to exclude any individual from the (benefits of the good). Everyone, regardless of whether they “consumed it”/were involved in the market transaction/contributed to its construction/maintenance will benefit from its creation.
(Definition: firms are unable to/find it prohibitively costly to exclude any potential customer from enjoying the good.
Non-rejectable
No individual can opt out of (receiving the benefits of the good.) even if an individual does not wish to (receive the benefits of the good), they will still receive the benefits of the good as long as they stay within the country/area
(Definition: inability of consumers to reject the consumption of the good, once it has been produced)
[public good] How is imperfect information a limitation of direct provision?
The challenge of determining the socially optimal level of provision stems from the difficulty of accurately estimating the MSB and MSC. With imperfect information, governments may misjudge the MSC or MSB, and produce too much or too little relative to the socially optimal value. Overprovision would impose excessive costs on taxpayers without delivering proportional benefits, while under provision may result in inadequate protection in certain areas, and failing to correct the market failure entirely.
