Market Failure

Question 1

What are the effects of a price ceiling?

Answer 1

-A loss of consumer and producer surplus from the buyers and sellers who cannot trade
-This is a deadweight loss

Question 2

What is the impact of a sales tax?

Answer 2

-Supply Curve shifts inwards
-Price increases at every quantity
-Deadweight loss
-The more elastic the demand curve, the higher the proportion of tax paid buy the buyer

Question 3

How do you calculate the proportion of the sales tax paid by the buyer?

Answer 3

elasticity of supply/ (elasticity of supply) + mod[elasticity of demand]

Question 4

What is the equation of the supply curve when a tax is imposed?

Answer 4

S= a+b(p-t)

Question 5

What makes a good tax?

Answer 5

-Easy to collect
-Hard to avoid
-Non distorting (low DWL)
-Progressive (poorer people pay a smaller proportion of their income)

Question 6

What is a subsidy?

Answer 6

A subsidy is a direct or indirect payment to individuals or firms

Question 7

How can a subsidy be modelled?

Answer 7

-A subsidy can be modelled as an outward shift in the supply curve
-This decreases the price to the buyer, however the price to the seller is still the same
-The difference between the revenue of the subsidy and non-subsidy curves is paid by the government
-This results in a loss of efficiency, as the price paid by the government is greater than the benefit to producers and consumers

Question 8

What are three examples of market failure?

Answer 8

-Asymmetric information
-Externality
-Market power

Question 9

What are the two main types of asymmetric information?

Answer 9

-Adverse Selection: Hidden information, where sellers have information and buyers do not
-Moral Hazard: Buyers have information that sellers do not

Question 10

What are the market outcomes with asymmetric information?

Answer 10

• If buyers and sellers have different values for a given good, this results in a separating equilibrium where different goods are treated differently
  -This results in a pooling equilibrium, where different goods are treated the same (using expected values)

Question 11

What is an externality?

Answer 11

-An externality is a cost or a benefit of an activity that is borne by somebody other than the person who decides on the activity
-A negative externality makes other people worse off
-A positive externality makes other people better off

Question 12

What is the market structure of a negative externality?

Answer 12

-Demand = Marginal Private Benefit = Marginal Social Benefit
-Supply = Marginal Private Cost
-Marginal Social Cost > Marginal Private Cost
-Social Optimum= Marginal Social Cost = Marginal Social Benefit

Question 13

How can a Pigovian tax be used to correct a negative externality?

Answer 13

-This raises the price of a good equal to the price of the externality
-This discourages consumption and shifts the Marginal private cost curve upwards
-This results in a new equilibrium at the socially optimal level

Question 14

How can a quota be used to correct a negative externality?

Answer 14

-This means that no firm can produce a good past the point where the marginal social cost is greater than the marginal social benefit

Question 15

How can creating a market be used to correct a negative externality?

Answer 15

• An externality can be thought of as a situation where a market is missing
  -For markets to work, there must be clear property rights and cheap enforcement
  -Governments can create markets by emitting tradable permits

Question 16

How can governments deal with market power?

Answer 16

-Make sure there is competition
-Prevent mergers
-Break up companies
-Monitor to stop collusion and cartels
-Price Regulation

Question 17

What are excludable goods?

Answer 17

This is when if one does not pay for a good, they cannot use it

Question 18

What are rival goods?

Answer 18

This is when the use of a good by one person diminishes another person’s ability to use it

Question 19

What are the characteristics of club goods?

Answer 19

-Non-rival but excludable
-High fixed cost but very low marginal cost
-IRS
-Often natural monopolies
-Commonly subject to government ownership or price regulation

Question 20

What are the characteristics of common resources?

Answer 20

-Non excludable but rival
-Markets do not work well
-Consumption of common resources has negative externalities

Question 21

What are the typical solutions for the common resources problem?

Answer 21

-Taxes
-Quotas
-Establishing property rights

Question 22

What are the characteristics of public goods?

Answer 22

-Non excludable, non rival
-Markets do not work well
-Cannot stop free-riding
-Purchase of public goods has positive externalities

Question 23

What is the typical solution to the public goods problem?

Answer 23

The government provides for the good, paid for by taxation or compulsory contributions

Question 24

How can the Principal-Agent Problem be modelled?

Answer 24

-Game with a payoff matrix where the optimal solution is when the payment to the agent is good with low effort
-In this situation, the profit to the principle in the good and bad states are the same

Question 25

What are the constraints to the Principal-Agent solution?

Answer 25

-Participation constraint: The agent must earn enough in the bad state to make it worth his while to work at the level the principal wants
-Incentive compatibility constraint: The agent must be better off honestly reporting a good state of nature and giving high effort than pretending the state is bad and giving low effort
-The Principal must be better off with this contract than with any other alternative

Question 26

What are real world solutions to the Principal-Agent Problem?

Answer 26

-Adopt a professional code of ethics
-Give the agent a share of the output