Market Failure

Question 1

Define Price Mechanism.

Answer 1

The price mechanism allocates in such a manner as to MAXIMISE SOCIETY’S WELFARE. This outcome is achieved when the FREE MARKET SIGNALLING leads producers to produce goods most desired by consumers in the CORRECT QUANTITIES, using the most effective methods of production.

Question 2

Define Market Failure.

Answer 2

Market Failure occurs when free markets , operating WITHOUT GOVERNMENT INTERVENTION, fail to allocate SCARCE RESOURCES EFFICIENTLY and society’s welfare is NOT MAXIMISED.

Question 3

Define negative/positive externalities.

Answer 3

Externalities could either be positive or negative spillover effects that benefit or harm third parties

Question 4

What does the EMC in the negative externality diagram represent?

Answer 4

external cost-cost to third parties.

Question 5

What is the purpose of (Pigouvian) tax?

Answer 5

It internalises the (negative) externality such that market failure does not occur, as the external costs are priced in such that the full cost is accounted for by the producers and consumers.

Question 6

What are the limitations of taxes?

Answer 6

1. Lack of information: It is difficult to accurately estimate and appoint the correct amount of tax.
2. Impractical to use different tax rates: Firms produce varying types and amount of externalities and it is impractical to allocate different rates of taxes.
3. Evaluation: imposing a pollution tax which makes emission level more easily measurable.
   (consumption: ) lack of compliance and high administrative costs

Question 7

In the ban diagram, when area Y is greater than area X, what does it represent?

Answer 7

Net welfare gain(benefits society) and vice versa(harms society).

Question 8

What are the limitations of ban/regulation?

Answer 8

It can be costly to administer and enforce.

Question 9

Tradable/Marketable Permits: (cap and trade)

Answer 9

The government will estimate the socially efficient level of emissions, and firms are allowed to pollute up to the permitted level.
Firms can sell unused permits to other firms who will pay them for the extra permits. This INTERNALISES the negative externality.

Question 10

Advantages/benefits of permits:

Answer 10

1. efficient allocation of permits: once the caps being determined accurately, the government can leave it to the markets to distribute the permits to the firms.
2. incentive to cut back on pollution: since unused permits can be sold, more firms will be more willing to cut back on the emissions they produce so that they can sell their permits, thereby increasing their total revenue, while polluting less.

Question 11

Limitations of permits:

Answer 11

1. lack of information: To obtain accurate data hence they need information, which is difficult to obtain.
2. lack of compliance and high administrative costs: they must be effective in monitoring and enforcing the firms to ensure they may pollute beyond their permits illegally.

Question 12

which curve, supply or demand does subsidy affect?

Answer 12

supply

Question 13

which curve, supply or demand, does tax affect?

Answer 13

supply

Question 14

what are the limitations of subsidies?

Answer 14

1. lack of information: the government may not be able to accurately estimate the correct amount of subsidies to provide such that social welfare is maximised, hence, they may end up over-subsidising or under-subsidising a good.
2. opportunity costs due to budget constraint: the government may have to prioritise another good or service over subsiding this good, as they may feel that another good will maximise society welfare more.

Question 15

what are the conditions for public goods?

Answer 15

1. non-excludable: this means that both consumers that paid for the good and non-payers of the good can both use the good.
2. non-rival: this means that a consumer that uses a good or a service will not deprive another consumer that consumes an additional unit of the same good or service.

Question 16

what are examples of public goods?

Answer 16

military defence and street lighting (NOT MILITARY GOODS AND STREET LAMPS)

Question 17

limitations of public goods:

Answer 17

1. free ridership: non-payers also can receive the benefits of such goods.
2. no price signals: there is no price signals to indicate consumers preference for the good, hence producers will be unwilling to produce it and there will be no such product on the market.
3. no user charge: the marginal cost of providing a public good to an additional consumer or user is zero.

Question 18

what is the solution to public goods?

Answer 18

direct provision by government with full subsidy. Since the government’s role is to maximise social welfare and take into account the full social cost.

Question 19

limitations of direct provision by government with full subsidy:

Answer 19

lack of information: difficult to accurately identify the optimal level of public demand of the public good.
lack of public funds: it is not always possible to provide sufficient public goods if there is not enough revenue.
political pressures: government may make decisions based on political popularity.

Question 20

imperfect information: what is it?

Answer 20

it is a major cause of market failure. the free market allocates resources efficiently assuming that all producers and consumers have full and perfect information about the market and goods, and are hence able to make choices to optimise their welfare. however, in real life, this is not the case.

Question 21

what are the types of imperfect information and how does it affect consumers and/or producers?

Answer 21

1. incorrect information: consumers may make bad choices because they have been “misinformed” or received the wrong information from sellers. an example is persuasive advertising.
2. ignorance: some consumers choose not to consume a good as they are not aware of the benefits that they bring. an example is cancer screening. (pmb actual and pmb perceived).

Question 22

what are the solutions to solve imperfect information?

Answer 22

1. mandatory food labelling/ health warning
2. laws to protect against incorrect information (lemon law: introduced to protect consumers from exploitation by producers)
3. minimum age
4. moral education in schools

Question 23

limitations of solutions:

Answer 23

education is a long term process and is not effective if consumers choose not to respond to the information provided.

even with full information, consumers of addictive products such as cigarettes may still choose to consume the good.

Question 24

what are merit goods and demerit goods?

Answer 24

merit goods: private goods that are deemed by the government as socially desirable, but when left to the free market, is under consumed.
demerit goods: private goods that are deemed by the government as socially undesirable, but when left to the free market, is over consumed.

Question 25

definition of government failure:

Answer 25

government failure is defined as the situation where government intervention results in greater market inefficiencies than without government intervention.

Question 26

causes of government failure:

Answer 26

1. information failure or information gap: governments rarely possess complete and accurate information on which to make rational informed decisions. hence, they make wrong policies that result in government failure.
2. costs of administration and compliance
3. bureaucratic inefficiency: the time taken for reaction is too long

Question 27

public goods defn

Answer 27

public goods are goods that are non-excludable and non-rival in consumption

Question 28

problem with public goods

Answer 28

free ridership:
a consumer who receives benefits from this good without having to pay for it.

no price signals:
therefore when there is no demand for such goods, producers will receive no price signals

Question 29

solution to public goods

Answer 29

therefore, governments usually provide a full subsidy for public goods to maximise EMC

however, there may be limitations such as lack of public funds or lack of information on how to allocate resources