Market failure and government intervention

Question 1

When does market failure occur?

Answer 1

When a free market fails to achieve allocative efficiency.

Question 2

What are externalities?

Answer 2

Spillover effects on third parties arising from production or consumption

Question 3

Name the causes of information failure

Answer 3

• lack of information, understanding and awareness
• inadequate or misleading information
• persuasive advertisinig

Question 4

When does information failure occur?

Answer 4

When a lack of information causes consumers and/or producers to make decisions that don’t maximise their welfare

Question 5

Information failure means that consumers….

Answer 5

over or under estimate the private benefits that the consumption of a good or service would create for them and thus under or over consume it

Question 6

What is a merit good?

Answer 6

A good that is better for consumers than they realise. (e.g healthcare, education and healthy food)

Question 7

What are private costs?

Answer 7

Costs paid by the producer for the factors of production needed to produce a good or service

Question 8

What are external costs?

Answer 8

The costs arriving to third parties as a consequence of negative externalities

Question 9

What are social costs?

Answer 9

The total cost of production to society ( private costs + external costs)

Question 10

Possible solutions to information failure

Answer 10

• The provision of information
• State provision
• Regulation (law)
• Taxes and subsidies

Question 11

What is a positive externality?

Answer 11

A favourable or beneficial effect on a third party

Question 12

What is a negative externality?

Answer 12

An unfavourable or adverse effect on a third party

Question 13

What are private benefits?

Answer 13

Benefits that accrue directly to the decision makers

Question 14

What are external benefits?

Answer 14

The benefits accrued to a third party or society as a whole

Question 15

What is a de-merit good?

Answer 15

A good that is worse for a person than that person realises

Question 16

What are the characteristics of private goods?

Answer 16

Excludable and Rival in consumption

Question 17

What are the characteristics of public goods?

Answer 17

Non-excludable and non-rival

Question 18

What is a quasi - public good?

Answer 18

Goods which are possessing some but not all of the characteristics of a public good.

Question 19

What does non-excludability mean?

Answer 19

A consumer cannot be prevented from consuming the good

Question 20

What does non-rivalry mean?

Answer 20

One consumer’s consumption does not reduce the amount available for consumption by others

Question 21

What is indirect tax?

Answer 21

A tax placed on producers / retailers of a good or service that can be passed on to the consumers of that good or service

Question 22

Name some examples of indirect taxation

Answer 22

• VAT
• APD
• excise duties on demerit goods such as tobacco and alcohol

Question 23

What does the effectiveness of indirect taxation depend on?

Answer 23

• The size of the tax
• The price elasticity of demand
• The extent to which the tax can be avoided
• How the tax revenue is spent

Question 24

What is a subsidy?

Answer 24

A payment made (usually by a government) to a producer per unit of a good or service that is supplied

Question 25

Name some examples of subsidies

Answer 25

• payments made to the transport providers in rural areas

Question 26

What does the effectiveness of a subsidy depend on?

Answer 26

• The size of the subsidy (and hence the increase in supply)
• The price elasticity of demand
• The extent to which a subsidy can be diverted away from the production or consumption of the targeted good
• The opportunity cost of the tax revenue spent on the subsidy

Question 27

What is information provision?

Answer 27

• Aims to reduce the information failure associated with the consumption of a good or service by increasing or decreasing demand as appropriate

Question 28

Name some examples of information provision

Answer 28

• information films
• advertising by state-financed bodies such as the NHS
• improvements in product labelling

Question 29

What does the effectiveness of information provision depend on?

Answer 29

• the nature of the information failure ( e.g no. of people lacking information)
• the nature of the information provision (e.g medium used)
• the receptiveness of consumers and producers to change their views and behaviour ( e.g relatively minor misunderstanding or culturally ingrained belief
• the time available

Question 30

What is regulation?

Answer 30

• The imposition of laws, standards and controls intended to influence the behaviour of producers and consumers and correct market failure

Question 31

Arguments for regulation:

Answer 31

• relatively easy and cheap to impose
• sets a clear standard that should be easily understood
• should have an instant effect
• can be backed up by fines and other incentives to comply

Question 32

Arguments against regulation:

Answer 32

• costly to police and enforce
• difficult to set the right standard
• some producers and consumers may be unaware of the regulation and seek to avoid it
• usually involves no incentive to make positive improvements beyond meeting the regulation

Question 33

What are tradable permits?

Answer 33

• a market based approach for correcting market failure that involves creating property rights for a particular activity that can then be bought and sold, with the resulting market being manipulated to achieve the desired outcome

Question 34

What is the most common type of tradable permit?

Answer 34

• Attempting to reduce industrial pollution in the form of carbon emissions (EU’s Emission Trading System (ETS) allocates permits that allow the holder to emit one tonne of carbon

Question 35

What is state provision?

Answer 35

• occurs where a good or service is supplied by central or local government, usually financed from general taxation and free at the point of consumption

Question 36

What are some examples of state provision?

Answer 36

merit goods such as:
- health care
- education
public goods such as:
- defence
- broadcasting

Question 37

What are the advantages of private sector provision?

Answer 37

• The competition / efficiency argument that suggests greater competition between self-interested profit-maximising producers will lead to increases in quality and lower prices that will benefit consumers
• the moral hazard argument suggests consumers may behave in more desirable ways if they don’t have the safety net of provision to catch them if they suffer private costs

Question 38

What are the disadvantages of private sector provision?

Answer 38

• consumption depends on an individual’s ability to pay
• some goods and services will be under consumed
• quality may be compromised if prices are driven too low
• regulation may be required to endure free market prices and quantities are acceptable

Question 39

What are the advantages of state provision?

Answer 39

• consumption is accessible to all irrespective of income
• consumption levels are likely to be higher than for private provision due to the zero price
• regulation of quantity and quality is generally easier

Question 40

What are the disadvantages of state provision?

Answer 40

• the lack of competition may reduce incentives to improve quality
• free provision may lead to some individuals over-consuming a service at the expense of others

Question 41

What is a free rider?

Answer 41

• an individual able to enjoy the benefits of consumption without paying for the good or service