MARKET FAILURE AND GOVT INTERVENTION Flashcards
What are positive/negative externalities?
It refers to a beneficial/adverse impact on a third party not involved in the consumption or production of a good or service
How do you explain that positive externalities leads to market failure?
- Explain the positive externality - e.g. the consumption of immunisation against transmittable diseases allows those who nvr take the vaccination to enjoy a positive externality which is an external benefit to third parties not involved in consumption or production of the good since they are less likely to get that disease as well
- Explain how the positive externality causes MSB to be larger than MPB - Since MSB includes the additional private benefits to consumers as well as additional private benefits to those not involved, MSB curve higher than MPB
- Explain how under free market what consumers will do - consumers base their decision on their MPB, ignoring the MEB. Left to market forces, eqm at …
- Compare to socially optimal output by using area under the graph
How does consumer ignorance lead to market failure?
- Explain how the good or service provides benefits/harm to the consumer - e.g. The consumption of healthcare confers long-term benefits to ones own health and well-being as it can reduce likelihood of health complications in the future. However, consumers may be ignorant about these games and under-estimate the true value of healthcare
- Explain how consumers make decisions - The consumers would base their consumption on their perceived MPB, the market demand curve, which is lower than the true MPB
- Explain the graph - Assuming no externalities, the MSB curve will be the same as the ‘true MPB’ while MSC=MPB. Left to market forces, the market eqm output will be at… where DD=SS. However, the socially optimal level is where … meets … and societys welfare is maximised. There is an underconsumption of … units where the MSB is greater than MSC. This means that more welfare can be reaped is more healthcare is consumed so there is a deadweight loss of …
How does adverse selection lead to market failure for knowledgeable?
- Explain what the sellers know that the buyers do not -e.g. the quality of the cars they are selling
- Explain the P sellers are willing to accept - based on quality of good
- Explain that consumers know what kind of goods and services are available but do not know which one they get Hence, they only offer an average price.
- Sellers of high quality cars not prepared to accept this low price so they will leave the market while the sellers of lower quality come in and sell their cars at avrg price
- Explain what happens to the quality of available goods and services - high quality goods will leave the market and market dominated by lower quality goods
- Explain the disappearance of market of high quality good
- Explain that the potential net benefit to society from having some good products are gone and society’s welfare maxed
Explain how moral hazard leads to market failure
- State how moral hazard can arise - a party to a contract changes their behaviour as a consequence of the contract
- Explain the moral hazard - e.g. when someone purchases insurance they are likely to take greater risks as they know the cost from undesirable outcomes are lowered
- Explain how this leads to missing markets - The increased probability of the event happening ups the insurers cost to the point the business is not profitable so the firms wont provide it leading to a missing market where potential net benefit to society is lost
What are the conditions for a good to be public
non-excludable - impossible or very costly to prevent someone who has not paid from consuming the good
non-rivalry - consumption of good by one person will not diminish the availability of good for someone else
non-rejectability - inability of consumers to refuse consumption of a good
Explain how public goods lead to market failure
Due to the non-excludable nature of public goods it is impossible or impractical to exclude those who haven’t paid for the good from consuming it. This creates free-riders as consumers realise that they do not need to pay yet can consume the good resulting in no effective demand for the good. This causes profit-motivated firms to stop producing the goods as they are no longer willing and able to with no effective demand because they cannot cover the COP of the public good. This leads to a missing market where a potential net benefit could have been gained but is lost, leading to allocative inefficiency
What market-oriented policies are there to address market failure?
Taxes, Subsidies, Tradable permits and Grants/Vouchers
How do taxes help with market failue
note: tax is to discourage consumption or raise tax revenue
1. Explain the cause of market failure leading to overconsumption
2. state how a production tax will reduce consumption/productive levels of a particular good to the socially optimal level
3. Demonstrate in the graph by showing an upward shit of MPC by imposing per unit output tax = MEC at socially optimal
4. Explain why there is no more allocative efficiency
How do subsidies address market failue?
note: encourage consumption and make a good more affordable
1. Define subsidy - a payment made by the govt to producers to encourage the production of certain goods or services
2. Explain how govt can pay firms a per unit output equal to MEB at the socially optimal output
3. Explain that it increases supply and lowers price
4. Explain that it internalises MEB to society
Explain how tradable permits help address market failure.
1.Govt decides on optimal level of consumption for a good
2. Govt can auction or distribute permits to firms
3. Afterwards, they are free to buy and sell permits with their prices determined by demand and supply
4. Talk about diff aspects for firms that pollute alot vs very little
5. Explain how this reduces consumption of a good and how it can help in the long run e.g. find cleaner methods of production, targeting root cause of the problem
Explain how grants/vouchers work
- Define grants and vouchers - lump sum of payment for a specific purpose
- Explain how they increase C - increase consumers ability to spend on good or service increasing their DD and consumption to socially optimal level
- Explain that grants can also help firms increase their ability to produce goods
What command policies are there to address market failure?
Free-direct provision, Rules and regulations(total ban/quota) and other policies
Explain how free-direct provision helps with market failure
- Define direct provision - when the govt supplies the good directly to consumer, taking the role of producer
- Explain market failure resulting in MM
- Explain why govt producing eliminates this - govt is non-profit orientated and cares more about producing at socially optimal output so they can use taxes collected and provide them free of charge to consumers
- explain back draw of free-direct provision - govt will incur an opp cost as govt funds used can be used for other areas like education. Lack of perfect info may also result in govt over or under producing the good
- How to address draw back? - outsource to private firms - instead of being producer, they can provide funding and outsource by awarding private firms contracts. They are more efficient in minimising costs since it has a direct effect on their profitability eliminating the productive inefficiency of direct provision
Explain how total bans help with externalities
In some cases where the MEC is very large, a total ban can lead to a situation where societies welfare improves as deadweight loss is greater than the net total social benefit of consuming Q* units
