Market Failure & Government intervention

Question 1

Def + profitability + shift + excess demand + contraction + ATQ

Indirect Tax - Standard An

Answer 1

• An indirect tax will increase a firms’ cost of production, meaning that at any given price the production of x will become less profitable thus reducing the incentive to supply.
• This will cause a leftwards shift in supply, from S1-S2, meaning that suppliers are less willing and able to supply at each and every price.
• There is excess demand at the previous equilibrium price of P1 as there is less supply for the same price. Consequently, the new market-clearing price is at P2.
• The increase in price causes a contraction of demand from Q1-Q2 due to the law of demand.
• This can solve the problem of overconsumption of x, thus correcting the market failure, as Q2 is the socially optimal quantity.
• However, an indirect tax is a regressive tax and therefore disproportionately affects those with lower income possibly increasing income inequality.

Question 2

if PED is inelastic+ numerical example + quantity

Indirect Tax Evaluation - Depends upon the PED

Answer 2

• However, the effectiveness of an indirect tax depends upon the price elasticity of demand. If PED for the good is price inelastic, then an increase in price will lead to a proportionately smaller decrease in quantity demanded.
• For example, if price increases by 10%, quantity demanded may only fall by 5% resulting in a PED of 0.5 (price inelastic).
• As a result, quantity may not fall to the socially optimal quantity that the government desires. This is particularly likely…….(Adapt it to the question so that evaluation is contextualised).
• Therefore the market failure for x will not be corrected……..

Question 3

Indirect Tax - government failure argument

Answer 3

• However, if the government imposes an indirect tax, then this can lead to government failure due to unintended consequences wherby government intervention in a particular market causes inefficiencies and a further misallocation of resources.
• If the government imposes an indirect tax, ceteris paribus, the price of good x will increase.
• Consequently, this may create a black market for good x as it may be cheaper to buy from the unregulated black market.
• As a result, quantity demanded will not fall to the socially optimal quantity that the government desires.
• Furthermore, due to the creation of the black market further negative externalities (costs to third parties) may be caused such as increased crime leading to higher policing costs.
• Therefore, the government imposing an indirect tax may be less effective as the unintended consequences derived from such a policy is a form of government failure and can cause a net welfare loss to society.

Question 4

Subsides - Standard An

Answer 4

• A subsidy is a government grant that decreases a firms’ cost of production, meaning that at any given price the production of x becomes more profitable, thus providing a greater incentive for firms to supply good x.
• As a result, the will be a rightwards shift in supply, from S1-S2 as suppliers are now more willing and able to supply at each and every price.
• Excess supply at the previous market price, P1, causes the market equilibrium price to decrease from P1-P2, thus causing an extension of demand from Q1-Q2 due to the law of demand.
• This solves the problem of underconsumption of x so that the market failure can be corrected as consumption has increased to the socially optimal quantity, Q2.

Question 5

if too small, if too large, gov failure, This is because of…

Subsidy Evaluation - Depends upon if the subsidy is set at the right level

Answer 5

• However, the success of the subsidy depends upon if the government can set the subsidy at the correct level.
• If the subsidy is too small, then production will not be stimulated to the socially optimal quantity that the government desires.
• If the subsidy is too large, then firms may have greater incentives to become less productively efficient in order to profit maximise. As a result, firms will fail to reduce LRAC per unit leading to wastage and only a fraction of the subsidy being passed onto the consumer in the form of lower prices.
• Consequently, government failure can occur whereby government intervention into a particular market leads to inefficiencies and a further misallocation of resources.
• This is because, unintended consequences, a form of government failure ocurred as the government, who intended to give firms a subsidy to reduce costs of production in order to increase quantity to the social optimum did not take place.
• Instead, firms as a result of the subsidy become more productively inefficient……(ATQ)

Question 6

government may decide, supply curve, free at point of consumption

Direct State Provision - Standard An

supply is fixed at Q1 free of charge….ATQ

Answer 6

• The government may decide to provide a merit good via direct state provision and supply all the resources in the market especially if that merit good is underconsumed in the free market.
• This is shown by the perfectly price inelastic supply curve, S1. Supply is perfectly price inelastic as there is a fixed quantity in the market for x.
• Product x is provided free at the point of consumption i.e the public does not pay a price to consume x. For example, NHS care.
• As supply is fixed at Q1, those who demand the good up to the point of Q1 recieve the good free of charge and as a result, there may no longer be a market for good x.
• Therefore, direct state provision can increase consumption of x to the socially optimal quantity correcting market failure.

Question 7

no market, market mechanism does not exitst, area, consumers past Q1..EV

Direct State Provision Evaluation - Excess Demand

Answer 7

• However, direct state provision may not be as effective if there is excess demand.
• Since the government decided to provide product x via state provision there is no longer a market for product x.
• As a result, the free market price mechanism will not exist for x and therefore the rationing function of prices whereby price can help with rationing scarce resources will not exist.
• Consequently, there may be excess demand denoted by the area Q1AB as the government cannot ration their limited resources via the price mechanism.
• Therefore, consumers past the point of Q1 are excluded from consuming the good (adapt to question + ATQ - why is that bad - poverty? inequality?… negative externalities0
• However, the size of the excess demand depends upon any shortfall in government spending.

Question 8

Regulation - Standard An + EV

Answer 8

(if you have a regulation that increases a firm’s cost of production you can use the exact same arguments for indirect tax)

Question 9

demerit + instead of law def + Changes in pref + demand shift + contrac

Information Provision - Standard An

Answer 9

(Insert demand and supply diagram) This words the opposite way for merit goods then it does for demerit I am going to do demerit goods as an example.
* Perhaps the government could introduce an information provision campaign for the demerit good in order to reduce consumption and information failure.
* This is where instead of using the law to compel businesses to provide provision, the government could seek to do this directly, either through education or by advertising the harmful effects of consuming a particular good.
* By the government giving people information (e.g be practical) this enables them to understand the harm done by the demerit good and change their tastes and preferances.
* As a result, there is less incentive to buy, shifting the demand curve to the left from D1-D2 as consumers are now less willing to consumer x.
* This lowers the equilbrium price from P1-P2 and causes a contraction of supply from Q1-Q2.
* Since Q2 is the social optimum this solves the market failure for x….(ATQ)

Question 10

Information provision - Evaluation

Answer 10

I CBA writing one for information provision, however, talk about it can be ignored people do not understand the information and link to bounded rationality and other behavioural economic concepts.

Question 11

Minimum Price - Standard An

Answer 11

• A minimum price is the lowest price that firms are allowed to charge for a good or service. For example, in Scotland a minimum price was introduced on alcohol initally at 50p per unit of alcohol but this has risen to 65p as of 2024.
• Initially, in a competitive market, the price of good x is at Pc and quantity is at Qc. The government may decide that the price is too low given the costs to society of x (give example).
• As a result, they may impose a minimum price above the free market equilibrium at Pmin.
• At Qmin there is an extension of supply from Qc-Qs due to the law of supply.
• However, there is also a contraction of demand reducing quantity from Qc-Qd. This results in excess supply of good x (Qs-Qd).
• Therefore, the government imposing a minimum price on good x reducing quantity to Qd can correct market failure and make the market more allocatively efficient.

Question 12

Minimum Price Evaluation - Black Market

Answer 12

(same as indirect tax/regulation black market analysis)

Question 13

Maximum Price - Standard An

Answer 13

• A Maximum Price is a ceiling price meaning the maximum firms are able to legally charge. For example, the UK government set a maximum price on energy between April-June 2024, the energy price cap is set at £1690 per year.
• Initially, the competive market equilibrium is at price Pc and quantity Qc. However, the government may decide that this is too high due to the fact that too many people are being excluded via the price mechanism.
• As a result, they may decide to impose a maximum price below the free market equilibrium at Pmax.
• At Pmax, there is a contraction of supply from Qc-Qs due to the law of supply. However, there is also an extension of demand increasing quantity from Qc-Qd.
• Consequently, the excess demand of product x is Qd minus Qs.
• Therefore, the government imposing a maximum price on good x may correct the market failure as quantity demanded increases to the social optimum at Qd…..

Question 14

at max price excess demand and why + exclusion + negative externalities

Maximum Price Evaluation - The excess demand can cause negative extenalities and government failure.

Answer 14

(this is very largely dependant on the question at hand)
* However, perhaps the government imposing a maximum price may be less effective as it can lead to government failure.
* At the maxmimum price, Pmax, there is an contraction in supply from Qc-Qs and an extension of demand from Qc-Qd.
* At the maximum price there is excess demand as Pmax is below the competitve equilibrium price so more consumers want to buy x then suppliers are willing to sell.
* This denoted by the difference between Qd minus Qs.
* As a result, some consumers may be excluded from consuming good x. This is particularly problematic as good x is essential….(adapt) and can cause negative externalities (adapt)…
* As a result of negative externalities derived from the maximum price government failure will occur whereby government intervention in a particular market leads to inefficiencies and a misallocation of resources…..(ATQ)

Question 15

Def + consumers’ perceptions + demand + where do consumers consume.

Information Failure - Standard Analysis

Answer 15

(insert demand and supply diagram)
* One reason for overconsumption of x is due to information failure. For example, not knowing harmful effects of x.
* Information failiure is where people have inaccurate or incomplete information on a particular good or service.
* consumers’ perceptions do not match the true costs and benefits.
* As a result of consumers not knowing the harmful effects of x the demand for x will be at D2 as opposed to D1 with perfect information.
* Consequently, consumers will overconsume at Q2. This is particularly likely (use behavioural economic theory)

Question 16

Tradeable Pollution Permits - Standard An

Answer 16

• The government may decide that the problem of pollution in market x is causing market failure and therefore it needs to intervene by limiting the amount of pollution that is produced.
• As a result, the government may decide to impose a limit on the amount of pollution that can be emitted and issue permits that is equal to that limit therefore supply of these permits is perfectly price inelastic as the number permits issued does not vary with price.
• These permits are allocated either through auctioning or by “grandfathering” permits based on previous emissions records.
• Over time, the supply of permits is restricted resulting in a leftwards shift in supply from S1-S2.
• This increases the market price from P1-P2. Firms will only buy a permit if it is cheaper than their marginal cost of abatement.
• The increase in price causes a contraction of demand and the quantity of permits bought falls from Q1-Q2.
• This reduces the quantity of pollution to the social optimum and corrects the market failure.

Question 17

Tradeable Pollution Permits Evaluation - Opportunity cost

Answer 17

• However, perhaps tradeable pollution permits may not be as effective due to the fact that there is an opportunity cost of the UK government imposing it.
• If the UK government issues tradable pollution permits to UK companies, then perhaps the UK receives less foreign direct investment as a result.
• This is because, in order for tradeable pollution permits to be successful at reducing pollution it needs to be international thus causing jurisdiction issues. For example, an agreement may be required.
• Consequently, this may deter multinational corporations from relocating to the UK as it can be more costly to do so. For example, firms have higher abatement costs to reduce pollution to the amount set out by the UK government.
• However, in doing so, this may reduce economic growth in the UK. For instance, if multinational corportations are deterred from settling in the UK then investment in the UK may fall. This is a component of aggregate demand, and ceteris paribus, the rate of economic growth in the UK could fall.
• This poses an opportunity cost as by the UK government trying to correct the market failure caused by pollution they can harm economic growth of the UK.
• …..ATQ

Question 18

Externalities - Standard An

Answer 18

This is a very general way to learn how to analyse externalities:
* Identify how a third party or third parties have been affected and how
* Explain how this causes a difference between the MSB and MPB or MPC or MSC.
* Explain why a free market will lead to the private optimum - link this to rational utility maximisation or profit-maximisation.
* Identify why the social optimum is where it is
* Explain the difference in quantity
* Identify the welfare loss
* Explain why the market fails

Question 19

Positive externalities of consumption - Standard An example

Answer 19

• Education benefits future employers (through a more productive workforce) and society as a whole (for example through future innovation or treatment by doctors).
• As a result, the benefit to society as awhole from the consumption of an additional unit of education (Marginal social cost) is greater than the benefit to the learners themselves (marginal private benefit).
• Rational utility-maximisers will make their decision over how much education to consume based on the costs and benefits to themselves, consuming at the private optimum of Q1, where the marginal private benefit equals the marginal private cost.
• If, however, they took into account the full social benefit, they would consume where the marginal social benefit equals the marginal social cost at Q2.
• This means that education will be underconsumed by Q2-Q1. leading to a welfare loss being shown on the diagram which is caused by the units of education not being consumed where the MSB>MSC).
• Too few resources are used for education and as this is allocatively inefficient, the market fails.

Question 20

Property Rights - Standard An

Answer 20

• Market failure of CPR can potentially be resolved through the extension of property rights. This is where someone is given legal control or ownership of a good. For example, it could give water companies the right to charge firms that dump waste into rivers.
• Third parties who suffer externalities as a result of economic activities would be able to recieve compensation equivalent to the external cost. Since this cost would be borne by the party generating the externality, the negative externality has been internatlised.
• As a result, the marginal private cost is equal to the marginal social cost.
• This can remove the welfare loss to society from the externality e.g…. and correct the market failure for x.

Question 21

Property Rights Evaluation - Opportunity cost

Answer 21

• However, perhaps extending property rights may not be as effective at solving the market failure as there is an opportunity cost that can lead to government failure.
• If the government extends property rights, then they need to oversee/resolve disputes surrounding them.
• For example,…. (give contextual example and explain)
• This may result in high policing costs. If the government does not police these disputes properly then the negative externalities may not be internalised thus posing an opportunity cost as if the government does police property rights correctly this may result in excessive costs to the government but if they do not,
• The welfare loss to society from x will not be reduced resulting in an inefficient allocation of resources, this is a form of government failure, wheby government intervention into a particular market leads to inefficiencies and a misallocation of resources.

Question 22

one way, example, shift, excess demand at p1 + shortage, pressureonprice

How the price mechanism allocates resources - Standard An (demand)

Higher price signals, incentive extension of supply, rationing allocativ

Answer 22

(insert demand and supply diagram - rightwards shift in demand)
* The price mechanism is the way in which prices are determined in a market economy.
* One way that the price mechanism can allocate resources is if there is an increase in demand or excess demand.
* For example, if there is a change in tastes and preferences towards leather jackets, the demand in the market for leather jackets increases.
* As a result, there will be a rightwards shift in demand from D1-D2.
* At the current market price P1, there is excess demand (Qd minus Q1) and a shortage of leather jackets.
* Consequently, excess demand puts upward pressure on prices causing a price rise from P1-P2.
* Higher prices act as a signal (signalling function of prices) that there are scarcites in the market for leather jackets, and increased resources are allocated towards leather jackets.
* As a result, this incentivises firms (incentive function of prices) to supply more leather jackets as there is a greater profit per unit to be made (ceteris paribus) shown by the extension in supply.
* Resources are rationed in the market for leather jackets from the increase in price (rationing function of prices) as some consumers are disincentivised from consumption shown by the contraction of demand at P2 at D2.
* Finally, there is a new market equilbrium at P2 and Q2 (allocating function of prices) which is allocatively efficient as demand is new equal to supply therefore demonstrating how resources are allocated via the price mechanism.

Question 23

How the price mechanism allocates resources - Standard An (supply)

Answer 23

(insert demand and supply diagram - righwards shift in supply)
* One way that the price mechanism can allocate resources is if there is an increase in supply or excess supply.
* For example, if due to a positive supply side shock in the market for fruit and vegetables e.g higher harvest, then ceteris paribus, there will be a rightwards shift in supply in the market for fruit and vegetables.
* At the current market price P1, there is excess supply, as quantity supplied is greater than quantity demanded at P1 (QS>Q1).
* This puts downwards pressure on prices, leading to a fall in the price of fruit and vegetables from P1-P2.
* At the new market clearing price P2, lower prices signal (signalling function of prices) that there are surpluses in the market for fruit and veg, and decreased resources are allocated towards fruit and veg.
* As a result, this disincentivies firms (incentive function of prices) to supply less fruit and vegetables as there is a lower profit per unit to be made (ceteris paribus) as shown by the contraction along the supply curve at S2.
* Resources are rationed in the market for fruit and veg from the decrease in price (rationing function of prices), shown by the extension in demand Q1-Q2.
* Finally, there is a new market equilibrium at P2 and Q2 (allocating function of prices) which is allocatively efficient as demand is now equal to supply.

Question 24

Privatisation - Standard An

Answer 24

(for this use a pure monopoly diagram without the SN profit and other features)
* Privatisation is where state-run organisations are sold off to the private sector.
* Initially, under state ownership, the government run organisation produces at the productively efficient point at the minimum point on the AC curve and charges the price Pm.
* However, when the government privatises the industry, this opens up market x to increased competition. Give example…..
* As a result of increased competition, prices fall and output increases. This is because firms compete on lowering prices and since there are more firms in the market output rises.
* (where you go from here largely depends upon the question at hand - could talk about consumer surplus and also efficiencies)
* An industry where this is the case is: For example, the privatisation of BT has largely been considered successful due to increased competition, innovation and efficiency.

Question 25

Privatisation Evaluation - Depends upon if there is competition

Answer 25

(For this I would use a pure monopoly diagram)
* However, it is not necessarily the case that privatisation results in increased efficiency/and or increased consumer surplus as it depends upon if there is increased competition due to privatisation as this is always not necessarily the case.
* For example, if the government choose to privatise an industry but do not deregulate the industry thus reducing the barriers to entry, there may not be high levels of competition in that industry and the theoretical benefits of privatisation will not be felt.
* Instead, the industry can become a privatised monopoly.
* In a pure monopoly, there is one firm in the industry due to high barriers to entry and imperfect information.
* As a result, the firm is a price maker and assumed to be profit maximising, charges where MC=MR.
* The monopolist, charges the price Pm and produces at Qpm.
* (again where you go from here very largely depends upon the question…could talk about consumer surplus + efficiency)

Question 26

Privatisation Evaluation - Loss of natural monopoly and economies of scale

Answer 26

• However, perhaps privatisation is not beneficial in an industry where there is a natural monopoly that is exploiting huge economies of scale.
• For example, in the UK the water and sewage industry is an industry with a natural monopoly.
• If the government privatises water and sewage thus opening the market up to greater competition.
• As a result, huge economies of scale will be lost as by lots of firms entering the industry, each individual firm will not be able to produce as much therefore will not be able to exploit all potential economies of scale.
• This can increase inefficency and loss of consumer surplus……

Question 27

Privatisation benefit - Standard An - raise revenue

Answer 27

(talk about AD/AS diagram)
* Privatisation can be benefical as the revenue raised can be used to promote economic growth thus benefitting the wider macroeconomy.
* If the government chooses to privatise a certain industry, then it will sell the state-owned assets which raises revenue for the government. Also, there may be increased corporation tax also from privatisation potentially increasing revenue further,
* Consequently, the government will have a greater ability to spend (ceteris paribus) and may choose to increase government spending.
* For example, the government may use the revenue generated to invest in infrastucture projects. This would generate jobs in the economy.
* As a result, investment increases due to increased government investment in infastucture and consumption also increased as by greater job creation, ceteris paribus, more people have incomes which can then be spent in the economy.
* These are components of aggregate demand resulting in a rightwards shift in AD from AD1-AD2 (ceteris paribus)
* ….Standard Macro Analysis.