Market Failure Pt 2 Flashcards
Government failure
Situation where government intervention in market leads to worse outcome in terms of greater inefficiency and greater misallocation of resources
Taxes- Negative production/ consumption externalities
Levy a per unit production tax equivalent to monetary value of marginal external cost at socially optimal output level
1. Specific tax which is equal to marginal external cost at socially optimal output level raises firm’s marginal private cost of production, shifting the supply curve from MPC to MPC + Tax
2. Rise in market price of good, resulting in consumers to reduce quantity demanded, causing effective price to fall, causing producers to reduce quantity supplied
3. Reduction in quantity from free-market output level to socially optimal level where marginal social benefit = marginal social cost
4. Achieve efficient allocation of resources and eliminating deadweight loss
Tax on output VS tax on pollutants
- Tax per unit of output increases per unit cost of production, incentivising profit-maximising producers to reduce supply
- Over-allocation of resources to good is corrected
- Tax on pollutants however creates incentives for firm to buy less pollutants to pay less tax and switch to cleaner technologies
- Marginal external costs of producing each additional unit of output will fall, reducing divergence between MSC and MPC curves
- Social optimal quantity rises with fall in external costs
Tax on output only reduces amount of output produced while tax on pollutant encourages producers to adopt new technologies
Taxes advantages and disadvantages
Advantages
- Provides revenue which can be used for redistribution purposes
- Provide flexibility and financial incentives for behavioural changes
- Allow market to continue to operate according to market forces and reach new state of equilibrium
- Maintain consumer sovereignty-> consumers have power to determine what goods and services are produced
Disadvantages
- Accurate and complete info on size of external costs, hard to measure and place accurate monetary value on externalities
- Over-valuation means output is reduced to level that is below social optimum, under-valuation is insufficient to bring output down to socially optimal level
- Regressive and inequitable and undesirable, taxes a proportionally greater amount from those with lower incomes
Unintended outcomes
- Perverse incentives-> encourages action that has opposite effect of what is intended
- Unexpected drawback-> unexpected detriment occurring in addition to desired effect of policy
Subsidies- Positive production/ consumption externalities
Negative tax, payment made either to a firm or consumer when firm produces or when consumer buys a good, used to incentivise private producers to increase supply of goods that generate positive externalities
Indirect subsidy
1. To achieve allocative efficient level, government can provide a subsidy of an amount equal to the positive production/ consumption externality
2. Given to the firm for per unit of good produced, lowering the MPC of production, reflecting by a downward shift of MPC curve from MPC to MSC (MPC - subsidy)
3. By lowering private cost of product, profit-maximising producers receive higher post-subsidy price, hence are incentivised to increase quantity supplied
4. Increases output to socially optimum level, where MSC = MSB
5. Deadweight loss to society arising from underproduction/ overproduction of good is thus eliminated by subsidy
Direct subsidy
1. Direct subsidy to consumers equal to MEB will shift the MPB curve from MPB to MSB
2. Direct subsidy increases consumers’ ability to increase consumption, leading to higher effective demand
3. Resulting in socially optimal level where MSC= MSC
Subsidy advantages and disadvantages
Advantages
- Popular and easily implemented to bring about increase in production and consumption and is flexible enough to be adjusted according to magnitude of problem
- Consumer sovereignty is present since subsidies allow market to operate, financial incentives given to economic agents to internalise positive externalities, resulting in change in behaviour
Disadvantages
- Accurate information on size of external benefits is required, valuation of external benefit is difficult to quantify
- Huge burden on government and taxpayers due to huge financial resources to finance subsidies, governments may have to set high direct tax rates above optimal rates, discouraging work effort, savings and investment, being politically unpopular. Also can lead to unsustainable levels of government debt
- Huge subsidies resulting in opportunity costs due to less government financial resources available for another developmental project
Government legislation/ laws- Negative consumption externality/ positive consumption externality
Negative consumption externality
Prevent/ limit consumer activities that impose cost on third parties, decreases demand shifts DD= MPB curve towards MSB, eliminating externality with consumption, removing deadweight loss
Positive consumption externality
Promote greater consumption of goods with positive externalities or underconsumption due to imperfect information, increases demand, shifting the DD=MPB curve right to MSB, eliminating deadweight loss
Production quota- Negative production externality
Limit on quantity produced
1. Free market equilibrium output level where MPB=MPC is higher than socially optimal output level where MSB= MSC
2. To achieve allocatively efficient output level and eliminate deadweight loss, can impose production quota to limit products
Advantages disadvantages of legislation
Advantages
- Simpler to implement compared to market-based measures, easier to impose regulations that limit quantity of output produced, in turn limiting negative externalities
- Result in greater certainty in achieving its targeted output level than taxes
Disadvantages:
- Displaces price mechanism, meaning output level is no longer responsive to changes in price
- Government has to predict as best as it can the socially desired level of output, but suffers from imperfect information, can only be partially effective
Tradable permits system- negative production externality
- Permits to pollute are issued to firms by a government and can be traded in a market
- Each firm is granted a particular number of permits to discharge a define quantity of greenhouse gas
- Permits to pollute can be bought and sold among interested firms, with price of permits determined by market demand and supply
- If can emit less pollutants, can sell unused permits, if emits more, need to buy more, facing heavy penalties
- Cap on total number of permits, supply is perfectly price inelastic
- Equilibrium price is determined with demand for permits
- If demand rises, price rises, penalising buyers for polluting and rewarding sellers for reducing
- Government can reduce quota for tradeable permits if socially optimal level of pollution falls
Advantages and disadvantages of tradable permits
Advantages
- Socially optimal level of emissions can be targeted, reduction in overall pollution level is highly possible, desired level can be achieved with greater certainty, can progressively reduce/ increase no. of permits issues
- Most cost effective than regulation, if firms can reduce emissions at low cost, it is in their interests so they can sell excess permits for profit
- Encourages promotion of cleaner and greener technology to reduce pollution as it provides firms with incentives to reduce emissions
Disadvantages
- Subject to many technical difficulties, like how many permits to issue and what the permits entail exactly
- High administration costs as greater number of firms means its harder to enforce policy, hence more regulators need to be employed. Fines also need to be high enough if not firms can decieve regulators
- Need to find how to distribute permits to firms in fair way
Direct provision of goods that are underconsumed
Joint provision- government supplements what is being provided in the private sector, as free market equilibrium output level of merit goods are lower than socially optimum level
When government supplements the products,
1. Market supply of merit good increases
2. Market output increases towards socially desired output level via price adjustment process
3. Allocative efficiency is achieved, eliminating deadweight loss to society
4. Lower price of good allows for low-income households to access such goods ensuring there is greater equity
Government set price at 0, quantity demanded increases to a level that would coincide with the socially optimal level, eliminating deadweight loss and achieving allocative efficiency
Advantages and disadvantages of direct provision
Advantage
- Government has direct control over supply of good, by controlling supply, government can control quantity, affordability and quality
Disadvantage
- Unable to perfectly correct under-consumption of goods, difficult to measure size of external benefits and extent of underconsumption
- Production may be inefficient as employees have no incentive to keep costs at minimum due to lack of profit-motive
- Use of government funds which may have alternative uses, incurring an opportunity cost
- Need to make sure they are not exploiting unfair advantages over private sector and stifling innovation or improved efficiency that private firms bring
Direct provision of public goods (not tested)
not tested
Measures to regulate market dominance
- Reducing barriers to entry
- Anti-trust laws
- Regulations on standards of provision
- Lump-sum tax to reduce excessive monopoly profits
- Indirect subsidy to increase monopoly’s output towards allocative efficient level
Reducing barriers to entry- regulate market dominance
Deregulation of access, ensuring greater competition and lower prices
- Total market demand for good remains unchanged, entry to new firms causes demand for existing firm’s product to fall
- Demand for firm’s output also becomes more price-elastic due to more substitutes
- Equilibrium price decreases
Advantages and disadvantages of reducing barriers to entry
Advantages
- Reduction in difference between existing firm’s profit-maximising price and marginal cost, exploitation of consumers and allocative inefficiency is reduced, with fall in profits causing firm to have less incentive to be allocatively inefficient
- Equitable income distribution because profits are spread among more firms
Disadvantages
- Lower profits affect firm’s ability to do research and development and innovate, hence quality and choices may stagnate in future, adversely affecting dynamic efficiency
Anti-trust laws
Promote or maintain market competition
- Prohibit certain kinds of anti-competitive or restrictive practices that lead to a firm acquiring dominant position, including price fixing/ predatory pricing that aims to destroy competition as rival firms are forced out of business or potential new firm is dissuaded from entering the market, thus maintaining or strengthening the monopolist’s position
- Supervise merger and acquisitions of large corporations including joint ventures, transactions that threaten competitive process can be prohibited or approved subject to conditions
- Can break up monopoly firm into smaller independent units if it becomes too powerful
Disadvantages
- Difficult, costly time consuming to prove anti-competitive behaviour, may prevent benefits of mergers to be enjoyed where cost savings due to internal economies of scale leads to lower prices for consumers
Regulations on standards of provision
Guaranteed quality of product or service provided in monopoly markets
- Enforcement of such laws are difficult and expensive
- Constant monitoring is needed, translating into high costs for the government
- Penalties for breaking law must be sufficiently harsh
Price Regulation- FOR NATURAL MONOPOLY
Requiring firm to employ MC/ AC pricing, setting price at marginal cost OR average cost
- MC Pricing
Marginal cost pricing achieves social optimum as consumers’ marginal benefit from last unit sold is equal to marginal cost of producing last unit
Natural monopolist may have to face losses unless government subsidises producer
- AC Pricing
By setting prices at average cost, monopolist can break even but output level would be less than socially optimum output
Advantages and disadvantages of price regulation
Advantages:
- Both average cost and marginal cost pricing reduce price and increase output, increasing consumer surplus, measure of consumer welfare
Disadvantages
- MC pricing: socially optimal level of output is produced, natural monopoly makes subnormal profits and government has to subsidise it, if not it would shut down
- Incur opportunity cost of such spending, risking natural monopoly becoming complacent, in absence of other forms of regulation
- AC pricing: natural monopoly can make normal profits, but socially optimal level of output is not reached
- Government has to decide whether quantity of average cost is close enough
- Revenue and cost curves can only be estimated as regulated firm may withhold or distort info by overstating costs
Lump-sum tax to reduce excessive monopoly profits
Fixed amount of tax, representing a fixed cost to the firm
- Shift AC curve upwards, keeping MC curve unchanged
- Maximise profits where MC=MR, at same output level but different price level
- Reduce profits
Disadvantages
- Supernormal profits provides incentives and means for research and development, leading to dynamic efficiency for society
- Conflict with other economic objectives such as economic growth and efficiency
Indirect subsidy to increase monopoly’s output towards allocatively efficient level
Government wishes to increase monopolist’s output to socially efficiency level with a per-unit subsidy, shifting both AC and MC curves down
Disadvantages
- Increases supernoaml profits of monopolist, worsening income distribution
Nationalisation and advantages and disadvantages
Transfer in ownership of firm away from private sector towards government ownership
Advantages
- Beneficial in case of natural monopolies, as government can act in interest of public to promote equity, ensuring prices are lower and output greater than unregulated monopoly
- Result in higher investment than if they were under private ownership when government provides funds for investment purposes
- Protect strategic industries
Disadvantage
- More inefficient, other objectives tend to be more important than maximising profits, protected from competition hence increasingly allocatively inefficient and dynamically inefficient
- Suffer from moral hazard, knowing taxpayer would come to rescue means that inefficient behaviour of nationalised industry can continue
Measures to manage information failure- Education and campaigns
Influence behaviour of consumers through public education and campaigns, so private demand moves to socially desirable levels, causing firms to produce at levels that correspond with socially optimal output
CASE OF IMPERFECT INFO
- During education, consumers can learn about full private benefits from consuming
- Consumers seek to maximise self-intersts by increasing demand for these services
- Socially desired output level will be achieved via price adjustment process
- Consumers can maximise own well-being and society’s well being
CASE OF ASYMMETRIC INFO
- Directly supplying information to consumers through avenues
- Education and campaigns influence demand so socially desired output level will be achieved and deadweight loss arising from underconsumption. overconsumption is eliminated
Advantages and disadvantages of education and campaigns
Advantage
- If info failure is source of market failure, education and campaigns will effectively target root cause of into asymmetry
Disadvantage
- Difficulties involving accurate collection and effective dissemination of all necessary information to consumers
- Public education and campaigns are costly and drain government resources
- Ineffective in short run as changing consumers’ habits values attitudes and mindset requires long time to achieve it
Laws to address consequences from asymmetric information (from goods market) for adverse selection in goods market
- Lemon law, protecting consumers against defective goods that fail to conform to contract or meet satisfactory quality at time of purchase
- Consumer can make claim for defective product sold within a few months of purchase
- Compulsory for seller to repair replace refund or reduce price of good
- Correcting for any asymmetric information that seller has but buyer does not as it reduces incentive of seller to lie
- Seller may opt not to sell their product in these countries if it is too prohibitive, consumers face a lower range of goods if regulations framed too strictly
Laws addressing consequences from asymmetric information from adverse selection in health insurance market + disadvantages
- To provide missing market or over-representation of unhealthy buyers and under-representation of healthy buyers
- Mandatory participation in social health insurance
- Consumers required to provide accurate and complete information regarding existing state of health when buying products
Disadvantages
- Influence medical decisions, lead to moral hazard, or doctors pressuring patients to opt for unnecessary medical care
- Weak management and accountability systems lead to inefficiencies being perpetuated due to tendency to spend more than necessary and pass costs to government to finance
- Lack of privacy, where taxman can check sensitive financial and health details without explicit consent is not negligible
Laws addressing consequences from asymmetric information from moral hazard + disadvantages
- Government can make it compulsory for consumers to pay for part of cost of damages or make partial payment for healthcare bills
- Make buyer face consequences of irresponsible or risky behaviour, leading to less incentive from buyer to engage in irresponsible or risky behaviour
Disadvantages
- Prevent poorer families from accessing goods
- Can be useful to reinforce responsible service utilisation and appreciation of true costs, but cannot be high enough to deter consumers from seeking appropriate merit goods, or encourage them to cut corners
- Need to be affordable otherwise differences in access will be apparent and it would not be equitable to everyone’s needs
Policies to deal with factor immobility (not tested)
Not tested
Policies to ensure greater income equality and equity
- Minimum wage law/ price floor
- Measures to increase productivity of workers
- Measures to reduce supply of low skilled workers
- Taxes and subsidies
- Price controls for necessities
- Government provision
MInimum wage law
- Minimum wage set above existing equilibrium wage rate
- Help reduce wage inequality
- Employment falls as firms reduce quantity demanded for labour, resulting in unemployment
- Workers who want to work at the price but cannot find work
- Minimum wage lead to productive inefficiency since labour resource is not used to maximum capacity
- Benefit workers who retain their jobs by guaranteeing higher wage while impact those who are retrenched due to higher minimum wage
Measures to increase productivity of workers
- Demand for high skilled workers is higher due to higher productivity
- Improvement in skills lead to increase in labour productivity, increasing labour demand increasing wages
Measurs to reduce supply of low skilled workers
- Large supply of low skilled labour dampens wage rates in market
- Supply of low-skilled labour is reduced by restricting number of low skilled labour from overseas
- Increase wage rates prevent further widening of income gap in society
Taxes and subsidies and their disadvantages
Taxes
- Redistribute income and wealth from rich to poor
- Disadvantages:
=> Reduce reward to individuals for work effort and savings, especially among high-income earners who are taxed more heavily, reducing quantity of labour offered and willingness to save
=> High administrative costs
Subsidies
- Cash benefits subsidises a person’s income
- Benefits in kind leads to goods and services which is provided free or at reduced price to low-income households
- Disadvantages:
=> Financed with tax revenue, draining government finances if tax collection falls short
=> Low-income individual gets complacent and reliant, where individuals collect welfare payments than find work, resulting in long-term burden on government while reducing labour supply in economy
Price controls in market for necessities
Price ceiling on necessities
- Poor may not benefit them
- Long run, landlord who keeps property available for rent may cut maintenance cost and let property fall into disrepair
- Price support to help producers sell goods at minimum price, but may bring little benefit to poorer producers if larger producers are main ones
Government provision
Lack of education or inadequate healthcare
- Poor levels of education and health can hinder one from achieving satisfactory levels of income
- Tackle root causes of poverty, reducing extent of income inequality
- Sustain high level for employment, creating income for those who work and government to collect tax revenue and fund welfare schemes to support this
Government failure
Government intervention increases market distortions, reduces economic efficiency and welfare, leading to worsening of resources allocation
1. Unintended consequences unaddressed
2. Imperfect information
3. Bureaucracy and inefficiency of government intervention- Involving administrative costs, more wide-reaching and detailed the more resources needed, reducing economic welfare
4. Time lags -> Time needed to recognise market failure, come up with solutiion and implemente it, by the time solutions are implemented problems may have worsened or circumstances may have changed
5. Shifts in government policy
- Changes too frequently, making it hard for firms to plan ahead and allocate resources efficiently if cannot prevent tax rates or subsidies
6. Rent seeking
- Maximise own self-interest, principal-agent problem, when there is poor governance weak institution or widespread corruption
