micro 1.3 and 1.4 - market failure and government intervention ✅ Flashcards
market failure and externalities
3 types of market failure:
- Externalities - Impact on a third party not involved in the economic transaction. For example, pollution from a factory affects the health of nearby residents
- Under-provision of public goods: Public goods are non-rivalry and non-excludable, meaning they are under provided by the private sector due to the free-rider problem (private firms have no incentive to provide them since people can benefit without paying)
- Information Gaps: This happens when buyers or sellers don’t have full or accurate information, leading to bad decisions. For example, for second hand products, seller has more info than buyer —> buyer may make an irrational decision to buy the car
These all lead to the inefficient allocation of resources, which is why governments may intervene to correct them
- private cost/benefit- costs/benefits to the individual participating in the economic activity
- social cost/benefit- costs/benefits of the activity to society as a whole
- external cost/benefit- costs/benefits to the 3rd party not involved in the economic transaction
- SC = PC + EC
- SB = PB + EB
- marginal cost —> extra cost of producing/consuming one extra unit of the good
- marginal benefit —> extra benefit of producing/consuming one extra unit of the good
MSB > MPB —> positive externalities
MSC > MPC —> negative externalities
how to draw NE/PE consumption/production diagram?
consumption —> demand curve
production —> supply curve
NE consumption:
1. y axis - costs and benefits, x axis - quantity
2. draw demand and supply curves
3. label the curve you’re not shifting —> supply curve —> MPC = MSC = S
4. write out inequality MPB > MSB
5. draw on new demand curve
6. draw on initial e at MPB
7. draw on other e at MSB
8. draw on welfare loss (triangle pointing towards social optimum)
NE production:
1. y axis - costs and benefits, x axis - quantity
2. draw demand and supply curves
3. label the curve you’re not shifting —> demand curve —> MPB = MSB = D
4. write out inequality MSC > MPC
5. draw on new demand curve
6. draw on initial e at MPC
7. draw on other e at MSC
8. draw on welfare loss (triangle points towards social optimum)
information gaps
imperfect information (asymmetric info and lack of information) —> prevents consumers acting in a rational way
lack of information- info may not exist at all / info not clear —> under / overconsumption —> irrational decisions
- e.g. merit goods —> not enough info that tells consumers how good merit goods are —> under-consumed e.g. healthcare and education —> irrational decisions are made
- de-merit goods —> not enough info that tells consumers how bad de-merit goods are —> over consumption e.g. cigarettes and alcohol —> irrational decisions are made
symmetric information (perfect information) - buyers and sellers have access to the same information
asymmetric information- asymmetric information - when 1 party has more info than the other party
- e.g. labour markets —> employer and worker —> worker has more info than the employer —> employer may make irrational decision to employ the worker
- second hand markets —> seller and buyer —> seller has more info than buyer —> buyer may make an irrational decision to buy the car
- insurance markets —> driver and insurance company —> driver has more info than insurance company —> individuals may under report the level of risk to keep insurance prices low —> insurance company may make an irrational decisions by issuing a price lower than what should be charged
THIS ALL LEADS TO MARKET FAILURE WHICH IS A MISALLOCATION OF RESOURCES
different types of goods
Public goods:
- Non rivalrous —> the quantity of the good available doesn’t diminish upon consumption
- Non excludable —> no price can be charged for the good that excludes others who haven’t paid —> the benefits of consuming the good cannot be confined to the individual that has paid (even those who haven’t paid are able to benefit in the same way as someone who has paid for it) e.g. streetlights
Private goods:
- Rivalrous
- Excludable
Quasi public goods:
- Mixture between private and public goods e.g. toll road —> non-rivalrous when it’s not congested (one person using the road doesn’t stop others from using it). However, it is excludable because people can be prevented from using the road unless they pay the toll
Free rider problem:
- Public goods are non rivalrous and non excludable —> leads to the free rider problem —>
- Individuals have little incentive to contribute towards the provision of the public good because they will wait for others to contribute and then free ride off their contributions —> this is because the benefits cannot be confined to those who have paid// if that person does pay and they consume, the same amount will be available to the person who hasn’t paid to consume —> if everybody acts that way then no one will pay —> no incentive to supply
minimum prices and market failure?
minimum price —> fixed price (price floor) enacted by the government usually set above the equilibrium market price —> legally price cannot go below it, implying that the current price is too low
why do minimum prices exist?
- solves market failure —> discourages over consumption/production of demerit goods
diagram:
- the imposition of a minimum price (price above the equilibrium price) will lead to a higher price for consumers —> this is shown on the diagram by the increase in price from P to PMIN —> as a result of an increase in the price, there is an extension of supply from Q to QS and a contraction of demand to from Q to QD —> this is due to the law of demand —> quantity demanded falls to socially optimum level of output —> solves overconsumption/production
- QD to QS shows the excess supply as a result of the imposition of the minimum price
- cost of intervention buying (excess supply x PMIN): —> government buying up excess supply
- producer revenue with intervention buying —> QS x PMIN
- producer revenue without intervention buying —> QD x PMIN
issues?
- inelastic demand —> in the case the intention is to reduce demand for a demerit good, a minimum price may be ineffective if the good has inelastic demand —> quantity demanded may not decrease enough to solve market failure
- regressive (takes a greater proportion of income from the poor than from the rich) —> widen inequalities —> goes against key macro objective
- rate of the increase in price from the equilibrium level —> in the case the intention is to reduce demand for a demerit good, the effectiveness depends on the rate of the increase in price from the equilibrium level —> in the case the minimum price level is set a bit above equilibrium level, it may not be as effective in trying to reduce demand
- formation of black markets —> dangerous as we don’t know about quality of a good in the black market —> could make market failure worse —> more government interventionist policies needed to solve market failure —> expensive// government lose out on tax revenue
- minimum price may not be set at the right level —> set too high —> could impact firms as they may shut down due to less revenue —> unemployment// HOWEVER if product is price inelastic then producers will see an increase in revenue
- minimum price may not be effective due to regulatory capture —> individuals have associates within government bodies and can avoid following policies/interventions
- intervention buying is costly to the government —> cuts to other areas of government spending so opportunity cost is created// if money is borrowed then debt interest has to be paid which creates an opportunity cost// taxes will be higher to fund it
positives:
- producers will benefit from the minimum price if there is inelastic demand —> producers will see an increase in revenue
- intervention buying could take place —> revenue and producer surplus increases
- minimum price can provide a stable income for suppliers/producers
impact of minimum price on consumers:
- higher prices
- consumer surplus decreases
- quantity decreases (on diagram) —> choice is lower
- regressive
- consumers have to bear the cost of intervention buying - taxes will be higher, cuts to other areas of gov spending, if money is borrowed then debt interest has to be paid which creates an opportunity cost
producers:
- if there’s intervention buying —> increase in revenue, increase in PS
- if set too high —> could impact firms as they may shut down due to less revenue —> unemployment
gov:
- concerned about impact of higher prices on consumers e.g. unintended consequences like black markets
- concerned about intervention buying costs
maximum prices and market failure?
maximum price —> a fixed price (price ceiling) enacted by the government usually set below the equilibrium market price —> legally price cannot go above it, implying that the current price is too high
why do maximum prices exist?
- to increase affordability of necessity goods/services
diagram:
- the imposition of a maximum price (price below the equilibrium price) will lead to a lower price for consumers —> this is shown on the diagram by the decrease in price from P to PMAX —> as a result of a decrease in the price, there is a contraction of supply from Q to QS and an extension of demand from Q to QD —> this is due to the law of demand —> quantity demanded rises to the socially optimum level of output —> solves under consumption/production of merit goods
- QS to QD shows the excess demand as a result of the imposition of the maximum price
- producer revenue —> decreases from P x Q to PMAX x QS
issues?
- excess demand —> people will go to the black market —> dangerous as we don’t know about quality of a good in the black market —> could make market failure worse —> more government interventionist policies needed to solve market failure —> expensive// government lose out on tax revenue
- setting the right level —> maximum price set too low could cause massive excess demand but if it’s set too high then we won’t see greater consumption that’s desired
- fall in price —> consumers assume quality of good/service has fallen —> quantity demanded won’t rise
- government may want to get rid of excess demand by increasing supply e.g. subsidies —> costly for government
- unintended consequences —> lower prices —> fall in producer revenue and producer surplus —> producers may leave the market —> unemployment
positives?
- consumer surplus increases due to greater affordability
- inequality improves —> lower income households can access necessities
impact of maximum price on consumers:
- those who can access the market are benefitting —> greater affordability/greater CS
- those who can’t access the market due to excess demand —> turn to the black market
producers:
- fall in producer revenue
- fall in PS
- producers may leave the market due to lower prices/revenue —> unemployment
gov:
- concerned about other impacts of maximum price on consumers and producers e.g. excess demand can lead to black markets forming —> unintended consequence// producers may leave the market due to lower prices/revenue —> unemployment
information provision?
information provision- government funded information provision/advertising/education to encourage or discourage consumption
diagram:
- negative advertisement —> (use context)
- y axis- price and x axis- quantity
- 2 demand curves and keep price the same —> demand curve shifts left —> the diagram showcases that as a result of negative advertisement, the level of quantity demanded will fall from ___ (opposite for positive advertisement)
- information provision for merit goods —> encourage consumption —> quantity demanded increases to socially optimum level —> solves underconsumption/ production
- information provision for demerit goods —> discourage consumption —> quantity demanded decreases to socially optimum level —> solves overconsumption/ production
advantages:
- targets thought process behind a consumer —> allows consumers to make more rational decisions
- works very well alongside other policies
- it can make demand more elastic in the long run
evaluation:
- cost —> expensive —> taxes may increase to fund information provision
- no guarantee of success —> people don’t have to listen
- more of a long run policy not short run —> takes while for consumers to change consumption habits// takes time for consumers to keep repetitively seeing adverts which will change consumption behaviour
- longevity —> if the information campaign is only in place for a short period of time then it will be ineffective
- depends on how well the advertisement is being carried out and if it’s reaching large audiences
subsidy and market failure?
subsidy —> money grant given to producers by the government to lower costs of production and encourage an increase in output (merit goods)
diagram:
- prior to the subsidy, the equilibrium price and quantity was P1Q1 —> due to the imposition of the subsidy, the cost of production for firms decreases —> this causes supply to increase from S1 to S1+subsidy —> this is because it is now less expensive to produce so firms will be more willing to increase production —> this lowers the price from ____ —> as a result, quantity demanded increases from ___ —> this is due to the law of demand —> therefore, in the case there is a misallocation of resources and underconsumption of merit goods with positive externalities, the government are able to impose a subsidy in that market in order to stimulate demand for it —> quantity demanded rises to social optimum level of output —> solves underconsumption/production of merit goods —> solves market failure
issues with subsidies to solve market failure?
- costly —> vertical distance between 2 supply curves x quantity = cost to government —> cuts to other areas of government spending so opportunity cost is created// if money is borrowed then debt interest has to be paid which creates an opportunity cost// taxes will be higher to fund subsidies
- inelastic demand —> in the case that there is inelastic demand, a fall in price may not be that effective in increasing quantity demanded —> market failure not solved
- depends on the rate of the fall in price
- depends on the longevity of the fall in price
- setting subsidy at the right level- we are assuming that government has perfect information so will set subsidies perfectly —> however governments don’t have perfect information and are likely to under/over subsidise// under —> won’t fully solve market failure//over
- firms may not use the subsidy how the government wants them to —> they could spend subsidy on other things —> government failure
positives:
- consumer surplus increases due to a fall in price
- producer revenue and surplus increases
- improves affordability of goods/services
impact on consumers:
- lower prices for consumers
- consumer surplus increases
- higher quantity —> higher choice
- greater affordability
- taxes increase, cuts to gov spending etc to fund subsidies, if money is borrowed then debt interest has to be paid which creates an opportunity cost ❌
producers:
- increase in producer revenue
- increase in PS
- higher quantity —> labour is a derived demand —> greater employment
gov:
- costly
- concerned about how subsidies are being used
merit and demerit goods
merit goods- goods deemed more beneficial to consumers than they realise
why is there an under consumption/production of merit goods?
- irrational decisions made by consumers to under consume merit goods due to lack of info —> info failure (info not present, not clear or consumers are choosing to ignore info)
- asymmetric info (info not shared equally between 2 parties)
merit goods generate positive externalities in consumption e.g. healthcare, education and exercise —> can increase demand for merit goods through subsidies, public provision, info provision
diagram?
PE consumption diagram
demerit goods- goods deemed more harmful to consumers than they realise
why is there an over consumption/production of demerit goods?
- irrational decisions made by consumers to over consume demerit goods due to lack of info (don’t know how bad it is for them) —> info failure (info not present, not clear or consumers are choosing to ignore info)
- asymmetric info (info not shared equally between 2 parties)
demerit goods generate negative externalities in consumption e.g. cigarettes, alcohol, gambling —> can reduce demand of demerit goods through taxes, regulation (banning or restricting the sale and use of these goods), info provision (negative advertising), subsidising alternatives (healthier or safer alternatives)
diagram?
NE consumption
market failure is the misallocation of scarce resources —> this could be in the form of underconsumption/production of merit goods with positive externalities in consumption/production// overconsumption of demerit goods with negative externalities
indirect taxes and market failure?
indirect tax —> tax that increases a firms cost of production which is then translated to consumers via higher prices
application:
- sugar tax came into effect in 2018 —> over 50% of manufacturers have reduced the level of sugar within their drinks
diagram:
- a tax can be imposed on demerit goods with negative externalities to reduce the consumption of the good and correct market failure —> prior to the indirect tax, the equilibrium price and quantity was at P1Q1 —> due to the imposition of an indirect tax, cost of production for firms increases —> it is now more costly for firms to supply the good —> this causes the supply curve to shift upwards from S1 to S1+tax —> as a result of the tax, firms will increase the price of the good for consumers —> this is shown by the increase in price from P1 to P2 —> the law of demand states that a rise in price will cause a fall in quantity demanded —> quantity demanded falls from ____ —> quantity demanded decreases to socially optimum level of output —> solves overconsumption/production of demerit goods
- government revenue is generated (vertical distance between 2 supply curves x new quantity) —> revenue can be used to reduce market failure
issues?
- inelastic demand —> in the case the intention is to reduce demand for a demerit good, an indirect tax may be ineffective if the good has inelastic demand —> quantity demanded may not decrease enough to solve market failure
- setting the right level // overtax —> black markets form, some firms may shut down due to less revenue —> unemployment// undertax —> quantity demanded won’t fall enough —> market failure not solved
- regressive (takes a greater proportion of income from the poor than from the rich)
- rate of tax —> in the case that the price increases by a small amount, quantity demanded may not decrease enough to solve market failure
- longevity of tax —> in the case that the tax is put in place for a short period of time, it will not be that effective
- formation of black markets —> dangerous as we don’t know about quality of a good in the black market —> could make market failure worse —> more government interventionist policies needed to solve market failure —> expensive// government lose out on tax revenue
- money raised on taxes from demerit goods might not be spend on reducing the externality (tax isn’t ring fenced)
positives:
- fall in consumption of demerit goods (cigarettes) could mean that there is now a healthier population —> as a result, there may be less people needing to go to the hospital which in turn means that there is less strain on the NHS
- tax revenue generated can be spent on things such as education, healthcare and infrastructure or even negative advertising of demerit goods
consumers:
- prices increase
- CS decreases
- lower quantity —> lowers choice
- regressive
producers
- lower producer revenue
- PS decreases
- quantity falls —> labour is a derived demand —> unemployment
gov
- unintended consequences —> black markets forming, some firms may shut down due to less revenue —> unemployment
regulation
regulation- rule/law enacted by the government that must be followed by economic agents to encourage a change in behaviour
there has to be a punishment so there’s an incentive to follow it
examples:
- bans- public smoking ban
- limits- age limits on buying cigs and alcohol
- caps- emission caps
- compulsory- graphic imagery on cig packages
- innovative regulations- pay a bit extra for a plastic bottle and only get the money back if we recycle it
cons:
- costs- e.g. regulation requires policing —> opportunity cost
- setting the right regulation- too strict —> unintended consequences e.g. burdens firms —> costs increase significantly for firms —> profitability decreases —> reduce production —> unemployment// may leave country and operate elsewhere where regulations aren’t so strict// strict on consumers —> turn to black market —> loss of tax revenue for gov/more policing which costs money// too lax —> no incentive to follow it —> won’t change behaviour enough to solve market failure
government failure
government failure - when the costs of intervention outweigh the benefits of intervention —> worsening of the allocating of scarce resources
causes of government failure:
information failure
- government don’t have perfect info
- valuing externalities —> government don’t have perfect info to value externalities perfectly —> policies may be too strict or too lax —> government failure
admin and enforcement costs very high
- regulation
- subsidies
- state provision
- price controls
regulatory capture
- in the case that a firm has allies with a government regulation body, firms can reduce the extent of the regulation
unintended consequences
- black markets
- impact on the poor e.g. minimum price
- impact on firms e.g. taxation —> may shut down, decrease in size or relocate —> unemployment
- firms becoming dependant on subsidies// firms becoming more wasteful because of subsidies —> costly for government
tradable pollution permits
tradable pollution permits —> government policies implemented to reduce the levels of pollution by ultimately restricting the amount of pollution a particular firm can emit
diagram:
- y axis: price of permits
- x axis: quantity of permits
- vertical supply curve at S1 —> supply curve shifts left to S2
- normal demand curve
- imposition of the tradable pollution permit will restrict the volume of pollution being emitted by firms at S1
- without the permit, firms can pollute as much as they would like
- in the case that the government recognise that there is still too much pollution, they will reduce the amount of pollution even further by reducing the supply of permits from S1 to S2 —> this leads to an increase in the price of permits from P1 to P2 —> this will incentivise firms to find more efficient methods of production in order to avoid paying such a high price to operate —> this could be in the form of firms investing into more environmentally friendly/green technology which will mean they do not have to pay the cost of such high pollution permits
- always LR incentive to invest in green tech —> firms can profit from sale of spare permits/ they will never be burdened when permit prices rise
evaluation:
- regulatory capture —> in the case that a firm has allies with a government regulation body, they can avoid following this policy
- need for international corporation —> many countries would need to partake in the scheme for it to be effective but getting lots of countries involved is difficult
- regulation costs —> the government will have to hire regulators —> wage costs involved —> this creates an opportunity cost as the money could have been spent elsewhere such as education/healthcare/military
- unintended consequences —> COP increases for firms —> pass this onto consumers via higher prices —> demand could fall —> firms shut down and move elsewhere —> pollute elsewhere —> carbon leakages (co2 emissions move form one part of the world to another part of the world)
- imperfect info —> cap could be too strict or too lax —> unintended consequences e.g. too strict —> firms shut down —> job losses (unemployment) and pollute elsewhere// too lax —> fail to achieve the desired environmental objectives
- rate and magnitude of TPP —> large decrease in the supply of permits —> effective// small decrease in the supply of permits —> ineffective
state provision
state provision- direct provision of goods/services by the government free at the point of consumption
why is state provision needed?
- if left to the free market/ producers, there will be a missing market due to the idea of little profit being made —> if one person purchases ___ (use context), everybody else will be able to free ride off this purchase —> this is because, ___ are public goods - non excludable and non-rivalrous —> no one will be willing to purchase ___ and therefore, firms/producers willl not be able to carry out their aim of profit maximisation which is why they will not provide ___ —> therefore the government will provide these goods for free
diagram?
- y axis: price of ___ and x axis: quantity of ___
- normal demand curve (touches x axis)
- vertical supply curve (fixed supply)
- price = 0 —> bottom left corner of diagram
- excess demand —> triangle in right corner
Advantages:
- This corrects market failure by providing important goods which would otherwise not be provided/under-provided
- Accessible to everyone regardless of income —> ensures everyone has access to basic goods
Disadvantages:
- Expensive —> higher taxes, cuts to other areas of gov spending in the economy, higher debt interest that needs to be paid, opportunity cost
- State provision of public goods diagram - excess demand exists - government may try to reduce the level of excess demand e.g. subsidies however this could be very costly and burdensome
- Inefficiency of state organisations —> e.g. NHS and other state organisations lack a profit motive as their main goal is to provide services to benefit the public rather than to make profit —> costs tend to be higher due to less emphasis on cost efficiency —> not effective use of public money —> gov failure
