micro 1.3 and 1.4 - market failure and government intervention ✅ Flashcards
market failure and externalities - inc diagrams
3 types of market failure:
- externalities - impact on a third party not involved in the economic transaction
- under-provision of public goods
- information gaps
- private cost/benefit- costs/benefits to the individual participating in the 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 activity
- 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
diagrams:
PE consumption:
- y axis: costs and benefits, x axis: quantity
- demand curve - MPB
- supply curve - MPC
- label the curve you’re not shifting - MPC=MSC=S
- MSB > MPB
- draw on new demand curve
- draw on welfare loss - triangle pointing towards social optimum
NE production:
- y axis: costs and benefits, x axis: quantity
- demand curve - MPB
- supply curve - MPC
- label the curve you’re not shifting - MPB=MSB=D
- MSC > MPC
- draw on new supply curve
- draw on welfare loss - triangle pointing towards social optimum
information gaps
imperfect information:
- imperfect information - prevents consumers acting in a rational way
- 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
- 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
perfect information:
- perfect information (symmetric information) - buyers and sellers have access to the same information
different types of goods
public goods:
- non rivalrous - the quantity of the good doesn’t diminish upon consumption
- non excludable - the benefits of consuming the good cannot be confined to the individual that has paid e.g. streetlights, flood defences
private goods:
- rivalrous
- excludable
quasi public goods:
- mixture between private and public goods
- for example, toll roads - rivalrous - heavy traffic can make them rivalrous// excludable - 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 - if everybody acts that way then no one will pay - no incentive for private sector firms to supply public goods - missing market
minimum prices
- minimum price - price floor - set above the equilibrium market price
diagram:
- the imposition of a minimum 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, there is an extension of supply from Q to QS (law of supply) and a contraction of demand to from Q to QD (law of demand) - quantity demanded falls to socially optimum level of output - solves overconsumption
- QD to QS shows the excess supply as a result of the imposition of the minimum price - government will buy up the excess supply - cost of intervention buying = excess supply x PMIN
- producer revenue with intervention buying = QS x PMIN
- producer revenue without intervention buying = QD x PMIN
issues:
- inelastic demand - quantity demanded may not decrease enough
- regressive - takes a greater proportion of income from the poor than from the rich
- rate of the increase in price
- setting the right level//set too high - firms may shut down due to less revenue - unemployment
- regulatory capture - individuals have associates within government bodies and can avoid following policies
- intervention buying is costly to the government
consumers:
- higher prices
- CS decreases
- regressive
- consumers have to bear the cost of intervention buying
producers:
- if there’s intervention buying - revenue and PS increases
- if set too high - firms may shut down due to less revenue - unemployment
government:
- costly - intervention buying costs
maximum prices
- maximum price - price ceiling - set below the equilibrium market price
diagram:
- the imposition of a maximum 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, there is a contraction of supply from Q to QS (law of supply) and an extension of demand from Q to QD (law of demand) - quantity demanded rises to the socially optimum level of output - solves under consumption of merit goods
- QS to QD shows the excess demand as a result of the imposition of the maximum price
- producer revenue —> decreases from PxQ to PMAXxQS (watch econplusdal)
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 worsen market failure - more government interventionist policies needed to solve market failure - costly// government lose out on tax revenue
- setting the right level//too low - excess demand//too high - 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
- unintended consequences - lower prices - fall in producer revenue and producer surplus - producers may leave the market - unemployment
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 - lower revenue - leads to unemployment
government:
- unintended consequences (government failure) - lower prices - fall in producer revenue and producer surplus - producers may leave the market - unemployment
- government may want to get rid of excess demand by increasing supply e.g. subsidies - costly
information provision
- information provision - government funded information provision/advertising/education to encourage or discourage consumption
diagram:
negative advertisement:
- y axis - price, x axis - quantity
- 2 demand curves and keep price the same - demand curve shifts left
- as a result of negative advertisement, the level of quantity demanded will fall from ___ - falls to socially optimum level - solves overconsumption of demerit goods (opposite for positive advertisement)
advantages:
- allows consumers to make more rational decisions
- works very well alongside other policies
- it can make demand more elastic in the long run
evaluation:
- costly
- no guarantee of success - people don’t have to listen
- more of a long run policy - takes a 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 —> costly
- 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 —> consumer savings
- producer revenue and surplus increases
impact on consumers:
- lower prices for consumers —> diagram —> before consumers were buying Q1 at the price of P1 —> due to subsidies decreasing price, consumers can buy Q1 at a lower price of P2 —> consumer savings can be shown by ___
- consumer surplus increases
- higher quantity —> higher choice
- 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 —> show on diagram —> were receiving P1aQ10 but now receiving revenue coming from consumers as well as the subsidy given to producers —> revenue is now __
- increase in PS —> show on diagram
- higher quantity —> labour is a derived demand —> greater employment
gov:
- costly —> show on diagram —> go to new equilibrium and work out vertical distance between 2 supply curves and times this by new quantity —> represents government cost
- concerned about how subsidies are being used
DWL
- triangle __
indirect taxes
- indirect tax - increases COP for firms which is then translated to consumers via higher prices
diagram:
- a tax can be imposed on demerit goods with negative externalities to reduce the consumption of the good
- prior to the indirect tax, the equilibrium price and quantity was at P1Q1
- due to the imposition of an indirect tax, COP for firms increases - this causes the supply curve to shift upwards from S1 to S1+tax
- as a result, prices increase from __ - the law of demand states that a rise in price will cause a fall in quantity demanded - quantity demanded falls from __ - quantity demanded falls to socially optimum level of output - solves overconsumption of demerit goods
- government revenue is generated (vertical distance between 2 supply curves x new quantity)
issues:
- 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 - unintended consequence//undertax - quantity demanded won’t fall enough
- regressive - takes a greater proportion of income from the poor than from the rich
- rate of tax
- longevity of tax
- formation of black markets - dangerous as we don’t know about the quality of goods - could worsen market failure - more government interventionist policies needed to solve market failure - costly// 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
consumers:
- prices increase
- CS decreases
- regressive
producers:
- lower producer revenue
- PS decreases
- quantity falls —> labour is a derived demand —> unemployment
government:
- unintended consequences - black markets forming, some firms may shut down due to less revenue - unemployment
regulation
regulation - law enacted by the government that must be followed by economic agents
examples:
- bans - public smoking ban
- limits - age limits on buying cigarettes and alcohol
- caps - emission caps
- compulsory - graphic imagery on cigarette packages
cons:
- costly to regulate
- setting the right regulation//too strict - consumers turn to black markets// too lax - no incentive to follow it
government failure
- government failure - when the costs of intervention outweigh the benefits of intervention
causes of government failure:
information failure:
- governments don’t have perfect information
- e.g. 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
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 - unemployment
- firms becoming dependant on subsidies// firms becoming more wasteful because of subsidies
tradable pollution permits
- tradable pollution - reduce the levels of pollution by restricting the amount firms 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
- 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 invest in green technology which will mean they do not have to pay the cost of such high pollution permits
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
- imperfect info - cap could be too strict or too lax//too strict - firms shut down//too lax - fail to achieve the desired environmental objectives
- rate and magnitude of TPP
state provision
- state provision - direct provision of goods/services by the government free at the point of consumption
why is state provision needed:
- 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 - if everybody acts that way then no one will pay - no incentive for private sector firms to supply public goods - missing market
- therefore, the government will provide these goods for free
diagram:
- y axis: price of ___ and x axis: quantity of ___
- normal demand curve
- vertical supply curve
- 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:
- costly to the government
- excess demand
- inefficiency of state organisations e.g. NHS and other state organisations lack a profit motive - costs tend to be higher due to less efficiency
