Micro 1.8 Market Mechanism, Market Failure and Government Intervention

Question 1

(1.8.2)
What does market failure mean?

Answer 1

Market Failure occurs where there is a misallocation of resources.

Resources can be under or over allocated, resulting in over-/under-consumption or over-/under-production.

Question 2

(1.8.2)
What are the types of market failure?

Answer 2

Complete missing market
Partially Failed Market

Complete missing market generally occurs where there is a free rider problem and relates to public goods which private firms have no incentive to produce.
Partial Market Failure occurs where the market mechanism does work but the goods are produced at the wrong quantity or at the wrong price.

Question 3

(1.8.2)
What are the causes of market failure?

Answer 3

• Externalities
• Information Failure
• Tragedy of the Commons
• Monopolies
• Public Goods

Question 4

(1.8.2)
How do externalities lead to market failure?

Answer 4

Externalities occur where private parties do not take into account the external impacts to the third party so too much of a bad product or too little of a good product is consumed/produced.
eg. smoking results in negative externalities such as healthcare system pressures

Question 5

(1.8.2)
How does information failure lead to market failure?

Answer 5

Information failure occurs when somebody has incorrect, incomplete, misunderstood or uncertain information so do not fully understand the impacts of production/consumption and make “wrong” choices. eg. a firm will not reveal the true risks of smoking so consumers will continue to smoke despite the costs

Question 6

(1.8.2)
How does a tragedy of the commons lead to market failure?

Answer 6

Tragedy of the Commons is where a public resource (common) is overused or abused to the point of depletion and it can no longer be used in production or consumed. eg. overfishing

Question 7

(1.8.2)
How does monopoly lead to market failure?

Answer 7

A monopoly is when one firm has dominant power within a market and this can lead to too high prices as there are no close substitutes or underproduction. eg. railways where one operator may set a high price

Question 8

(1.8.2)
How do public goods lead to market failure?

Answer 8

Public goods can lead to a free rider problem which in turn can result in either a missing market. eg. public transport

Question 9

(1.8.3)
What is a private good?

Answer 9

A good that is excludable and rival.

Meaning that the owner can exercise private property rights, restricting consumption (excludable)
And that one person consuming the good can cause the quantity supplied of the good or its benefits to diminish (rival)

Question 10

(1.8.3)
What is a pure public good?

Answer 10

A good that is completely non-excludable, non-rival and non-rejectable.

This means that there are no restrictions on usage (non-excludable), one person consuming the good does not cause the quantity or benefits to diminish (non-rival) and it cannot be rejected as a public good is collectively supplied (non-rejectable).
eg. nuclear defence system or flood defence projects

Question 11

(1.8.3)
What is a quasi-public good?

Answer 11

A good that is either non-excludable or non-rival but it cannot be both.
eg. congested roads are rival but still non-excludable whereas toll roads are non-rival but are excludable

Question 12

(1.8.3)
How has technology changed public and private goods?

Answer 12

Technological advancements have begun to blur the distinction between public and private goods.
eg. satellite and cable TV has made television broadcasting excludable

Question 13

(1.8.3)
What is the free rider problem?

Answer 13

Where public goods are provided but the those who benefit do not pay. This removes the profit incentive for firms to produce a good leading to a missing market. It can also lead to a tragedy of the commons where the good is overused without payment, eventually leading to its depletion.

Question 14

(1.8.4)
What are externalities?

Answer 14

An indirect cost or benefit to a third party not involved in a market transaction as a result of the external costs and benefits of consumption or production not being taken into account by firms or consumers.
They exist where there is a divergence between social costs and benefits.

Question 15

(1.8.4)
What misallocation do negative externalities result in?

Answer 15

Over production or Over consumption
Products that generate negative externalities are considered to be “bad” products as they have a negative impact on third parties. This impact is not realised so they are generally over produced and over consumed.

Question 16

(1.8.4)
What misallocation do positive externalities result in?

Answer 16

Under production or under consumption.
Products that generate positive externalities are considered to be “good” products as they have a positive impact on third parties. But, because this impact is not realised, they are generally under produced and under consumed.

Question 17

(1.8.4)
What is a welfare loss?

Answer 17

The total cost to society created by market inefficiency, which occurs when demand and supply are out of equilibrium.

Question 18

(1.8.4)
What is marginal social cost?

Answer 18

Marginal private cost + marginal external cost

Question 19

(1.8.4)
What is marginal social benefit?

Answer 19

Marginal private benefit + marginal external benefit

Question 20

(1.8.4)
What are mixed externalities?

Answer 20

When production and/or consumption results in both external costs and external benefits.

Question 21

(1.8.4)
When will a good have net social costs / net social benefits?

Answer 21

When the external costs or benefits of production/consumption outweigh the other (C/B)

Question 22

(1.8.4)
Where the socially optimal level?

Answer 22

Where the marginal social cost (MSC) = marginal social benefits (MSB)

Question 23

(1.8.5)
What is a merit good?

Answer 23

A good where:

• people do not realise the true private benefits
• there is also a positive externality

Therefore, in a free market these goods will be under-consumed.

eg. vaccines, education, museums

Question 24

(1.8.5)
What is a demerit good?

Answer 24

A good where:

• the consumer is harmed
• there is a negative externality

Therefore, in a free market, there will be overconsumption of these goods.

eg. smoking, alcohol, sugary soft drinks

Question 25

(1.8.5)
How do merit and demerit goods involve value judgments?

Answer 25

A value judgement is an evaluative normative statement based on how good or bad an action is.
The consumer has to decide whether a good is “good” or “bad” and therefore classify a good as merit or demerit.
This isn’t always clear, such as with cannabis where it is widely a demerit good but its supporters would argue that it is harmless and helps people deal with pain and enjoy life more.

Question 26

(1.8.5)
How could imperfect information lead to over-provision of demerit goods and under-provision of merit goods?

Answer 26

With imperfect information, consumers and producers have less understanding of the long term implications of consuming or producing a good.

Question 27

(1.8.9)
Why would a government intervene in a market?

Answer 27

To correct market failure
eg. providing healthcare and education, which the free market would underprovide

Question 28

(1.8.9)
What are indirect taxes and what effects do they have?

Answer 28

A charge levied on expenditure.
They increase production costs, so producers supply less. This increases the market price and demand will contract.
They are generally used to discourage the production or consumption of a demerit good or service and reduce negative externalities.

Question 29

(1.8.9)
What are the types of indirect taxes?

Answer 29

Ad valorem taxes are percentages of the unit price, such as VAT

Specific taxes are a set tax per unit, such as fuel duty

Question 30

(1.8.9)
How does price elasticity of demand affect the incidence of the tax?

Answer 30

Producers could set the whole tax onto consumers (P3 – P2) or, if they feel this would lower sales, they might choose to pay part of it (ie they pay P1 – P2 whilst consumers pay P3 – P1).
The incidence will then depend on PED, where, if demand is inelastic, consumers might have the larger tax burden.
Because demand only falls slightly with the tax, government revenue will be higher if demand is price inelastic.

Question 31

(1.8.9)
How does indirect tax internalise an externality?

Answer 31

By increasing the good’s price, the quantity consumed could decrease. If tax is equal to the external cost of each unit the supply curve becomes MSC instead of MPC so the free market equilibrium will become the socially optimal equilibrium. The producer will pay the cost.

Question 32

(1.8.9)
What is a subsidy?

Answer 32

A payment from the government to a producer to lower their costs and encourage an increase in production. It does not have to be paid back.
It could also be given to consumers in the form of vouchers or a cash payment to encourage an increase in consumption.

Question 33

What is the price mechanism?

1.8.1

Answer 33

The means by which decisions of consumers and businesses interact to determine the allocation of resources.
The free market price mechanism does not ensure an equitable distribution of resources and this can result in market failure.

Question 34

How do changes in market price act as a signal?

1.8.1

Answer 34

Changes in market price act as a signal about how scarce resources should be allocated.
A rise encourages producers to make that good but encourages consumers to use an alternative substitute.
A fall leads to an extension of demand but less profitable for a producer to supply the good.

Question 35

What is the signalling function?

1.8.1

Answer 35

Prices rise and fall to reflect scarcities and surpluses.
A price rise resulting from high demand signals to firms to expand production.
The market price will fall when there is a surplus to eliminate the surplus

Question 36

What is the incentive function?

1.8.1

Answer 36

Through choices, consumers send information to producers about their changing nature of needs and wants. It motivates a producer or consumer to follow a course of action or to change behaviour. ie. increasing demand/increasing supply

Question 36

What is the rationing function?

1.8.1

Answer 36

Prices will deter consumers from buying a resource in shortage, leaving only those with both the willingness and ability to pay to buy. Consumers without the willingness and ability to pay ration the good more.