Micro Pack 4

Question 1

What is market failure?

Answer 1

when the price mechanism fails to deliver efficiency and results in a misallocation of resources

Question 2

What are the 7 different types of market failure?

Answer 2

EXTERNALITIES: effects on third parties, which are ignored in decision making. Can lead to too much consumption or production (if negative externalities ignored) or too little consumption/production (if positive externalities ignored)

UNDER-PROVISION OF PUBLIC GOODS: (non-rival and non-excludable), businesses will find it difficult to profitably provide these as consumers can refuse to pay and still consume. Means they will be underprovided

INFORMATION GAPS: for free markets to work efficiently both consumers/producers need to have perfect information to make informed decisions. However, information gap leads to exploitation of consumers and a misallocation of resources

GEOGRAPHICAL AND OCCUPATIONAL IMMOBILITY OF LABOUR: when workers lose a job there can be factors which prevent them from becoming employed againdue to either geographic immobility or occupational immobility

MONOPOLY POWER: businesses face lack of competition they can exploit consumers with higher prices.Could mean that businesses with monopoly power may have less incentive to be efficient as they can raise their prices to improve profits rather than needing to reduce production costs

UNSTABLE COMMODITY MARKETS: prices of commodities fluctuate over time due to changes in demand and supply. these price changes can impact on the incomes earned by producers and the welfare of consumers as well as leading to underinvestment by producers due to uncertainty of their future incomes

INEQUALITY: lack of equality in market can lead to market failure as price mechanism may result in an income distribution that is unfair

Question 3

What are private costs?

Answer 3

direct cost to producer/consumer

Question 4

What are private benefits?

Answer 4

direct benefit to producer/consumer

Question 5

What are external costs? (negative externality)

Answer 5

• negative third party (spill-over) effects
• costs external to an exchange, ignored by the price mechanism

Question 6

What are external benefits? (positive externality)

Answer 6

• positive third party (spill-over) effects
• benefits external to an exchange, ignored by price mechanism

Question 7

What are some examples of external costs?

Answer 7

pollution
impact on climate change
reduction in biodiversity

Question 8

What are some examples of external benefits?

Answer 8

healthier UK workforce
faster economic growth

Question 9

What are social costs?

Answer 9

private costs + external costs

Question 10

What are social benefits?

Answer 10

private benefits + external benefits

Question 11

What is the shape of the marginal private benefit line and marginal private cost line on an externality diagram?

Answer 11

• marginal private benefit will be downward sloping
• the more extra units you consume of a good/service, the lower the benefit (law of diminishing marginal utility)
• marginal private cost will be upward sloping
• the more extra units produced/consumed, the higher the cost

Question 12

What is a public good?

Answer 12

• both non-rivalry and non-excludable

Question 13

What is a private good?

Answer 13

both rival and excludable characteristics such as an apple

Question 14

What is the free rider problem?

Answer 14

once a public good is provided, it is impossible to prevent people who have not paid for it, consuming it

Question 15

What is
imperfect information
symmetric information
asymmetric information

Answer 15

imperfect = economic agents lack all the information in order to make informed choices

symmetric = all parties have the same amount of information

asymmetric = one party has more information than the other

Question 15

What are the problems associated with information gaps with insurance?

Answer 15

• consumer has more information than the seller (know their actions/future actions)

Lack of care by those insured (moral hazard): make less effort to prevent problems arising if they know they will be compensated

Under-provision of insurance (adverse selection): insurer finds it hard to know whether individual high/low risk
- offers average price to all clients (unfair as low risk price to high so wont purchase and high risk will be keen to purchase)

Question 16

What are the problems associated with information gaps in Education?

Answer 16

• household may have less info about schools/quality of them than the school has

Under-consumption of education: private education under-consumed as individuals ignore external benefits of it or unaware of future benefits (imperfect information)

Problems of choosing correct schooling: asymmetric information as parents have incomplete information compared to the schools

Question 16

What are the problems caused by information of gaps in Healthcare?

Answer 16

Patient exploitation: recommending costly drugs/treatments if it was private, that are not needed.

Medical conditions not diagnosed: people may be discouraged from visiting doctor if they have to pay and so healthcare is under consumed

Ignoring external benefits: patients may not see external benefits to entire economy and so under-consume it

Question 16

What are the problems associated with information gaps in Pensions?

Answer 16

• consumers do not understand workings of pension markets

Individuals underinvesting in pension funds:
do not understand need for pension in the future or how much will be needed
- numerous options makes it more difficult

Question 16

What are the problems associated with information gaps in Tobacco and alcohol?

Answer 16

• in past consumers unaware of health issues : asymmetric information

Overconsumption of tobacco/alcohol: consumers ignore external costs (e.g crime, noise pollution) and so will over consume these from society’s POV

Question 17

What affects the effectiveness of indirect taxation?

Answer 17

difficult to set the right tax level: difficult to estimate exact value of negative externalities, so unlikely indirect tax will be set equal to marginal external cost of consumption/production, so equilibrium quantity may be above/below social optimum

Less effective when demand is price inelastic: less than proportionate decrease in quantity demanded and so may be unable to reduce quantity to social optimum

Impact on low income consumers: tend to be regressive, meaning as consumer’s income rises, they pay a smaller percentage of their income in taxation. May seem unfair as those on low incomes will be affected more than those on higher incomes by indirect taxes on goods/services they consume

Negative impact on businesses: higher cost of production and lower profits, may relocate abroad. Could result in lower employment, GDP and tax revenue for economy. For those who remain in country, could suffer from a fall in international competitiveness if they export goods abroad.

Cost of collection: administration costs could offset some of social benefit achieved from indirect tax

Possible secondary markets: may result in creation of secondary markets such as cash in hand transactions. May see a fall in tax revenue and need to increase spending on policing of these markets, all increases chance of gov failure where an intervention leads to further distortions in the market and a net welfare loss

Question 18

How are subsidies used to solve market failure?

Answer 18

• reduce costs of productions and increase supply
• so can be used to increase the quantity nearer the social optimum for goods and services with external benefits or reduce qty of substitutes with external costs

Question 19

What are the limitations of subsidies which affect their effectiveness?

Answer 19

Difficult to set subsidy at right level: hard to estimate exact value of positive externalities, so unlikely subsidy set at level to achieve social optimum. Could mean uner/over consumption still occurs.

Cost of subsidy: administration costs and cost to gov can increase budget deficit and leads to opportunity cost

Impact on efficiency: by providing subsidies reduces production costs for producers and therefore reduces their need to improve efficiency to reduce costs, (can become complacent)

Will subsidies change behaviour: depends on price elasticity of demand of good/service being subsidised, if inelastic unlikely to change

Question 20

How can provision of information be used to solve market failure

Answer 20

• help to reduce information gaps
• lead to people making better decisions = better allocation of resources
• and so decreasing demand for goods/services with external costs to social optimum whilst increasing demand for goods/services with external benefits to social optimum

Question 21

What are the limitations of provision of information?

Answer 21

Cost of providing information: e.g public health campaigns and can have opportunity cost, also sometimes costs will be imposed on businesses such as adding health warnings to products which can reduce their profitability

will in change decision making: habitual behaviour can be harder for information to change decision making for the better

Question 22

How can regulation be used to solve market failure and what are the limitations of it?

Answer 22

• regulation is rules, laws and restrictions put in place by the government
• decreasing production/consumption with external costs to social optimum
• preventing consumer exploitation due to information gaps/monopoly power

hard to set the right level of regulation: gov have information gaps so may set regulation levels too low or too high and impose significant costs to businesses

Impact on business: higher costs of production could reduce international competitiveness and profitability, lead to some businesses leaving the country and small businesses closing

Cost of regulation: gov face costs of designing, implementing and enforcing regulations

Will they be effective: if fines issued small may be ignored or if regulators lenient to some industries rather than others may not work

Question 23

How can state provision be used to solve market failure and what are the limitations of using it?

Answer 23

• provide public goods that are unprovided due to free rider problem
• can provide goods/services with external benefits such as education and healthcare
• without things such as education/healthcare likely be under-consumed as consumers do no appreciate external benefits society gains from education or cannot afford it (inequality issues)

Evaluation:
cost of state provision: significant cost for gov = opportunity cost
inefficiency of the government: without profit motive, government has less incentive to reduce costs and become more efficient, compared to private sector
possibility of government failure: information gaps for the government and high administration costs could increase chance of gov failure if these outweigh the benefits of providing the goods/services

Question 24

What is the tradable permit scheme?

Answer 24

• where a limit is placed on firms’ carbon emissions through issue of permits
• these can be bought/sold and fines are imposed if firms exceed limit without buying permits

Question 25

How can tradable pollution permits be used to solve market failure?

Answer 25

• permits tradable between firms
• if firms can reduce their pollution levels below their allocation, they can sell their permits to firms who find it expensive to do so
• incentivises businesses to work more efficiently, to reduce pollution so can sell their permits, reducing negative external costs
• for businesses who exceed their allocation will see an increase in costs of production due to fines and so will internalise the negative externality and so change their decision making to meet social optimum

Question 26

Limitations of tradable permits

Answer 26

will right number of permits be issued:
gov needs to set right number of permits to ensure social optimum but difficult to estimate externalities so hard to do so (too many permits=price too low)

Volatility of price of permits:
demand/supply for permits changes over time, cause change in price, could reduce incentive to invest in renewable energy as uncertain what they will earn from selling surplus permits in future

Impact on business:
impose higher costs of production on businesses, could reduce international competitiveness/profitability, lead to some businesses leaving the country

Equity issues:
larger businesses more likely to be able to afford permits than smaller ones. could be issues of monopoly power as these businesses dominate market, especially as barriers to entry higher

Cost of running scheme:
gov incur costs setting up scheme/issuing permits as well as enforcing it by fining businesses

Question 27

How can a maximum price be used to solve market failure

Effectiveness?

Answer 27

• will benefit consumer welfare
• implement on goods/services have external benefits as lower price will encourage higher consumption of the product
• if set correctly will increase quantity to social optimum

Limitations:
Shortages on the market:
even though lower price, less availability meaning fewer consumers are provided for

Possible secondary markets:
- due to lower availability of goods/services more incentive for secondary markets to exist
- involve consumers agreeing to pay above max price in order to guarantee service (leads to reduced tax revenue for gov, increases enforcement costs)

Impact on businesses:
- lower revenue/profit due to lower price
- less corporation tax revenue ( some small businesses may not survive = unemployment)

Impact depends on maximum price:
no effect if above equilibrium price

Impact depends on PED/PES:
- max price will have more impact on demand/supply when price elastic, creating larger excess demand

Question 28

How is minimum price used to solve market failure?

Limitations?

Answer 28

• help support producers when prices are low or increase price of goods to help reduce consumption of goods/services with external costs
• higher price help to reduce external costs by raising price and helping to internalise the externality into decision making
  -* when gov guarantee min price, they will buy up excess supply*

Limitation:
Impact on consumer welfare/inequality:
- high prices for consumers/lower consumer surplus
- affect those on low income most/increase inequality

issues of inefficiency:
- creation of excess supply due to distortion of price signals can be inefficient use of resources (if min price too high = excess supply)

Issues when governments guarantee to purchase the excess supply:
- opportunity cost for gov
- issue with what gov does with excess supply, perishable goods may be sold at lower price to other countries to gain revenue (called dumping and can undermine producers in other countries)

Impact depends on minimum price:
- no effect if below equilibrium price

impact depends on PED/PES:
- min price more impact on demand/supply when price elastic, creating larger excess supply

Question 29

What is a buffer stock scheme?

Answer 29

system of agency intervention to buy or sell a commodity to reduce price fluctuations and meet a target price range

Question 30

How can buffer stock schemes be used to solve market failure?

Limitations?

Answer 30

• gov set target price, as well as min price and max price for the commodity
• will allow commodity prices to fluctuate only within this target band
• gov agency buy up stocks when price drops too low and to release stock onto market when price gets too high
• helps to solve issues of unstable commodity markets

Limitations:
Cost of scheme:
- could make a profit
- storage, administration and security mean costs for gov

Historic collapse of buffer stock schemes:
- wrong target price (due to imperfect information) could mean succession of ‘good harvests’ (if set too high) or a succession of ‘bad’ harvests (if set too low)
- can lead to collapse of buffer stock scheme as either financial costs become too great or stocks run out

Less effective for perishable products:
- commodities need to be stored over time

Co-ordination issues:
- need to get agreement between many producers in the market to get a comprehensive scheme

Question 31

What is government failure?

Answer 31

• when governments act to deal with market failures but in the process create further distortions/inefficiencies and a net welfare loss

Question 32

What are the causes of government failure?

Answer 32

Distortion of price signals:
- (e.g min or max prices**
- can lead to excess supply if min price put in as incentivises more production (farmers may over-produce food)
- can lead to lack of supply if max price put in (e.g rental properties if max price landlords may decide to sell)

Unintended consequences:
- e,g high taxes on cigarettes may lead to increased consumption on secondary markets
- cigarettes may be lower quality and more damaging
- less tax revenue and higher cost of policing/more pressure on NHS

Information gaps:
- often govs choose to go ahead with policy without having information required

Excessive Administration costs:
- costly to administer/enforce