Micro - Policies to solve market failure Flashcards
Indirect taxation to solve negative externality in production
An indirect tax such as a carbon tax will increase the costs of production for polluting firms shifting the
MPC curve upwards from MPC to MPC+tax, now equal to MSC. The price increases in the market from
P1 to P* with quantity decreasing from Q1 to Q, the socially optimum level of output. The externality has now been fully internalised with the price reflecting the full social cost of production hence the polluter is now paying the full cost of their actions. The overproduction and overconsumption that existed in the market is now solved with resources allocated efficiently at Q. There is no longer a misallocation of resources with welfare maximised due to this intervention.
Indirect taxation to solve negative externality in consumption
An indirect tax such as a cigarette, alcohol or sugar tax will increase the costs of production for firms shifting the MPC curve upwards from MPC to MPC+tax. The price increases in the market from P1 to P2 and due to the law of demand, consumption is discouraged, decreasing quantity from Q1 to Q, the socially optimum level of output. The externality has now been fully internalised with the overconsumption and overproduction issues now solved. There is no longer a misallocation of resources with resources allocated efficiently at Q. Welfare is now maximised due to this intervention.
Indirect taxation government revenue analysis
An indirect tax also generates government revenue (PABC and P2ABP in the above diagrams), which can be used to further solve the existing market failure for example by subsidising better alternatives, funding advertising campaigns, providing education or funding alternative/complimenting policies. This wider benefit can justify the use of indirect taxation even fi the tax itself is ineffective in fully reducing quantity to the socially optimum level.
Indirect tax to solve market failure evaluation
Demand for cigarettes, alcohol, sugar and fuel is price inelastic.
This is because they are either necessities, addictive or there aren’t many good substitutes available. Therefore as price increases, quantity decreases from Q1 to Q2 due
to the law of demand, but proportionately less than the price increase from P1 to P2. The decrease in quantity will help to reduce the misallocation of resources but not by enough to fully solve the market failure if Q* is below Q2. In this sense, consumers are absorbing a large proportion of the price rise and not reducing consumption greatly. Any overconsumption and overproduction problems will remain.
Subsidy to solve positive externality in consumption
A subsidy such as public transport, solar panel, vaccination, electric car, gym/leisure centre and museum subsidies will reduce the costs of production for firms shifting the MPC curve downwards from MPC to MPC+sub. The price decreases in the market from P1 to P2 and due to the law of demand, consumption is encouraged, increasing quantity from Q1 to Q, the socially optimum level of output. The under consumption and under production issues are fully solved. There is no longer a misallocation of resources with resources allocated efficiently at Q. Welfare is now maximised due to this intervention.
Subsidy to solve positive externality in production
A subsidy such as in work training or R&D subsidies will reduce the costs of production for firms shifting the MPC curve downwards from
MPC to MPC+sub, equal to MSC. The price decreases in the market from P1 to P* and quantity increases from Q1 to Q, the socially optimum level of output. The under production and under consumption issues are fully solved. There is no longer a misallocation of resources with resources allocated efficiently at Q. Welfare is now maximised due to this intervention.
Subsidy to solve market failure evaluation
Subsidies are very expensive to implement. This is because all firms in a given industry must be eligible for the subsidy to prevent discrimination and unfair competitive advantages. There is a substantial opportunity cost involved therefore as this money needs to be generated from somewhere fi no surplus tax revenue exists. Perhaps cuts will be made to education, public transport or health budgets worsening market failures in these areas. Maybe welfare spending will be cut or regressive taxes rise in the future burdening the poor and widening income inequality. These are difficulties the government faces if borrowing money is the only way to fund this subsidy. fI the cost of the subsidy outweighs the gains in welfare, there will be government failure and a worsening of the misallocation of resources.
Regulation to solve market failure
Regulations are rules or laws enacted by the government which economic agents must operate within. It is a non-market based approach to solving market failure; a command and control policy which starts with a rule intending to either decrease or increase consumption/production to resolve market failures without use of the price mechanism. Therefore regulation can overcome the problems of more market based approaches such as taxation and subsidy where inelastic demand can be a major reason for such policies being ineffective in fully solving market failures. There is a strong incentive for consumers/producers to follow rules set by the government as long as the control side of the policy is strong. This involves strict punishments for those found to be breaking the
rule (fines, negative publicity etc) and
crucially, strong enforcement of the policy via policing for example. In this way the behaviour of economic agents will be altered whereby quantity in the market either decreases or increases according to the intention of the regulation. Quantity in the market will now reflect the socially optimum level where allocative efficiency is achieved and welfare maximised.
Regulation to solve market failure evaluation
It is difficult to set the regulation at the right level. This is because measuring the value of the externalities is difficult in reality and because knowing the exact impact of certain regulations altering the behaviour of economic agents is imperfect. As a result, regulations might be set too lax where behaviour is not altered enough to bring quantity in the market to the social optimum. Another way of looking at this is that enforcement is weak where rational individuals (consumers or producers) ignore the regulation taking a perceived low risk action thus continuing to over or under consume/produce. Perhaps regulation will be set too strict e.g. with pollution caps, advertising bans, smoking bans, vehicle quotas or excessive requirements for firms to provide certain information on packaging/menus. This could lead to unintended consequences and government failure where the costs of intervention outweigh the benefits. For example, firms may shut down or leave the country causing unemployment.
State provision to solve market failure
1) The missing market problem with public goods. State provision allows there to be a supply of public goods, in theory at the socially optimum level, where otherwise in the market they would not be provided at all. This clearly improves social welfare and solves a complete market failure.
2) The under consumption and under provision of merit goods. There are two problems with merit good provision in the free market that state provision can solve. Firstly the state is assumed to maximise social welfare thus will consider all private and external benefits in the consumption of merit goods. As a result the quantity in the market will be fixed at Q1, the socially optimum level improving the allocation of resources and increasing welfare.
State provision to solve market failure evaluation
State provision is a very expensive policy. This is because the state provides all resources in the market with very little private sector involvement. There is a substantial opportunity cost involved surplus tax revenue does not exist. Perhaps cuts will be made to welfare or public transport worsening existing market failures and income inequality. Maybe regressive taxes will rise in the future, burdening the poor and widening income inequality. Government may also need to deal with excess demand; there is no price rationing with state provision. Over-consumption is a major issue putting large strain on public services and on those who work in these sectors, with workers potentially leaving the industry or working elsewhere in the world. It will be too costly to increase supply to meet demand, therefore government failure.
Tradable pollution permits
Property rights
