Module 12 - Government intervention in markets

Question 1

Social efficiency

Answer 1

Production and consumption at the point where Marginal Social Benefit (MSB) = Marginal Social Cost (MSC), ie the best allocation of resources (allocative efficiency) for society.

Question 2

Equity

Answer 2

The fair distribution of a society’s resources between individuals and between regions.

Question 3

Explain why the social optimum occurs where MSB = MSC

Answer 3

The MSB is the additional benefit to society of an additional unit of a product and the MSC is the additional cost to society of an additional unit of a product.

If:

• MSB > MSC, then total welfare will increase by producing more of the product
• MSB < MSC, then total welfare will increase by producing less of the product
• MSB = MSC, then total welfare is at a maximum, ie any reallocation would lead to a reduction in net benefit (ie welfare)

The free market normally fails to achieve social efficiency.

Question 4

List the main types of market failure

Answer 4

1. Market power
2. Externalities
3. Public goods
4. Merit goods
5. Ignorance and uncertainty
6. Immobility and time lags
7. Inequality

Question 5

Explain how each type of market failure causes an unsatisfactory (suboptimal or inequitable) allocation of resources

Answer 5

.

Question 6

Consumer surplus

Answer 6

The difference between the maximum a person would have been prepared to pay for a good (ie. the utility measured in money terms) over what the person actually pays. Total consumer surplus equals total utility minus total expenditure.

Question 7

Producer surplus

Answer 7

The difference between the minimum price required for a firm to supply a good and the price that is actually paid. Total producer surplus is the excess of a firm’s total revenue over total (variable) costs.

Question 8

Total (private) surplus

Answer 8

It is the consumer surplus plus producer surplus.

Question 9

Deadweight welfare loss

Answer 9

The reduction in total surplus below the maximum amount that is possible.

Question 10

Externalities

Answer 10

Costs or benefits of production or consumption experienced by people other than the producers and consumers directly involved in the transaction. They are sometimes referred to as ‘spillover’ or ‘third-party’ costs or benefits.

Question 11

Consumption externalities

Answer 11

Spillover effects on other people of consumers’ consumption.

Question 12

Production externalities

Answer 12

Spillover effects on other people of firms’ production.

Question 13

External costs

Answer 13

Costs of production (or consumption) borne by people other than the producer (or consumer) directly involved in the transaction.

Question 14

External benefits

Answer 14

Benefits from production (or consumption) experienced by people other than the producer (or consumer) directly involved in the transaction.

Question 15

Social costs

Answer 15

Private costs plus production externalities.

Question 16

Social benefits

Answer 16

Private benefits plus consumption externalities.

Question 17

Public goods

Answer 17

A good or service that has the features of non-rivarly and non-excludability.

Question 18

Non-rivarly

Answer 18

Where the consumption of a good or service by one person will not prevent others from enjoying it.

Question 19

Non-excludability

Answer 19

Where it is too costly to implement a system that would effectively prevent people who have not paid from enjoying the benefits from consuming a good.

Question 20

Free-rider problem

Answer 20

When people enjoy the benefits from consuming a good without paying anything towards the cost of providing it.

Question 21

Merit goods

Answer 21

Private goods which the government feels that people will under-consume and which therefore ought to be subsidised or provided free

Question 22

Give examples of external costs and benefits of production

Answer 22

External costs of production:
Polluted rivers from a firm’s waste products

External benefits of production:
More efficient staff as a result of the training given by previous employers

Question 23

Give examples of external costs and benefits of consumption

Answer 23

External costs of consumption:
Effects of passive smoking

External benefits of consumption:
Improved health of the nation as a result of a vaccination programme.

Question 24

Give examples of public goods

Answer 24

Defence, policing, street lighting

Question 25

Give examples of merit goods

Answer 25

Education, healthcare, pension, training

Question 26

List the main types of government intervention

Answer 26

The government can intervene in the following ways:

1. Persuading consumers and producers to modify their behaviour using:
   - indirect taxes and subsidies
   - extensions to property rights
   - laws and regulatory bodies
   - price controls
   - the provision of information
2. Providing goods and services directly
3. Welfare systems

Question 27

Explain how each type of intervention aims to correct market failure

Answer 27

.

Question 28

Discuss the relative merits of each type of government intervention

Answer 28

.

Question 29

Explain the Coase theorem

Answer 29

When there are well-defined property rights and zero bargaining costs, then negotiations between the party creating the externality and the party affected by the externality can bring about the socially efficient market quantity.

Question 30

Government surplus from a tax on a good

Answer 30

The total tax revenue earned by the government from sales of a good.

Question 31

Excess burden of a tax on a good

Answer 31

The amount by which the loss in consumer surplus exceeds the government surplus.

Question 32

List the problems caused by government intervention in a market economy

Answer 32

1. Shortages and surpluses when price controls are used
2. Problems caused by measurement difficulties and a lack of information
3. Bureaucracy and inefficiency
4. A negative effect on incentives
5. The reduction in individual freedom of choice
6. The adverse effect on efficiency if there are frequent changes in government policy.

Question 33

Discuss the case for more or less government intervention

Answer 33

Less government intervention:
Though possessing many faults, a free market would benefit from
- automatic adjustments to changes in market conditions
- incentives for risk taking and innovation
- a competitive environment (even where oligopoly and monopoly is prevalent)

Question 34

What are the two major objectives of government intervention

Answer 34

1. Social efficiency

2. Equity