Policies to reduce market failure

Question 1

Define market failure.

Answer 1

When the free market leads to a misallocation of resources in an economy.

Question 2

Define complete market failure.

Answer 2

When the free market fails to create a market for a good or service, also referred to as a missing market.

Question 3

List the types of market failure.

Answer 3

1) Public goods - free rider problem
2) Positive externalities - production and consumption
3) Negative externalities - production and consumption
4) Environmental market failure - tragedy of the commons
5) Merit and demerit goods
6) Market imperfections - imperfect and asymmetric information - monopoly - immobility of FoP
7) Inequitable distribution of income and wealth

Question 4

What are the reasons for govt intervention?

Answer 4

• Free market failing to achieve an efficient or equitable allocation of resources
• Wider macro objectives - focussed on improving the UK economy and living standards

Question 5

List the possible govt policies to reduce market failure

Answer 5

1) Indirect tax
2) Subsidies
3) Minimum price
4) Maximum price
5) Direct provisio
6) Regulation
7) Correcting information failure
8) Extending property permits
9) Competition policy

Question 6

Define indirect tax

Answer 6

A tax on spending, sometimes used to reduce consumption of demerit goods.

Question 7

What 2 types of indirect tax are there?

Answer 7

1) Specific, or unit taxes - fixed amount being added per unit of a good or service - e.g. bottles of alcohol
2) Ad valorem taxes - adding % of price of good or service - e.g. VAT at 20% - adding 20p to £1 product, but £20 to £100 product

Question 8

What effect will an indirect tax have?

Answer 8

• Increase a firm’s costs - leftward shift in supply

Question 9

Advantages of using indirect tax.

Answer 9

1) Often placed on goods that have inelastic demand - strong tax revenues can be gained for governments - assigned to specific areas of spending
2) Use of price mechanism leaves it up to consumers and producers to decide how to adjust their behaviour
3) Assuming correct rate has been applied - tax helps to internalise the external cost - reflects more accurately the impact of a negative externality on P and Q

Question 10

Disadvantages of using indirect tax.

Answer 10

1) Indirect taxes often on inelastic goods - Qd may not fall very much unless the tax is very large - reduces impact of it
2) Can be extremely difficult to place an accurate monetary value on external costs - almost impossible to ‘internalise’ a negative externality
3) Tend to be regressive - take a large % of a poorer person’s income
4) UK firms may be concerned that their international competitiveness may be reduced by imposition of this tax - increases production costs relative to those of foreign competitors

Question 11

Define a subsidy

Answer 11

A payment to producers to encourage increased production of a good or service.

Question 12

What effect will a subsidy have.

Answer 12

• Usually granted to production of merit goods
• Reduces price of specific goods and services - govt attempting to increase their consumption
• Can be used to promote the use of products that reduce external costs, such as public transport
• Granting a govt subsidy will shift the supply curve to the right

Question 13

Advantages of using subsidies.

Answer 13

• On merit goods - can increase consumption - bringing equilibrium quantity closer to internalise the external benefit.
• Reduce the price of a good - more affordable for those on lower incomes - reduces effects of relative poverty

Question 14

Disadvantages of using subsidies.

Answer 14

• Difficult to place monetary value on size of external benefits

Question 15

Define a minimum price.

Answer 15

A price floor placed above the free market equilibrium price.

Question 16

What effect will a minimum price have?

Answer 16

• Establish legal level below which prices aren’t allowed to fall
• E.g. - setting of NMW + guaranteed minimum prices paid to farmers for their agricultural products
• Impact - set above free market price for a good an will create excess supply

Question 17

Advantages of minimum prices.

Answer 17

• Give producers guaranteed minimum price and income - helps to generate a reasonable standard of living - such as in the case of farmers in less-developed countries
• Encourage production of essential products - such as the foodstuffs produced by farmers
• Excess supplies may be bought up and stored - to be released in times of future shortage

Question 18

Disadvantages of minimum prices.

Answer 18

• Consumers must pay higher price - reduces disposable income
• Can encourage over-production - especially in agriculture - inefficient use of resources - excess supply may need to be put into storage - further costs
• If govt - or other authorities has to purchase excess supplies - leads to opportunity costs - funds could have been used elsewhere
• May reduce international competitiveness - if price raised above those of foreign competitors
• In case of interventions - to reduce affordability of demerit goods - such as tobacco or alcohol - may encourage people to seek cheaper, potentially more harmful alternatives - govt failure

Question 19

Define a maximum price.

Answer 19

A price ceiling above which prices are not permitted to rise.

Question 20

What is the justification for maximum price?

Answer 20

• Justification - free market equilibrium too high for many consumers - leads to problems of reduced affordability
• E.g. - rent controls in densely populated cities - limits on ability of utility companies to raise their price above the rate of inflation

Question 21

What is the effect of a maximum price?

Answer 21

Set below free market price for a good and will create excess demand.

Question 22

Advantages of maximum prices.

Answer 22

• Without one - some people would be unable to afford certain goods and services - e.g. prescription medications - maximum prices promote equity and fairness
• Can reduce ability of firms with monopoly power to exploit consumers through charging higher prices

Question 23

Disadvantages of maximum prices.

Answer 23

• Some people who want a good or service - will simply not be able to obtain it leading to frustration and dissatisfaction
• Creation of excess demand - implies queues, shortages and waiting lists - in case of markets such as health care - can have serious implications
• May lead to black markets for goods and services (shadow economy) - secondary markets for music and sporting event tickets