Theme 1 Topic 3 Flashcards
What is market failure ?
When the allocation of goods/services are inefficient to meet the needs of society.
When will allocative inefficiency occur ?
When there is always going to be market failure.
What is the government’s job ?
To eliminate market failure. This is done by intervening in markets (government intervention).
What is government intervention ?
When the government takes action to remedy allocatively remedy inefficient markets.
What does a government try to ensure (in terms of government intervention) ?
That a market works both efficiently and in a fair manner.
How does a misallocation of resources occur ?
The market creates the mechanism for allocating scarce resources, however, the markets are often inefficient in doing this job. Therefore, there is a misallocation of resources.
What are the 3 reasons for a misallocation of resources ?
- Externalities
- Information gaps
- Under-provision of public goods
What is complete market failure ?
When there is no market at all (a missing market). Goods/services won’t be supplied to the market as firms don’t receive revenue for supplying the product.
What is an example of a good/service that is in complete market failure ?
Street lighting
What is partial market failure ?
When a market exists but there is a misallocation of resources. Goods/services will be supplied, but in the wrong amounts.
What is an example of a good/service that is in partial market failure ?
Merit and demerit goods
What is a public good ?
It’s consumption doesn’t reduce the amount available for consumption by others.
What are the 2 key characteristics of public goods ?
- Non rival goods
- Non excludable goods
What is a non-rival good ?
Where consumption of the good doesn’t reduce the amount available for consumption by others.
What is a non-excludable good ?
Where, once provided, it is impossible to stop other individuals from using them. E.g. a public park
What can both public goods and private goods have ?
Positive and negative externalities
What are 2 examples of public goods ?
- Army
- Street lighting
What is a pure public good ?
It is impossible to exclude someone from consuming it if they are unwilling to pay for its use.
What is an example of a pure public good ?
The air that we breathe.
Why is it difficult to place a value on public goods ?
Because they don’t have a market price.
What is valuation ?
A method used to try and estimate the worth of public goods.
What is one way in which valuation estimates the worth of public goods ?
Through primary research, to find out how much the good is worth to a consumer if they had to pay for it.
What is one reason why market failure occurs ?
Due to the free rider problem.
What is a free-rider ?
Someone who benefits from a good/service without paying for it.
If there is little incentive for firms to supply public goods, the government is likely to intervene.
What is a private good ?
It’s consumption reduces the amount available for consumption by others.
What are the 2 key characteristics of private goods ?
- Rival goods
- Excludable goods
What is a rival good ?
Where consumption of the good reduces the amount available for consumption by others.
What is an excludable good ?
Where, once provided, it is possible to stop other people from using them.
What are 2 examples of private goods ?
- Clothing
- Cars
What is quasi ?
‘Having a likeness to’
What is a quasi public good ?
A private good that is similar to a public good but there is a chance to stop non-paying consumers from using it.
What is an example of a quasi public good ?
Restricting access to a beach or public park
What is a technical change ?
The process of innovation, invention, and the widespread use of technology in society.
What can a technical change lead to ?
Markets efficiently providing goods which were previously regarded as non-excludable and non- rival goods (public goods).
Public goods become private goods over time.
How can a technical change be achieved ?
- IPR
- Monitoring + Controlling systems
What is IPR ?
intellectual property rights is when granting payments, or copyright, so goods become protected and excludable.
What are monitoring and controlling systems ?
Restricting the use of a good by monitoring usage e.g. digital tv
Is technology rival or non rival ?
Non rival
How can technology become rival goods ?
It’s use can create tangible goods.
What is information failure ?
A type of market failure where consumers or producers either have asymmetric information or don’t have symmetric information
What is asymmetric information ?
When someone parties in a transaction have more information regarding the products than others.
What is symmetric information ?
When all the relevant information is known by both parties
How can information failure lead to misallocation of resources ?
Without having full information about a product, it’s hard for consumers and producers to make decisions regarding price, quality, and other relevant factors when buying and selling. This leads to a misallocation of resources.
What is perfect knowledge ?
A theoretical concept which occurs when all consumers in a market are fully aware of price, quantity available, and other information for all products when making buying decisions.
What are 2 characteristics of quasi-public goods ?
- Semi non rival - more consumers don’t reduce the space available for others.
- Semi non excludable - it is costly to exclude non paying consumers
What are externalities ?
Costs and benefits to a third party created by economic agents when undertaking their activities.
The costs and benefits can be negative or positive.
These lead to the over or under production of public goods, so resources are not allocated efficiently.
What are negative externalities ?
Costs to a third party that are not included in the price of economic activity.
What are positive externalities ?
Benefits to a third party that are not included in the price of economic activity
Why do negative externalities arise ?
Due to the divergence between private costs and social costs.
What is the equation for social costs ?
SC = PC + EC
What are private costs ?
Costs of consuming or producing goods/services that have to be paid for by third parties (e.g. individuals/firms)
What are social costs ?
Costs of consuming or producing goods/services that are paid for by society. These include private costs
What are external costs ?
The costs to a third party not involved in economic activity. Thru are the difference between private costs and social costs
What happens when social costs exceed private costs ?
Negative externalities occur.
What are the PC and SC to a firm creating sir pollution by using a factory to produce a good ?
PC = cost of making the good for the firm
SC = society suffering from poor air quality
Why do positive externalities arise ?
Due to the divergence between private benefits and social benefits.
What is the equation for social benefits ?
SB = PB + EB
What are private benefits ?
Benefits of consuming or producing goods/services that are received by an economic unit e.g. The individual or firm.
These are paid for.
What are social benefits ?
Benefits of consuming or producing goods/services that are received by society.
What is a third party ?
Person not directly involved in the production and/or consumption of a good or service. i.e. Not the business or the customer. They are also known as spill-over effects.
How do social benefits create the free rider problem ?
Social benefits are unpaid for.
What are external benefits ?
Benefits to a third party not involved in the economic activity.
They are the difference between PB and SB.
What happens when social benefits exceed private benefits ?
Positive externalities occur
Give the PB and SB of a local firm investing heavily into training its workforce :
PB to the firm = having well trained employees
SB = local communist having a pool of better trained workers.
Social benefits include private benefits of training, but also include benefits to society.
What is a marginal analysis ?
It enhances our understanding of externalities .
It looks at the benefits or costs we receive from consuming/producing one more unit.
What is marginal benefit ?
The benefit to a consumer of consuming one more unit of a good/service.
What is marginal cost?
The cost to a producer of producing one more unit of a good/service.
What is marginal private benefit ?
The additional amount of satisfaction that a consumer gains from an additional unit of a good/service.
It can be represented by a demand curve.
Demand = MPB
How does demand show MPB ?
- The vertical distance at each quantity shows how much consumers are willing to pay for that unit (e.g., £10 for the 50th unit).
- This reflects the benefit or satisfaction from each unit.
- As consumption increases, the price consumers are willing to pay decreases because satisfaction diminishes with each additional unit.
When does allocative efficiency occur ?
When price = marginal cost.
If the price of a producing product is above the marginal cost of producing it, then firms should increase output.
As the price is above the cost of production, the firm will increase output and make additional profit.
What happens at P=MC.
Firms allocate more resources into producing the product until it reaches that point.
At this point, the firm is maximising profits.
What happens when MC > P ?
Firms would be making a loss on producing each additional unit.
What is supply equal to ?
Marginal private cost.
What is marginal private cost ?
The cost to a producer of producing an additional unit.
Can be represented by the supply curve.
How does the supply curve reflect MPC ?
Firms will supply an extra unit if its price covers the cost of production.
Higher prices lead to more supply, as firms can cover production costs.
Producers need the price to be at least equal to production cost to make a profit.
A firm stops supplying when the cost of producing an extra unit exceeds the price.
The MPC curve shows how cost, price, and quantity supplied are related.
What does MSB + MSC do ?
Enhances our understanding of externalities.
What are marginal social benefits ?
Benefits of producing or consuming an additional unit of goods/services that are received by society.
This includes marginal private benefits and marginal external benefits.
What are marginal external benefits ?
The additional benefits to society of consuming or producing one extra unit.
MSB equation :
MSB = MPB + MEB
MSC equation ?
MSC = MPC + MEC
What are marginal social costs ?
Costs of consuming or producing an additional unit of goods/services that are paid for by society.
Includes marginal private costs.
What are marginal external costs ?
The additional costs to society of consuming or producing one extra unit.
When does the marginal optimum position occur ?
When MPB = MPC
Equilibrium
Market optimum position ?
In a market economy, the economic unit only considers the private costs / benefits of its activities.
Consumers and producers operate in a market where MPB = MPC.
this leads to the maximisation of private benefit.
MPB < MPC ?
consumers can achieve additional benefit from consuming more goods and services.
MPB > MPC ?
Producers can achieve additional profits by increasing supply.
externalities lead to market failure :
Externalities (positive/negative) cause market failure because consumers or producers don’t account for full costs/benefits.
In a market economy, individuals only consider private costs/benefits, not the social costs/benefits.
This leads to inefficient outcomes because not all impacts (good or bad) are included in decision-making.
4 externalities graphs ?
- Negative production externalities
- Negative consumption externalities
- Positive consumption externalities
- Positive production externalities
Why do externalities lead to market failure ?
- The social optimum happens when MSB = MSC (social benefit = social cost).
- Market failure occurs when private and social costs/benefits differ, leading to government intervention.
- Producers/consumers focus on MPB = MPC, but society benefits when MSB = MSC.
- Since individuals ignore social impacts, the government steps in to correct this.
5 ways of government intervention ?
- Indirect taxes + subsidies
- Regulation
- Tradable pollution permits
- Provision of the goods
- Provision of information
Indirect taxes and subsidies :
Taxes can be placed on goods with negative externalities and subsidies on goods with positive externalities.
These help to internalise the externalities, moving production closer to the social optimum position.
Regulation :
Can limit consumption of goods with negative externalities.
E.g. banning adds on smoking.
Tradable pollution permits :
These allow firms to produce up to a certain amount of pollution, and can be traded amongst firms so give them a choice whilst reducing the total level of pollution.
Provision of the good :
When social benefits are very high, the government may decide to provide the good through taxation.
They do this with healthcare and education.
Provision of information:
Since some externalities are associated with information gaps, the government can provide information to help people make informed decisions and acknowledge external costs.
Marginal private and social cost and benefit curves :
- The market equilibrium occurs at QE, where marginal private benefit (MPB) and marginal private cost (MPC) intersect.
- To improve resource allocation, the price should be increased and output reduced so that MSB = MSC (marginal social benefit = marginal social cost) at Q1.
- The optimum allocation of resources occurs when MSB = MSC, ensuring that the social costs and benefits are balanced. This corrects any market failure caused by externalities.
Positive consumption externalities graph :
Consumer’s optimal level of output is Q.
Society’s optimal level is Q1.
Society is benefiting over and above the individual consumer by Q-Q1.
The consumer is under consuming.
The benefit to society is shown by a shaded area (welfare gain).
Consumer gains the benefit of consuming a good/service on the demand curve.
Social benefit is above and to the right of the private benefit (D1) as the benefits to society will be greater than the benefits to the individual consumer.
A consumer will maximise their private benefits by consuming where S=D at PQ.
However, if social benefits were included, we would operate where S=D1 at P1Q1.
Welfare gain measures the difference between social benefit and private benefit at output levels between Q-Q1.
What is welfare gain ?
A situation where the social cost is lower than the private cost and society gains as it doesn’t have to pay for the difference.
When do positive private consumption externalities occur ?
When the activities of consumers lead to benefits to a third party that are not included in the price of the economic activity.
When do when do positive production externalities occur ?
When the activities of producers lead to benefits for a third party that aren’t included in the price of economic activity.
Positive production externalities graph :
Firm’s optimal level of output is Q.
Society’s optimal level of output is Q1.
The firm is underproducing by Q-Q1.
Price is too high and output is too low. There is allocative inefficiency.
SI is down and to the right of S as the costs to society of a positive externalities will be less than the costs to the producer.
If social costs were included (full costs)l then we would operate where S1=D at P1Q1.
The benefit to society is shown on a shaded area.
This measures the difference between social cost and private cost at output levels between Q and Q1.
When do negative consumption externalities occur ?
When activities of consumers lead to a loss of benefit to a third party that aren’t included in the price of the economic activity.
Negative consumption externalities graph :
The consumer gains the benefit of consuming a good/service on the demand curve.
Society benefit is below and to the left of private benefit as the benefits to society of a negative externality will be lower than the benefits to the individual consumer.
A consumer will maximise its private benefits by consuming where S=D at PQ.
However, if social benefits were included, we would operate where S=D1 at P1Q1.
The consumer’s optimal level of output is Q1. Society’s is at Q1l
The consumer is therefore over consuming by Q-Q1.
The loss of benefit to society (welfare loss) is the shaded area.
This measures the difference between social benefit and private benefits at output levels between Q-Q1.
When do negative production externalities occur ?
When the activities of producers lead to costs to a third party that aren’t included in the price of the economic activity.
Negative production externalities graph equations :
MPB = MPC market equilibrium at QP
MSC = MSB social optimum position at Q1P1.
Negative production externalities graph :
Firm is overproducing by Q-Q1.
Supply curve takes into account the cost to the firm of prodding the product.
If we include the cost to society, the supply curve would shift up and to the left (S1) as the costs to society of a negative externality will be greater than the costs to the producer.
If social costs were included, then we would operate where S1=D at P1Q1.
The costs to society (welfare loss) can be seen by the shaded area.
This measures the difference between the social costs and private cost at output levels between Q and Q1.
What type of goods are negative externalities caused by ?
Demerit goods,
associated with information failure (consumers aren’t aware of long run effects of consuming the good, and they are usually over provided).
What type of goods are positive externalities caused by ?
Merit goods,
associated with information failure (consumers don’t realise the long term benefits of the good).
these are under provided by the market/free market.
What is welfare loss ?
The excess of social cost over social benefit for a given output.
what’s the government can intervene :
- Tradable pollution permits (limits how much pollution and you can exchange it between companies)
- indirect taxes, subsidies
- control of provision of goods (if the benefits to society of a good is very high the government chooses to supply it directly to society)
why are public goods under provided ?
the government has insufficient funds to do so
asymmetric information structure :
consumers have less information, producers take advantage of the information gap by increasing the price or decrease quality, this leads to irrational decision making, leading to market failure
