topic 5: mkt failure Flashcards
characteristic of public good
- non-rivalrous: consumption of good does not reduce amt available to others
allocative inefficient to charge a price for the good
non rivalrous: MC of providing good for an additional user is 0
- profit-maximising firms will not provide goods at price of 0
non-provision -> mkt failure - non-excludable: impossible/ very costly to exclude non-payers from consuming good once it is provided
those who cannot pay won’t be excluded, no one has incentive to pay
free rider problem: everyone hope to enjoy MB w/o paying
no effective demand
rational firm will not enter mkt to supply good. no resources would be allocated to production of good
complete mkt failure -> missing mkt
complete mkt failure -> socially optimal level of provison more than 0
mkt failure
failure of free mkt to distribute resources efficiency or distribute output equitably
underproduction (Q1) VS overproduction (Q2)
- underproduction
at Q1, additional benefit Q1CEQs is greater than additional cost Q1DEQs.
additional production of good towards socially optimal output will lead to positive marginal net benefit
DWL incurred - overproduction (MSC>MSB)
provision of public goods
- direct provision: govt produces public good using its resources (govt revenue) to finance.
govt will estimate MSC and MSB and provide amt equivalent to Qs.
allocative efficiency: non-rivalrous, MC=0. under free mkt, allocative efficient price to set is where P=MC, since MC=0, price to charge=0 - joint provision (subsidise/pay firms to produce)
advantages & limitations of direct/joint provision of public goods
advantage:
- financial burden shared
- govt decide amt and quality
- productive efficient - firms will minimise costs
limitation:
- govt lack info to accurately determine Qs (difficult to determine Qs) ->DWL
- opt cost
- producers in public sectors not productive efficient
externality
spillover cost/ benefit borne by third party due to production/consumption of good/service.
5 steps to explain positive externality
- define externality, state what is MPB, MPC, MEB
- explain divergence
MSB>MPB
MSB lies above MPB curve by vertical dist of MEB
no -ve externality so MPC=MSC - graph
- explain mkt eqm output Qm and Qs
self-interested, consider MPC and MPB, consume at Op where MPC=MPB but Qs is where MSC=MSB - explain allocative inefficinecy
Qp underallocation of resources
btn QpQs, marginal benefit> marginal cost, societal welfare could have been gained by increase qty
DWL
allocative inefficiency, mkt failure
subsidies (+ve externality)
reduces COP, decrease MPC (MPC shift downwards), eqm qty increases to Qs where MSC=MSB
externality is internalised, DWL eliminated
advantages:
- flexible
limitation:
- imperfect info - diff to estimate MEB
- the more price inelastic the demand, more subsidy needs to be given
- govt expenditure -> opt cost
public education (+ve externality)
govt provide info to encourage to internalise externality
MPB will move closer to MSB
+ target root cause
- long drawn process
direct provision (+ve externality)
directly provide Qs for free -> MPC to consumers is 0
qty dd is where MPB intersects horizontal axis
(-) small MEB -> overconsumption leads to larger welfare loss \+ equal access \+ govt can set quality - public sector not productive efficient - do not know Qs due to imperfect info
legislation and regulation (+ve externality)
making behaviours compulsory by law
increase consumption to Qs, eliminate DWL
+ substantial MEB
- high monitoring cost
(+ve externality) measures
subsidy
public education
legislation and regulation
direct provision
tax (-ve externality)
impose tax per unit on production that is equal to MEC, indirect tax increases COP, firms made to internalise MEC, shifts MPC upwards to MPC+tax
firms reduce output to Qs, DWL eliminated
on consumption: increase COP, firms decrease SS, increase P, MPC shift upward and consumers internalise external cost
+ incentive
+ govt revenue (esp if DD is price inelastic)
- lack of info how much to tax: difficult to access in monetary terms
- not feasible to use diff tax rates for diff firms
- DD is price inelastic -> higher tax req, politically infeasible
quota (-ve externality)
quantitative restriction on output imposed by govt
limits qty to Qs
ban: MEC is so large that Qs=0
MSC and MSB intersects at vertical axis where qty=0
inefficient ban: still a +ve Qs that should be produced
positive net marginal benefit lost -> create large welfare loss-> not allocative efficient
+simple and immediate to implement
- monitoring
tradeable permits (-ve externality)
e.g. EU emissions trading system
tradeable pollution permits: firms given rights to buy/ sell pollution permits in artificially created mkts, firms can bid for permit that allows them to create a fixed amt of pollution
if firms do not use up, can sell credits to other firms.
govt can reduce no of pollution permits available so total emissions can be reduced to Qs
businesses can either buy permits(MPC higher, qty falls to Qs) or invest in tech (reduce MEC, reduce divergence, move towards Qs) to reduce pollution depending which save more cost
+incentive
+ lower opt cost
- monitoring costs, funding to develop new tech in poor countries is a prob
- do not know Qs
- may lead to emissions concentrated in certain regions where firms have money to buy excess credits
legislation (-ve externality)
enact law such that compulsory for all producers to equip with emission reduction devices
reduce externality, fall in divergence, MSC shifts to MSC2, new socially optimal level Qs2 closer to Qs, DWL is reduced
public education (-ve externality)
take into account external cost, MPC moves towards MSC, MEC reduced, DWL reduced
+ simple
- penalties must be heavy if not monitory costs high
(-ve externality) measures
public education legislation and regulation taxes tradeable permits ban/quota
merit goods
- education, public housing, healthcare
goods/services that are deemed socially desirable by govt but under consumed when left to free mkt
sources of mkt failure:
1. imperfect info on private benefits of consumption (primary source)
2. positive externality (secondary source)
5 steps of merit goods
- define merit goods, identify sources of mkt failure
- using diagram, explain how allocative inefficiency arises due to imperfect info
- ^due to positive externality in consumption
- ^due to inequity (if relevant)
- reiterate
both imperfect info & externality reinforce each other to cause underconsumption and underallocation of resources -> DWL
demerit goods
cigarettes, alcohol, sugary drinks
to address mkt failure of merit goods
info failure:
- legislation, public education, subsidy
+externality:
- subsidy, direct provision, education, legislation
inequity:
- min wage
- to reduce income inequity: redistributive policies, to reduce factor immobility
- affordability: price ceiling, indirect subsidy
to address mkt failure of demerit goods
to address info failure:
- legislation, public education, tax
to address -ve externality:
- tax, quota, legislation, public education
info failure
arises when econ agents lack critical info to make rational decisions on choices and resource allocation
5 steps to info failure
- define info failure: explain MPC(actual vs perceived), MPB
ignorance of actual benefits - explain divergence
underestimate MPB (actual), MPB(actual)>MPB (perceived) - diagram
- QpQs
assume no externalities, MPB(actual)=MSB
Qp: MPB (perceived)= MPC
Qs: MSB = MSC - explain allocative inefficiency
under allocation of resources, DWL, could have gain societal welfare by increasing qty
legislation and regulation (info failure)
mandatory food labelling, health warning on cigarette packs
- MPC(perceived) corrected to MPC (actual), consumers consume up till MPB=MPC(actual), hence Qs is achieved
+ immediate impact
- high monitoring cost
asymmetric info
econ agents involved in the transaction do not have same amt of knowledge, resulting in distortion of incentives and inefficient mkt outcomes. causing good to be sold in v small qty/ not at all
adverse selection
occurs when uninformed side of mkt has to choose from an undesirable selection of goods offered by the more informed party
5 steps case 1: mkt for lemons (used car mkt)
- describe
- asymmetric info leading to adverse selection for lower quality cars
- second hand car mkt, car that req frequent repairs - explain informed seller and uninformed buyers
seller have more info about true quality of car(service history, traffic incidents)
cars look identical
in order to sell at higher price, seller have little incentive to real true info to buyer. - explain mkt outcome
- buyers offer lower price due to likelihood of buying lemons
- sellers of good quality cars not willing to offer car at sale and leave mkt - explain mkt failure
- missing mkt for good quality cars
-PS could have been gained by sellers of good quality cars and CS, DWL
- mkt fail to produce mutually beneficial trade is allocative inefficient, mkt fialure
govt strategy: legislation (adverse selection)
product liability laws (Lemon Law) forces producers to replace defective goods at the point of sale if not restricted from doing business until they made needed repairs
protect consumers from being stuck w defective products
CASE: consumer association of SG
+ improves accountability and transparency ( such as providing warranties, protect buyers who do have income and knowledge)
- costs of monitoring
firm strategy (adverse selection)
action taken by informed party to reveal info about itself to help less informed make better decision
reduce asymmetric info to increase demand and earn more profits
a. warranty -> credible signals of quality to reflect true benefits of good to buyer
- less ex for firms of higher quality product to signal to potential buyer [warranty -> liable for repairs]- unlikely to offer low quality car that req frequent maintenance
+ accountable, transparence, incentive for sellers
- fake warranties
b)info from third parties on standards and certification. build seller reputation for quality control
- convince that good is trustworthy, reduce adverse selection (avoid low quality products) consumer goods, non-profit organisation, govt agencies provide info of quality
SAFETY MARK
mechanic -> accurate report of car condition
low quality seller: MC of hiring mechanic>MB
build seller reputation:
sellers of high-quality products have incentive to ensure they consistently produce high-quality products
buyer informed of firms past product quality
+accountability and transparence
- high transaction cost
- little ability to maintain reputation if other firms engage in price war
case 2: health insurance mkt
- describe mkt
health insurance: covers cost of an insured indiv medical expenses in return for a payment of a premium - explain informed buyers, uninformed sellers
- buyers have more info of their health condition (diet, habits)
identical on paper
- indivs incentivised to conceal actual health condition from insurance companies to pay lower premium - adverse selection
- sellers tend to offer higher price for health insurance due to high risk of insuring unhealthy indiv
- healthy indiv unwilling to buy health insurance as they unlikely to req reimbusement for any medical fees
, leave mkt - mkt failure
- missing mkt for healthy indivs
CS and PS could have been gained, DWL
govt strategies (asym info)
- direct provision
carry out risk pooling to ensure universal coverage
reduce adverse selection by getting compulsory nationwide health insurance
spread risks
medishield life _> less costly, insurance premiums more affordable
+ govt sponsored -> output to socially optimal output
insurer enjoy IEOS, lower AC
+ fair and equitable
- govt spending
- overly low price overconsumption -> moral hazard
firm strategies (asym info)
screening
action taken by uninformed person to determine info possessed by informed person
determine risk by checkup at certified clinic/ medical history
gauge true costs, estimate probability that it will have to reimburse medical fees
better reflect true cost
- high-risk indivs in national insurance mkt
moral hazard
occurs when econ agents take greater risks than they normally would as resulting costs will not be borne by them (hidden action prob)
e.g. insurance mkt (buyer has less incentive to protect against theft/incident), insurance firm faces moral hazard mkt, missing mkt as firms feel consumers will change behaviour aft purchasing insurance
e.g. principal-agent prob(healthcare mkt) - agent performs task on behalf of principal
action cannot be perfectly monitored, tend to take more risk/ less effort
doctor has more expertise, recommend more than necessary medication/procedures
engage in opportunistic behaviour, econ inefficiency, higher COP, production of good below Qs
measures to address moral hazard
govt:
- legislation: mandatory that agent reduce risk excessively
co-payment, deductible (must pay bef paying a claim): both present in medishield life + claim limit and benchmark of fees
firms:
- legislation - personal stake in outcome
- contingent contracts/incentives
- commissions: receives payoffs contingent on some variables - efficiency wages: MC>MB if agent exercise moral hazard
- deferred payment
- monitoring
5 steps to factor immobility
inability of FOP to move freely across diff uses
- changing needs of economy
- state type of factor immobility
- explain unemployment/underemployment of FOP
- surplus of labour in agricultural industry, shortage in tech industry - mkt failure
- economy not productive efficient as it is not producing max output with given amt of input, economy producing inside PPC
- not allocative efficient: underallocation of resources to tech industry, foregone societal welfare that could have been gained by increasing production in tech industry
causes of occupational immobility of capital
- inability to repurpose specialised capital
- exclusive ownership rights on factor by firm
to address
- incentivise firms to purchase capital (invest in new capital goods/ replace old ones) reduce COP
- high opt cost
govt intervention for occupational immobility of labour
- retraining, upgrading
- grants, subsidies for new industries (to expand and increase employment)
- reduce info gap in job matching
govt intervention to address income inequality
- to reduce factor immobility - education, retraining
- redistributive policies - progressive tax system, transfer payments
- tax evasion/ lower productivity
- need for competitive tax rates
(-) imperfect info
(-) under report income - min wage
- labour surplus
- cost push inflation - price ceiling
- black mkt, shortage - indirect subsidy
- opt cost
- high income consumers can buy more of essential goods, worsen inequity
