Unit 1.D - Market Failure + Govt. Intervention in the Market

Question 1

What is market failure?

Answer 1

Market failure occurs when the free market produces an outcome which is deemed unacceptable to society (particularly by the voting segment). This is an issue bc an economy exists to serve a society, and so if the society is unsatisfied something must change.

Question 2

What are the four types of market failure?

Answer 2

• provision of goods and services and management of common resources
• income inequality
• abuse of market power
• externalities

Question 3

What qualifies a public good?

Answer 3

A public good/service must be non-rival and non-excludable.

Question 4

What is the public goods problem?

Answer 4

They won’t be produced in a free market society because they’re subject to the free rider effect so businesses can’t profit from producing them and have no clear financial motive to do so.

(Long version: In a free market goods and services will only be produced in return for payment: if they can’t make a profit they won’t produce those goods/services, even if these goods/services benefit society (e.g. lighthouses, defence, streetlights). Because public goods are subject to the free rider effect businesses can’t profit off them so they won’t be produced.)

Question 5

What is the free rider effect?

Answer 5

The free rider effect occurs in goods that can be consumed without paying for them.

Question 6

What are merit goods?

Answer 6

Goods that are beneficial to society

E.g. public health, education

Question 7

What is is the merit goods problem?

Answer 7

In a pure free market economy merit goods will be produced at prices too high and quantities too small to maximise benefit to society.

Question 8

What are demerit goods?

Answer 8

Goods that have a negative impact on society
E.g. illegal drugs, polluting cars, alcohol
(Ranging from annoying to mortally dangerous)

Question 9

What is the demerit goods problem?

Answer 9

In a free market society demerit goods will be produced at too low a price and too high a quantity.

Question 10

What’s the solution to the public goods problem?

Answer 10

Given that the private sector won’t, govt provides.
- Usually indirectly via taxation: gov pays subcontractors to build roads for example. OR gov makes people pay for TV licenses for example

Question 11

Solution to the merit goods problem?

Answer 11

Gov implements a subsidies, which reduces prices and makes them more affordable, so equilibrium quantities are increased.

Question 12

Solution to the demerit goods problem?

Answer 12

Gov implements a tax or other restriction

Question 13

What’s the common goods problem?

Answer 13

The common goods problem related to how commonly-held resources are protected and/or made available for the good of all. Encompasses the public goods problem, merit goods problem, demerit goods problem. The problem is that they must be managed because its businesses’ inventive to exploit them before someone else does.

Question 14

What are common goods?

Answer 14

Goods which are owned collectively.

E.g.

Question 15

What are common resources?

Answer 15

Resources that are collectively owned so anyone can use them.
E.g. rivers, wild fisheries, mineral deposits, clean air

Question 16

What’s the common goods problem:

Answer 16

Relates to maintenance and protection: whose job is it to fix/protect property.

Cuba faced this problem: no-one owns homes, so no one looks after them.

Question 17

What’s the common resources problem?

Answer 17

Mainly relates to distribution:

• How does each person get their fair share?
• How do we prevent over-exploitation by a small number of people?
• How can benefits be evenly distributed?

This is an issue with some sustainable resources.

E.g. how to manage a wild fishery? How to manage forest resources?

Question 18

What is the tradgedy of the commons?

Answer 18

The tradedy of the commons relates to the idea that people aren’t incentivised to look after commonly-held property, while when privately-owned, people have more self-interested reasons to look after property.

Question 19

What’s the solution to the common goods problem?

Answer 19

The common goods problem can be addressed by:
- Regulation of use of common property
E.g. restrictions on how many people can walk the Overland Track.
- Use of licenses/quotas.
E.g. fishing licenses and bag limits for recreational fishing.
- Assigning private property rights

Question 20

What is abuse of market power?

Answer 20

• Abuse of market power may arise when the conditions of perfect competition are not met, and typically stems from businesses taking advantage of consumers.

Question 21

Why is abuse of market power a problem?

Answer 21

Abuse of market power is a problem because it may result in

• Higher prices for consumers
• Lower quality goods and services
• Inefficient resource use
• Less disposable income left over to spend on satisfying other wants, so less money spent on other businesses.

Question 22

What are two key situations where abuse of market power may occur?

Answer 22

• Monopolies

- Oligopolies

Question 23

What is a monopoly?

Answer 23

A market or industry where there is only 1 seller

Question 24

Why do some monopolies exist?

Answer 24

Some monopolies because…

• High barriers to entry (e.g. building planes, phone networks)
• Monopolisation: one business forced its competitors out of business (usually owing to an advantage exploited ruthlessly).
• Govt-granted monopolies (patents on drugs, artists)
• Natural monopolies (e.g. we mightn’t want multiple water companies all with their own pipelines and infrastructure, or multiple sets of powerlines.

Question 25

What are some of the possible features of monopolies?

Answer 25

• Consumers pay a higher price
• Quality of service likely to suffer
• Businesses less responsive to changes in consumer behaviour

Question 26

What are some solutions to monopolies subject to abuse of market power?

Answer 26

• Regulate existing monopolies if they must exist
• Preventiton of formation of monopolies (e.g. ACCC prevents Coles from buying out Woolies).
• Introduction of competition to remove monopolisation.
• Gov may break up existing monopolies forcibly
• Gov may operate natural monopolies itself, but will still be less efficient than one subject to competition.

Question 27

What is an oligopily?

Answer 27

• An oligopily is a market or industry in which there are only a few sellers (usually 2-5)

Question 28

What are some properties of industries that often lead to formation of oliopilies?

Answer 28

• High barriers to entry
• Industries where economies of scale matter
• Small-scale oligopolistic markets in places with small populations

Question 29

Are oliopolies good or bad?

Answer 29

Oligopies are not necessarily problematic. In fact, often oligopilistic industries are subject to intense competition. Yet issues arise when firms collude… This may lead to decreased competition and increased prices for consumers and decreased product quality.

Question 30

What is collusion?

Answer 30

Collusion may occur in oligopolistic industries and may lead to several forms of manipulation of markets including

• Carving up a market into geographic areas
• Agreeing not to compete in price
• Agreeing to artificially restrict supply to boost price

Question 31

What is a cartel?

Answer 31

A cartel is a secret, illegal arrangement of businesses agreeing to collude.

Question 32

What is the solution to issues in and existence of oligopolies?

Answer 32

• Regulation where oligopilies are unavoidable (e.g. by ACCC to ensure that industries don’t collude)
• Introduction of additional competition (e.g. by deregulation of an industry with high operating costs and/or barriers to entry
• Prevention of businesses merging or buying each other out.

Question 33

What are externalities?

Answer 33

Externalities are a cost or benefit incurred or received by a third party as a result of a private transaction.

E.g. me buying a bus ticket is an example of a transaction with positive externalities. The transaction is between me and the bus company, and results in me catching the bus to work instead of driving, which means that since I am no longer using a private vehicle I will reduce carbon emissions, sound pollution, congestion and risk of accidents: in this way benefits are received by third parties.

Question 34

What is the key issue associated with externalities?

Answer 34

The key issue associated with goods with externalities is that the price is not representative of the full impacts to society:

• Goods with negative externalities: with full cost pricing the price would be higher to include the costs of dealing with the issues that result from their consumption, yet without a tax there is effectively an oversupply: e.g. if price of smoking was more representative of health costs the equilibrium would be higher (which it is, because we’ve implemented a tax).
• Goods with positive externalities: if the price was more indicative of the true cost to society it would be lower, resulting in an effective undersupply at the current price e.g. buses are subsidised because if they weren’t there would be far fewer people catching them, and so more congestion, and we wouldn’t reap the benefits of improved pollution, road safety, and health outcomes.

Question 35

Why is income inequality an inevitable result of a free market economic system?

Answer 35

• Income represents the returns on the factors of production, so income inequality actually represents inequalties in the sharing of the factors of production (how much land, labour, capital, and enterprise you command) and so if you have more income you are more able to purchase or otherwise invest in more factors of production to increase your income, which allows you to continue to purchase more factors of production to increase your income, and so the cycle continues with wealth getting more concentrated at the top, while at the other of the spectrum, those who most need to increase their income, who may be living in relative or absolute poverty, often have the least means to do so and may be most at risk by being exploited for their labour. Those who were born into higher income families may have better access to education and other skills development opportunities and things that improve health as an outcome, and may enter the workforce stronger and generally as a more hopeful candidate, vs the kid who grew up in poverty with no overseas camps to study Latin outside the Vatican, who went to a public school and had to work to support his siblings rather than get to study.

Question 36

What are the benefits of a little income inequality?

Answer 36

Some income inequality may be good at times as it

• Incentivises people to work harder and to take risks with their resources
• Rewards people who succeed in innovating, following consumer preferences, and making well-informed decisions.

Question 37

Why is income inequality bad?

Answer 37

Income inequality is a form of market failure because

• It’s deemed unacceptable by society (particularly by the voting segment): we have decided collectively that profound levels of income inequality don’t fit well into our value system as its results in a range of political and social issues, and at the end of the day, the economy exists to serve a society.
• Results in social problems: lack of cohesion, increased unemployment, unrest e.g. Indonesia, Mexico.
• May become entrenched as intergenerational poverty where people are born poor and never have access to the means to elevate their financial status: the stress of living paycheck to paycheck etc.
• People with lower incomes are likely to be less productive, as they have less access to education and training to directly improve the quality of their labour, and may also have leser access to things that improve health and general welfare, which may also impact the worker’s ability to be productive: they may get sick and not recover, wheras someone with more access to healthcare would have.
• Marx’s central paradox of capitalism: that to be more profitable businesses will try to lower costs and production, so will cut wages. Since incomes decrease there will be less spending on businesses, so businesses will feel they have to cut wages further to reduce costs of production to increase profitability, and so the cycle continues.
• Economy isn’t operating at its potential: imagine if Bill Gates or the guy who invented vaccines never got to enter the workforce because they were born into less fortunate circumstances.

We need to decide as a society how much income inequality is acceptable to balance the benefits and the costs: trade-offs and efficiency and equity.

Question 38

Absolute vs relative poverty?

Answer 38

Absolute poverty: cannot afford the basic necessities of life.

Relative poverty: household income less than a % of the median.

Question 39

What are the solutions to income inequality?

Answer 39

• Redistribution of income: progressive tax system + welfare system.
• Provision of public and merit goods: public health, education, travel services.

These free up income for other purposes and increase access to opportunities.

Question 40

Merit goods vs goods with positive externalities?

Answer 40

Pos ex. might be small/limited say to one person’s morning, merit goods impact all of society.

Note that de/merit goods can be very subjective: e.g. traditional marriage.

Question 41

How might we label curves of a market diagram for a good with positive externalities?

Answer 41

If we implement a subsidy we may have an initial supply curve Sprivate with doesn’t represent benefits passed on to society, and a second, Ssubsidy or Ssocial, which is more indicative of additional benefits.

Question 42

Why does the govt intervene in the free market?

Answer 42

A key reason why the govt. would intervene in the free market is to address market failures: when the free market produces an outcome which is deemed unacceptable by society (particularly by the voting segment).

In a mixed-market economic system the govt. is able to intervene!

Question 43

What are some of the ways that the govt. intervenes in the free market?

Answer 43

Price controls:

• Price ceilings
• Price floors

Quantity controls:
- Quotas/licenses (same thing)

Supply controls:

• Subsidies
• Taxes
• Regulations

Question 44

What is the effect of a price ceiling?

Answer 44

A price ceiling prevents the market price from rising to equilibrium.

Question 45

What is the effect of a price floor?

Answer 45

A price floor prevents the market price from falling to equilibrium.

Question 46

What is the effect of a quota/license?

Answer 46

A quota/licensing system prevents the quantity supplied from responding to changes in price.

Can be reduced over time, e.g. quotas for carbon emissions.

Question 47

What is the effect of taxes/regulations?

Answer 47

Decreases supply: lowes QE, raises PE.

- B/c increase costs of production

Question 48

What’s the effect of subsidies/deregulation?

Answer 48

Increases supply: lowes PE, raises QE

- B/c decreases costs of production

Question 49

What’s the relationship between elasticity and taxes?

Answer 49

• Taxes on elastic goods are better at reducing QE than generating revenue.
• Taxes on inelastic goods are better at generating revenue than reducing QE.

Question 50

What are some of the impacts of a price floor?

Answer 50

• Prevents price from falling to equilibrium: disrupts price mechanism. This means that Qs>Qd so an oversupply will result. The idea is usually to protect suppliers, particularly in situations where the profit margin is low at equilibrium price and qty or the goods + services are devalued, and while it DOES address this devaluation, the resulting oversupply also means that not all sellers will be able to do so, even if they have the goods and would like due, because essentially they’re excess supply. When this surplus production can’t be saved up, a lot of wastage may occur, say if there’s a price floor in the market for lettuce. All the excess lettuce can’t really be saved up for a bad week or to export: it will probably be thrown away.
  Also, means higher costs for consumers, so they’ll have less disposable income to spend elsewhere.