Unit 2.8: Market Failure Flashcards
Market Failure
The failure of the free market to allocate resources efficiently to what is deemed socially desireable
Externalities
The spillover benefits or costs imposed on third parties through consumption or production
Positive externalities
External benefits imposed to third parties through economic activities
Due to external benefits imposed to a third party, the MSG of a merit good is larger than the MPB: MSB>MPB
Positive externalities of consumption
The external benefits imposed to third parties through economic activities
Government intervention correcting positive externalities
Markets associated with positive externalities of consumption or production suffer from an under-allocation of resources leading to market failure.
Legislation and regulation
Laws enforced by the government to ensure certain behaviour from consumers and producers.
Advantages and disadvantages of legislation and regulation in correcting positive externalities
Advantages:
1. Effective in reducing externalities from a command-and-control approach
Disadvantages:
1. Monitoring and enforcing costs incurred by the government
2.People may choose to break the rules if penalties are not significant
- Political pushback
Education-awareness creation
Governments may educate the public about the benefits of merit goods through ads, campaign, and schools to encourage consumption
The government may also discourage the consumption of demerit goods through education and awareness campaigns so that the public is more aware of the negative effects of the good.
Advantages and disadvantages of education-awareness creation in correcting positive externalities
Advantages
1. Effective campaigns may change consumer behaviour for the long term
Limitations
1. Education campaigns only encourage people to change behaviour; effectiveness may vary
- Requires time for the message to be accepted and behaviour to change
3.Opportunity cost of government spending
Direct provision
Governments may directly provide goods and services in the public sector associated with positive externalities such as education, healthcare, and infrastructure.
Disadvantages of direct provision in correcting positive externalities
Opportunity cost – Direct provision requires government spending, which always involves foregone benefits of alternative uses.
Economic inefficiency – Goods and services may be provided free of charge or at a very low cost, potentially resulting in overconsumption such use of A&E (accident and emergency) services for common illnesses.
Inequality – If the goods provided are in shortage, the government may need to prioritize certain groups e.g., healthcare services for the elderly.
Advantages and disadvantages of subsidies in correcting positive externalities
Advantages:
1. Incentivizes production and consumption.
- Reduces the price of the good, increasing its affordability to lower income groups.
Disadvantages:
1. Imperfect market information – difficult to accurately calculate the level of subsidy and externalities in order to achieve the socially-optimum output.
- Effectiveness is dependent on PED – larger subsidies required for price inelastic products.
- Opportunity cost – Subsidies require government spending, which always involves foregone benefits of alternative uses.
Negative externalities of consumption
The negative spillover costs (negative benefits) generated to third parties by consumers during consumption activities.
Negative externalities of production
The negative spillover costs generated to third parties by producers during production activities.
Government intervention correcting negative externalities
Markets associated with negative externalities of consumption or production suffer from an over-allocation of resources leading to market failure.
Advantages and disadvantages of indirect taxes in correcting negative externalities
Advantages
1. The price increase discourages consumption.
- The higher cost discourages production.
- Tax revenue is generated for the government.
Disadvantages
1. Regressive – low-income groups pay a higher portion of their income for the tax.
- Relatively ineffective for goods with inelastic PED
- Imperfect market information means the size of the tax is unlikely equal to the external cost.
- Emergence of parallel markets – smuggling activities for demerit goods.
Advantages of legislation and regulation in correcting negative externalities
Advantages:
1. Effective in reducing externalities from a command-and-control approach
Disadvantages:
1. Monitoring and enforcing costs incurred by the government
- Political pushback
- People may choose to break the rules if penalties are not high enough.
Collective self-governance
The voluntary communal actions that combat negative externalities.
Successful campaigns may change social norms and cultural behaviours.
Carbon emissions
The release of carbon into the atmosphere and is one of the most common and significant negative externalities which occur from economic activity.
Carbon taxes
Imposed on producers for carbon emissions from production activities with the aim of minimising environmental pollution.
Advantages and disadvantages of carbon taxes in correcting negative externalities
Advantages
1. Long term benefits – create incentives for firms to use cleaner technologies in production
- Internalize externality – producers and consumers pay for the environmental costs
- Tax revenue generated
- Easily implemented
Carbon taxes - disadvantages
1. Regressive – low-income groups pay a higher portion of their income for the tax
- Ineffective for products with inelastic PED
- Imperfect market information – difficult to accurately calculate the level of externalities and carbon tax in order to achieve the socially-optimum output.
