Economics 1.3 Market Failure +1.4 Government failure

Market Failure

What is market failure?

Market failure occurs when the market fails to allocate scarce resources efficiently, causing a loss in social welfare.

What are the three main types of market failure?

Externalities

Under-provision of public goods

Information gaps

What is an externality?

An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism, leading to over or under-production of goods.

Give examples of negative and positive externalities.

Negative externalities: Cars, cigarettes

Positive externalities: Education, healthcare

What is meant by the under-provision of public goods?

Public goods are non-rivalry and non-excludable, meaning they are underprovided by the private sector due to the free-rider problem. Example: Streetlights.

What is the free-rider problem?

The free-rider problem occurs when individuals can benefit from a good without paying for it, leading to under-provision of public goods by the market.

What are information gaps in economics?

Information gaps occur when economic agents do not have perfect information, leading to irrational decision-making and inefficient resource allocation.

How do information gaps impact consumer decisions?

Consumers may not know the quality of second-hand goods, like cars, or may find complex products, like pension schemes, hard to evaluate.

How does the government address asymmetric markets?

the government provides information to help people make informed decisions, e.g., information on smoking and drink driving. It may also require companies to provide this information.

What are private costs/benefits?

Private costs/benefits are the costs/benefits to the individual participating in the economic activity. The demand curve represents private benefits, and the supply curve represents private costs

what are social costs/benefits?

External costs/benefits are the costs/benefits to a third party not directly involved in the economic activity. They are the difference between private costs/benefits and social costs/benefits.

What is a merit good?

A merit good has external benefits, where the benefit to society is greater than the benefit to the individual. These goods are typically underprovided by the free market.

What is a demerit good?

A demerit good has external costs, where the cost to society is greater than the cost to the individual. These goods are typically overprovided by the free market.

What is a marginal cost/benefit?

A marginal cost/benefit is the extra cost/benefit from producing/consuming one more unit of a good.

What is the difference between marginal private benefit (MPB) and marginal social benefit (MSB)?

MPB: The extra satisfaction gained by the individual from consuming one more unit of a good.

MSB: The extra gain to society from the consumption of one more unit of a good.

What is the difference between marginal private cost (MPC) and marginal social cost (MSC)?

MPC: The extra cost to the individual from producing one more unit of a good.

MSC: The extra cost to society from the production of one more unit of a good.

What are negative externalities of production?

Negative externalities of production occur when social costs are greater than private costs, leading to inefficiency in the market.

What happens when the market is left to operate freely in the presence of negative externalities?

The market will ignore the external costs and produce at the market equilibrium (MPB = MPC), leading to a loss in social welfare at the output level Q1P1.

What is the result of producing at Q1 in the presence of negative externalities?

At Q1, the costs to society are higher than the benefits, resulting in welfare loss, represented by the shaded area in a diagram. The external cost at Q1 is the difference between private and social costs (line AB).

Where should the economy ideally produce to maximize social welfare?

The economy should produce where Marginal Social Benefit (MSB) = Marginal Social Cost (MSC), which is the social optimum position at Q2P2.

How does the difference between marginal social cost (MSC) and marginal private cost (MPC) change with output?

The difference between MSC and MPC increases as output grows because external costs grow the more people engage in an activity.

Give examples of negative production externalities.

Examples include pollution from cars, noise pollution from airplanes, and industrial waste.

What are positive externalities of consumption?

Positive externalities of consumption occur when social benefits are greater than social costs, leading to underproduction if the market ignores these benefits.

What happens when the market ignores positive externalities?

The market will produce where MPB = MPC, resulting in underproduction at Q1P1, leading to a welfare loss (shaded area) as the external benefits are not considered.

Where should the economy ideally produce in the presence of positive externalities?

The economy should produce where Marginal Social Benefit (MSB) = Marginal Social Cost (MSC), which is the social optimum at Q2P2.

Why does the difference between MPB and MSB grow with increased consumption of a good?

The difference grows because external benefits increase as more people undertake the activity. For example, the external benefits of vaccinations grow as more people get vaccinated.

Give examples of positive consumption externalities.

Examples include healthcare and education, where the benefits to society exceed the benefits to the individual.

Why is it difficult to measure the size of an externality?

It is difficult because externalities are based on value judgments and are hard to monetize, especially when they involve information gaps where individuals are unaware of the full implications of their decisions.

What is one way the government can address negative externalities?

The government can impose indirect taxes on goods with negative externalities to reduce their production, internalizing the external costs.

What is one way the government can address positive externalities?

The government can provide subsidies on goods with positive externalities to encourage more consumption and internalize the external benefits.

What are tradable pollution permits?

tradable pollution permits allow firms to produce up to a certain level of pollution, with permits that can be traded among firms, reducing overall pollution.

How can the government provide the good directly to address positive externalities?

The government can provide the good through taxation when social benefits are very high, e.g., healthcare and education.

how can the government address information gaps related to externalities?

The government can provide information to help people make informed decisions and understand the external costs and benefits of their actions.

How can regulation help reduce negative externalities?

The government can use regulations to limit the consumption of goods with negative externalities, such as banning smoking advertisements.

What are public goods?

Public goods are goods that are not provided by the free market but offer significant benefits to society.

What are the two key characteristics of public goods?

1. Non-rivalry: One person’s use of the good doesn’t prevent someone else from using it.

2. Non-excludability: You cannot stop someone from accessing the good, and people cannot choose not to access it.

Give an example of a public good.

An example of a public good is streetlights, as one person's use of the light doesn't prevent others from using it, and it's impossible to exclude someone from benefiting from it.

Are there many examples of pure public goods?

There are very few examples of pure public goods that are both non-rival and non-excludable.

what are quasi-public goods?

goods which aren’t perfectly non-rivalry and non-excludable but aren’t perfectly rival or excludable. example roads or a park bench

What is the free rider problem?

The free rider problem occurs when individuals cannot be charged for the provision of a non-excludable good, leading to some people benefiting from it without paying.

Who is a free rider?

A free rider is someone who receives the benefits of a good or service without paying for it.

Why won’t private sector producers provide public goods?

Private sector producers won’t provide public goods because they cannot ensure a profit due to the non-excludability of these goods.

What happens if public goods are left to the mar

If public goods were left to the market, the market would fail to provide them, as private producers cannot profit from them. As a result, the government provides and finances these goods through taxation.

What is symmetric information?

Symmetric information occurs when buyers and sellers have access to the same information, meaning there is perfect information available to both parties.

What is an information gap?

An information gap occurs when economic agents make decisions based on imperfect information, preventing them from making fully informed choices.

What is asymmetric information?

Asymmetric information is when one party (usually the seller) has more information than the other party (usually the buyer), which can lead to exploitation, such as higher prices being charged.

How does advertising contribute to information gaps?

Advertising often leads to information gaps by changing consumers' attitudes and making them perceive the benefits of a product as greater than they actually are

How has technology affected information gaps?

Advances in technology have reduced information gaps by making it easier for consumers to access information.

How do information gaps lead to market failure?

Information gaps lead to market failure by causing misallocation of resources, where people do not buy products that maximize their welfare, leading to incorrect demand and supply levels.

What are some examples of information gaps?

• Drugs, where users may not understand the long-term health consequences.

• Pensions, where young people may not recognize the long-term benefits of contributing to pension schemes.

• Financial services, where suppliers may have more information and exploit consumers (moral hazard).

How can the government address negative externalities in the market?

The government can introduce indirect taxation on goods with negative externalities to reduce market failure and internalize the externality.

What effect does indirect taxation have on the supply curve?

Indirect taxation increases costs to the producer, shifting the supply curve (MPC) from S1 to S2, reducing supply.

What happens to market equilibrium after the introduction of indirect taxation?

The market equilibrium shifts from P1Q1 (where MPC = MPB) to P2Q2 (where MSB = MSC), aligning with the social optimum.

How does indirect taxation "internalize the externality"?

By increasing the cost of the good, the tax ensures that producers and consumers account for the external costs, aligning private and social costs, and maximizing social welfare.

What is the difference between a specific tax and an ad valorem tax?

Both taxes shift the supply curve, but a specific tax is a fixed amount per unit, while an ad valorem tax is a percentage of the price, leading to a slightly different shift in the curve.

What is an advantage of using indirect taxation to address negative externalities?

It internalizes the externality, causing the market to produce at the social equilibrium, thus maximizing social welfare.

How does indirect taxation raise government revenue?

Indirect taxation generates government revenue, which can be used to address the externality in other ways, such as funding education or programs that reduce demand for the taxed goods.

How might indirect taxation affect the elasticity of demand?

Over time, indirect taxation may make goods more elastic as consumers respond to higher prices by reducing consumption, especially if the government uses the revenue for education or alternatives.

What is a disadvantage of setting the right tax rate for an externality?

It is difficult to determine the size of the externality and set the correct tax, as the government faces imperfect information when deciding on the tax rate.

What potential conflict can arise with indirect taxation?

There may be a conflict between the government's goal of raising revenue and addressing the externality, making it challenging to balance both objectives.

What is a possible unintended consequence of indirect taxation?

Indirect taxation could lead to the creation of a black market, where goods are sold illegally to avoid the tax.

When is indirect taxation ineffective?

If the demand for the good is inelastic, the tax will have little effect on reducing output, as consumers continue to buy the good despite higher prices.

Why are taxes politically unpopular?

Taxes are often unpopular because they increase prices for consumers, and governments may be reluctant to introduce them due to public opposition.

What is a regressive aspect of indirect taxes?

Indirect taxes are regressive, meaning they take a larger proportion of income from the poor than from the rich, as low-income households spend more on taxed goods.

What are some examples of indirect taxes used to address externalities in the UK?

Examples include landfill taxes, fuel duties, alcohol duties, tobacco duties, air passenger duties, and sugar taxes.

How can subsidies be used to address positive externalities?

The government can introduce subsidies to encourage the production or consumption of goods with positive externalities, shifting the supply curve to the right by lowering production costs.

What effect does a subsidy have on the market equilibrium?

The subsidy shifts the supply curve to the right, lowering costs and increasing output. The market moves from the free market equilibrium at Q1P1 to the social optimum at Q2P3, where MSC = MSB.

How do subsidies help maximize social welfare?

By shifting the supply curve and increasing production to the social optimum (Q2P3), subsidies help allocate resources efficiently, maximizing social welfare.

What are the advantages of using subsidies?

• They ensure society reaches the social optimum output, maximizing welfare.

• Subsidies can have positive impacts, such as encouraging small businesses, promoting equality, and boosting exports.

What is a disadvantage of subsidies related to government spending?

Subsidies require significant government spending, which has a high opportunity cost, meaning the funds could be used for other purposes.

Why are subsidies difficult to target?

Subsidies are difficult to target because the exact size of the externality is often unknown, making it hard to set the appropriate subsidy level.

What issue can subsidies cause for producers?

Subsidies can cause producers to become inefficient, especially if they are in place for a long time, as producers may rely on subsidies instead of improving productivity.

What is a drawback of subsidies once they are introduced?

Once introduced, subsidies are difficult to remove, even if they are no longer needed or effective.

What are some examples of subsidies?

xamples include subsidies for biofuels, solar panels, apprenticeship schemes, wind farms, and rail industries.

What is a maximum price, and when does it have an effect?

A maximum price is a legally imposed price limit on a good. It has an effect only if it is set below the current market equilibrium price, creating excess demand.

When is a minimum price effective?

A minimum price is effective when it is set above the current market equilibrium price, leading to excess supply.

What is the purpose of setting a maximum price?

Maximum prices are set on goods with positive externalities, like food, to prevent negative impacts on society, such as higher healthcare costs. They can also prevent monopolies from exploiting customers.

What happens when a maximum price is imposed?

The equilibrium price is P1Q1, but the maximum price leads to excess demand (QD - QS), shown by the shaded area on the diagram.

What is a minimum price?

A minimum price is a legally imposed price below which a good cannot be sold. It can be set on goods with negative externalities to raise the price to the social optimum and reduce consumption.

How does a minimum price affect supply and demand?

When a minimum price is set above the equilibrium price (P1), it creates excess supply, as quantity supplied (QS) exceeds quantity demanded (QD). This results in a surplus, shown by the shaded area in the diagram.

When can a minimum price be useful?

A minimum price can be set to discourage the consumption of goods with negative externalities, or to ensure producers get a fair price for goods with social benefits that are underprovided in the market.

What is an advantage of setting a minimum price in relation to externalities?

Minimum prices can be set at the social optimum (MSB = MSC), allowing for consideration of externalities and increasing social welfare.

How can minimum prices improve equity?

Minimum prices ensure that producers receive a fair price for their goods, which can help reduce poverty and increase equity in the economy.

What is a disadvantage of setting minimum prices?

Minimum prices distort price signals, causing either excess demand or supply. Excess demand can create allocation issues, while excess supply leads to questions about managing surpluses.

Why is it difficult for governments to set minimum prices correctly?

Governments face challenges in determining the correct price to set, as the size of externalities is hard to measure, and setting the price impacts the degree of excess supply or demand.

What potential issue can arise from setting a minimum price?

Minimum prices can lead to the creation of black markets, where goods are sold illegally at lower prices, bypassing the minimum price.

Where have minimum prices been applied in practice?

Minimum prices have been implemented in areas like rent controls in Manhattan, and price caps on essential goods such as milk, toilet paper, medicine, and petrol.

What is the purpose of minimum pricing on alcohol in Scotland?

The minimum price on alcohol targets cheap drinks to reduce binge drinking, but it may negatively impact those addicted to alcohol, especially in terms of affordability.

How has the minimum price on limousines in Nashville affected competition?

The minimum price has stifled competition, forcing the most price-competitive firms out of the market.

What is a buffer stock scheme?

A buffer stock scheme involves setting both maximum and minimum prices for a good, often used in agriculture. The government buys excess supply when the price is below the minimum and sells it when the price exceeds the maximum, stabilizing prices.

What is the problem with buffer stock schemes?

Buffer stock schemes can cause inefficiency and place a large cost on the government, as prices may remain below the minimum because producers know the government will buy up any surplus.

What are tradable pollution permits?

Tradable pollution permits allow firms to pollute up to a specific limit. Companies must buy permits to pollute, and unused permits can be sold to other companies, creating an incentive to use greener technologies.

How do tradable pollution permits help reduce pollution?

By limiting the total number of permits and allowing them to be traded, firms with lower pollution-reduction costs can sell permits to firms with higher costs, making the overall reduction cheaper.

How does the trading of pollution permits reduce costs for firms?

Firms with lower reduction costs can sell their permits to firms with higher costs, creating a market for pollution reduction that minimizes overall costs. For example, Firm A may sell permits to Firm B if it's cheaper for Firm B to buy than to reduce pollution.

How much would it cost to reduce pollution for three firms with tradable pollution permits?

Without permits, the cost of reducing pollution for firms A, B, and C would be £1700.

With tradable permits, the total cost is reduced to £1100, as firms buy and sell permits to cut costs, showing that tradable permits can be more efficient.

What are the advantages of tradable pollution permits?

• Guaranteed pollution reduction: The government caps the number of permits, ensuring that pollution reduces to set targets.

• Revenue generation: The government can raise funds by selling permits and fining firms that exceed their limits.

• Incentivizes green technology: Encourages firms to invest in environmentally-friendly technologies.

• Efficiency: Firms make their own decisions whether to cut pollution or buy more permits, encouraging efficient outcomes.

What are the disadvantages of tradable pollution permits?

• Monitoring costs: It can be expensive to enforce, and the government must impose sufficient fines to ensure compliance.

• Higher business costs: Firms may pass on the costs of purchasing permits to consumers.

• Difficulty in setting permit levels: It's hard to determine the exact number of permits to issue.

• Example: The US Sulphur trading scheme and the EU Emissions Trading Scheme (ETS) reduced pollutants and greenhouse gases.

What is the role of the government in the provision of public goods?

• Market failure correction: Public goods are non-rival and non-excludable, meaning they are underprovided by the market. The government provides them directly via taxation.

• Merit goods: The government may also provide merit goods, which have external benefits.

What are the advantages of state provision of public goods?

• Corrects market failure: Ensures important goods are available that would otherwise be underprovided.

• Improved social welfare: By providing goods like healthcare and education, the government can improve overall welfare.

• Promotes equality: Guarantees access to basic goods, ensuring everyone benefits.

• Economic growth: For example, providing healthcare improves workforce health, contributing to economic growth.

• Efficiency: Using competitive tenders can ensure efficient government provision of goods.

What are the disadvantages of state provision of public goods?

• High opportunity cost: State provision is expensive, leading to significant opportunity costs for the government.

• Inefficient allocation: The government may provide the wrong mix of goods, as it doesn't have market signals (like price) to guide resource allocation. For example, there may be too many soldiers and too few hospital beds.

• Government inefficiency: Governments may lack incentives to reduce costs and improve efficiency.

• Potential for corruption: Government officials may have conflicting objectives or be influenced by corruption.

• Resource misallocation: Example: The UK government spends more on railways than roads, even though most journeys are made by road, indicating inefficient resource allocation.