Market failure & government intervention 1.3&1.4

Market failure

• when the market fails to allocate scarce resources effectively

• causing a loss in social welfare loss

Externalities

• the cost or benefit a third party receives from an economic transaction outside of the market mechanism

• cigarettes

• education

Under provision of public goods

• public goods are non rivalry and non excludable

• meaning they are underprovided by the private sector due to the freerider problem 

• street lights

Information gaps

• when a buyer or seller doesnt have the full information they need to make a fully informed decision

private costs/benefits

• the cost/benefits to the individual participating in the economic activity

• private benefits= demand

• private costs= supply

social costs/benefits

• the costs/benefits of the activity to society as a whole

external costs/ benefit

costs/benefits to a third party not involved in the economic activity

what is a merit good

A good with external benefits

• underprovided in he free market

Negative production externalities

• occurs when social costs are greater then private costs

• market left to operate freely will ignore the external costs involved in producing a good

Positive consumption externalities

• social benefits are greater then social costs

• market is left to its own devices, will produce where MPB=MPC

• wont consider the benefits to society so will produce Q1P2

• misallocation of resources so there is an under production 

• healthcare and education

Many externalities are involved with information gaps as people are aware of full implications of their decisions

Government intervention

Governments can intervene to ensure the market considers the external costs and benefits

• indirect taxes and subsidies

• tradeable pollution permits

• provision of the good

• provision of information

• regualation

Public goods

• missing from the free market but offer benefits to society

• non rivalry

• non excludable

free rider problem

• you cannot charge an individual a price for the provision of a non excludable good

• a free rider is someone who receives the benefits without paying for it

• Private sector producers will not provide public goods to people because they cannot be sure of making a profit

• the market would fail and so they are provided by the government and financed through taxation

Symmetrical information

• occurs when buyers and sellers have potential ccess to the same information

• perfect information

Asymmetric information

• when one party has superior knowledge compare to another

• usually the seller has more information than the buyer and this means they can take advantage of the other party’s lack of knowledge

what information gaps lead to

• market failure

• there is a misallocation of resources because people do not buy things that maximise their welfare

• consumer demand for a good or producer supply of a good may be too high or too low

• economic agents are unable to make rational decisions

• eg drugs

government use of indirect taxation

• to prevent market failure

• fall in supply and increase the costs to individuals

advantages of indirect tax

• It internalises the externality- market now produces at the social equilibrium position and social welfare is maximised

• raises government revenue- could be used to solve the externality in other ways eg education, may help goods become more elastic

disadvantages of indirect tax

• difficult to know the size of the extenality so difficult to target the tax- depends on where the tax is set- government suffers from imperfect information where setting the tax

• conflict between gov goal of raising revenue and solving the externality

• creation of black market

government use of subsidies

• in order to fix information gaps

• shift supply curve right- lower cost of production

• social welfare is maximised

advantages of subsidies

• society reaches the social optimum output and welfare is maximised

• encourage small businesses, bring abt equality

disadvantages of subsidies

• high opportunity costs

• difficult to target

• producers can become inefficient

• subsidies are difficult to remove

Maximum prices

• must be set below current price equilibrium

• a legally imposed price for a good that the suppliers cannot charge above

• set on good with positive externalities

• prevent monopolies from exploiting customers

Minimum prices

• must be set above current price equilibrium

• a legally imposed price at which the price of the good cannot go below

• set on goods with negative externalities, the price is raised to the social optimum point and consumption is discouraged

• encourage producers to produce goods so can be set on goods with social benefits that are underprovided by the market

advantages of minimum and maximum prices

• they can be set where MSB=MSC so allow for soe consideration of externalities and so help to increase social welfare

• maximum price- will ensure that goods are affordable

• minimum price will ensure that poducers get a fair price

• both reduce poverty and increase quality

disadvantages of minimum and maximum prices

• is a distortion of price signals and this causes excess supply/demand

• excess demand will lead to questions about how to allocate goods and excess supply will lead to questions about what to do with the surplus goods

• difficult for the government to know where to set the price

• can lead to the creation of the black market 

tradable pollution permits

• allows the owner to pollute up to a specific amount of pollution and the gov controls how many permits there are so limits the maximum amount of pollution

• companies have to buy permits in order to pollute- companies may use greener technology

• incentive to cut emissions so maximise profits

advantages of tradeable permits

• guaranteed that pollution will fall- maximise social welfare

• government raise revenue

• encourage efficiency

Disadvantages of tradeable pollution permits

• can be expensive to monitor and police

• will raise costs for business- higher costs will be past onto consumers

• difficult to know how many permits the government should allow

advantages of public goods

• corrects market failure by providing important goods with otherwise would not be provided

• helps bring abt equality- ensuring everyone has access to basic goods

• benefits for the goods them self

disadvantages of public goods

• expensive and represents a high opportunity cost for the government

• the government may produce combination of goods as consumers can not indicate their prefernece

• government may be inefficient as they have no incentive to cut costs

• government officials may suffer from corruption and conflicting objectives

• eg NHS suffer from severe underfunding

Provision of information 

• government provides information to allow people to make informed decision

advantages of provision of information

• helps consumers act rationally

• can make demand more elastic in the long run and so help indirect taxes to become more effective at reducing output

disadvantages of provision of information

• can be expensive for the government to do, incurring an opportunity cost

• consumers may not listen to the information provided due to irrational behaviour

regulation

• governments are able to to impose laws and caps to ensure that levels are set where MSB=MSC or to ensure that companies provide full information on products

• ensures firms follow regulation and do not exploit their costumers or take advantage of market position

advantages of regulation

• can ensure consideration of externalities, prevent exploitation of consumers and keep consumers fully informed

• help to overcome market failure and maximise social welfare

disadvantages of regulation

• laws may be expensive for government to monitor- incurring to opportunity cost

• dont take into account the different costs of following the laws for different companies

• firms may pass on costs to consumers in the form of higher prices

government failure

• is when government intervention in the market leads to net welfare loss and a misallocation of resources

• the total social costs arising from the intervention are greater than the social benefit

distortion of price signals

• some types of gov intervention change price signals in the market and distort the free market mechanism

• as a result they keep some companies n business when they are inefficient so the resources should be switched to somewhere else or make consumers pay too much for a good (taxes)

• by intervening the gov distorts the mechanism and so resources may be allocated inefficiently

unintended consequences

• cause effects which the government did not intend to happen

• consumers and producers may react to new policies in unexpected ways and so the policy doesnt have the effect it should

• eg the buffer stock scheme in the EU- lead to overproduction and fall in agricultural prices

excessive administration costs

• a lot of money that is allocated by the government is actually used up on basic administration costs

• the social costs may be higher than social benefits once administration costs are taken into account

governments causing information gaps

• it is impractical and impossible for the government to get every piece of information they need