AP Micro Market Failure & The Role of Government

market failure

a situation where free markets fail to allocate resources efficiently

reduce waste

in imperfect markets, well-designed government policy can _______

socially optimal

when the production or consumption of a good by the free market takes place at a level that is NOT ______________, the free market fails

too much / too little

free markets fail when either ______________ of the good will be produced by the free market

market clearing price

price at which the market is in equilibrium (no shortages & no surpluses)

MC = MB

the market clearing price is where _______, and it is allocatively efficient

allocative efficiency for society

happens when marginal social benefit of consuming the last benefit = marginal social cost producing that last unit

maximizes total economic surplus

MSB = MSC does what

market failure

when allocative efficiency is not achieved, __________ occurs

deadweight loss

when allocative efficiency is not achieved, it creates

not allocatively efficient

price of beef is above equilibrium price, creates surplus, MC < MB

not allocatively efficient

price of beef is below equilibrium price, creates shortage MB > MC

internalized

the market equilibrium quantity is equal to the socially optimal quantity only when all social benefits and costs are _____________ by individuals in the market

market power

refers to a company’s relative ability to manipulate the price of an item in the marketplace by manipulating the level of supply, demand, or both (monopoly, monopsony)

missing markets

market fails to form, resulting in failure to meet a need or want such as a need for public good (defense, street lighting, highways)

incomplete markets

markets may fail to produce enough merit goods (education, health care)

de-merit goods

markets can fail to control the manufacture and sale of goods which have less merit than consumers perceive (cigarettes & alcohol)

negative externalities

consumers and producers may fail to take into account the effects of their actions on a third-party (pollution, noise)

monopoly

market power that allows for a monopolistic producer to have excessive power (pricing, quality, access)

unstable markets

markets may become highly unstable where stable equilibrium may not be established and become volatile (agriculture, foreign exchange, credit)

property rights

markets work most effectively when consumers and producers are granted the right to own property but that right may not be clearly defined or well protected (industrial pollution poisoning wells of private homes)

inequality

markets may fail to limit the size of the gap between income earners (income gaps), markets reward with income and profits but the rewards may be concentrated in the hands of few

information failure (asymmetric information)

markets may not provide enough information because, during a transaction, it may not be in the interest of one party to provide full information to the other party (landlords know more about their properties than tenants; used car sellers know more about the cars than the buyers)

government intervention

policymakers use cost-benefit analysis to evaluate different actions to reduce or eliminate market inefficiencies, goal is to design policies that equate MSB to MSC, producing any non-efficient quantity results in DWL

excludable good

a good or service where the provider can prevent non-paying individuals from consuming it (movie tickets, cable TV subscriptions, a meal at a restaurant, or clothing)

non-excludable good

public goods that cannot exclude a certain individual or group of individuals from using them, nearly impossible to restrict access to the consumption of non-excludable goods (roads, parks, clean air, fish), people have incentive to free ride when a good is non-excludable

rival good

a good that can only be possessed or consumed by a single user

equal

with an ordinary rival good like a car, the marginal benefit of one more unit is ______ to the extra benefit received by the individual who receives that unit (that particular car)

nonrival good

a good that can be consumed or possessed by multiple users (internet, radio stations, street lights, clean water, fireworks display)

sum

for nonrival goods, the marginal benefit or providing an extra unit is the ____ of the marginal benefits received by each of the individual users

public goods

goods that are non-rivalrous and non-excludable, not provided by the free market (public education, roads, bridges, street lights)

Qso

for public goods ____ is the socially optimal quantity (where MSC=MSB), the free market will not provide these street lights (because of the free rider problem)

zero

marginal cost of providing a pure public good to one more consumer is

common access resources

natural resources that nobody owns but that anybody can exploit (ocean fish, fresh water), non-excludable but rivalrous

tragedy of the commons

occurs when an economic good is rivalrous in consumption, non-excludable, scarce, and a common-pool resource, private individuals inefficiently overconsume such resources at the expense of society (common pasture land)

MSC>MSB

tragedy of the commons, cost to society is greater

Qso

for tragedy of the commons, the equilibrium price & quantity Qe is lower in price and higher in quantity that ___ - too many fish being caught, rights to use these resources must be managed by the government

cap and trade

solution to the tragedy of the commons, allows companies to voluntarily trade the “right to fish” or the “right to pollute” from one company to another - the companies willing to pay will buy the “right to fish” or “right to pollute” - permits make it costly for companies to pollute

externality

the uncompensated impact of one person’s or firm’s actions on the well-being of another

negative externality

the impact is adverse, markets produce a larger quantity than socially desirable (exhaust from cars creates smog - the government sets emission standards and taxes gasoline)

positive externality

the impact is beneficial, markets produce a smaller quantity than is socially desirable (new technologies: the government maintains a patent system, subsidizes scientific research) (education leads to more informed voters, lower crime, and technological advances - the government funds education)

production externalities

when the production of a good creates spillover benefits or costs on a third party (deforestation: when when a logging company clears a forest, this leads to habitat loss, less biodiversity, and increased flood risk, Honey-making: bee-keeping results in better pollination)

consumption externalities

when the consumption of a good creates external or spillover benefits for a third party (using public transportation: reduces congestion on the roads and air pollution)

internalizing the externality

offering incentives so that people take account of the external effects of their actions, government can tax/subsidize goods

negative production externalities

production of a cost creates negative spillover costs passed on to society (environmental costs, health costs)

marginal private cost

actual monetary costs to firms of producing a good (raw materials, wages, etc), at every quantity there is a greater cost to society than MPC

marginal social cost

total cost of production born by society as a whole (includes the MPC and all external costs such as pollution and health costs)

marginal private cost

supply = MC =

external costs of production

MSC curve takes into account the

socially optimal quantity

when all costs are taken into account (both external & private)

socially optimal price

price if all costs were taken into account

deadweight loss (MSC > MB)

at market equilibrium price, there is _________________ and an overallocation of resources to create the good

negative production externality

MSC > MPC

negative externalities, unless business are forced to internalize the external costs

higher, lower

if producers had to bear all the external costs, then their private costs would be _______ and the equilibrium quantity would be _________

exceed

when there are negative Externalities associated with the production of a good, marginal social costs will _______ marginal private costs unless business are forced to internalize the external costs

marginal external cost

equal to the vertical distance between MSC and MPC at any quantity of output

command-and-control

government responds to negative production externalities by regulate behavior directly, (EPA regulations)

market-based policies

provide incentives so that private decision makers will choose to solve the problem on their own (corrective tax - gives incentive to reduce negative externalities, move the allocation of resources closer to the social optimum)

positive production externality

least common, when the production of a good or service creates spillover benefits that help a third party not involved in the market transaction - firms do not try to externalize any of the benefits of their production, firms want to maximize profits (malaria, HIV, COVID, tree farms, sports stadiums)

below

positive production externality will have a marginal social cost curve that lies ____ the marginal private cost curve (MPC higher)

MPC = MSB, MSB > MSC

positive production externality is at equilibrium where ________. resources are under-allocated

positive production externality graph

subsidies, tax breaks

government responds to positive production externalities by introducing:

negative consumption externalities

when the consumption of a good creates negative external or spillover costs from a third party not involved in the market

MSB < MPB

negative consumption Externalities occur when

MC

in a negative consumption externality graph, supply =

demerit goods

activities or goods that create spillover costs as a result of their consumption (alcohol, tobacco, cars)

negative consumption externality graph

corrective taxes, subsidizing substitutes, regulations

solutions to negative consumption Externalities include ________, which shifts the supply curve to the left, leads to smaller quantity demanded

positive consumption externality

happens when consumption of a good or service creates spillover benefits enjoyed by a third party not involved in the market transaction

market failure

positive consumption externalities result in ________ because the quantity produced by the free market will be less than the socially optimal quantity (education, public transport, vaccines)

MSB > MPB

positive consumption externalities occurs when

MPC = MPB

equilibrium quantity for positive consumption externality is

MPC = MSC

supply curve for positive consumption externality is

greater

for a positive consumption externality, at Qe, the benefit to society is _______ than the personal benefit

MSB = MSC

a positive consumption externality is only efficient where

positive consumption externality graph

positive advertising, subsidies increasing supply

government solutions to positive consumption externalities include

regressive tax system

proportional (flat), lump-sum, tax rate decreases as taxable income increases

less able to pay

in a regressive tax system, people tend to decrease taxes on those with a higher ability to pay and shift greater burden to those ______________

Regressive tax system: proportional

fixed tax rate, equal tax incidence, constant marginal rate

regressive tax system: lump-sum

quantitatively equal tax charge ($4000 for all households), efficient and has minimum administrative burden), creates larger burden for those with low income, will NOT change market quantity of output (fixed)

tax policies to reduce poverty

gives tax break to workers on the middle and lower-end of the income scale

low-income

raising taxes on savings and providing subsidies to _________ households will lead to more equal after-tax and transfer incomes

downward

a lump-sum subsidy will shift the ATC

positive

for a lump-sum subsidy, in the short-run the firm will enter ______ economic profits due to the subsidy, in the long-run firms are attracted to this industry’s profits and will enter the market

increases, increases, normal

for a lump-sum subsidy, as more producing firms enter the market, supply ________, pushing down the market price and _________ the quantity produced, in the long-run the price will decrease to the point that the firm is only making ______ profit/zero economic profit

lump-sum

what action would a government take when regulating a natural monopoly to produce the socially optimal quantity?

a subsidy that increases as output increases

what will cause an unregulated monopolist to produce a more allocatively efficient level of output?

the income gap

markets may fail to limit the size of the gap between income earners, markets reward with income and profits but the rewards may be concentrated in the hands of a few

lorenz curve

shows the distribution of income (or wealth) in an economy

the degree of inequality in dist. of income within a country

what does the Lorenz curve show?

gini coefficient

measures income inequality for a nation - 0 is perfect equality, 1 is perfect inequality

production function

income inequality is measured by what economic concept?

progressive tax system

tax rate increases with greater taxable income and ability to pay