micro 1.3 and 1.4 - market failure and government intervention Flashcards
market failure
Market failure —> misallocation of scarce resources
3 main types of market failure:
- Externalities
- Under-provision of public goods
- Information gaps
externalities
externalities —> impact on a third party not involved in the economic transaction
- private cost- costs to the individual participating in the economic activity
- private benefit- benefits to the individual participating in the economic activity
- social costs- costs of the activity to society as a whole
- social benefits- benefits of the activity to society as a whole
- external costs- costs to the 3rd party not involved in the economic transaction
- external benefits- benefits to the 3rd party not involved in the economic transaction
SC = PC + EC
SB = PB + EB - marginal cost —> extra cost of producing/consuming one extra unit of the good
- marginal benefit —> extra benefit of producing/consuming one extra unit of the good
MSB > MPB —> positive externalities
MSC > MPC —> negative externalities
how to draw NE/PE consumption diagram?
consumption —> demand curve
production —> supply curve
example NE consumption:
1. y axis - costs and benefits, x axis - quantity
2. draw demand and supply curves
3. label the curve you’re not shifting —> supply curve —> MPC = MSC = S
4. draw on initial e at MPB
5. write out inequality MPB > MSB
6. draw on new demand curve
7. draw on other e at MSB
8. draw on welfare loss (triangle pointing towards social optimum)
how to draw NE/PE production diagram?
NE production
1. y axis - costs and benefits, x axis - quantity
2. draw demand and supply curves
3. label the curve you’re not shifting —> demand curve —> MPB = MSB = D
4. draw on initial e at MPC
5. write out inequality MSC > MPC
6. draw on new demand curve
7. draw on other e at MSC
8. draw on welfare loss (triangle points towards social optimum)
.
information gaps
imperfect information (asymmetric info and lack of information) —> prevents consumers acting in a rational way
lack of information- info may not exist at all / info not clear —> under / overconsumption —> irrational decisions
- e.g. merit goods —> not enough info that tells consumers how good merit goods are —> under-consumed e.g. healthcare and education —> irrational decisions are made
- de-merit goods —> not enough info that tells consumers how bad de-merit goods are —> over consumption e.g. cigarettes and alcohol —> irrational decisions are made
symmetric information (perfect information) - buyers and sellers have access to the same information
asymmetric information- asymmetric information - when 1 party has more info than the other party
- e.g. labour markets —> employer and worker —> worker has more info than the employer —> employer may make irrational decision to employer the worker
- second hand markets —> seller and buyer —> seller has more info than buyer —> seller may make an irrational decision to buy the car
- insurance markets —> driver and insurance company —> driver has more info than insurance company —> individuals may under report the level of risk to keep insurance prices low —> insurance company may make an irrational decisions by issuing a price lower than what should be charged
THIS ALL LEADS TO MARKET FAILURE WHICH IS A MISALLOCATION OF RESOURCES
different types of goods
public goods:
2 characteristics of public goods?
- non rivalry —> doesn’t limit someone else’s consumption
- non excludable —> you cannot stop someone from accessing the good and someone cannot choose not to access the good e.g. streetlights
private goods:
- rivalry
- excludable
quasi public goods:
- mixture between private and public goods
- e.g. beaches —> some beaches are only accessible to people staying at the hotel —> excludable however beaches can also be non excludable// if there’s a lot of people on the beach then it can limit someone else’s consumption —> rivalrous
free rider problem
- public goods and non rivalrous and non excludable —> leads to the free rider problem —> if goods are non excludable then people can benefit without paying —> little incentive for free market to supply as they’re not sure if they will make profit —> under provision of public goods —> MARKET FAILURE
minimum prices and market failure?
minimum price —> fixed price (price floor) enacted by the government usually set above the equilibrium market price —> legally price cannot go below it, implying that the current price is too low
why do minimum prices exist?
- solves market failure —> discourages over consumption/production of demerit goods
diagram:
- the imposition of a minimum price (price above the equilibrium price) will lead to a higher price for consumers —> this is shown on the diagram by the increase in price from P to PMIN —> as a result of an increase in the price, there is an extension of supply from Q to QS and a contraction of demand to from Q to QD —> this is due to the law of demand —> quantity demanded falls to socially optimum level of output —> solves overconsumption/production
- QD to QS shows the excess supply as a result of the imposition of the minimum price
- cost of intervention buying (excess supply x PMIN): —> government buying up excess supply
- producer revenue with intervention buying —> QS x PMIN
- producer revenue without intervention buying —> QD x PMIN
issues?
- inelastic demand —> in the case the intention is to reduce demand for a demerit good, a minimum price may be ineffective if the good has inelastic demand —> quantity demanded may not decrease enough to solve market failure
- regressive (takes a greater proportion of income from the poor than from the rich) —> widen inequalities —> goes against key macro objective
- rate of the increase in price from the equilibrium level —> in the case the intention is to reduce demand for a demerit good, the effectiveness depends on the rate of the increase in price from the equilibrium level —> in the case the minimum price level is set a bit above equilibrium level, it may not be as effective in trying to reduce demand
- formation of black markets —> dangerous as we don’t know about quality of a good in the black market —> could make market failure worse —> more government interventionist policies needed to solve market failure —> expensive// government lose out on tax revenue
- minimum price may not be set at the right level —> set too high —> could impact firms as they may shut down due to less revenue —> unemployment// HOWEVER if product is price inelastic then producers will see an increase in revenue
- minimum price may not be effective due to regulatory capture —> individuals have associates within government bodies and can avoid following policies/interventions
- intervention buying is costly to the government —> cuts to other areas of government spending so opportunity cost is created// if money is borrowed then debt interest has to be paid which creates an opportunity cost// taxes will be higher to fund it
positives:
- producers will benefit from the minimum price if there is inelastic demand —> producers will see an increase in revenue
- intervention buying could take place —> revenue and producer surplus increases
- minimum price can provide a stable income for suppliers/producers
maximum prices and market failure?
maximum price —> a fixed price (price ceiling) enacted by the government usually set below the equilibrium market price —> legally price cannot go above it, implying that the current price is too high
why do maximum prices exist?
- to increase affordability of necessity goods/services
diagram:
- the imposition of a maximum price (price below the equilibrium price) will lead to a lower price for consumers —> this is shown on the diagram by the decrease in price from P to PMAX —> as a result of a decrease in the price, there is a contraction of supply from Q to QS and an extension of demand from Q to QD —> this is due to the law of demand —> quantity demanded rises to the socially optimum level of output —> solves under consumption/production of merit goods
- QS to QD shows the excess demand as a result of the imposition of the maximum price
- producer revenue —> decreases from P x Q to PMAX x QS
issues?
- excess demand —> people will go to the black market —> dangerous as we don’t know about quality of a good in the black market —> could make market failure worse —> more government interventionist policies needed to solve market failure —> expensive// government lose out on tax revenue
- setting the right level —> maximum price set too low could cause massive excess demand but if it’s set too high then we won’t see greater consumption that’s desired
- fall in price —> consumers assume quality of good/service has fallen —> quantity demanded won’t rise
- government may want to get rid of excess demand by increasing supply e.g. subsidies —> costly for government
- unintended consequences —> lower prices —> fall in producer revenue and producer surplus —> producers may leave the market —> unemployment
positives?
- consumer surplus increases due to greater affordability
- inequality improves —> lower income households can access necessities
information provision?
information provision- government funded information provision/advertising/education to encourage or discourage consumption
diagram:
- negative advertisement —> (use context)
- y axis- price
- x axis- quantity
- 2 demand curves —> demand curve shifts left —> the diagram showcases that as a result of negative advertisement, the level of quantity demanded will fall from ___
information provision for merit goods —> encourage consumption —> quantity demanded increases to socially optimum level —> solves underconsumption/ production
information provision for demerit goods —> discourage consumption —> quantity demanded decreases to socially optimum level —> solves overconsumption/ production
- (price stays same but quantity demanded changes)
- (opposite for positive advertisement)
advantages:
- targets thought process behind a consumer —> allows consumers to make more rational decisions
- works very well alongside other policies
- it can make demand more elastic in the long run
evaluation:
- cost —> expensive —> taxes may increase to fund information provision
- no guarantee of success —> people don’t have to listen
- more of a long run policy not short run —> takes while for consumers to change consumption habits// takes time for consumers to keep repetitively seeing adverts which will change consumption behaviour
- longevity —> if the information campaign is only in place for a short period of time then it will be ineffective
- depends on how well the advertisement is being carried out and if it’s reaching large audiences
subsidy and market failure?
subsidy —> money grant given to producers by the government to lower costs of production and encourage an increase in output (merit goods)
diagram:
- prior to the subsidy, the equilibrium price and quantity was P1Q1 —> due to the imposition of the subsidy, the cost of production for firms decreases —> this causes supply to increase from S1 to S1+subsidy —> this is because it is now less expensive to produce so firms will be more willing to increase production —> this lowers the price from ____ —> as a result, quantity demanded increases from ___ —> this is due to the law of demand —> therefore, in the case there is a misallocation of resources and underconsumption of merit goods with positive externalities, the government are able to impose a subsidy in that market in order to stimulate demand for it —> quantity demanded rises to social optimum level of output —> solves underconsumption/production of merit goods —> solves market failure
issues with subsidies to solve market failure?
- costly —> vertical distance between 2 supply curves x quantity = cost to government —> cuts to other areas of government spending so opportunity cost is created// if money is borrowed then debt interest has to be paid which creates an opportunity cost// taxes will be higher to fund subsidies
- inelastic demand —> in the case that there is inelastic demand, a fall in price may not be that effective in increasing quantity demanded —> market failure not solved
- depends on the rate of the fall in price
- depends on the longevity of the fall in price
- setting subsidy at the right level- we are assuming that government has perfect information so will set subsidies perfectly —> however governments don’t have perfect information and are likely to under/over subsidise// under —> won’t fully solve market failure//over —> costly to government
- firms may not use the subsidy how the government wants them to —> they could spend subsidy on other things —> government failure
positives:
- consumer surplus increases due to a fall in price
- producer revenue and surplus increases
- improves affordability of goods/services
merit and demerit goods
merit goods- goods deemed more beneficial to consumers than they realise
why is there an under consumption/production of merit goods?
- irrational decisions made by consumers to under consumer merit goods due to lack of info
- info failure (info not present, not clear or consumers are choosing to ignore info)
- asymmetric info (info not shared equally between 2 parties)
merit goods generate positive externalities in consumption e.g. healthcare, education and exercise
diagram?
PE consumption diagram
demerit goods- goods deemed more harmful to consumers than they realise
why is there an over consumption/production of demerit goods?
- irrational decisions made by consumers to over consume demerit goods due to lack of info (don’t know how bad it is for them)
- info failure (info not present, not clear or consumers are choosing to ignore info)
- asymmetric info (info not shared equally between 2 parties)
demerit goods generate negative externalities in consumption e.g. cigarettes, alcohol, gambling
diagram?
NE consumption
market failure is the misallocation of scarce resources —> this could be in the form of underconsumption/production of merit goods with positive externalities in consumption/production// overconsumption of demerit goods with negative externalities
reducing demand for demerit goods is ineffective if demand for the good is inelastic
tax —> quantity demanded will fall —> corrects market failure of overconsumption of demerit goods
indirect taxes and market failure?
indirect tax —> tax that increases a firms cost of production which is then translated to consumers via higher prices
application:
- sugar tax came into effect in 2018 —> over 50% of manufacturers have reduced the level of sugar within their drinks
diagram:
- a tax can be imposed on demerit goods with negative externalities to reduce the consumption of the good and correct market failure —> prior to the indirect tax, the equilibrium price and quantity was at P1Q1 —> due to the imposition of an indirect tax, cost of production for firms increases —> it is now more costly for firms to supply the good —> this causes the supply curve to shift upwards from S1 to S1+tax —> as a result of the tax, firms will increase the price of the good for consumers —> this is shown by the increase in price from P1 to P2 —> the law of demand states that a rise in price will cause a fall in quantity demanded —> quantity demanded falls from ____ —> quantity demanded decreases to socially optimum level of output —> solves overconsumption/production of demerit goods
- government revenue is generated (vertical distance between 2 supply curves x new quantity) —> revenue can be used to reduce market failure
issues?
- inelastic demand —> in the case the intention is to reduce demand for a demerit good, an indirect tax may be ineffective if the good has inelastic demand —> quantity demanded may not decrease enough to solve market failure
- setting the right level // overtax —> black markets form, some firms may shut down due to less revenue —> unemployment// undertax —> quantity demanded won’t fall enough —> market failure not solved
- regressive (takes a greater proportion of income from the poor than from the rich)
- rate of tax —> in the case that the price increases by a small amount, quantity demanded may not decrease enough to solve market failure
- longevity of tax —> in the case that the tax is put in place for a short period of time, it will not be that effective
- formation of black markets —> dangerous as we don’t know about quality of a good in the black market —> could make market failure worse —> more government interventionist policies needed to solve market failure —> expensive// government lose out on tax revenue
- money raised on taxes from demerit goods might not be spend on reducing the externality (tax isn’t ring fenced)
positives:
- fall in consumption of demerit goods (cigarettes) could mean that there is now a healthier population —> as a result, there may be less people needing to go to the hospital which in turn means that there is less strain on the NHS
- tax revenue generated can be spent on things such as education, healthcare and infrastructure or even negative advertising of demerit goods
regulation
regulation- rule/law enacted by the government that must be followed by economic agents to encourage a change in behaviour
there has to be a punishment so there’s an incentive to follow it
examples:
- bans- public smoking ban
- limits- age limits on buying cigs and alcohol
- caps- emission caps
- compulsory- graphic imagery on cig packages —> 2016 cigarette act —> find stats - how much has cig use decreased since 2016 cigs act
- innovative regulations- pay a bit extra for a plastic bottle and only get the money back if we recycle it
cons:
- costs- e.g. regulation needs policing —> opportunity cost
- setting the right regulation- too strict —> unintended consequences e.g. burdens firms —> costs increase significantly for firms —> profitability decreases —> reduce production —> unemployment// may leave country and operate elsewhere where regulations aren’t so strict// strict on consumers —> turn to black market —> loss of tax revenue for gov/more policing which costs money// too lax —> no incentive to follow it —> won’t change behaviour enough to solve market failure
government failure
