5. Market Failure Flashcards
Define productive efficiency.
Productive efficiency is achieved when a firm chooses the least cost combination of inputs to produce the maximum level of output possible from those inputs
Define allocative efficiency.
Allocative efficiency is achieved when the current combination of goods and services produced and consumed maximizes the societal welfare.
What is market failure and why do government intervene when there is market failure.
Market failure refers to the situation where free markets, when unregulated fails to deliver a socially efficient allocation of resources to produce or consume goods and services. As such, the governments will intervene with a wide range of policies to change society’s production and consumption to a more efficient outcome.
Use an example to illustrate public goods.
A public good is a good that has the characteristics of non-excludability and non-rivalry in consumption. Non excludability means it is impossible or prohibited expensive to exclude any non-payers from using the good/ service. Non-rivalry means the consumption of the good by one does not diminish the amount available for others.
Example: National Defense
An army of a given size protects all the nation’s citizens. Even if a particular individual does not pay taxes to support it, he cannot be denied the protection as long as he is in the country. Moreover, the amount of protection each citizen enjoys does not diminish regardless of the number of new citizens the country takes in.
Why the presence of public goods lead to market failure? How does the government tackle it and what are some limitations of the policies.
Due to the non-excludable nature of a public good, people who do not pay for the good also get to enjoy it. This gives rise to the free-ridership problem where no one is willing to pay for the good. And since no-profit seeking producer will be willing to produce a good that nobody is willing to pay for, the market will not produce the good, though consumers want the good. Complete market failure. Missing market.
Due to the non-rival nature of a public good, the marginal cost of serving an additional user is zero. With zero marginal cost, the principle of optimal resources allocation calls for provision of the good to anyone who wants them at no cost. This is because any non zero price would discourage some users from consuming the good, thereby causing a reduction in society’s total welfare. In this instance, there will be a incomplete market failure as the market exists but fail to produce at the output that is allocative efficient.
Market failure necessitates government intervention to provide such a good.
Limitations:
1. Govt failure may overproduce due to lack of info. Inefficiency may still exist.
2. Govt may not be able to produce these goods as efficiently as profit driven firms, which results in a possible wastage of resources. State monopoly no pressure to maximize profits and minimize cost.
3. Strain on government budget. Increase in tax and macro impacts
Explain with a diagram positive externalities necessitate government intervention. Discuss the effectiveness of policies.
- Positive externality refers to the benefits of production or consumption on persons other than consumers and producers themselves. The third parties do not make payments to enjoy the external benefits.
- MPB, 3rd parties, MEB
- Since MSB = MPB + MEB, the presence of positive externality will cause MSB to be greater than MPB. Assume that there are no negative externalities.
- Diagram
- Qm occurs when MPB = MPC since individuals only consider their private cost and benefit in decision making. They do not take into account the benefits that can be enjoyed by third parties.
- Qs occurs when MSB = MSC
- Under consumption
- DWL (triangle pointing towards Qs)
- Allocative inefficiency leads to Mkt failure, which necessitates government intervention.
Policies (when you explain the effectiveness, make sure you touch on the concept that societal welfare is maximized)
To increase demand
1. Grants (Grants = MEB) Eg. Scholarships, bursaries
2. Legislation Eg. Compulsory education up t an age
3. Moral suasion Eg. Campaigns, advertisements
To increase supply
1. Subsidies (subsidies = MEB)
2. Government supplements production
Limitations
1. Hard to estimate the size of MEB (either underconsumption persists or overconsumption occurs)
2. Strain on the government budget (OC)
3. Cost of monitoring < benefit of a efficient market
4. Moral suasion is voluntary
Discuss the effectiveness of policies to tackle negative externalities.
Decrease supply
1. Indirect taxes (Pigouvian tax = MEC) Eg SG carbon tax goes up to $25 in 2024.
- administrative cost
- hard to determine the exact amount of the tax
2. Cap and trade
- firms that end up selling their tradable permits are those that can cut emissions most cheaply. Hence, cap-and-trade would encourage pollution reduction at the lowest cost to the society.
- difficult to determine the optimal cap on total pollution
-volatility in permit price may discourage investment in green tech, as firms cannot know for sure whether or not the future payoff from the sale of permits justifies the adoption of emissions-reducing tech
- high cost in administration and enforcement
3. Legislation
4. Nationalization
To decrease demand
1. Moral suasion
What are the causes for information failure?
- Ignorance Eg. Smoking
- Complex information Eg. Computers
- Misleading information Eg. Products with misleading advertisements
- Missing or info,plate information Eg. Labeling of food products
- Uncertainty about the future Eg. Insurance products
Explain using a diagram how information failure leads to market failure.
- Indentify source of imperfect info
- Identify Qm, where misperceived MPB=MPC
- Identify Qs, where actual MPB= MSC
- Under/over consumption
- DWL
- Allocative inefficiency leads to Market failure
What is asymmetric information? Explain how adverse selection and moral hazard might arise from asymmetric information and lead to market failure.
Asymmetric information occurs when there is an imbalance in terms of the level of information between two parties, despite the information being available.
Adverse selection (using example of used cars)
Sellers know more about the quality of the u send cars than buyers. (Imbalance)
To profit from the sale of used cars, sellers have incentive to hide some info from buyers.
Since potential buyers cannot distinguish between high and low quality used cars, they are only willing to offer average price for used cars.
At this price, sellers with high quality used cars will not want to offer their cars for sale. Overtime, this leads to the situation where the market adversely selects against high quality used cats in favor of low quality ones.
Buyers further lower the price, reducing number of high quality used cars for sale
Thin markets, inefficient resource allocation, market fails
Moral hazard
After transaction is completed, economic agents do not bear the cost of their actins and thus have a tendency to act less carefully.
Explain some forms of government intervention and their limitations in correcting market failure arising from info failure.
- Campaigns/ roadshows/ TV advertisements
To educate the less-informed party and reduce their information gap. Shift misperceived MPB (or MPC) to actual MPB (or MPC) shift Qm to Qs.
Eg. Anti-smoking campaign (ignorance)
National Financial Literacy Programme MoneySense (Complex Info)
-voluntary, effects will only be evident in the LR - Regulations/ legislations/ law/ guidelines
- more effective in SR
Eg. Sale of Food Act (labeling of the food)
Eg. Singapore Code of Advertising Practice. Advertisements should not refer to any testimonial unless it is genuine. When a product is being advertised to be sold at a discount, the discounted price must be lower than its usual price and cannot be offered indefinitely.
Eg. MOH publish info such as guidelines for common surgical procedures, estimated hospital bills etc.
Eg. Consumer Protection Act (Lemmon Law) stipulates that sellers are to repair, replace or refund, or reduce the price of goods found to be defective within six months of purchase.
- high monitoring/ enforcement cost
Explain how factor immobility leads to market failure and explain some measures and their limitations in correcting market failure caused by factor immobility.
Factor immobility
- Geographical (high cost of relocation, language barriers)
- Occupational (Lack of relevant skills, lack of qualifications)
When producers face constraints in allocating factors of production to where they are in demand, factor immobility exits. As such, producers may not be able to make production decisions to bring about allocative efficient outcome. Market fails.
Policies
Geographical
- improving transport networks, or increase supply of affordable housing
- Strain on government budget
Occupational
- provide training subsidies/ skills upgrading
- effectiveness depends on workers’ attitudes and aptitude.
Explain how market dominance leads to market failure. Explain measures and their limitations in correcting market failure caused by market dominance.
Qm, Qs, underproduction, DWL, allocative inefficiency, market failure.
Monopoly becomes complacent, productive inefficiency.
Policies: competition laws, nationalization and price regulation.
Suggest 4 possible methods that the government can adopt in order to prevent the monopoly from abusing its power.
- Competition policies
Eg. The Competition and Consumer Commission of Singapore (CCCS) promotes a strong competitive culture and environment, and has the power to investigate and impose sanctions on firms guilty of anti-competitive practices. - Nationalisation
- Lump Sum Taxes
- Price regulation (MC pricing and AC pricing)
Explain with a diagram how the imposition of a lump sum tax affects to equilibrium price and output of a monopolist.
A lump sum tax is fixed in amount and levied without regard to the output or revenue of the firm. It is regarded as a fixed cost to the firm and hence, will simply raise the fixed costs but will not affect variable cost or marginal costs.
