8 - The Market Mechanism, Market Failure and Government Intervention in Markets Flashcards
(157 cards)
1
Q
What are the functions of prices?
A
- Signalling
- Incentive
- Rationing
- Allocative
2
Q
How are resources allocated in the free market economy?
A
Price mechanism
3
Q
What does the signalling function mean in the price mechanism?
A
Price acts as the signal (information) to consumers and firms. Price changes show where resources are needed in the market.
4
Q
What does the price incentive function mean in the price mechanism?
A
This encourages a change in behaviour of a consumer or producer. Higher price would encourage firms to supply more to the market because it is more profitable.
5
Q
What does the rationing function mean in the price mechanism?
A
Rising prices ration demand for the product. Lowering prices ration supply of the product.
6
Q
What does the allocative funtion mean in the price mechanism?
A
This is where the markets scarce resources are placed between markets. Resources from markets with excess supply are removed. And resources are added to markets with excess demand.
7
Q
What did the Adam Smith refer to the price mechanism?
A
‘The Invisible Hand of the Market’
8
Q
What are the advantages of the price mechanism?
A
The price mechanism allows the consumer to gain sovereignty in the market. They have ‘spending votes’ in the market, which enable them to choose what is bought and sold. Consumer is DOMINANT
Is a method of allocating resources, in theory it leads to a productively efficient allocation of resources.
9
Q
What are the disadvantages of the price mechanism?
A
However there may be inequality in income and wealth with the price mechanism. Those with money have buying power. Essentially, price mechanism ignores inequality.
Also, in a free market there is under supply of public and merit goods, so gouvernement intervention is required
10
Q
What is Market Failure?
A
When the market mechanism leads to an MISALLOCATION of resources in the economy, either completely failing to provide a good or service of providing the wrong quantity.
11
Q
What is complete market failure?
A
Occurs when there is a missing market. The market does not supply the products at all.
12
Q
What is partial market failure?
A
When the market produces a good, but it is the wrong quantity or the wrong price. Resources are misallocated where there is partial market failure.
13
Q
What are the types of Market failure?
A
Externalities
The under-provision of public goods
Information gaps
Monopolies
Inequalities in the distribution of income and wealth
14
Q
Explain how externalities create market failure?
A
An externality is the cost of benefit a third party receives from an economic transaction outside the market mechanism. The spill over effect of the production or consumption of a good or service, like cigarettes. Positive externalities are caused by the consumption of merit goods, such as recycling schemes.
15
Q
Explain how the under-provision of public goods create market failure?
A
Public goods are non-excludable and non-rival, and they are under provided in a free market because of the free-rider problem.
16
Q
Explain how information gaps create market failure?
A
It is assumed consumers and producers have perfect information when making economic decisions. This is rarely the case and lack of information cause misallocation of resources.
17
Q
Explain how monopolies create market failure?
A
Since consumers have very little choice where to buy goods from offered by a monopoly, they are often overcharged. Leading to the under consumption of a good or service. Therefore a misallocation of resources as consumer needs and wants aren’t fully met.
18
Q
Explain how Inequalities in the distribution of income and wealth create market failure?
A
There is an inequitable distribution in income and wealth. Income refers to a flow of money, whilst wealth refers to a stock of assets. This can lead to negative externalities like Social Unrest.
19
Q
What are private goods?
A
A good that is excludable and rival. For example an orange can only be consumed by one consumer.
20
Q
Explain the two characteristics of a private good.
A
Excludable good - people who are unprepared to pay can be excluded from benefiting from the good.
Rival good - when one person consumes a private good, the quantity available to others diminishes.
21
Q
What is a public good?
A
A good which is non-excludable and non-rival, like a lighthouse, street lights, flood control system, National defense, police
22
Q
What is the problem with public goods in the free market.
A
Public goods are not provided but they offer benefits to society.
23
Q
Explain the two characteristics of public goods.
A
Non-excludable - by consuming the good someone else is not prevented from consuming the good aswell.
Non-rival - the benefit other people get from the good does not diminish if more people consume the good.
24
Q
Why are public goods not provided in the free market?
A
The non-excludable nature of the public good gives rise to the free-rider problem. People who pay for the good still receive the benefits from it, as the people who don’t pay for the good. This is why public goods are under provided in the private sector as they do not make a profit as consumers do not see the need to pay as they still receive the benefits without paying.
25
What are Quasi Public goods?
A good which is not fully non-rival and/or where it is possible to exclude people from consuming the product. Have characteristics of both public and private goods.
Roads are semi-excludable as there are toll roads and semi-non-rival as if it’s rush hour people are not able to use it.
26
How has technical change changed previously pure public goods to quasi public goods?
Television broadcasting in now excludable with subscriptions available to those willing and able to pay for them.
Roads also now have electronic pricing to charge all motorists for road use, ULEZ.
27
What is the tragedy of the commons?
Refers to how individuals prioritise personal gain over the well-being of society. The tragedy of the commons is a situation where there is overconsumption of a particular product/service because rational individual decisions lead to an outcome that is damaging to the overall social welfare.
For example, hypothetical area of common grazing land, in which villagers all took their cows to this common grazing land, but this led to overgrazing and a loss of the resource.
A resource held in common means no one owns the resource but everyone can access it
For example, the problem of over-fishing in areas where fishing grounds are poorly protected
28
What is an externality?
An externality is the cost or benefit a third party receives from an economic transaction outside the market mechanism.
Spill over effect of the production or consumption of a good or service.
Key feature, externalities are produced and received outside the market, can’t be bought or sold.
29
What is positive externality?
An external benefit that occurs when the consumption or production of a good causes a benefit to a third party, where the Social Benefit is greater than the Private Benefit.
30
What is the negative externalities?
An external cost that occurs when the consumption or production of a good causes a cost to a third party, where the Social Cost is greater than the Private Cost .
31
What are negative externalities caused by?
And give an example
Demerit goods. Associated with information failure, since consumers are not aware of the long run implications of consuming the good, and they are usually overprovided. For
example, cigarettes and alcohol are demerit goods. The negative externality to third parties of consuming cigarettes is second-hand smoke or passive
smoking.
32
What are positive externalities caused by?
With example
Caused by merit goods. These are associated with information failure too, because consumers do not realise the long run
benefits to consuming the good. They are underprovided in a free market. For example, education and healthcare are merit goods. The positive externality to third parties of education is a higher skilled workforce.
33
What is a property right?
The exclusive authority to determine how a resource is used. Like an owner of house
34
Explain negative consumption externalities.
An example would be going to the cinema and having people on their phones and talking loudly making the experience worse.
Walking trough litter and chewing gum.
35
Explain negative production externalities in a power house.
A negative production externality (or external cost) from a power station such as pollution. The power station evades paying the true real costs of production to the negative effects on the third parties.
For example the people living in near by houses respiratory problems and visual pollution, people in the commercial forest industry from acid rain caused by pollution.
This under-pricing of the good promotes over-consumption of electricity and therefore over-production of both electricity and pollution.
36
Explain positive production externalities in a power house.
Production of electricity yields positive production externalities (external BENEFITS). The power station discharges the warm water used into the local lake. Warmer Tempreture increases fish. Therefore fishing boats and fishermen benefit from the power house .
37
Explain positive consumption externalities.
A good example are passer-by walking past beautiful houses or gardens and gaining pleasure.
Atomosphere created by other people also add pleasure like watching a football match on TV or picking a restraunt .
However positive consumption is very subjective could be negative for others
38
How do externalities lead to the ‘wrong’ quantity of a good being consumed and produced?
Negative externatlities of production do not take into account the true cost, the third party cost, therefore are under valued. The market has created the wrong incentives Therefore Too much of the good ends up being produced and consumed.
Opposite happens for positive production externalities. Prices end up too high, wrong incentives, this discourages consumption. Not enough of the good is produced or consumed
39
Explain how the fishing industry has fallen victim to the tragedy of the commons.
Fishing shortages have become apparent due to no regulation and people fishing as many fish as possible in order to make the most amount of money from selling fish.Without keeping enough fish in the sea to keep fish stock high from reproduction. This causes for fish to migrate away and no new breeding stock coming through.
40
Example of environmental market failure has caused change for Great Britain.
The great Smog in 1952 a mixture of smoke and pollutants. Caused for the Clean Air Act to be introduced. So pollution was to be regulated. As the increase in deaths per day drastically from the smog.
41
Where does private benefit maximisation occurs:
Marginal Private Benefit (MPB) = Marginal Private Cost (MPC)
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Where does social benefit maximisation occurs:
Marginal Social Benefit (MSB) = Marginal Social Cost (MSC)
43
MSB =
MPB + MEB
(Marginal Private Benefit + Marginal External Benefits)
44
MSC =
MPC + MEC
(Marginal Private Cost + Marginal External Cost)
45
46
What does the private cost determine?
Private costs like rent, Labour, affect the amount supplied and the market price
47
Where is the external costs on a diagram?
External costs are shown by the vertical distance between the two curves. In other words, external costs are the difference between private costs and
social costs.
48
What determines the private benefit and what is it?
The price consumers are prepared to pay decides this.
Private benefits could also be a firm’s revenue from selling a good.
49
Where is external benefits on a diagram?
External benefits are the difference between private and social benefits.
50
Draw the diagram to show how negative production externalities cause market failure?
51
Explain this diagram.
The vertical distance between two curves MSC and MPC shows the MEC, marginal external cost
52
Explain the dead weight loss in this negative productive externalities diagram.
53
Explain how the MPB and MSB can be written as a straight line in this diagram.
Assuming that there are only negative externalities are being produced no positive externalities. Therefore the MSB and MPB is the same, this is a simplification. For example assuming only pollution is released in a power station.
54
55
Draw the diagram to show how postive production externalities cause market failure?
56
Explain this diagram.
The vertical distance between the two curves MSC and MPC shows a negative external cost (MEC) at each level
57
Explain the welfare loss in this diagram.
58
Why is the MPC curve above the MSC curve in this diagram?
59
Why the absence of property rights leads to externalities in both production and consumption and hence market failure?
Markets become inefficient where there are no property rights. For example:
1) It is practically impossible to establish property rights on goods such as sea water and air. This means that free-riders can have unlimited access, which results in the exploitation of the good.
2) The moral hazard assumes someone else will pay the consequences for a poor choice. For example, some people might litter the street if they think that other people will clear up after them.
3) Scarce resources could be over-used or exploited. For example, rainforests are depleting and many species of fish are becoming endangered. This is because the environment cannot be protected by applying property rights.
60
What is a Merit Good?
A good, such as healthcare and education, for which the social benefits of consumption exceed the private benefits. They have two characteristics, usually have positive externalities and people lack information on the true benefit. A value judgement is required in deciding whether it’s a merit good.
61
What is diagram for the positive consumption externalities (merit good)?
A
62
Explain this Diagram for the positive consumption externalities with the merit good Education?
63
Examples of Merit goods.
Health care / vaccinations - getting a vaccination personal benefits from protecting you against the disease but also external benefits from protecting the rest of society from not spreading the disease.
Education - people undervalue it decide to leave school early or not get good grades.
Fruit and vegetable - healthy diet instead of unhealthy.
Car Seatbelt’s and Helmets
Museums - educational benefit under appreciated.
64
What is a demerit good?
Goods, such as tobacco, for which the social costs of consumption exceed the private costs. The two characteristics are they usually have negative externalities and a good which harms consumers.
A value judgement is required in deciding whether it’s a demerit good.
65
What are some examples of demerit goods?
Smoking – People underestimate health costs or risks of getting addicted.
Drinking – Health costs to drinkers. Costs to society include more expenditure on health care and policing.
Taking drugs – Health costs to drug users, people underestimate risks of getting addicted. External costs of more crime.
Driking sugary softdrinks – which damage teeth and cause obesity.
66
Why are value judgments required for merit and demerit goods? Give examples
Some it is personal view whether a service or product is good or bad for you. For example:
Cannabis - is widely considered a demerit good as it contributes to lung cancer and can lead to psychological problems, such as paranoia.
However, supporters of cannabis might argue cannabis is a harmless drug which can help people deal with physical pain and enjoy life more.
Contraception/Abortion - Supporters of family planning may argue contraception is a merit good because contraception can help prevent the personal costs of unwanted pregnancy.
However, the Catholic church views contraception as a sin and may argue it is actually a demerit good because contraception encourages sexual promiscuity and undermines family values.
67
Draw the diagram to show how negative consumption externalities can cause over-consumption of demerit goods.
68
Explain this diagram.
69
How does information failure affect merit and demerit goods?
Merit - long term benefits out weight the short term benefit, individuals often take into account only short-term benefits and costs. So like for dentistry people will not have check ups due to the price and teeth will rot only later in life.
De merit- many people become addicted to de merit goods in teenage years due to peer pressure or influence, and see in the short term cost are not great but in the long term to costs will be exponential.
70
What is symmetric information?
Symmetric information means that consumers and producers have perfect market information to make their decision. This leads to an efficient allocation of resources.
71
What is Asymmetric information?
This is when there is unequal knowledge between consumers and producers. This leads to market failure.
72
Examples of asymmetric information.
Sellers of second-hand cars will have more information on the quality of the car then the buyers so are able to charge a higher price then what the car is actually worth.
73
How does asymmetric information cause a misallocation of resources?
Consumers might pay too much or too little, and firms might produce the incorrect amount. For example, monopolies might exploit the consumer by charging them more than they need to.
74
How does principal-agent problem cause asymmetric information?
Individual act in their own best interest, managers will maximise their profit instead of give money to the shareholders holders.
75
How does monopoly lead to market failure?
The basic model of monopoly suggests that higher prices and profits and inefficiency may result in a misallocation of resources compared to the outcome in a competitive
market.
Monopolies could exploit the consumer by charging them higher prices.
This means the good is under-consumed, so consumer needs and wants are not fully met.
This loss of allocative efficiency is a form of market failure.
Monopolies have no incentive to become more efficient, because they have few or no competitors, so production costs are high.
There is a loss of consumer surplus and a gain of producer surplus.
76
What is the immobility of Labour?
The mobility of Labour is the inability of workers to change between jobs, either of occupational reasons, need training, or geographical reasons.
77
What is frictional unemployment?
Frictional unemployment may exist whilst people move between jobs and search for new ones.
78
What is structural unemployment?
Structural unemployment occurs when there is a decline in an industry. This can mean worker skills do not match the location and skills required for the job.
79
What is an example of geographical immobility?
For example, labour might find it hard to find work due to family and social ties, the financial costs involved with moving, imperfect market knowledge on work and the regional variations in house prices and living costs across the UK.
80
What is an example of occupational immobility?
For example, labour might find it difficult to change the occupation. This occurred in the UK with the
collapse of the mining industry, when workers did not have transferable skills to find other work. The causes include insufficient education, training and skills.
81
What shows market failure in the labour market?
Unemployment
82
What is competition policy?
The part of the governments economic policy which aims to make goods markets more competitive. It comprises policy toward monopoly, mergers and restrictive trading policies.
83
What is the CMA?
Competitive and Markets Authority - is the UK government agency responsible for implementing UK competition policy. Stopping monopolies, mergers.
84
What are the competition policy’s aims?
- Technological innovation which promotes dynamic efficiency in different markets
- Effective price competition between suppliers
- Safeguard and promote the interests of consumers through increased choice and lower price levels
85
What is public ownership?
Ownership of industries, firms and other assets such as social housing by the government.
86
What is nationalisation?
Nationalisation occurs when private sector assets are sold to the public sector. In other words, the government gains control of an industry, so it is no longer in the hands of private firms.
87
What is the example of complete or partial nationalisation?
From the financial crisis the government, the governmen nationalised Northern Rock, Lloyds and other banks, which were regarded as too important to fail. And sold these banks to the private sector as soon as the became financially viable.
In 1945 the rail way industry in the UK was nationalised.
88
What are the pros for public ownership?
If the good is a public good then it will have positive externalities, education, healthcare.
- Provides jobs which are usually protected so reduces unemployment
- Finite resources such as water and energy can be guaranteed and controlled
- Able to provide essential services to the whole country
89
What are the disadvantages of public ownership?
- Higher costs for the government which means higher taxes
- Inefficiency – public organisations are often inefficient due to diseconomies of scale and no profit incentive.
- Government and political interference may reduce efficiency of operations
90
What is privatisation?
The transfer of assets from the public sector to the private sector.
91
What is regulation?
The imposition of rules and other constraints which restrict freedom,of economic action.
92
Arguments for privatisation
1. Revenue Raising
2. Reducing public spending
3. The Promotion of competition
4. The promotion efficiency
5. Popular Capitalism
93
Arguments against Privatisation (Pro Nationalisation)?
1. Natural Monopoly
2. Short-termism wins over long-termism
3. Selling the ‘Family Silver’
4. Public Interest
94
How is revenue raising a case FOR privatisation?
Privatisation is a way to sell state-owned assets and generate a windfall for the government. It will provide a short-term source of revenue when the business is sold off initially. But an asset can only be sold once.
Also In theory, this could be used to finance long-term investment. Though as a drawback, Many of the privatised companies in the UK are quite profitable. This means the government misses out on their dividends, instead going to wealthy shareholders.
95
How is reducing public spending a case FOR privatisation?
96
How is the promotion of competition a case FOR privatisation?
Often privatisation was accompanied by de-regulation, where the government also tried to increase competition. Increased competition from deregulation will bring more benefits for the consumer, such as:
- Increased competition leads to lower prices
- Increased competition encourages the development of new products
- Increased competition encourages better quality service
97
How is the promotion of efficiency a case FOR privatisation?
(Most Important)
When firms are privately owned, there is a greater profit incentive to increase efficiency. In the private sector, managers are accountable to shareholders, who will want a good return on their investment. For example, a nationalised industry may be reluctant to get rid of surplus workers due to political reasons (bad publicity). But, the private firm may be more willing to cut costs and improve efficiency.
98
How is popular capitalism a case FOR privatisation?
UK privatisation programme saw a rise in share ownership. Created more incentive for employees and other people who had not previously owned shares to own shares. This was popular for political parties support this privatisation as voters were happy as they could now own shares.
99
How is Natural Monopoly a case AGAINST privatisation?
Privatisation creates private monopolies, such as water companies and rail companies. These need regulating to prevent abuse of monopoly power. Therefore, there is still a need for government regulation, similar to under state ownership.
100
How is Short-terminism wins against long-terminism a case AGAINST privatisation?
101
How is selling the ‘family silver’ a case AGAINST privatisation?
102
How is the Public Interest a case AGAINST privatisation?
There are many industries which perform an important public service, e.g., health care, education and public transport. In these industries, the profit motive shouldn’t be the primary objective of firms and the industry. For example, in the case of health care, it is feared privatising health care would mean a greater priority is given to profit rather than patient care. Also, in an industry like health care, arguably we don’t need a profit motive to improve standards. When doctors treat patients, they are unlikely to try harder if they get a bonus.
103
What is deregulation?
The removal of previously imposed regulations.
104
What are the argument FOR Regulation in the market?
- Protect consumers from harmful products and to maintain quality standard.
- Protect the ENVIRONMENT
- Protects Workers from labour market quality standards.
- Protect consumers from abuse monopoly powers and negative externalities (like smoking)
- Improve positive externalities, minimum school leaving age 16 so a higher skilled work force
105
What are the argument AGAINST Regulation in the market?
Firms which fail to follow regulations could face heavy fines, which acts as a disincentive to break the rule.
It could raise costs of firms, who might pass on the higher costs to consumers.
Also certain schemes to police may be very expensive, for example a recycling scheme.
Regulations may increase the consumption on the black market
106
What are the argument FOR Deregulation?
(important) Lower costs for consumers:
Excessive regulation is also called ‘red tape’. It can limit the quantity of output that a firm produces. For example, environmental laws and taxes might result in firms only being able to produce a certain quantity before exceeding a pollution permit.
Excessive taxes, such as a high rate of corporation tax, might discourage firms earning above a certain level of profit, since they do not keep as much of it. This might limit the size that a firm chooses, or is able to, grow to
- Promotes competition By deregulating, reducing barriers to entry, a market will become more competitive, improving economic efficiency.
- The removal of 'Red Tape' which impose unnecessary costs on businesses.
107
What are the argument AGAINST Deregulation?
(The FOR regulation points)
108
What is regulatory capture?
This is when regulators start acting in the interests of the company rather than in consumer interests.
109
What is an example of regulatory capture?
The director of Oflot, the organisation that regulates the national lottery, was caught accepting free air tickets and sweeteners from one of the lottery organisation he was supposed to regulate.
110
What causes regulatory capture?
- The communication between the regulator and regulated, which has to happen, may cause for the regulator to be persuaded with bribes or become sympathetic to the firm.
- Also misinformation, as the regulator relies on the information given by the businesses, the information given may be biased.
- Regulators may not be given enough money or resources to complete a complete job and there is no profit incentive for the workers.
111
Why is there Government Intervention?
Governments intervene in the market to correct market failure. But may also seek to improve the distribution of resources. Aims:
- stabilise prices, avoid excessive prices.
- discourage de-merit goods/encourage merit goods.
112
What are examples of Government Intervention to target market failure?
1. Taxes (indirect taxes)
2. Subsides
3. Maximum and Minimum Prices
4. Tradeable Pollution Permits
5. State provision of Public Goods and Merit Goods
6. Provision Information
7. Regulation
113
What is Indirect Taxes?
Indirect taxes are taxes on expenditure. They increase production costs for producers, so producers supply less. This increases market price and demand contracts. They could be used to discourage the production or consumption of a demerit good or service. For example, the government could impose a £1 tax per packet of cigarettes.
114
What are the two types of indirect taxes and give what they are?
1. Ad Valorem Taxes - taxes which are percentages, such as VAT.
2. Specific taxes - taxes which are a set tax per unit, like 58p per litre of pertrol.
115
What is an Evaluation of Privatisation?
1. It depends on the industry in question. An industry like telecoms is a typical industry where the incentive of profit can help increase efficiency. However, if you apply it to industries like health care or public transport the profit motive is less important.
2. It depends on the quality of regulation. Do regulators make the privatised firms meet certain standards of service and keep prices low?
3. Is the market contestable and competitive? Creating a private monopoly may harm consumer interests, but if the market is highly competitive, there is greater scope for efficiency savings.
4. Can you create incentives in a nationalised firm? For example, performance-related pay could replace the profit incentive.
116
Draw a diagram for tax
117
Draw diagram for the taxation of cigarettes.
Demand inelastic big change in price results is small change of demand. Consumers may also have a high tax burden.
118
Explain this diagram.
The incidence of tax might fall differently on consumers and producers. Producers could make consumers pay the whole tax (P3 – P2), or if they feel this would lower sales and lose them revenue, they could choose to pay part
of the tax. Producers might pay P1 – P2, whilst consumers might pay P3 – P1.
The incidence of the tax depends on the price elasticity of demand of the good. For cigarettes, since the demand is fairly price inelastic, consumers might have the larger burden of tax.
This should, in theory, discourage consumption of the demerit good and reduce negative externalities.
Government revenue from ad valorem taxes is larger if demand is price inelastic. This is because demand falls only slightly with the tax.
119
How can tax correct market failure by ‘internalise the externality’ (make the polluter pay for the damage)?
Indirect taxes could reduce the quantity of demerit goods consumed, by increasing the price of the good. If the tax is equal to the external cost of each unit, then the supply curve becomes MSC rather than MPC, so the free market equilibrium becomes the socially optimum equilibrium. This internalises the externality. In other words, the polluter pays for the damage.
120
What is a subsidy?
A subsidy is a payment from the government to a producer to lower their costs of production and encourage them to produce more
121
Draw a diagram for government intervention with subsidy.
122
How do subsidies correct market failure?
Subsidies encourage the consumption of merit goods. This includes the full social benefit in the market price of the good. Therefore, the external benefit is internalised.
For example, the government might subsidise recycling schemes so it is cheaper for consumers to recycle waste, which will yield positive externalities for the environment.
123
Explain this government intervention diagram for subsidies.
The supply curve shifts to the left. More of the merit good is produced and the price falls from P1 to P2.
The vertical distance between the supply curves shows the value of the subsidy per unit.
Consumers gain more from the subsidy when demand is price inelastic, whilst producers supply more when demand is price elastic.
124
What is the problems with subsides?
- High cost to gouvernement
- Government may have to rise taxes to fund them.
- Opportunity cost to the government for other industries.
- Subsidies may encourage firms to be inefficient because they can rely on government aid.
125
Problems with Taxation?
- Demand may be inelastic
- Hard for the government to know external cost and how much to tax
- May encourage tax evasion – e.g. rubbish tax can encourage fly-tipping
- Decrease tax revenue (laffer curve)
126
What is a price ceiling?
A price above which it is illegal to trade. But can create excess demand.
127
What is a price floor?
A price below which it is illegal to trade. Can create excess supply.
128
What is the price minimum diagram?
129
What is the price maximum diagram?
130
Explain this minimum price diagram?
Explain the minimum wage diagram explanation
131
Explain this maximum price diagram?
Maximum prices have to be set below the free market price, otherwise they would be ineffective. The free market equilibrium is at P1, Q1.
If suppliers only produced at Q3, some consumers would be willing to pay P2. The shaded area shows the consumer surplus producers can take with the higher price.
A quantity of Q3 would require rationing or auctioning, since quantity demanded is Q2
132
Problems with minimum price?
As with price ceilings, price floors interfere with the incentive function of price. This is because falling prices cause inefficient or high-costing firms to levé the market. A price floor prevents this from happening.
133
Problems with maximum price?
- Encourages the black market goods are sold at a higher price so the price maximum has no effect.
- Households are rationed of quantity, queues, waiting lists, bribery occur and favoured customers gain the good.
- However, it could reduce a firm’s profits, which could lead to less investment in the long run. Moreover, firms might raise the prices of other goods, so consumers might have no net gain.
- Maximum prices control the market price, but this could lead to government failure if they misjudge where the optimum market price should be.
134
How can minimum prices correct market failure?
The government might set a minimum price where the consumption or production of a good is to be discouraged. This ensures the good never falls below a certain price.
For example, the government might impose a minimum price on alcohol, so it is less affordable to buy it. The National Minimum
Wage is an example of a minimum price.
Minimum prices would reduce the negative externalities from consuming a demerit good, such as alcohol.
135
How can maximum prices correct market failure?
The government might set a maximum price where the consumption or production of a good is to be encouraged. This is so the good does not become too expensive to produce or consume.
They prevent monopolies exploiting consumers. For example, in the EU, price caps on roaming charges are in place to make sure it is not too expensive for consumers to use their mobile phones abroad.
Maximum prices could lead to welfare gains for consumers by keeping prices low, and they could increase efficiency in firms, since they have an incentive to keep their costs low to maintain their profit level.
136
How do Tradeable pollution permits correct market failure?
Pollution permits involve giving a firm a legal right to pollute a certain amount.
These could limit the amount of negative externalities, in the form of pollution,
created in industries. Firms will be allowed to pollute up to a certain amount, and any surplus on their permit can be traded.
This means firms can buy and sell allowances between themselves.
For example, there could be a limit on the quantity of carbon dioxide emissions released from the steel industry.
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What are the advantages of pollution permits?
This should benefit the environment in the long run, by encouraging firms to use green production methods.
The government could raise revenue from the permits, because they can sell them to firms. This revenue could then be reinvested in green technology.
If firms exceed their permit, they will have to purchase more permits from firms which did not use their whole permit. This raises revenue for greener firms, who might then invest in green production methods.
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What is the disadvantages of Tradeable Pollution Permits?
However, it could lead to some firms relocating to where they can pollute without limits, which will reduce their production costs.
Firms might pass the higher costs of production onto the consumer.
Competition could be restricted in the market, if the permits create a barrier to entry for potential firms.
It could be expensive for governments to monitor emissions.
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Draw the diagram for pollution permits.
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What is an example of pollution permits in the real world?
US sulphur trading scheme which reduced sulphur dioxide emissions by 40%. Sulphur causes acid rain.
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How does state provision of public goods correct market failure?
The government could provide public goods which are underprovided in the free market, such as education and healthcare. These have external benefits.
This makes merit goods more accessible, which might increase their consumption and yield positive externalities.
It could be expensive for governments to provide education, and the government
will incur an opportunity cost of spending their revenue.
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How does provision of information correct market failure?
By providing information, governments can ensure there is no information failure, so consumers and firms can make informed economic decisions.
For example, governments might make it illegal for second-hand car dealers not to reveal the entire history of a car, so consumers know exactly what they are buying.
This could be expensive to police.
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What is government failure?
Occurs when government intervention reduces economic welfare, leading to an allocation of resources that is worse than the free-market outcome.
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What are the causes of government failure?
- Administrative Costs
- The ‘Law of Unitended Consequence’
- Distortion of Price Signals
- Information gaps/conflicting policies
- Regulatory capture
- Lack of incentives (privatisation)
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How does administrative costs cause government failure?
The social benefits of a policy might not be worth the financial cost of administering the policy. It might cost more than the government anticipated. The government has to consider whether the policy is good value for money.
HS2 is a good example cost around 66 billion pounds way over the budget projected.
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How does the ‘law of unintended consequence’ cause government failure?
This is when the actions of producers and consumers have unexpected, or unintended, consequences.
With government policies, consumers react in unexpected ways. A policy could be undermined, which could make government policies expensive to implement, since it is harder to achieve their original goals.
Benefits good example introduced to solve one problem of relative poverty but create new problems of higher spending and lower levels of labour market participation.
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How does distortion of price signals cause government failure?
Government subsidies could distort price signals by distorting the free market mechanism. A free market economist would argue that this could lead to government failure. There could be an inefficient allocation of resources because the market mechanism is not able to act freely.
For example, the government might end up subsidising an industry which is failing or has few prospects.
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How does information gaps/conflicting policies cause government failure?
Some policies might be decided without perfect information. This might require a full cost-benefit analysis, and it could be time-consuming and expensive.
For example, government housing policies are long term, and have failed several times in the past.
Governement may want to grow the economy by building roads but this takes a very long time and economic growth will be seen a lot later. This means governement usually favour short-terminism over long-terminism.
However, it is impractical for governments to gain every bit of information they need, so assumptions are made.
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Example of Government failure?
When the uk government introduced a landfill tax hoping to increase jobs and reduce waste.
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But this created a massive fly tipping problem where in 2016/17 £58 million of tax payers money to clean up.
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How are the policies the compétions policy implement?
- Enhancing competition between firms through the promotion of small business.
- Deregulation
- Privatisation
- Stopping Mergers
- Punishing or breaking up Monopolies
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How does deregulation as policy increase competition?
Deregulation is the act of reducing how much an industry is regulated. It reduces government power and enhances competition.
Excessive regulation is also called ‘red tape’. It can limit the quantity of output that a firm produces. For example, environmental laws and taxes might result in firms only being able to produce a certain quantity before exceeding a pollution permit. Excessive taxes, such as a high rate of corporation tax, might discourage firms earning above a certain level of profit, since they do not keep as much of it. This might limit the size that a firm chooses, or is able to, grow to.
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How does Merger policy as policy increase competition? And example
Stops monopolies from forming.
The merging of activision and Microsoft was stopped as a monopoly would have been created in the gaming industry.
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How does privatisation as policy increase competition?
For example, British Airways was privatised in the UK and now operates in the competitive market.
Free market economists will argue that the private sector gives firms incentives to operate efficiently, which increases economic welfare. This is because firms operating on the free market have a profit incentive, which firms which are nationalised do not.
Since they are operating on the free market, firms also have to produces the goods and services consumers want. This increases allocative efficiency and might mean goods and services are of a higher quality. Competition might also result in lower prices. However, firms which profit maximise in a competitive market might compromise on quality.
By selling the asset to the private sector, revenue is raised for the government. However, this is only a one-off payment.
The Royal Mail was privatised in the UK. This was done by allowing the Royal Mail to float on the stock market. At the offer price, the government owned 30% of the shares.
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How does promotion of small business as policy increase competition?
The UK government has established the ‘Red Tape Challenge’, which aims to simplify regulation for businesses. It is especially aimed towards small businesses. This aims to make it cheaper and easier to meet environmental targets and create new jobs.
Small and Medium Sized Enterprises (SMEs) are important for creating a competitive market. They create jobs, stimulate innovation and investment and promote a competitive environment. ‘Creative Destruction’.
Governments aim to improve access to finance and reduce barriers to entry, which will make it easier for smaller firms to enter the market.
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How does competitive tendering of government contracts as policy increase competition?
The government provides some goods and services because they are public or merit goods, and they are underprovided in the free market. The government could contract out this provision, so that private firms operate things such as roads or hospital.
The firm which offers the lowest price and best quality of provision wins the government contract. This saves the government money, since the public sector can be bureaucratic and inefficient. The private sector has an incentive to reduce their costs, since they operate in a competitive market.
It also frees the government of maintenance, since the private sector might have the expertise and knowledge to fulfil the project and maintain the infrastructure.
This can be evaluated by considering how the private sector might not meet the specification of the contract. Moreover, the private sector firm might try and cut costs by lowering wages, and they are less likely to have social welfare as a priority.
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Example of competition policy in real life.
European competition fines google €4.3 billion for abusing its market dominance.
