Chapter 5 - Market Failure Flashcards
(28 cards)
What are the 4 basic questions to allocating resources in a free market economy?
What to produce? How much to produce? How to produce? For whom to produce?
What are the functions to the price mechanism?
Signalling, Rationing, Incentive
What is the Signalling function?
Through their choices consumers send information to producers about the changing nature of needs and wants. Prices adjust to demonstrate the relative value of the products in the market. Changes in prices provide information to producers and consumers about changes in market conditions. For example, if prices are rising due to rising demand, this is a signal to producers to expand production. Conversely, if prices are falling due to a falling demand, this is a signal to producers to cut back or reduce production.
What is the Incentive function?
Changes in prices provide incentives for producers to reallocate their scarce resources. For example, rising prices act as an incentive for producers to allocate more resources to earn more profits. Higher prices act as an incentive to raise output because the supplier stands to make a better profit. When demand is weaker in a recession then supply contracts as producers cut back on output.
What is the Rationing function?
Prices serve to ration scarce resources when demand in a market outstrips supply (or vice versa). Changes in prices enable scarce resources to be rationed to the parties who are most willing to pay. For example, when there is a shortage, those with greater willingness and ability to pay will bid up the price of the good, thus enabling the goods to be rationed to these buyers. Therefore the market price acts a rationing device to equate quantity demanded with quantity supplied.
What is economic efficiency?
It is the socially optimal level of output ie level of output where society’s welfare is maximised, where no individual can be made better off without making another individual worse off.
What is efficient allocation of resources?0
Adequate available resources are used in the production of goods and services to bring about maximum total economic surplus to ensure maximisation of social welfare.
What are the assumptions that have been made under the price mechanism?
Decision-making is based on self-interest
There are no externalities
No consumer/producer can influence the market
There is perfect information
Factors of production are perfectly mobile
What is marginal private cost?
It is the change in total private cost as a result of undertaking an additional unit of an economic activity.
What is marginal private benefit?
It is the change in total private benefit as a result of undertaking an additional unit of an economic activity.
Why is Net Private Benefit of consumers maximised at Qp?
MPB=MPC. For all quantities below Qp (MPB>MPC), consumption adds more to benefit than cost, hence consumers are better off raising consumption. For all quantities above Qp (MPB<MPC), consumption adds more to cost than benefit, hence consumers are better off lowering consumption.
What are public goods?
Goods that are non-rivalry, non-excludable and cannot be rejected in consumption.
How does public good lead to market failure?
MC=0. There is no effective supply. Consumption also has ‘free-rider problem’ ie there is no incentive for people to pay for the good. There is no effective demand.
How can government intervene in the market for public goods?
The government will have to resort to direct provision (Command and Control Policy to be the sole producer of public goods)
What are the advantages to government intervention for public goods?
They can ensure that output maximises Net Social Benefit
What are the disadvantages to government intervention for public goods?
The government must have funds to implement such a measure, otherwise there is opportunity cost incurred (cutting down expenditure in other areas eg education or healthcare). The government may also not produce goods at the lowest possible cost as they are not motivated by profits.
What is the approach to explain how externalities lead to market failure?
- Define and illustrate MPB and MPC of Consumption/Production
- Identify and explain market equilibrium (MPB=MPC)
- Explain how third parties are affected by the decisions of consumers/producers (Define and illustrate MEC/MEB)
- Identify and explain socially optimal level of output (MSB=MSC)
- Explain that the market has failed (over/under consumption/production)
How to define and illustrate MPB and MPC of production?
When a firm produces a good, it will only take into account MPB which is additional revenue generated from the sale of the product, and MPC which is additional cost of production.
How to explain market equilibrium?
Profit-motivated firms would maximise their NPB by equating MPB to MPC and produce at Qp.
What is negative externalities?
Negative externalities are external costs when individual actions inflict costs upon a third party without compensation to the third party.
How does the market fail from overproduction?
Qp is greater than Qs which adds more to costs than benefits for the society and society’s welfare is not maximised. Thus, the failure of the firms to take into account negative externalities results in net costs to society. This incurs a deadweight loss which leads to market failure.
How can government impose a tax to address the problem of negative externalities from production?
It can correct over-production due to negative externalities. The tax raises cost of production and disincentivise firms from producing. The indirect tax should be equal to MEC (vertical MPC=MSC distance at Qs). If this tax accurately reflects this, the firms will internalise the externality (pay for the harm it causes to third parties). They will produce at Qp’ which is equal to Qs (socially optimal level). The deadweight loss to society ceases to exist and NSB is maximised. Hence, there is allocative efficiency.
What are the advantages of imposing a tax to solve the problem of negative externalities from production?
The government can raise revenue (can be channelled to reduce harm inflicted on third parties). There is also flexibility in that the tax can be varied or adjusted according to the magnitude of the problem (size of MEC).
What are the disadvantages of imposing a tax to solve the problem of negative externalities from production?
The external cost is arbitrary and very difficult to estimate due to MEC being intangible and differing between different third parties. Thus, the government may over-tax the production of goods, which will create a new deadweight loss from under-production. This deadweight loss might be larger than the original deadweight loss, which means that the problem has been exacerbated.
