Market Failure Flashcards
1
Q
Market failure definition
A
- Markets failure occurs when there is an inefficent allocation of resources in a free market.
- This can be a result of a over or under consumption or production of a good.
- It will results in a situation where welfare is not maximised.
2
Q
Allocative efficieny in markets
A
- This is when we make best use of our scarce resources, we say that we are being allocatively efficient.
- This is achieved when the cost of producing a good is equal to the benefit of consuming it.
Marginal Benefit = Marginal Cost
3
Q
Diagram illustrating allocative efficiency
A
- At Popt and Qopt producer and consumer surplus is maximised and the marinal benefits = marginal costs.
4
Q
MPB curve
A
- Demand curve
- The value consumers place on consuming a good, the price they are willing to pay for a good, reflects the marginal benefit from consuming an extra unit of that good.
5
Q
MPC curve
A
- Supply curve
- The value producers place on producing a good, the price they are willing to sell the good for, reflects the marginal cost of producing a extra unit of that good.
- Additional costs incruued by an individual firm when producing an extra unit of a good.
6
Q
Externalities Definition
A
- Spill-over or external effects felt by 3rd parties from producing or consuming a good.
- These could be a cost or a benefit.
- There is a market failure when consumers and producers do not consider these external effects.
7
Q
MSC
A
- Marginal Social Costs
- Supply curve
- MPC + External costs
8
Q
MSB
A
- Marginal social benefits
- Demand curve
- MPB + External costs
9
Q
Negative Production Externalities
A
- Production of a good generates external costs that are not directly paid by the producer but by third parties.
E.G - Air pollution from factories
- Methane emissions
10
Q
Negative Production Externality - Air pollution from factories
A
- Poor health, therefore increased costs for the NHS. Decrease in productivity and a possible fall in economic growth.
- Negtaively effects the health of individuals, they have to spend more on health, take more time of work, less productive.
- Reduces land value in polluted areas, negative impact on landowners.
- River and water pollution
11
Q
Negative Production Externality - Methane Emissions and other animal waste.
A
- Greenhouse gas effect, global warming, rising sea levels, coastal groups can be displaced.
- Accumalted animal wastes can leak and cause contamination of rivers and streams and render the water unsafe for human consumption.
12
Q
Negative consumption externality
A
- These occur when consumption of a good generates external or spill over costs for third parties not directly involved in the consumption or production of the good.
E.G - Sugar consumption
- Using a car in central london
- Smoking
13
Q
Negative consumption externality - sugar consumption
A
- Obesity, NHS costs, less productive as more trips to the doctor, less output, less tax revenue.
14
Q
Negative consumption externality - Using a car in central london
A
- Pollution, health issues
- Congestion, traffic and increased journey times for others.
- Slower moving traffic, delays
15
Q
Positive consumption externality
A
- These occur when the consumption of a good has external benefits.
E.G - Vaccines
- Education
16
Q
Positive consumption externality - Vaccines
A
- Herd immunity
- Lower NHS costs
- Prevent the spread
17
Q
Positive consumption externality - Education
A
- Inceased tax revenue, increased economic growth, greater innovation and increase in the labour supply.
18
Q
Negative consumption externality - Smoking
A
- Disease in the non smoking population, health issues for individual and NHS costs rising.
19
Q
Positive production externality
A
- These occur where the production of a good generates external benefits to society.
E.G - R&D
- Job training
- Flood defence system
20
Q
Positive production externality - R&D
A
- Not only benefits the firm can be adopted from this, but innovation can help other firms to cut costs and possibly increase prodcutivity
21
Q
Positive production externality - Job training
A
- External benefits to other firms.
- Increase producitivty, economic growth as labour supply increases.
22
Q
Positive production externality - Flood defence scheme
A
- Beneficial for people who live in this area, protection from floods,avoids damage to infastructure.
23
Q
Negative production externality diagram + explanation
A
Explanation -
- The market equilibrium occurs where the MPB curve intersects the MPC curve.
- At the market equilibrium, the output level is Qm and the market price is Pm.
- However due to the external costs of producing the good, the marginal social costs are greater than the marginal private costs.
- The vertical distance between the MPC curve and the MSC curve represents the level of external costs.
- The socially optimal level of production is Qopt where the MSC = MSB.
- The distance bewteen Qopt and Qm represents the level of overproduction.
- The market failure is represented by the welfare loss triangle, it is the welfare that is lost by producing at the Qm as opposed to the socially optimal level.
- At any level of output beyond Qopt the marginal social costs from producing the good are greater than the marginal social benefits, this leads to a net fall in social welfare.
24
Q
Negative consumption externality diagram + explanation
A
- The market equilibrium occurs when the MPB curve intersects the MPC curve.
- At the market equilibrium the level of output is Qm and the market price is Pm.
- However due to the external costs of consuming the good, the marginal social benefits are less thatn the marginal private benefits.
- The verticle distance between the MSB curve and the MPB curve is the level of external costs.
- The socially optimal level of production is Qopt where MSC=MSB.
- The horizontal distance between Qm and Qopt is the level of overconsumption.
- The market failure is represented by the welfare loss triangle. It is the welfare that is lost by producing at the Qm as opposed to the socially optimal level of production.
- At any level of output beyond Qopt the marginal social benefits of consuming the good are less than the marginal private benefits. This leads to social welfare not being maximised.
25
Positive consumption externality diagram and explanation
- The market equilibrum occurs where the MPB curve intersects the MPC curve.
- At the market equilibrium the output level is Qm and the market price is Pm.
- However due to the external costs of producing the good, the marginal social benefits are greater than the marginal private benefits.
- The verticle distance between the MPB curve and the MSB curve shows the positive external effects.
- The socially optimal level of production is Qopt where MSC = MSB.
- The horizontal distance between Qopt and Qm is representing a underconsumption of the good.
- Market failure is represented by the welfare loss triangle.
- At any level of output less than Qopt the MSB of consuming the good is greater than the MSC, this means if we were to increase consumption to Qopt there would be a net welfare gain.
26
Positive production externality diagram and explanation
-
27
Positive Production externality diagram and explanation
- The market equilibrium occurs where the MPB curve intersects the MPC curve.
- The market equilibrium price and quantity is shown as Pm and Qm.
- However due to the external benefits of producing the good, the marginal social costs are less than the marginal social benefits.
- The verticle distance between the MPC and MSC represents the level of external benefits felt by 3rd parties.
- The socially optimal level of production is shown as Qopt.
- The horizontal distance between Qopt and Qm is the level of underproduction of the good.
- At any level of output less than Qopt, the MSC are less than the MSB so this would mean if we increased consumption there would be a net welfare gain.
28
Merit good
A merit good occurs where people may underestimate or be unaware of the benefits of consuming a good. This results in market failure.
- They often have positive externalities
- They are underconsumed in the free market
- Consumers dont account for the true private benefits.
E.G
- Students may underestimate the benefits of studying and therefore leave school early.
- People may be reluctant to get vaccinated from diseases as they dont understand the benefits on 3rd parties and themselves.
29
Demerit good
A demerit good occurs where people under-estimate or ignore the costs of consuming a good.
This results in market failure.
- Demerit goods often have negative externalities as well.
- Consumers dont account for the true private benefits.
- They are usually overconsumed in the free market.
E.G
- People may not be aware of the danger of smoking and the externalities it has.
30
Reasons for underconsumption of merit goods
1. Low levels of income and poverty may mean consumers want certain goods or services but cannot afford them.
2. Lack of infomation (infomation gap)
- consumers may be better of if they consumer certain goods or services but they may lack infomation about their benefits and so dont demand them.
31
Reasons for underconsumption of demerit goods
1. Ignorance about its negative effects, indifference, consumers arent aware or do not care about the harmful effects on 3rd parties.
2. Consumers place greater weight on current benefits than future benefits/costs.
32
Imperfect infomation
When decisions are based on the lack of infomation and are not optimum decisions that have been made if there was perfect (full infomation)
33
Asymmetric infomation
When either the producer or the consumer has more infomation than the other, which they exploit and use to their own advantage.
34
Information asymmetries and gaps
Market failure can occur due to lack of infomation, thes can come in two different forms...
- Imperfect infomation
- Asymmetric infomation
35
Symmetric information
Both parties share the same knowledge.
36
EXAMPLE of Asymmetric information
Insurance markets -
- In a market where people want life insurance who all have varying risk, there are both unhealthy and healthy people.
- There is asymmertic infomation as the insurance comapany does know the true health of the individual, whereas the individual does.
- Therefore to work out how much they will charge they take into account the average risk of the population.
- Therefore only people who are high risk will be getting a good price for the product.
- THE OUTCOME is low risk people wont buy health insurance beause the price doesnt reflect their risk
37
Price stability
Some goods exhibit price stability, the prices do not change much over a period of time.
38
Price Volatility
Many commodities are subject to this. They exhibit large fluctuations in price, sometimes quite dramatically, compared to manufactured goods,
- These fluctuations arent always predictable.
39
Causes of price volatility
- Large fluctuations in supply due to exogeneous shocks.
- Relatively large price inelastic demand, this is because primary commodities are necessities and there are few subsitutes.
- Price inelastic supply, this is because of the time needed for quantity supplied to respond to price changes.
40
Why is supply for commodities price inelastic?
- Dificulties storing the product
- There is a lag in the supply response to price changes as the agriculture sector requires a considerable time to make changes to production, which can cause cyclical adjustments that add extra degree of volatility to the markets.
41
The more inelastic the demand the greater price volatility DIAGRAM
For a given inward shift in supply, inelastic demand will cause a proportionatly larger increase in price, and a proportionaly smaller decrease in quantity. Whereas if demand is elastic there is a proportionaly smaller increase in prices and a proportionaly larger decrease in quantity
42
The more inelastic the supply the greater price volatility DIAGRAM
For a given outward shift in demand, inelastic supply means that there will be a proportionaly larger rise in price and a proportionaly smaller fall in quanitity. WHEREAS if supply is relatively elastic this will cause a proportionalty smaller rise in price and greater fall in quantity.
43
Consequences of price volatility
1. Fluctuations in producers incomes may inhibit investment as suppliers are concerend about their expected profits.
2. Unstable level of employment
3. Unstable level of exports
4. Serious obstacles to growth and development
5. Volatile factor markets lead to volatile product markerts.
44
Consequences of price volatility - Fluctuations in producers incomes may inhibit investment as suppliers are concerend about their expected profits.
- As primary commodities fluctuate widely, so do their producers incomes they recieve from selling the good.
- Uncertainty amongst producers means that they are much more unlikely to invest as they are worried about future profits.
45
Consequences of price volatility - Unstable levels of employment
- A result of a fall in investment
- In developoing countries agriculture makes up for a signifcant proportion of employment, falls in agriculture prices can lead to unemployment.
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Consequences of price volatility - Unstable level of exports
- Agriculture price volitility may lead to volitility in export earnings for that country.
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Consequences of price volatility - Obstacles to economic growth
- Drops in unemployment, a fall in exports provide obsticles to economic growth and development.
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EVAL Price Volitility
- It can drive productivity gains on farms as farmers adopt strategies to improve their resilience to unexpected prcie swings.
- New zealand high commisioner for example reported 'staggering' productivity imrpovements in New Zealand s agriculture sector after the removal of subsidies that shielded farmers from price volatility.
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Government intervention to overcome price volatility
- Buffer-stock schemes
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Buffer-stock schemes
If the free market price threatens to go below the price floor, the buffer-stock scheme buys up the commodity which increases demand and raises prices.
If the free market price threatens to rise above the price cieling, where it sells the commodity. This increases supply and reduces the price.
The buffer stock is a physical stock of the commodity held in warehouses. When the free market price is below the minimum price, stocks will be rising.
51
Advantages of a Buffer-stock scheme
- Maintain food supplies, ensuring greater food security which has broader economic benefits, for example increasing levels of human capital.
- Stabalise prices and farmers incomes
- Higher investment and therefore productivity in the agriculture market.
- Help to protect consumers from excessive price rises.
52
Issues of a bufferstock scheme
- Minimum prices tend to be set too high which makes them unsustainable
- Significant costs of the schemes
- Distribution concerns
53
Issues with bufferstock schemes - Minimum prices tend to be set too high which makes them unsustainable
- Firstly there are economic costs of buying excess supply.
- Price floors incentivise firms to oversupply, they know excess supply will be brought by the government.
- Could encourage excess use of pestticides to maximise yields.
54
Issues with bufferstock schemes - signifcant costs of the scheme
- Storage costs, administration costs.
- It might be difficult to set the correct level of price cieling and floor as fluctuations are difficult to predicr.
- Schemes mau also require a tariff on imported goods to protect domestic farmers from foreign compeition.
55
Two Characteristics of private goods
1. They are rivalrous, consumption of the good by one person reduces is availability to someone else.
2. They are excludable, it is possible for the supplier of the good to exclude people from that good.
56
Two characteristics of a public good
1. Non-rivalrous, consumption of the good by one person does not exclude someone else from being able to consumer the good.
2. It is non-excludable, it is not possible/practicle to exclude someone from enjoying the benefit of the good after it has been provided.
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Examples of public goods
- An army
- Lighthouse
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Club goods
These are exludable but non rivalrous, for example subscriptions.
59
Why do private markets underprovide public goods
The good is non-excludable there is therefore no incentive for a individual to pay for the good, once it has been provided people can enjoy the benefits for free, this is sometimes known as the FREE-RIDER problem.
Therefore they will not be willing to pay anything for the good, this results in a underprovision or no provision at all.
60
Categorising public goods
If the good is both non-rivalrous and non exludable than they are pure public goods, if they are neither they are private goods.
If they are excludable and non-rivalrous they will be called club goods, if they are rivalrous but non excludable they are called common goods.
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Correcting the market failure arising from public goods
In most cases pure public goods are provided by government provision to ensure that they are produced at socially optimal levels.
BUT there is a oppurtunity cost of government provision, questions over which goods should be provided and exactly how much.
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Tragedy of the commons
This is a situation where there is a overconsumption of a particular good because rational individual decisions lead to a welfare loss. Common goods are non-excludable yet they are rivalrous and will run out. The individual has no incentive to conserve resorources.
In theory, individuals could limit their use so that they don’t deplete the common resource. However, there is a free-rider problem. Where people rely on others to cut back their production. If everyone free-rides and maximises their use, then we get a situation of over-consumption.
Individual fisherman have an incentive to catch as many fish as possible. However, if many fishermen have this same motive, then it can lead to fish stocks being depleted as fish are caught at a faster rate than they are replenished.
he EU has a fishing policy to try and regulate fish stocks in heavily fished areas. However, it is often controversial because agreeing and implementing quotas can be a source of friction.
63
Ownership rights
Markets are efficient at producing private goods largely because producers and consumers have the right of ownership of the resources exchanged in the transaction.
Markets where property rights done exist are much less efficient. Common goods have no specific owner and are available for everyone.
For example Tuna in the sea is non excludable because it is too expensive or physically impossible to establish boundaries on who can fish them. This allows for the free rider problem and overexploitation of resources.
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The effects of a lack of property rights
1. Opportunism may be encrouraged, individuals exploit the lack of private ownership. It is difficult to put ownership on a song, other individuals can 'steal' music and lyrics from you.
2. Misuse of scarce resources is likely, spilling oil in the sea, dropping litter on pavements. Made worse by moral hazard, assuming someone else will pick up litter or clean the seas.
3. Over use of resources, depletion of rain forests, over fishing and traffic congestion. Overuse can result in the exhuastion of natural resources.
4. Constraint on economic development.
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Income inequality
This means there is a gap between the highest income earners and the lowest income earners.
Market failures occur when there is a inefficient allocation of resources in a free market.
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Issues of Inequality as market failure
1. Monopoly power
2, Monopsony power
3. Diminishing marginal utility of income
4. Social issues
5. Unemployment
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Problems of income inequality - Monopoly power
If firms have monopoly power they are in a position to set higher price to consumers, this leads to redistribution of income from consumers to the shareholders of monopolies.
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Prolems with income inequality - Monopsony power
A monopsony occurs when a firm has market power in employing workers at a wage below the competitive equalibrium. This leads to unfair distribution of income away from the workers.
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Probelms with income inequality - Unemployment and social issues
- Arguably social inequality can lead to social friction, higher crime levels and riots, all members of society lose out.
Furthermore the biggest cause of releative poverty is unemployment, this is a market failure as there is inefficient allocatiion of resources.
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Advantages of inequality
- Incentive effect, if someone works harder and a a consequence recieves a higher wage this is not a market failure, rewarding hard work boosts productivity.
- Trickle down effect, if some people gain extra income this can trickle down to others, richer people can create jobs and provide incomes with businesses.
3. Fairness, it can be argued that people deserve to keep higher incomes if their is a skill merit.
