Market failure

Question 1

Economic efficiency

Answer 1

How well are scarce resources used? That is what is discussed when economists talk about economic efficiency

• Efficiency is about a society making optimal use of scarce resources to help satisfy changing & needs
• There are several meanings of efficiency but they all link to how well a market system allocated our scarce resources to satisfy consumers
• Normally the market mechanism is good at allocating these inputs, but there are occasions when the market can fail

Question 2

Allocative efficiency

Answer 2

• Allocative efficiency is reached when no one can be made better off without making someone else worse off. This is also known as Pareto efficiency
• Allocative efficiency occurs when the value that consumers place on a good or service (reflected in the price they are willing to pay) equals the costs of the factor resources used up in production
• The main condition required for allocative efficiency in a given market is that market price = marginal cost of supply
• All points that lie on the PPF are allocatively efficient because we cannot produce more of one product without affecting the amount of all other products available

Question 3

Productive efficiency

Answer 3

A firm is productively efficient when it is operating at the lowest point on its average cost curve i.e. unit costs have been minimised
- Productive efficiency exists when producers minimize the wastage of resources
- Productive efficiency also relates to when an economy is on their PPF
- An economy is productively efficient if it can produce more of one good only by producing less of another
- Productive efficiency is achieved when the long run unit cost of production is at a minimum

Question 4

Dynamic efficiency in markets: Innovation

Answer 4

• Innovations is putting a new idea or approach into action. Innovations is ‘the commercially successful exploitation of ideas’
• Innovation has demand and supply side effects n markets and the economy as a whole

Product innovation
- Small scale and frequent subtle changes to the characteristics and performance of a good or a service
Examples:
- Streaming to replace CD’s and DVD’s
- Smart watches and phones to replace wristwatches
- Hybrid and electric cars to replace oil fuelled cars

Process innovation
- Changes to the way in which production takes place or is organised
- Changes in business models and pricing strategies
Examples:
- Mass customisation in factories e.g. cars
- Service delivery via technology e.g. financial services

Question 5

Market failure

Answer 5

• This occurs where resources and inefficiently allocated due to imperfections in the working of the market mechanism

Main types of market failures
- Public goods
- Merit goods
- De-merit goods
- Negative externalities
- Positive externalities
- Monopolies
- Immobility of factor inputs

Question 6

Externalities

Answer 6

• Externalities are third party effects arising from the production and/or consumption of goods and services, for which no compensation is paid
• Externalities cause market failure if the price mechanism does not take account of the total costs and benefits of production and consumption
• Externalities create a divergence between private and social costs and benefits of production and consumption

Question 7

Private cost and benefit

Answer 7

• A private cost is the cost of an activity to a consumer or a firm (the decision maker/ first party)
• A private benefit is the benefit of an activity to a consumer or a firm (the decision maker/ 1st party)
• MPC is the cost to the producer of producing the last unit

Question 8

External cost and benefit

Answer 8

• An external cost is the cost to a third party
• An external benefit is the benefit to a third party

Question 9

Social cost and benefit

Answer 9

• Social cost is the total cost of an activity to society
• Social cost = Private cost + External cost
• Social benefit is the total benefit of an activity to society
• Social benefit = Private benefit + eternal benefit
• To find the optimum production and consumption quantities, we use the concept of the margin
• The optimum allocation of resources is where:
• Marginal social cost (MSC) = Marginal social benefit (MSB)
• MSC is the total cost to society of the last unit produced
• MSB is the total benefit to society of the last unit consumed
• MSC - MPC = Marginal external cost

Question 10

Negative externalities in consumption

Answer 10

• Consumers can create negative externalities when they consume goods and services
• These demerit goods are thought to be ‘bad’ for you and/or impose costs on 3rd parties
  Examples:
• Alcohol
• Drugs
• Cigarettes

Due to:
- Imperfect information, selfishness, short termism.
- Therefore in a free market demerit goods are over-consumed

Question 11

Methods to deal with market failure

Answer 11

• Indirect taxation
• Subsidies
• Advertising/ education/ information
• Legislation
• Maximum pricing
• Minimum pricing
• Buffer stock
• Carbon taxation

Question 12

Indirect taxes

Answer 12

• An indirect tax is a tax imposed by the government that increase the supply costs faced by producers
• The amount of the tax is always shown by the vertical distance between the two supply curves
• Because of the tax, less can be supplied at each price level
• The result is an increase in the market price and a contraction in demand to a new equilibrium output
• A specific tax is a set tax per unit e.g. £5 tax per unit sold
• An ad valorem tax is a percentage tax e.g. 20% on the unit price

Question 13

Indirect taxes with different coefficient of PED

Answer 13

• If the co-efficient of PED >1, then most of the burden of an indirect tax will be absorbed by the supplier
• If the co-efficient of PED <1 most of an indirect tax can be passed on to the final consumer

Question 14

Ad valorem tax

Answer 14

• The effect of on an ad valorem tax is to cause a pivotal shift in the supply curve
• This is because the tax is a percentage of the unit cost of supply the product
• So a good that could be supplied for a cost of £50 will now cost £60 when VAT of 20% is applied
• A different good that costs £400 to supply will now cost £470 when the same rate of VAT is applied
• The absolute amount of the tax will go up as the market price increases
• VAT is an example of an ad valorem tax

Question 15

Evaluation of indirect taxes as a means to correct market failure

Answer 15

• Effect of a tax depends in part on coefficient of elasticity of demand
• Problems in setting the tax rate at the right level to achieve aims
• Are there unintended consequences from a tax
• Who are the main winners and losers
• Does a tax have a regressive effect on lower income groups
• Might there be a possible loss of jobs and/or capital investment

Question 16

Government subsidies for producer and consumers

Answer 16

• A subsidy is any from of government support - financial or otherwise offered to producers and (occasionally) consumers

Example:
- Biofuel subsidies for farmers
- Solar panel “feed-in tariffs
- Apprenticeship schemes
- Aid to businesses making losses
- Subsidies for wind farm investment
- Food/ fuel subsidies for consumers
- Child care for working families
- Subsidies to the rail industry

Question 17

Justification for subsidies for producers

Answer 17

• Subsidies are a form of government intervention. They are introduced for a number of economic, social & political reasons
  Examples:
• Help poorer families e.g. food and child care costs
• Encourage output and investment in fledgling sectors
• Project jobs in loss-making industries e.g. hit by recession
• Making soe health care treatments more affordable
• Reduce the cost of training & employing workers
• Achieve a more equitable income distribution
• Reduce some of the external costs of transport
• Encourage arts and other cultural services

Question 18

Evaluating subsidies

Answer 18

Are the subsidies effective in meeting their aims?
- Will they achieve the desired stimulus to demand/ consumption?
- Is a subsidy sufficient? Might other incentives be needed?

Will a subsidy affect productivity/ efficiency?
- Subsidies for investment and research can bring positive spill overs
- But firms may become dependant on state aid/ financial assistance

How much does the subsidy cost and who benefits?
- Is a subsidy part self-financing? will it crate more tax revenue?
- Or does a subsidy create an expensive extra burden for taxpayers?

Does the subsidy help to correct a market failure?
- For example - do more people find work with child care subsidies
- Or does a subsidy lead to undesired/ unintended consequences

Question 19

Cost benefit analysis

Answer 19

• Cost benefit analysis is a process used to measure the estimated net social rate of return from an investment project.
• When governments are deciding how much to spend on public goods, they might use a cost benefit approach to aid them
• A typical cost benefit analysis involved the following processes:
  1. Set the key objectives for the project
  2. Set project decision criteria i.e. an acceptable benefit to cost ratio
  3. Identify and value the private & external costs of the project
  4. Identify and value the private & external benefits of the project
  5. Consider possible distributional effects e.g. on inequality
  6. Discount annual value of benefits that will happen in the future
  7. Adjust for various risks and uncertainties
  8. Consider the unvalued/ non-monetised costs and benefits
  9. Measure the expected net social return from the project
  10. Compare with expected net social returns from other projects i.e. the opportunity cost of £billion invested in a project

Question 20

Problems with cost benefit analysis evaluation

Answer 20

Assigning monetary values

Some aspects of a project can be assigned a monetary value
- Time savings e.g. for passengers and businesses
- Operating costs of the project
- Value of carbon emissions e.g. Lower CO2 from less car use
- Risk of death or injury

Other variables are much harder to assign values
- Bio-diversity
- Water quality
- Air quality
- Heritage
- Social inclusion/ accessibility

Uncertainties and risks

There are uncertainties involved in major projects with long construction times + operating life that can last decades
- Forecast errors for passengers numbers in different modes of transport
- Uncertainties about population growth
- Uncertainties about future operating costs
- Future business growth/ types of businesses/ impact of new technologies

Question 21

Price controls

Answer 21

The government may consider hat the market generates a price that is too high or too low or too variable

Question 22

Maximum price

Answer 22

• These could be used for merit good or a good with significant positive externalities
• It may also be used to help address income inequalities by ensuring that essential goods are priced at a level that even the poorest can afford (rented accommodation)

Question 23

Minimum price

Answer 23

• Could be used for demerit goods or goods with significant negative externalities
• It may also help in a market where the government judges the price to be too low for producers to survive in sufficient numbers (e.g. agriculture)
• The national minimum wage is an example of a minimum price

Question 24

Buffer stock scheme

Answer 24

• Operate in a market where the market price is subject to fluctuations (e.g. primary product like coffee)
• Price fluctuations are mainly because of changing supply conditions resulting from good and bad harvests
• High supply in a good year lowers price, while low supply in a bad year raises price
• Demand will fluctuate with general economic conditions
• High in a boom and low in a slump. Price will increase with a boom and fall with a slump.
• The government may introduce a buffer stock scheme to try to counter the price fluctuations
• It will buy up surplus produce at an agreed price if there is a surplus in the market and place these goods in stock
• When a shortage occurs in the market, goods are sold from the stock at the agreed price. In this way the price is stabilised at the agreed level
• It is a government measure to deal with market failure

Question 25

Arguments against buffer stock

Answer 25

- Buffer stock scheme are costly to set up and administer - They rely on a suitable intervention price. If the price is set too high or low, the scheme will not work because the government either buys up mountains of stock with no prospect of selling it or there is nothing in the stock to sell into the market - The scheme also relies on the membership of as many of the producers of the product possible

Question 26

State provision

Answer 26

- The government takes over the production and supply of a good - This can be done by nationalising existing privately owned producers (popular in the 1950s and 60s) or by the state setting up its own production from the outset - If state provision is undertaken, decisions have to be made about the aim of production (maximum profit or welfare?) - In many cases state produced goods are not sold at a price in a market (e.g. state education) so decisions have to be made about the quantity to supply and the standard to produce - There are no signals on these matters from the market - It is a government measure to deal with market failure

Question 27

State regulation

Answer 27

- The government can leave production in the hands of privately owned firms and set regulations to control their behaviour - This is done in dealing with the problems like pollution where emission levels are set for firms - Another example is the work of the Competition and Markets Authority (CMA) in seeking to regulate the behaviour of monopolies - It is a government measure to deal with market failure

Question 28

Legislation

Answer 28

- This involves making things compulsory, banning them or restricting their production and/ or consumption through the use of laws and regulation - Used for demerit goods such as alcohol, cigarettes and merit goods such as education - It is a government measure to deal with market failure

Question 29

Education/ Information

Answer 29

- Governments may try to encourage or limit consumption through the use of advertising and education - This had the effect of decreasing demand and shifting demand and pushing the demand curve inwards - It is a government measure to deal with market failure

Question 30

Immobility of factors of production

Answer 30

- When it is difficult for factors of production to move from one use to another, they may remain unused - This is an inefficient use of resources - Immobility may be occupational or geographical - Unemployment may be a consequence of the immobility of labour

Question 30

Asymmetric information

Answer 30

- This occurs when one side of a market has more information than the other side - For example, a second hand car dealer may have more information than the customer and so may charge a higher price than the car warrants

Question 31

Short termism

Answer 31

- Both consumers and producers might make decisions based on short term benefits without taking into account the longer term costs - For example consumers may be told that smoking will increase their risk of health problems in later life but will smoke anyway - Producers may take decisions to increase profits so as to increase the value of their share price in the short term, without considering the longer term effects on profits - The financial crisis was partly borne out of finical institutions focus on short term growth at the expense of longer term stability

Question 32

Imperfect competition

Answer 32

A monopoly occurs when: - There is one supplier in a market. This is called a pure monopoly. Train companies in the UK tend to be local monopolies - One supplier has a dominant position in a market. For example, Ikea is the dominant supplier of flat packed furniture in the UK - A supplier has 25% or more share of a market A lack of competition in a market is likely to lead to - Higher prices - Lower supply - Poorer quality Than in a competitive market

Question 33

Inequality

Answer 33

- If the degree of inequality in an economy is too great, it may damage the ability of the economy to use its resources efficiently - For example, those on very low income may have issues around nutrition and housing, and may, therefore find it difficult to access education and achieve their full potential in the economy - This would cause an inward shift in the PPF