Micro Booklet 3

Question 1

Explain the difference between a public and a private good

Answer 1

• A public good is one which is non- excludable, and non-rivalrous. This means that people can not be prevented from using it, and one person’s use of the good does not affect the utility that someone else gains from it.
  -Private goods are rivalrous and excludable.
  -Goods can also be Quasi- Public or non pure public goods

Question 2

Explain the free rider problem

Answer 2

• If no one can be prevented from gaining the benefit without paying, everyone expects the good for free. There is therefore no incentive for any firm to provide the good, and it is left to the government to provide

Question 3

Explain the functions of prices

Answer 3

• There are the three functions of price: signaling, rationing, and allocative function.
• The signaling function= changing prices give information to traders to enable them to plan their economic activity)
• The rationing function= when there is excess demand, price will rise so that only those willing and able to pay for the good can buy it.
• Incentive function= price level provides an incentive for consumers and producers to alter their behavior.

Question 4

Explain what a missing market is

Answer 4

Missing markets occur when the incentive function of prices completely breaks down and a market fails to come into existence or disappears completely.
- complete market failure

Question 5

Explain partial market failure

Answer 5

Partial market failure takes place when a market does provide a good but in an allocatively inefficient quantity. This is the case with merit and demerit goods and when externalities are not taken into account.

Question 6

examples of markets that fail due to information failure

Answer 6

-Houses- people may not see faults within a house which would knock their value
- Second hand cars- people may not know faults involved in certain cars
- Insurance/ health insurance- You may fail to inform to inform your insurance company of underlying health conditions.

Question 7

Explaining Market Failures using an externalities diagram

Answer 7

• Think about whether the externalities in consumption or production
• Draw the appropriate diagram
• Be clear on what the externalities are.
  -Explain why this causes a difference between MPB and MSB or MPC and MSC.
  -Explain why the free market will arrive at the private optimum
  -Explain why the social optimum is where it is.
• Identify the welfare loss
  -Explain the implications of this on consumption / production

Question 8

Diagram to show negative externality in consumption

Answer 8

-Draw and check

Question 9

Diagram to show positive externality in consumption

Answer 9

• Draw and check

Question 10

Diagram to show negative externality in production

Answer 10

• Draw and check

Question 11

Diagram to show positive externality in production

Answer 11

• Draw and check

Question 12

Externalities example- the market for energy drinks

Answer 12

The consumption of energy drinks generates negative externalities, particularly in in the healthcare system such as the UK’s, where consumers who require treatment will seek it from the NHS, thus imposing a cost to the third party of taxpayers. As a result, the marginal private benefit of energy drinks is more than the marginal social benefit. Consumers generally act in their own interest and ignore the impact upon society. In the diagram above (Externalities), this can be seen as consumers are consuming at the private optimum, where MPB is equal to MPC., rather than the social optimum where MSB is equal to MSC, and social welfare is maximised. There is a welfare loss equal to the triangle in the diagram. There is an overconsumption equal to Q1-Q2- too many resources are allocated to energy drinks, meaning that the market is allocatively inefficient and fails.

Question 13

Types of government failure

Answer 13

• distortion of price signals- gov intervention causes prices to change
• Conflicting objectives
• Information gaps
• Excessive admin costs
• Unintended consequences

Question 14

Indirect tax diagram

Answer 14

Draw and then check

Question 15

Indirect tax analysis

Answer 15

The use of an indirect tax will increase a firms cost of production and mean that at any given price suppliers will be less able to earn profit. This means that they have less incentive to supply and the supply curve will shift leftward from S1 to S2. Excess demand at the previous market price causes the equilibrium price to increase from P1 to P2 and this causes a contraction of demand from Q1 to Q2. This reduces the quantity to the social optimum, correcting the problem of overconsumption/ production and correcting the market failure.

Question 16

Indirect tax evaluative points

Answer 16

• It is difficult to put values on externalities
• Opportunity cost of monitoring
• Can be regressive
• Effectiveness depends on the price elasticity of demand
• Potentially inflationary
• Can be hypothecated, providing further helping to resolve the issue

Question 17

Subsidy diagram

Answer 17

Draw diagram and then check online

Question 18

subsidy analysis

Answer 18

A subsidy will decrease firms’ cost of production and mean that at any given price, suppliers will be able to earn more profit. This means they will have more incentive to supply and the supply curve will shift to the left, from S1 to S2. This decreases the equilibrium price from P1 to P2, and causes an extension of demand from Q1 to Q2. This extends the quantity to the social optimum, correcting the overconsumption/ underproduction, and correcting the market failure.

Question 19

Subsidy evaluative points

Answer 19

• Difficult to accurately value externalities
• Firms may not use the subsidy to increase production or may become productively inefficient
• Opportunity cost
• Effectiveness depends on PED

Question 20

Information provision diagram

Answer 20

Draw first then check online

Question 21

Information provision analysis

Answer 21

The provision of information enables consumers to understand the benefits/ negatives of a good, and changes their tastes and preferences towards/ away from the good. This gives consumers less/ more incentive to buy, shifting demand leftward/ rightward from D1 to D2. This lowers/ raises the equilibrium price from P1 to P2, and causes a contraction of supply from Q1 to Q2, where Q2 is the social optimum, correcting the over/ under consumption.

Question 22

Information provision evaluative points

Answer 22

• The information does not have to be listened to by consumers
• Very expensive policy to implement- possible government failure due to excessive administration costs.
  -The information may be too complex for some consumers to understand

Question 23

Diagram for minimum price

Answer 23

-Draw then check

Question 24

Diagram for maximum price

Answer 24

• draw then check

Question 25

Price control- evaluative points

Answer 25

- Government needs correct information- risk of government failure - Opportunity cost of monitoring - Can be ignored/ black market - Punishment needs to be effective - Market will not clear= e.g. unemployment from the minimum wage

Question 26

explain solving market failure by extending property rights

Answer 26

- Many argue that by assigning property rights, and then allowing people to waive these rights for fee or obtain compensation. - This allows people to sue for compensation from pollution, or water companies to charge firms who dump waste into rivers. - Allows consumer to be compensated equal to the external cost of the firms actions

Question 27

Extending property rights- evaluative points

Answer 27

- sometimes difficult to prove that a third party has been affected - Government needs to oversee and resolve disputes- this has an opportunity cost -Still difficult to value even for those involved

Question 28

Tradable permits diagram

Answer 28

- draw then check

Question 29

Tradable permits analysis

Answer 29

- The government decides that the market is failing, probably the due to the amount of pollution it generates - The government imposes a limit on the amount of pollution that can be emitted and produces a volume of permits equal to that limit. -The government allocates these permits either through auction or by "grandfathering" permits based on previous emission records -Over time, the government reduces the supply of permits and the supply curve for permits shifts leftward from S1 to S2. -Excess demand at P1 will bid up the market price to P2. Firms will only buy a permit if it is cheaper than their marginal abatement cost. Demand falls from q1 to q2. - Reduces level of pollution to the socially optimal level, correcting the market failure

Question 30

Tradable permits- evaluative points

Answer 30

- Price can be bid up with speculators, unlike a tax - Government requires correct info when setting cap - Administration and monitoring- opportunity cost -Potentially inflationary and regressive - Jurisdiction issue- needs to be international to be effective

Question 31

Explain the notion of bounded rationality

Answer 31

- Bounded rationality- people may want be behave rationality, but face three critical limitation to their ability to do so: The human mind has limited ability to process and evaluate info, info available may be incomplete and often unreliable, time is limited. - As a result, may economic agents end up utility satisficing. - Some people lack the self discipline to pursue the best option (Bounded self control)

Question 32

Explain the four decision making biases

Answer 32

- Heuristics= mental shortcut or rule of thumb - Anchoring= a particular piece of info skews a consumers perception of something, as they bases their valuation on it. - Availability bias= Misjudges likelihood of something happening based on the most recent piece of info. - Social norms= This means following what other people do.

Question 33

Explain the following choice Architectures, and how they can be used to correct market failure: framing, Default choice, and mandated choice

Answer 33

- Framing= The tendency of an individual to be influenced by the context in which info is presented. For examples insurance being quoted at a day rate. - Default choice= A pre set choice that the individual must make a conscious decision to change. For example, organ donation within the UK. - Mandated choice= Individuals are forced to make a decision pone way or another, without a default being set- E.G the instillation of software.

Question 34

Explain what the following choice architectures are and how they can be used to correct market failure: Restricted choice, nudges

Answer 34

- Restricted Choice= Giving people a limited number of options to prevent problems with the volume of information. EG- gov offering the top five pension schemes. - Nudges= Encouraging individuals to change their behaviour in a predictable way without actually revoking the ability to choose.

Question 35

Evaluative points for choice architecture

Answer 35

- Freedom to choose still means to choose badly - Therefore sometimes a shove may be more effective - Sometimes nudges seem to assume that people are stupid - Less effective in the case of deep rooted behavior - But, low cost means low opportunity cost