Theme 1: Introduction to markets and market failure Flashcards
(87 cards)
1
Q
What are positive economic statements
A
Positive economic statements are objective statements based on evidence or facts that can, therefore, be proved or disproved.
2
Q
What are normative economic statements
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Normative economic statements are subjective statements based on value judgements and cannot be proved or disproved.
3
Q
What are the factors of production
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The resources of a country are referred to as ‘factors of production’. Four factors of production may be identified:
- Land: includes all natural resources, raw materials, the fertility of the soil, and resources in the sea.
- Labour: refers to those involved in the production of goods and services and includes all human effort, both physical and mental.
- Capital: any man-made aid to production including factory buildings, machinery, and IT equipment that is used to make other goods and services.
- Enterprise: the entrepreneur performs two essential functions… 1) bringing together the other factors of production so that goods and services can be produced. 2) taking the risks involved in production.
4
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Define capital goods
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Goods that are required to produce other goods - both capital and consumer goods, eg machinery, factory buildings
5
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Define consumer goods
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Goods that give satisfaction (or utility) to consumers, eg smartphones, curry, and cars.
6
Q
Factors causing an outward shift in the PPF
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- Discovery of new natural resources, eg rare materials
- Development of new methods of production that increase productivity
- Advances in technology
- Improvements in education and training that increase the productivity of the workforce
- Factors that lead to an increase in the size of the workforce, eg immigration, an increase in the retirement age, better childcare enabling more women to join the workforce
7
Q
Factors causing an inward shift in the PPF
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- Natural disasters, eg earthquakes or floods that cause a destruction of productive capacity
- Depletion of natural resources
- Factors causing a reduction in the size of the workforce, eg emigration, an increase in number of years spent in compulsory education
- A deep recession that results in a loss of productive capacity with factories closing down permanently
8
Q
Advantages of specialisation and the division of labour in organising production
A
- Each worker specialises in tasks for which that worker is best suited
- The worker only has to be trained in one task. TF, training costs for the firm are likely to be lower.
- Less time is wasted because a worker no longer has to move from one task to another.
- In manufacturing, such an approach enables production line methods to be employed and allows an increased use of machinery. In turn, this helps to increase productivity and to reduce average costs of production.
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Q
Disadvantages of specialisation and the division of labour in organising production
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- Monotony and boredom for workers: this could result in a decrease in productivity
- Loss of skills: workers trained in one particular task have only limited skills. This could be a problem if they are made redundant.
- A strike by one group of workers could bring the entire production facility to a standstill.
There is a lack of variety because all goods produced on a production line are identical.
10
Q
Advantages of specialising in the production of goods and services to trade
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If a country specialises in the production of certain goods and services then trades these in exchange for goods and services that it does not produce, then it can benefit from increased output, greater choice, and lower prices.
11
Q
Disadvantages of specialising in the production of goods and services to trade.
A
Such specialisation might mean that a country becomes over-dependent on imported goods and services. If its goods and services are uncompetitive then unemployment could result, and the country’s value of imports may persistently exceed the value of its imports may persistently exceed the value of its exports.
12
Q
What are the limits to the division of labour
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1) The size of the market: if there is only a small market then it is more difficult to specialise.
2) The type of product: for example, designer fashion products are likely to be unique and not suitable for the division of labour.
3) Transport costs: if these are high then large-scale production and the division of labour may not be possible.
13
Q
What are the functions of money
A
Money performs various functions, which help to facilitate specialisation and the division of labour. The key functions are:
- Medium of exchange: enabling people to specialise, exchanging the money earned from doing a specialist job for the goods and services they wish to buy.
- Store of value: enabling people to save in order to buy goods in the future.
- Measure of value: enabling people to assess the value of different goods and services by comparing prices.
- Means of deferred payments: enabling people to buy gods and pay for them on credit.
14
Q
What is a free market economy
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An economic system in which prices are determined by supply and demand with no government intervention
15
Q
What is a command economy
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An economic system in which resources are allocated by the state
16
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What is a mixed economy
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A combination of a free market economy and a command economy
17
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Characteristics of free market economies
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- There is private ownership of resources
- Market forces, ie supply and demand, determine prices
- Producers aim to maximise profits
- Consumers aim to maximise utility (satisfaction)
- Resources are allocated by the price mechanism
18
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Characteristics of command economies
A
- There is public (state) ownership of resources
- The state determines price
- Producers aim to meet production targets set by the state
- The state allocates resources
- There is greater equality of income and wealth than in a free market economy
19
Q
Advantages of free market economies
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- Consumer sovereignty: this implies that consumer spending decisions determine what is produced
- Flexibility: the free market system can respond quickly to changes in consumer wants
- No bureaucracy: officials are not needed to allocate resources
- Efficiency: competition and the profit motive help to promote an efficient allocation of resources
- Increased choice: consumers have a wide choice of goods and services compare with a command economy
- Economic and political freedom: consumers and producers have the right to own resources
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Disadvantages of free market economies
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- Inequality: those who own resources are likely to become richer than those who do not own resources.
- Trade cycles: free market economies may suffer from instability in the form of booms and slumps.
- Imperfect information: consumers may be unable to make rational choices if they have inadequate information or if there is asymmetric information.
- Monopolies: there is a danger that a firm may become the sole supplier of a product and then exploit consumers by charging prices higher than the free market equilibrium.
- Externalities: these are costs and benefits to third parties that are not taken into account when goods are produced and consumed.
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Advantages of command economies
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- Greater equality: the state can ensure that everyone can enjoy a minimum standard of living and that no one is extremely rich.
- Macroeconomic stability: the state can ensure that booms and slumps are smoothed out.
- External benefits and external costs: these may be taken into account when planning production.
- No exploitation: privately owned monopolies are unable to exploit workers and consumers.
- Full employment: the state can ensure that all workers are employed
- Resources may be allocated by the state to maximise social welfare
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Disadvantages of command economies
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- Inefficiency: the absence of the profit motive and competition may result in an inefficient allocation of resources.
- Lack of incentives to take risks: the absence of the profit motive may reduce incentives for investment.
- Restrictions on freedom of choice: people would be directed into the jobs the state deems necessary.
- Shortages and surpluses: if the state miscalculates supply and demand then there may be excess demand and/or excess supply of goods and servcies.
- Bureaucracy: a vast army of officials is needed to allocate resources.
- No consumer sovereignty: decisions by the state rather than consumers determine what is produced.
- Inflexibility: the state may be slow to react to changes in consumer needs.
23
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Define utility
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Utility refers to the level of satisfaction a consumer receives from the consumption of a product or service
24
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What are the neoclassical assumptions of consumers and firms’ rational behaviour
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- Consumers act rationally by aiming to maximise their utility
- Firms act rationally by aiming to maximise profits
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What effects cause a fall in price to result in an increase in quantity demanded
1) The substitution effect: when there is a rise in price, the consumer (whose income has remained the same) tends to buy more of a relatively lower-priced goods and less of a higher-priced one.
2) The income effect: when there is a rise in price, consumers will suffer a fall in their real incomes, ie the purchasing power of their money incomes falls. With normal goods, the fall in real incomes will lead to a fall in the quantity demanded.
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What factors cause a shift in the whole demand curve
- Real incomes: an increase in real incomes implies that incomes (after discounting the effects of inflation) have increased. This would result in an increase in demand for most goods and services, causing a rightward shift in the demand curve.
- Size or age distribution of the population: an increase in the size of the population causes an increase in demand for most goods and services.
- Tastes, fashions, or preferences: for example, a decrease in the popularity of cabbage will cause a leftward shift in its demand curve.
- Prices of substitutes or complements: if there is a change in the price of a related good, it will affect the demand curve for the product. For example, if the price of beef rises, the demand for a substitute such as lamb will increase. In contrast, if there is a rise in the price of petrol (a complement to cars), the demand curve for cars would shift to the left.
- The amount of advertising or promotion: a successful advertising campaign would cause an increase in demand.
- Interest rates: affect the cost of borrowing money. For example, a rise in interest rates increases the cost of borrowing money for mortgages, so causing a decrease in demand for houses.
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Define total utility
Total utility represents the total satisfaction gained from the total amount of a product consumed
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Define marginal utility
Marginal utility represents the change in utility from consuming an additional unit of the product.
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What is the law of diminishing marginal utility
The law of diminishing marginal utility states that as a person consumes more and more of a product, the marginal utility (extra satisfaction or benefit) falls. Consequently, people are prepared to pay less as their consumption increases with the result that there will be an inverse relationship between the price and quantity demanded.
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What is price elasticity of demand
PED measures the sensitivity of the quantity demanded of a product to a change in its own price.
PED = % change in quantity demanded / % change in price
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What values of PED =
Inelastic demand
Elastic demand
Unitary elastic demand
Perfectly inelastic demand
Perfectly elastic demand
Inelastic demand: 0 < PED < 1
Elastic demand: PED > 1
Unitary elastic demand: PED = 1
Perfectly inelastic demand: PED = 0
Perfectly elastic demand: PED = infinity
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Factors influencing price elasticity of demand
- Availability of substitutes: if substitutes are available there will be a strong incentive to shift consumption to them when the price of the product rises. The existence of substitutes therefore tends to make demand for the product elastic.
- Proportion of income spent on a product: if only a small percentage of income is spent on a product such as salt then demand tends to be elastic, whereas if a high percentage of income is spent on the product then demand tends to be elastic, eg exotic holidays and works of art by famous artists.
- Nature of the product: if the product is addictive, eg alcohol and tobacco, then demand tends to be inelastic.
- Durability of the product: if the product is long-lasting and hard-wearing, eg furniture and cars, then demand is fairly elastic since it is possible to postpone purchases. However, demand for non-durable goods, eg milk and petrol, tends to be inelastic because these must be replaced regularly.
- Length of time under consideration: it usually takes time for consumers to adjust their expenditure patterns following a price change. For example, it takes time for motorists to switch from fuel-greedy to more fuel-efficient cars. Consequently, demand is usually more price elastic in the long run than in the short run.
- Breadth of definition of a product: if a product is broadly defined, eg fruit, demand is likely to be price inelastic. However, demand for particular types of fruit, eg apples, is likely to be more price elastic.
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What is the relationship between PED and total revenue?
When PED is inelastic, a price change causes TR to change same direction (ie price increase, TR increase)
PED is elastic, a price change causes TR to change in opposite (price increase, TR decrease)
PED is unit elastic, price change causes TR to remain unchanged
34
Define cross elasticity of demand
XED is a measure of the responsiveness of quantity demanded of one product (Y) to a change in the price of another product (X).
XED = % change in quantity demanded of product Y / % change in price of product X
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What XED are substitutes and complements
Positive = products are substitutes, eg a rise in the price of one product will cause an increase in demand for another product.
Negative = indicates that the products are complements, eg a rise in the price of one product will cause a decrease in demand for another product.
36
Define income elasticity of demand
YED is a measure of the responsiveness of quantity demanded of a product to a change in real income.
YED = % change in quantity demanded / % change in real income
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What YED are normal goods and inferior goods
Positive = normal goods, ie a rise in real income will cause an increase in demand.
Negative = inferior goods, ie a rise in real income leads to a fall in demand for the product.
38
Why does supply increase when the price rises
When the price rises it becomes more profitable for producers to supply a product and so they have an incentive to increase production.
In contrast, when there is a fall in price it becomes less profitable to supply a product and so firms will reduce output and/or exit the market.
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What factors cause a shift in the supply curve
- Costs of production: these include wages, raw materials, energy, and rent. An increase in costs of production, such as electricity prices, will cause the whole supply curve to shift to the left.
- Productivity of the workforce: labour productivity refers to the output per worker per hour worked. If there is a rise in productivity then the whole supply curve will shift to the right.
- Indirect taxes: an indirect tax raises the cost of supply and so causes the supply curve to shift to the left. A rise in VAT will cause the supply curve to become steeper because it is a percentage of the price of a product, whereas a rise in a specific tax, eg 20p per unit, will cause a parallel leftward shift in the supply curve.
- Subsidies: these are grants to producers from the government that effectively lead to a reduction in costs of production so causing a rightward shift in the supply curve.
- Technology: new inventions and new technology usually result in an increase in productivity so causing the supply curve to shift to the right.
- Discoveries of new reserves of a raw materials: if, for example, a country discovers new oil reserves, the supply curve will shift to the right.
40
Define price elasticity of supply
PES is a measure of the responsiveness of quantity supplied for a product to a change in its price.
PES = % change in quantity supplied / % change in price
NB: PES always has a positive value because price and quantity move in the same direction (since the supply curve is upward sloping).
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Factors influencing the price elasticity of supply
- Time: elasticity of supply is very likely to vary over time. It is often difficult to change supply quickly in response to a price change, making supply very inelastic in the short run. However, in the long run, supply is very likely t be more elastic because all resources are variable.
- Stocks: if stocks of finished goods are available, then supply will be relatively elastic because manufacturers will be able to respond quickly to price change.
- Spare capacity: if a firm has underutilised machinery and underemployed workers, or if it is possible to introduce a new shift or workers, then supply is likely to be elastic.
- Availability and cost of switching resources from one use to another: such as labour, have specific skills or machinery is highly specific, or if it is expensive to reallocate resources from one use to another, then supply will be relatively inelastic.
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Define short run
Short run is a time period in which there is at least one fixed factor of production
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Define long run
Long run is a time period in which all factors of production can be varied.
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Functions of the price mechanism
The key functions of the price mechanism in a free market economy may be summarised as follows:
- As a rationing device: market forces will ensure that the amount demanded is exactly equal to the amount supplied.
- As an incentive: the prospect of making a profit acts as an incentive to firms to produce goods and services.
- As a signalling device: to producers to increase or decrease the amount supplied.
- To determine changes in wants: a change in demand will be reflected in a change in price.
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What are consumer and producer surpluses
Consumers' surplus is the difference between how much consumers are willing to pay and what they actually pay for a product.
Producers' surplus is the difference between the price the producers receive and the cost of supply. In other words it represents profit.
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Factors affecting consumers' surplus
- The gradient of the demand curve: the steeper it is the greater the consumers' surplus will be.
- Changes in the conditions of demand: for example, an increase in demand will increase the amount of consumers' surplus.
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Factors affecting producers' surplus
- The gradient of the supply curve: the steeper it is, the greater the producers' surplus will be.
- Changes in the conditions of supply: for example, an increase in supply will increase the amount of producers' surplus.
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Define indirect tax
Indirect taxes are taxes on expenditure... Eg VAT, excise taxes, and taxes on gambling.
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What are ad valorem taxes
Ad valorem taxes are a percentage of the price of a product or service. Eg VAT. (shift with change in gradient)
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What are specific taxes
A specific tax is a set amount of tax on each unit consumed. (parallel shift)
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Define incidence of tax
Incidence of tax relates to how the burden of a tax is distributed between different groups, eg producers and consumers.
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Define subsidy
A subsidy is a grant from the government that has the effect of reducing costs of production.
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Reasons why consumers may not behave rationally
- Consideration of the influence of other people's behaviour: much of a person's behaviour is affected and influenced by that of others. Indeed, it is argued that a person subconsciously learns from the behaviour of others as a guide to their own behaviour is dependent - process known as 'social learning'. Examples of how our behaviour is dependent on others' might include the clothes and smartphones we buy or the food we eat.
- The importance of habitual behaviour: the frequency of our past behaviour influences our current behaviour. Consequently, such behaviour involves little or no thought - it is just done automatically. Habits are difficult to change if they are repeated frequently and if they are associated with rewards that arise quickly after the action. Incentives (which may be financial or non-financial) may be required to change such habits. For example, charging for plastic bags has had a major impact in countries such as the UK, Ireland, and South Africa.
- Inertia: this might arise because people are loss averse, ie they will put more effort into preventing a loss than winning a gain. This could explain, for example, why a relatively small proportion of consumers switch their bank accounts or their energy suppliers.
Other reasons why consumers might not make an active effort to change their behaviour include:
- Information overload
- The complexity of the information available
- Too much choice available
- Consumer weakness at computation, as people tend to pay more attention to recent events than to distant events when they make decisions. Linked with this, consumers find considerable difficulty in calculating the probability of something happening. They are also influenced by how a choice is presented.
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Define market failure
Market failure occurs when the forces of supply and demand (market force) do not result in the efficient allocation of resources.
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What are externalities
Externalities are costs and benefits to third parties who are not directly part of a transaction between producers and consumers.
They are, in effect, spillover effects arising from the production or consumption of a product or service that are not taken into account by the price mechanism.
Externalities are therefore a form of market failure because market forces will not result in an efficient allocation of resources.
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What are private costs
Private costs are the costs paid directly by the producer and consumer in a transaction
For producers these typically include wages, rent, raw materials, and energy
For consumers this is typically the price paid for the product/service
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What are external costs (negative externalities) and what are some examples - production and consumption
These are the costs in excess of private costs that affect 3rd parties who are not part of the transaction.
Examples of external costs of production include:
- Air pollution, eg noxious gases from a factory
- Noise pollution, eg from building work associated with a new factory or from machinery used in the production process
- Pollution arising from the destruction of the rainforest to grow crops
Examples of external costs of consumption include:
- Passive smoking, ie a non-smoker might suffer from adverse health effects through being in the presences of a smoker over a period of time
- Overeating by individuals, ie obesity might result in significant costs for the National Health Service and, in turn, taxpayers.
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What are social costs
Social costs are the sum of private costs and external costs
Social costs = private costs + external costs
TF External costs = social costs - private costs
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What are private benefits
Private benefits are the benefits that are received directly by the producer and consumer in a transaction.
For producers these typically include the revenues received from the sale of the product/service.
For consumers these are the utility gained by the consumer from the consumption of the product/service.
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What are external benefits and what are some examples - production and consumption
External benefits are benefits to third parties, ie other than to the producer or consumer directly involved in the transaction. They are spillover benefits from the production or consumption that the market fails to take into account.
Examples of external benefits of consumption:
- Individuals who decide to have vaccinations preventing the spread of disease to others
- Households with well-kept gardens increasing teh market value of neighbouring properties
Examples of external benefits of production:
- A farmer who keeps bees to make honey. The bees will benefit surrounding farmers by pollinating their crops.
- A firm that trains workers in computing skills. Other firms that do not train workers might benefit from employing workers from this firm.
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What are social benefits
Social benefits are the sum of private benefits and external benefits.
Social benefits = private benefits + external benefits
TF external benefits = social benefits - private benefits
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What does non-rivalrous mean
That consumption by one person does not limit consumption by others, ie the benefit to others is not reduced by one person's consumption.
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What does non-excludability mean
That if a good is available for one person, it is available for everyone, ie it is impossible to prevent or exclude anyone from using it.
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What are public goods
Goods that have the two key characteristics of being non-rivalrous and non-excludable. Eg street lighting, nuclear defence systems, and national parks
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What are private goods
Goods that have the two key characteristics of being rivalrous and excludable.
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What is the free rider problem
That once a product is provided it is impossible to prevent people from using it and, therefore, impossible to charge for it.
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What is asymmetric information
Where one party in a transaction has more or superior information compared to another
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Why is asymmetric information bad
Resources may be allocated inefficiently, resulting in a market failure
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What are examples of markets in which asymmetric information is possible
- Housing market: estate agents may know more about the potential problems of a house than the potential buyer.
- Life insurance: consumers may not reveal all aspects of their health profile to the insurance company, making it difficult for the firm to assess the risk
- Second-hand car sales: the car salesperson knows more about the car than a potential buyer
- Financial services: a bank may be unaware of the likelihood of a default by the borrower
- High-tech products: consumers are unlikely to have as much information as producers about products such as smartphones and pharmaceuticals.
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What are the advantages of using indirect taxes to address market failures
- Incentive to reduce pollution - the most polluting firms pay more than the least polluting firms
- Source of revenue for the government that can be used to compensate those affected by the pollution
- Few administrative costs involved with this method
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What are the disadvantages of using indirect taxes to address market failures
- Ineffective in reducing pollution if demand is price inelastic
- Difficulty of setting an appropriate tax because of the problem of quantifying the external cost
- Increased business costs
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What are the advantages of using subsidies to address market failures
- Reduction in cost of production enabling suppliers to reduce the price
- Incentive for people to increase consumption
- Might help to reduce inequality
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What are the disadvantages of using subsidies to address market failures
- Cost to the taxpayer of providing subsidies
- Ineffective in increasing consumption if demand is inelastic
- Difficulty of setting an appropriate subsidy because of the problem of quantifying the external benefit
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What are the advantages of using maximum prices to address market failures
- They enable consumers on low incomes to be able to afford on low incomes to be able to afford to buy a product
- They help to prevent an increase in the country's rate of inflation
- They can prevent exploitation of consumers by monopolie
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What are the disadvantages of using maximum prices to address market failures
- There is a danger that shortages mean some consumers are unable to find supplies of the product
- Producers may exit the market to use their resources to produce goods that are more profitable
- If the government subsidises producers to encourage them to maintain output, there will be a significant cost to the taxpayer
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What are the advantages of using minimum prices to address market failures
- Producers know in advance the price they will receive for their product
- This greater certainty enables producers to plan investment and output
- They can prevent exploitation of producers by wholesalers and retailers who have significant buying power
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What are the disadvantages of using minimum prices to address market failures
- If the minimum guaranteed price is set too high, there will be surpluses each year
- These schemes involve costs of storage, which must be borne by taxpayers
- These schemes encourage over-production and may therefore result in an inefficient allocation of resources
78
Define maximum price
A maximum price is a price, usually set by the government, which makes it illegal for firms to charge more than a certain price for a given quantity of a product
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Define minimum price
A minimum price is a price, usually set by the government, which is guaranteed to producers
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What are tradable pollution permits
A tradable pollution permit scheme is another method used to reduce external costs.
The government issues permits to firms that allow them to pollute up to a certain limit. Any pollution above this limit is subject to fines.
The key to this system is that the permits may be traded between firms so that 'clean' firms can sell their surplus permits to firms that are more polluting.
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Define tradable pollution permits
According to the OECD, are rights to sell and buy actual or potential pollution in artificially created markets.
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What are the advantages of using tradable pollution permits to address market failures
- These schemes work through the market mechanism
- They are an incentive for firms to reduce pollution
- The costs of administering these schemes are low relative to those associated with systems of regulation
- There can be a planned reduction in pollution over time
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What are the disadvantages of using tradable pollution permits to address market failures
- Pollution will continue, albeit at a lower level than previously
- Large, efficient firms might buy up the permits and continue to pollute
- They need to be internationally enforced to be effective
- They might make the country's goods less internationally competitive
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What are the advantages of using regulation to address market failures
- Regulation can limit the amount of pollution
- It might act as an incentive to producers to develop new technologies that reduce pollution
- It can limit external costs without an impact on price
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What are the disadvantages of using regulation to address market failures
- Enforcement on laws/regulation costs, eg inspectors may have to be employed to ensure that producers and/or consumers abide by the rules
- There is the problem of determining teh socially efficient level of pollution
- It limits consumer sovereignty
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Define government failure
Government failure is when government intervention results in a net welfare loss
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What are the causes of government failure
Distortion of price signals:
- Government intervention often involves manipulation of prices, for example, by maximum or minimum price controls
- However, such measures would undermine the key functions of the price mechanism such as signalling, rationing, and incentives.
- Ultimately, this could mean that resources are not allocated efficiently
Unintended consequences:
- Some types of government intervention may have an impact that policy-makers did not predict
- For example, high taxes imposed on spirits in teh UK designed to raise tax revenues actually resulted in a decrease in tax revenues.
- Similarly, very high taxes on cigarettes in the UK have resulted in a significant increase in cigarette smuggling from which the government gains no tax revenue
Excessive administration costs:
- Although government intervention might seem to be desirable, the costs may be considerable. For example, the cost of administering means-tested benefits may be very large.
Information gaps:
- When a government intervenes in a market it is unlikely to have all the information required. Consequently, the intervention could move output further away from the socially optimal level.
