Topic 2 - Market Failure Flashcards
(115 cards)
1
Q
How does market failure occur?
A
when the price mechanism fails to efficiently allocate the scarce resources to where they are best suited
2
Q
What is misallocation of resources?
A
Resources are misallocated when they are not devoted to the use that will give society the most welfare
3
Q
What is complete market failure ?
A
unless the good or service is provided outside the mechanism, there wouldn’t be a market for it.
E.g a country’s military services.
4
Q
What is partial market failure ?
A
when the private sector may partially provide it but at the wrong price or quantity.
E.g private healthcare vs NHS
5
Q
What are externalities?
A
When goods affect third parties (not the producer or the consumer) when produced or consumed
6
Q
Why is Producing and consuming at the wrong price and quantity is bad for society
A
because resources could be better used to improve welfare
7
Q
How can benefits and costs of a good be be separated?
A
the private and external benefits and private and external costs
8
Q
Private benefits are observed and accounted for by the market.
But, because of asymmetry of information, the external consequences of a good are often ignored.
What is this a source of and why ?
A
This is a source of market failure
So we see over/underconsumption/production of some goods in the free market.
9
Q
What are social benefits ?
A
The the sum of the external and private benefits
10
Q
Where is the socially optimal point ?
A
The socially optimal quantity is where it is allocatively efficient to produce and consume.
This is a different quantity to what is often observed in the free market
11
Q
What is the difference between the social benefit and private benefit ?
A
The external benefit
12
Q
If the social and private curves are parallel, what does this mean for the external benefit .
A
the external benefit is constant.
13
Q
If the private benefit and social benefit diverge, what’s mean for the external benefit?
A
the external benefit becomes greater as output is increased.
14
Q
What are the causes of market failure ?
A
Externalities
A lack of public goods
Information gaps
15
Q
What term refers to the total gain by society when a good is consumed?
A
Social benefit
16
Q
What are externalities?
A
Externalities are the effects that producing or consuming goods have on other third parties or society as a whole
17
Q
Why do externalities lead to market failure ?
A
Buyers or producers do not consider externalities when making decisions. This can lead to market failure because goods or services can be under or over consumed.
18
Q
What is a positive consumption externality ?
A
This is a ‘good’ externality created in the consumption of a good.
The marginal social benefit is the total benefit of consuming a good or service to society. MSB = MPB + Externality.
If the consumption externality is positive, then the marginal social benefit is more than the marginal private benefit.
Consumers do not account for the benefit of the externality and this good will be under-consumed.
E.g. school education is a positive consumption externality because students become more productive for employers
19
Q
What is a negative consumption externality ?
A
This is a ‘bad’ externality created in the consumption of goods/services (e.g cigarettes).
The marginal social benefit is the total benefit of consuming a good or service to society. It is equal to the marginal private benefit plus the value of the consumption externality.
If the consumption externality is negative, then the marginal social benefit is less than the marginal private benefit and the good will be overconsumed (vs the socially optimal level).
20
Q
What are positive production externalities ?
A
These are externalities incurred when producing a good or service.
Marginal social cost = Marginal private cost - Production externality. MSC is the total cost of producing a good or service to society.
If the production externality is positive, then the social cost is less than the private cost and the good will be underproduced.
21
Q
What are negative production externalities?
A
These are externalities created when producing a good or service.
If the production externality is negative, then the social cost is greater than the private cost and the good will be overproduced (vs the socially optimal level).
E.g a factory producing noise and air pollution is likely to have a social cost larger than the private cost.
22
Q
How are externalities created ?
A
through an asymmetry of costs or benefits
23
Q
What are private coats ?
A
Private cost:
The cost to an individual in the market
24
Q
What are external costs ?
A
External cost:
A cost put on a third party due to a negative externality.
25
What are social costs ?
Social cost:
The cost to society due to a negative externality.
Social cost = private cost + external cost.
26
What are private benefits ?
Private benefit:
The benefit to an individual in the market
27
What are external benefits ?
External benefit:
The benefit a third party receives due to a positive externality.
28
What are social benefits ?
Social benefit:
The benefit to society due to a positive externality.
Social benefit = private benefit + external benefit.
29
How was Cristiano Ronald an externality when he joined Juventus ?
Cristiano Ronaldo joined Juventus from Real Madrid in Summer 2018. He cost Juventus 112 million euros (private cost). But the benefit of him joining Juventus spilled over to other people. The MSB > MPB.
Chievo Verona, only sell enough tickets to sell their stadium for 1 game per year. However, in 2018, their first match against Juventus sold out at the start of the season (external benefit).
Some estimates suggest that the value of the TV rights for Serie A, the Italian football league, have risen 20-30% (external benefit).
KPMG predicted that the deal would be worth 340 million euros to Juventus over the 4-year period of Ronaldo's contract.
They may attract more sponsors, more social media followers and sell more Juventus shirts because of the deal (private benefit).
30
How is there a deadweight welfare loss in a negative production externality ?
Firms will only account for the MPC when producing goods and consumers will only account for the MPB when consuming.
The shaded triangle shows the deadweight welfare loss to society from the overproduction of something that has a negative production externality.
A government may want to reduce consumption to the socially optimal level of Qe.
31
What is the term given for the loss in utility due to externalities ?
A deadweight welfare loss.
32
What will firms account for when deciding production?
Marginal private costs (MPC)
33
What’s are examples of externalities?
Education (positive consumption)
Petrol cars (negative consumption)
Renewable energy (positive production)
Alcohol (negative consumption)
Vaccination (positive consumption)
34
How is education a positive consumption externality ?
A good with positive consumption externalities is often called a merit good.
Education has a positive consumption externality, so it is a merit good.
In education the MSB>MPB, so it is under consumed in the free market below the socially optimal level.
35
How are petrol cars a negative consumption externality?
Petrol cars have negative consumption externalities. This means that they are demerit goods.
Demerit goods are over consumed in the free market. This leads to a deadweight welfare loss to society
36
How is renewable energy a positive production externality ?
Renewable energy has positive production externalities.
It can replace the use of fossil fuels which can damage the environment - the opportunity cost would be using something negative instead of something neutral.
Governments have subsidised renewable energy (like wind and solar power) in the US and UK to try to increase production closer to the socially optimal level and deliver a gain in society's welfare.
37
How is alcohol a negative consumption externality?
Alcohol has a negative consumption externality.
Excessive alcohol consumption is linked to crime and antisocial behaviour which the rest of society has to deal with. The consumer doesn't pay the cost that the externality causes leading to the overconsumption of the negative consumption externality.
The MSB < MPB and this creates a welfare loss unless the government intervenes.
38
How is vaccination a positive consumption externality?
Vaccination has positive consumption externalities.
In addition to protecting someone from an illness, vaccination also reduces the risk of that person spreading the illness. As a result, the rest of society is better protected from the illness due to one person's consumption of the vaccine. This is called herd immunity.
39
Why is absence of property rights an issue that leads to externalities?
The absence of property rights means that it is not clear who owns what.
For example, it is not clear who owns the environment or air. This can lead firms to pollute more than is optimal because they do not account for external costs.
Ronald Coase found that allocating property rights is one way to stop market failures from happening. This is called Coase Theorem.
The absence of property rights can lead to market failure.
40
What are the positive externalities of higher education?
Social cohesion & cultural values
Crime reduction
Economic growth
41
What is social cohesion & cultural values (as a positive externality) due to education ?
Everyone in a society learning to get along with one another, mixing at school and having a shared knowledge base should have a positive impact on cohesion in a society.
42
What is crime reduction (as a positive externality) due to education ?
Crime reduces other people's welfare.
Moretti's (2001) research found that people with higher levels of education were more likely to vote and less likely to be involved in crime.
43
What is economic growth (as a positive externality) due to education ?
Economic growth involves using the same inputs to create more or higher quality outputs. This should benefit everyone. In the UK, someone with a median income probably lives better than the Queen 100 years ago.
Krueger & Lindahl (2001) find that people receiving better education is associated with faster economic growth.
Barro & Sala-i-Martin (1995) completed statistical analysis that found that a 1% rise in spending on education as a % of GDP led to a 0.15% increase in economic growth.
44
What is the negative externality in education ?
The signalling hypothesis
The signalling hypothesis outlined by Spence (1974) argues that education could be a signal.
If an employer cannot observe a person's ability or intelligence, they instead observe their education as a signal.
Harmon et al (2004) found 'little' support for the signalling hypothesis. However, if the signalling hypothesis were true everyone would be forced to get an education, even if it didn't add that much value.
45
In the signalling hypothesis of education, why do people get education ?
Because other people have education not having it is a bad signal
Because employers can’t observe talent or intelligence
46
What are public goods ?
Public goods are not provided by the free market and government intervention is needed to change this missing market.
47
What are the characteristics of public goods ?
Non-rivalry: if one person consumes a good this doesn't stop another person from consuming it.
E.g one person gaining benefit from a street lamp doesn't stop another person from gaining benefit from it.
Non-excludable: someone not paying for a good doesn't affect their ability to consume it.
E.g not paying for a streetlamp doesn't mean you can't see when you walk down a street at night.
48
What are private goods ?
Private goods exhibit both excludability and rivalry.
E.g a phone is a private good.
If I purchase a particular phone, that means someone else cannot have that phone (rivalry).
If I do not pay for the phone, I cannot have the benefits of the phone (excludable).
49
What are quasi-public goods ?
Quasi-public goods
A public good can start to have private characteristics and become quasi-public.
E.g putting a tollbooth on a road makes it excludable, and so a quasi-public good.
50
Why don’t the private sector provide public goods ?
The free-rider problem
The private sector rarely provides true public goods (as there is little financial incentive to).
The government must intervene and decide the suitable quantity of public goods for society. To do so, the government has to guess the marginal social benefit (which may be inaccurate).
51
What is the free rider problem ?
It is impossible to exclude the benefits of a public good from someone.
As a result, people that don't pay for the product will receive the same benefit as those that do.
This disincentivises people from producing a good in the free market because of the free riders who receive the benefit without paying.
This is a market failure.
It is hard to price a public good.
Producers may overvalue the product and consumers undervalue.
This further discourages the production of public goods in the free market.
52
What is asymmetric information ?
A situation of asymmetric information happens when both parties in a transaction have an unequal amount of information.
Asymmetric information can cause a decline in prices or quantity of products sold.
53
What is the lemons problem (asymmetric information) ?
Consider Marvin, who is buying a used car from a dealership.
The car could either be a 'lemon', which is a defective vehicle, or a high quality vehicle. Because of asymmetric information, Marvin does not know which the car is.
This is called a misallocation of resources.
This limits his ability to make a rational choice and pay the appropriate price for the car.
54
What does imperfect information cause ?
It can discourage buyers and sellers from participating in the market.
55
What is a thin market ?
If buyers and sellers are discouraged from participating in the market, there will be fewer active in the market
56
What is a thick market ?
If there are many buyers and sellers, it's called a thick market
57
Why does imperfect information distort price signals ?
Buyers with imperfect information often think that price signals product quality.
E.g A Michelin-starred restaurant selling expensive food is often assumed to be of better quality than a cheaper alternative, like McDonalds.
When buyers use market price to make assumptions about quality, markets can struggle to reach an equilibrium price and quantity.
58
What are merit goods ?
Consumers take into account only the private benefit.
If they had perfect information, they might realise the additional benefits a merit good can bring.
E.g they may realise how beneficial education is.
59
What are demerit goods ?
Consumers only realise the private gain.
If they had perfect information, they might realise the negative effects consumption of the good can bring.
E.g consumers may not realise the effect smoking can have due to imperfect information.
60
Food for thought
Think tanks in the UK have argued that there should be a 'red meat' tax.
What sort of specific market failure might this be aimed at?
Negative consumption externality
61
EU fishing directives aim to limit the amount of fishing in European waters.
Why is overfishing a form of market failure?
Absense of property rights
62
Why is the government provision of education not a public good?
People can be excluded from education
Private sector provides some education
63
Thames Water Utilities
Thames Water Utilities manages sewage disposal for parts of the UK. It was revealed in 2004 that they let untreated sewage flow into the Arford stream, three lakes, and Hampshire - killing all the marine life.
Explain why the Thames Water Utilities incident is an example of market failure and externalities.
Define market failure
Market failure happens when the price mechanism fails to efficiently allocate the scarce resources to where they are best suited.
Define externalities
Externalities are the effects that producing or consuming goods have on other third parties or society as a whole. Buyers or producers do not consider externalities when making decisions.
Explain the production externality
Thames Water Utilities did not have to consider the social costs, but only the private costs during waste disposal.
The pollution to natural water had a social cost greater than the private cost. This was not internalised in the market mechanisms.
The firm therefore did not have to consider the impacts on society which resulted in a deadweight loss and misallocation of resources.
64
What are reasons for governments intervention ?
Underconsuming merit goods
Overconsuming demerit goods
Irrationality
Meeting basic needs
65
Why does under consuming merit goods cause government intervention?
Governments may want people to consume more things like education, which have positive externalities.
66
What are ways the government intervene to encourage consumption of merit goods ?
Subsidies
free state provision
67
Why does over consuming demerit goods cause government intervention?
Demerit goods like cigarettes may be over consumed and cause negative externalities
68
What are ways the government intervene to discourage consumption of demerit goods ?
Taxes
bans
69
What are ways the government intervene to decrease irrationality?
The UK government has a Nudge unit, which implies that consumers may not be rational agents and need guidance.
70
Why does over the inability of consumers to afford basic needs cause government intervention?
In a market-based economy, a consumer's ability to consume goods and services depends on their income and wealth.
If a consumer has a low income, they may not be able to afford basic goods to satisfy their needs.
The market is under-providing these goods and this can be a source of market failure.
71
How is smoking a form of market failure ?
People are unaware of the negative impact of cigarettes on their health.
The negative externalities of smoking are not considered by consumers.
People may not be rational (they may be myopic or short-termist
72
How can the government attempt to internalise the externality of smoking ?
Governments can implement an indirect tax on goods.
E.g a tax on cigarettes.
This raises the cost of production, shifting the supply curve towards a more socially optimal level.
An indirect tax can either be specific, which is a parallel shift in the supply curve, or ad valorem, which is a non-parallel shift.
73
What’s an indirect tax ?
An indirect tax is a tax on household spending and consumption and is applied to goods and services
74
What can governments pay producers to help keep the price of products low ?
subsidies
75
How can subsidies correct market failure ?
by encouraging the consumption and production of a good with positive externalities.
This is represented on the diagram by a shift to the right in supply, toward a more socially optimal level.
76
What are the advantages of subsidies ?
Subsidies can reduce the cost of a product and allow a firm to exploit economies of scale.
This will improve long-run efficiency and competitiveness abroad.
Consumer preferences may change as a result of a subsidy.
77
What are the disadvantages of subsidies .
Subsidies may encourage laziness from producers because they do not need to be as efficient.
There is also an opportunity cost to a subsidy.
Elasticity of demand determines how effective a subsidy is.
Subsidised goods may be of a lower standard than alternatives they're trying to replace.
78
What are ways Governments can influence supply and demand ?
by enforcing maximum and minimum prices
79
What is a minimum price ?
A minimum price can be used to correct failures that can happen under monopsony power.
If the new minimum price is below equilibrium, there will be no change.
If the new minimum price is above equilibrium, there will be less demand but increased supply, leading to excess supply.
80
What is a maximum price ?
A maximum price is a policy to increase consumption levels of a good.
If the new maximum price is above equilibrium, there will be no change.
If the new maximum price is below equilibrium, there will be more demand but a shortage of supply, leading to excess demand.
So although more people can now afford the good, less people can have it as the supply is restricted.
This might lead to the good being sold in a black market.
81
What are the advantages of a minimum price ?
By having a minimum price, suppliers can get a reasonable price for their goods.
82
What are the disadvantages of a minimum price ?
Consumers will be paying more for their goods.
Resources are wasted when excess goods are destroyed.
Resources are allocated inefficiently - they could have been used elsewhere instead of producing excess supply.
Potential high opportunity cost, because governments could spend on other schemes.
83
What are the advantages of a maximum price ?
This protects consumers from exploitation.
It could make sure that firms are more efficient by forcing them to pay more attention to costs
84
What are the disadvantages of a maximum price ?
A maximum price could deter firms from entering the market.
It could also limit investment into the industry as the amount of profit firms can make is limited.
Firms could cut costs too aggressively in an attempt to boost profit, leading to poor quality goods, etc.
85
Why are trade pollution permits allocated to businesses ?
in an attempt to control pollution levels
86
What are the benefits of trade pollution permits ?
This system can put a cap on the level of pollution.
The lower the pollution of a firm, the more they can benefit. This encourages firms to lower their pollution levels.
Governments make revenue.
87
What are the disadvantages of pollution permits ?
There is a cost to implementing the scheme.
Deciding on the level of pollution is difficult.
The market for permits is subject to failure also
88
What are pollution permits ?
Governments can set an optimal limit on pollution by allocating permits to firms.
These permits can be traded through the price mechanism.
The European Union emissions trading system (ETS) is a way to do this. EU member governments are issued with permits to allocate to firms.
The ETS annually cuts the number of permits. This incentivises firms to reduce emissions because they may be forced to buy more permits for not doing so.
89
What is regulation ?
Regulation involves setting rules that firms must comply with. These rules are imposed by the government to try and correct market failures.
90
What is deregulation ?
These rules are imposed by the government to try and correct market failures. Deregulation is a loosening of these rules.
91
What are the benefits of regulation ?
Regulation can correct market failures that arise from externalities.
E.g regulation can be imposed to limit the level of pollution firms make.
Regulation can control monopolies and stop them from taking advantage of customers and reducing welfare.
Legislation provides a means of punishing firms for their anti-competitive behaviour.
Regulation can be used to protect the environment
92
What are the costs of regulation ?
It's hard to know which industries to regulate, and how to regulate them. This often needs a value judgement.
E.g what level does the government set for firm pollution? Why that particular level?
It can be expensive to monitor firms to enforce regulation, and there is an opportunity cost attached to this.
It can be expensive to follow regulations. Some firms may end up closing down or relocating because of high costs.
93
What are the benefits of deregulation ?
The allocation of resources will improve as the government will reduce their interference with the free market.
By reducing the bureaucracy associated with legislation, efficiency will improve.
94
What are the costs of deregulation ?
Customers are no longer protected from the anti-competitive behaviour of firms and might lose out.
There are some market failures it cannot fix, such as the problem with externalities.
E.g deregulation of industries may lead to an increase in pollution because of the tragedy of the commons.
Some natural monopolies need regulation.
E.g sewage services.
95
What are the issues with pollution permits ?
The emissions scheme only included flights between EU nations and not to nations outside the EU.
Comparative advantage turned against industries that have lots of carbon emissions. These industries may have moved their operations out of the EU to other markets, losing EU jobs and GDP growth.
The price of the permits in the marketplace has been volatile (unstable). Because of the lack of certainty that this creates, businesses may invest less in long-term alternatives to emissions-intensive production processes.
96
How much did the amount of pollution permits granted under ETS decline by in 2013?
1.7%
97
Who claimed that climate policy was still very minor in influencing businesses' investment decisions?
Laing et al (2013)
98
Who found that the EU power sector got huge windfall profits from the pollution permit scheme?
Lise et al (2013)
99
What is state provision or nationalisation?
The government either provides state provisions itself (e.g. state education) or provides free goods or services to the public that it's bought from the private sector (e.g. private health services offered free to NHS patients)
100
How does the government fund state provision ?
The government pays for goods/services through tax revenues. It then offers them to the public for free
101
What are examples of things that are nationalised/state provided ?
The National Health Service (NHS).
Police service.
Secondary school education.
102
What are the advantages of state provision?
State provision can reduce inequality by redistributing money from the wealthy to the poor. This is something the market doesn't always do.
Without state provision, some services might not exist as they aren't profitable.
E.g. some train routes that aren't profitable do not exist.
Value judgements need to be made about what the state can and can't provide well.
103
What are the disadvantages of state provision ?
Without a drive for profit, there is less incentive to make a service as efficient as possible. The economic incentives for efficiency could be eroded.
There is an opportunity cost of providing one service over another.
With asymmetric information, there is a risk of government failure.
104
How is the diphtheria vaccine a historic attempt by the UK government to improve market outcomes, welfare and market failure by spreading information ?
The diptheria vaccine was introduced in 1942. Before then it killed around 3,500 children each year.
Diptheria was a bacterial disease that could cause heart failure and paralysis.
People feared that wartime conditions would make diptheria more common, so the government introduced and advertised the vaccination (in newspapers, radio and posters).
105
How is the polio vaccine a historic attempt by the UK government to improve market outcomes, welfare and market failure by spreading information ?
Polio is caused by a virus and can cause paralysis. It attacks the body's nervous system and blood.
Polio caused up to 750 deaths and thousands of disabilities each year.
The polio vaccine was introduced in 1956 and a campaign to vaccinate everyone under 40 was launched.
By 1980, polio had been almost eradicated in Britain.
106
How are health campaigns a historic attempt by the UK government to improve market outcomes, welfare and market failure by spreading information ?
The government tried to improve people's health choices in the second half of the 20th century.
The Change4Life campaign was launched in 2009. It tried to improve people's diet and encourage exercise. Obesity has risen in the UK and it causes lots of health problems.
The consumption of alcohol has risen in the last 50 years. The government's 2004 Drinkaware campaign aims to reduce drinking.
These interventions are very different to the laissez-faire policies of UK governments 100-300 years ago.
107
What is government failure ?
Government failure is the unintended worsening allocation of resources as a consequence of a policy the government has implemented to correct a market failure. It produces a net welfare loss.
108
What are the causes of government failure ?
Administrative costs
Inadequate or imperfect information
Bureaucracy
Misallocation of resources
109
How are administrative cost a cause of government failure ?
Resources are needed to implement government intervention.
If the cost is too high, the intervention may not be worthwhile.
Daniel Kahneman's inside view explains why governments may frequently underestimate the cost of their projects. The Scottish parliament in Holyrood was forecast to cost £10-40M but cost £414M.
110
How is inadequate or imperfect information an example of government failure ?
In a world of perfect information, governments should be able to make the right decisions to improve allocation.
Asymmetric information limits the governments ability to critically assess market failures and possible solutions.
So the right decision isn't always made and government failure can arise.
111
How is bureaucracy an example of government failure?
The private sector has the incentive to maximise profits, but individuals working for governments rarely get the benefits.
Governments are also very large and may suffer from material diseconomies of scale.
112
How is a misallocation of resources an example of market failure ?
Government failure is the result of a policy trying to correct a market failure that has led to a misallocation of resources.
This means there is a welfare loss to society.
E.g the council might charge people for some forms of waste disposal.
This may increase fly-tipping, which is a worsening of the initial pollution externality.
113
How does government failure lead to conflicting policy objectives ?
In trying to satisfy one objective, others can be compromised.
E.g macroeconomic policy objectives often clash with environmental policy.
By causing firms to cut down on emissions, you may be limiting their potential growth, which is bad for the economy.
Politicians may be influenced by what's politically acceptable or unacceptable.
E.g governments won't ban car use to try to cut down on greenhouse gas emissions because people rely on cars for convenience.
114
How does government failure lead to market distortions?
Market distortions can affect the way the price mechanism works. These can be caused by government intervention. For example:
Income taxes give people less incentive to work hard, which reduces efficiency.
Subsidies may allow firms to make profit without being efficient. This is distortionary.
Minimum and maximum price controls can distort price signals (e.g overproduction because producers can guarantee a minimum price).
115
A group of coffee growers are complaining about price volatility. The government decides to intervene and set a minimum price to guarantee their incomes.
Evaluate the government's decision to implement a minimum price
Government intervention is where the government steps in to correct market failure and improve the allocation of resources. A minimum price is a price floor from which prices cannot fall below.
Minimum pricing can ensure that the coffee farmers do not suffer from price volatility and so it can stabilise their income. This occurs because agricultural markets face both inelastic supply and demand curves. The minimum price will prevent the farmers from leaving the
However, minimum prices can distort the market. It may encourage farmers to overproduce if they know they can get a guaranteed price. Also, the strategy would either require government subsidies to make up the difference, which costs the taxpayer, or higher prices for consumers which harms their surplus welfare.
The minimum price overall depends on where it is set. If the government sets it below the equilibrium, then the farmers will still see volatility. It will likely be hard for government officials to decide on the right price for coffee for the farmers.
