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2.8 (Part 2) The market mechanism, market failure and government intervention in markets. 2.0 (Created 6th April 2017)
Terms in this set (57)
With regards to information, what is assumed about a competitive market?
In a competitive market, it's assumed that there's perfect information, also known as symmetric information.
That means that buyers and sellers are assumed to have full knowledge regarding prices, costs, benefits and availability of products.
Is symmetric information advantageous for markets, and does it exist?
-Assuming buyers and sellers are rational in their behaviour, this symmetric information will allow efficient allocation of resources in and between markets.
-However symmetric information rarely exists,
E.g. Buyers don't have the time or resources to obtain full information on prices before buying a product.
What is asymmetric information, and give examples of asymmetric information for the buyer and the seller?
-Asymmetric information is where one party has more information in a transaction.
-Usually sellers have more information on a product than buyers. For example, a car salesman will have more information about the history of a car they're selling than a prospective buyer.
-Buyers may have more information than sellers. For example, an an antiques collector may know more about the value of an antique than the person selling it.
-When people take risks because they won't suffer the consequences themselves if things go wrong.
-For example, an individual could buy home insurance, by then behave recklessly (not lock the door), safe in the knowledge their covered. This can happen because the insurance provider lacks information about how the individual is acting.
Explain four reasons why imperfect information affects the consumption of merit and demerit goods?
-Consumers may not know the full benefit of a merit good. They may not realise that a good education could lead to improved future earnings, or that a regular medical check-up might improve their lifespan.
-Consumers may lack the information to decide which good or service is right for them.
-Consumers may not have the information on how harmful a demerit good, such as alcohol, can be.
Why does imperfect information affect provision of merit and demerit goods?
-Pension providers have a greater knowledge of the pension schemes available than their clients- this can lead to selling unnecessary schemes or more expensive schemes than may be needed.
-Doctors have a greater knowledge of medicine-They may persuade their client to purchase more expensive care than is required.
-Information on a good/service may be to complex to understand, e.g. the technical differences between computers may be confusing to a consumer, so they might struggle to work out which is best for their needs.
What is the difference between income and wealth?
-Income is the amount of money received over a set period of time, which can come from many sources, such as : wages, interest on bank accounts, dividends from shares and rents from property.
-Wealth is a stock concept,- the value in money of the assets held.
What is the problem with high levels of inequality and wealth distribution?
-In an economy, there can be people who are starving, whilst others have very high levels of income and wealth.
-Inequality can lead to differences in access to resources. People with very low income and wealth may not be able to afford vital resources and services, e.g. education. As a result, these people will continue to have low income and wealth as they will struggle to get a good job.
What is Inequality caused by?
How is unequal distribution of income and wealth a consequence and a cause of market failure?
-It is a consequence as free market has led to the inequitable distribution of income and wealth.
-However it is also a cause because, some people don't have the income and wealth to pay for the things they need, so resources won't be allocated efficiently.
What is the argument for government redistribution and how may they do this?
-The argument is that the benefit to a poor person of an additional £1 of income would be greater than the loss to a rich person who paid £1 extra tax.
-Government redistribution is done by government intervention. The level of redistribution undertaken by the government is a political decision based on value judgement.
-Some people argue redistributing income reduces the incentives for individuals and firms to work hard. These incentives are needed to encourage inefficiency within the market, and not having them may cause greater market failure.
What are the reasons for geographical immobility?
-Large house-price, rent and cost-of-living differences can make it very difficult for people to move areas to obtain work.
-There may be high costs involved in moving house.
-A reluctance to leave family or friends.
-A dislike of change.
-Imperfect information about the jobs available in different areas.
What are the reasons for occupational immobility of labour?
-Lack of education, training and skills required to do different jobs.
-Lack of required qualifications or required memberships of a professional body (e.g. doctors have to be registered with the General Medical Council).
-Lack of work expieriance.
How do immobile factors of production lead to market failure?
-Immobile factors of production means there's often inefficient use of resources- they are often unused or underused. The inefficiency in allocation of resources means there's a market failure.
How could government's improve labour mobility?
-To improve geographical mobility governments could offer relocation subsidies or mortgage relief to make moving to a particular area more affordable for workers.
-Governments could also offer incentives to encourage the construction of housing in areas where it's needed to provide homes for workers.
-To improve occupational mobility governments could provide more training programmes to increase people's skill.
What is a pure monopoly and what is monopoly power?
-A pure monopoly is a market with one supplier. However, markets with more than one supplier will also be referred to as a monopoly if one supplier dominates the market.
-Monopoly power is the ability of a firm to influence the price of a particular good in a market.
-A firm with monopoly power can control the supply of a good to influence its price- the firm is able to be a 'price maker'.
How do monopolies cause market failure or a misallocation of resources?
-By restricting output monopolies can fail to exploit some economies of scale. This means productive efficiency isn't achieved and the firm isn't producing output at the lowest point on its average cost curve.
-Monopoly firms can also experience higher costs of production than firms that exist in a competitive market- this can be because monopolies have less of an incentive to innovate to make production methods efficient as possible. They may also have no incentive to cut costs as there price makers.
-Market failure will be caused by the effects monopolies have on consumers. Consumer choice is restricted because there are fewer products to choose from, and monopolies won't necessarily react to the wants and needs of consumers because they can set their own prices.
How can monopolies bring benefits to an economy?
-In some markets the most efficient way if allocating resources is to have one producer who can exploit economies of scale.
-Thus, they can pass on the cost savings to their customers, who are able to take advantage of low prices. This will also help their international competitiveness.
-Monopolies can use their profits to research new production methods and products. This can lead to innovation and better products being made available for customers.
- These are fixed amounts charged per unit of a particular good, no matter what the price of that good is.
-For example, a set amount of tax could be put on bottles of wine regardless of their price.
Ad valorem taxes
-These are charged as a proportion of the price of a good.
-For example, a 20% tax on a price of a good would mean for a £10 products it's £2 and for a £100 product it's £20.
How is a specidfic tax and an ad valorem tax represented on a supply curve?
-A specific tax causes a parallel shift if the supply curve.
-Qn ad valorem tax causes a non-parallel shift of the supply curve, with the biggest impact being on higher priced goods.
How do governments use taxes?
-Governments often put indirect taxes on goods that have negative externalities, such as petrol, alcohol and tobacco.
-The aim is to internalise the externality that the good produces, I.e. makes the consumer or producer cover the cost of its externalities.
-The tax makes revenues for the government which can be used to offset the effects of the externalities, e.g. the revenue generated from tax on alcohol could be used to pay for the additional police time needed to pay for alcohol related crime.
How does the government use landfill tax?
-Local authorities or firms that dispose of waste at landfill sites are charged an environmental tax.
-This tax is set at an amount which attempts to reflect the true social cost of using landfill, for example the external cost linked to the burying of waste in landfill, such as pollution.
-The tax should encourage recycling, which in turn reduces negative externalities caused by landfill that harm the environment.
-However, the tax has led to an increase in fly-tipping by firms to avoid the tax.
What is the benefit of using a tax?
-The cost of the negative externalities is internalised in the price of a good- this may reduce demand for the good and the level of the production, reducing the effects of the negative externalities.
-If demand isn't reduced, there's still the benefit that the revenue gained from the tax can be used by the government to offset the externalities- e.g. tax on cigarettes could be used for funding government services to help people stop smoking.
What is the disadvantages of using a tax?
-It can be difficult to put a monetary value on the 'cost' of the negative externality.
-For goods where the demand is price inelastic, the demand isn't reduced by the extra cost if the tax.
-Indirect taxes may increase the costs of production, which reduces a product's international competitiveness.
-Firms may choose to relocate and sell their goods abroad to avoid the indirect taxation. This would remove their contributions to the economy, such as payment of tax and the provision of employment.
-The money raised by taxes on demerit goods might not be spent on reducing the effects of their externalities.
How may a government use a subsidy?
-The government's may pay subsidies with the aim of encouraging the production or consumption of goods and services with positive externalities, e.g. merit goods.
-Subsidies can be used to encourage the purchase and use of goods/services which reduce negative externalities, e.g. public transport (to reduce pollution), or as support for firms to help them become more internationally competitive.
What are the advantages of a subsidy?
-The benefits of goods with positive externalities is internalised, I.e. the cost of these externalities is covered by the government subsidy.
-Subsidies change preferences-Making a merit good cheaper by the presence of a subsidy makes it more affordable and increases demand for it.
-The positive externalities are still present. For example, if a subsidy is paid for wind farms, the wind farms will still reduce pollution levels.
-Subsidies can support a domestic industry before it grows to a point that it can exploit economies of scale and become internationally competitive.
What are the disadvantages of a subsidy?
-It can be difficult to put a monetary value on the 'benefit' of the positive externalities.
-Any subsidy has an opportunity cost-The money spent on it might be better spent on something else.
-Subsidies can make producers inefficient and reliant on subsidies. The subsidy means producers have less of an incentive to reduce costs and innovate.
-The effectiveness of a subsidy depends on the elasticity of demand- subsidies wouldn't significantly increase demand for inelastic goods.
-The subsidised goods and services may not be as good as those they're aiming to replace. For example, imported goods may be better quality than the domestically produced alternatives the subsidy is promoting.
What is a maximum price (price ceiling) , and how would you implement it to ensure it worked?
-A maximum price may be set to increase consumption of a merit good or to make a necessity more affordable.
-If a maximum price is set above the market equilibrium price, it will have no impact.
-If it's set below the market equilibrium, it will lead to an excess in demand and a shortage in supply. The excess demand can not be cleared by market forces, so to prevent shortages the product needs to be rationed out, e.g. By a ballot.
What is minimum price (price floor), and how would you implement it to ensure it worked?
-Minimum prices are often set to ensure suppliers get a fair price. The European Union's Common Agricultural Policy involves the use of guaranteed minimum prices for many agricultural products.
-If a minimum price is set below the market equilibrium, it will have no impact.
-If it's set above the market equilibrium, it will increase demand and increase supply, leading to excess supply.
-To make a minimum price for a good work the government must purchase the excess supply at the guaranteed minimum price. The good bought by the government will either be stockpiled or destroyed.
What are the advantages and disadvantages of a maximum price?
-They increase fairness, by allowing more people the ability to purchase certain goods and services.
- They can also be used to prevent monopolies from exploiting consumers.
-Since demand will be higher than supply, some people who want to buy the product aren't able to.
-Governments may want to introduce a rationing scheme to allocate the goods, e.g. Through a ballot.
-Excess demand can lead to the creation of a black market for a good.
What is the advantages and disadvantages of using a minimum price?
-They restrict monopsony power and they will provide a guaranteed price for suppliers and ensure that a firm that's a monopsony buyer can't keep negotiating lower prices.
-Producers have a guaranteed minimum income which will encourage investment.
-Consumers will be paying higher prices than the market equilibrium.
-Resources used to produce the excess supply could be used elsewhere- there's an insufficient allocation of resources.
-Government spending on a minimum price scheme could be used in other areas- schemes may have high opportunity cost.
-State provision is where the government provides certain goods and services.
-Governments use tax revenues to pay for certain goods and services so that they're free, or largely free when consumed.
-Examples: NHS, waste disposal and public goods such as defence and street lighting.
-The government can purchase the good or service from the private sector and provide it to the public for free, e.g. In some areas community health services are purchased from private companies and provided free to NHS patients.
Why is state provision a way to overcome market failure (advantages)?
-Governments might provide certain things to increase the consumption of merit goods, such as education and health.
-Free provision of services can help to reduce inequalities in access, e.g. due to differences in wealth.
-It can also redistribute income- most of the money to pay for the service comes from taxing wealthier citizens.
What are the disadvantages of state provision?
-State provision may mean there's less incentive to operate efficiently due to the absence of a price mechanism.
-State provision may fail to respond to consumers demand, as it lacks the motive of profit to determine what's supplied.
-The opportunity cost of state provision of a good or service is that other goods and services can't be supplied.
-State provision can reduce individuals' self-reliance- they know The good or service is there for them if they need it.
What are the advantages and disadvantages of the NHS system (state provision of healthcare)?
-The government funds the NHS so that society benefits from the positive externalities of healthcare.
-This contributes to a healthier, happier population, and reduce the number of days people take off work due to sickness.
Drawbacks to the state provision of healthcare by the NHS?
-Demand for healthcare has increased dramatically since the NHS was introduced. As the NHS,mis free at the point of delivery, this has led to excess demand and problems like long waiting lists.
-Hospitals and clinics can be wasteful of resources, such as money wasted on unused subscriptions.
-The NHS may not always respond to the wants and needs of the patients, e.g. local NHS officials might relocate medical services against the wishes of the population in the area for cost-saving reasons.
-NHS reduces patients' self-reliance,- e.g. it can reduce the incentive for patients to deal with medical issues themselves. For example going to a doctor for a throat problem that can be felt with by buying medicine in a shop.
Explain a pollution permits work?
-The government sets an optimal level of pollution and allocates permits that allow firms to emit a certain amount of pollution over a period of time.
-Tradable pollution permits use the market mechanism-Pollution is given a value and firms can buy and sell permits.
-Firms will be fined if they exceed their allowances, but firms can buy extra permits to cover extra emissions.
-Each year the number of allowances available is reduced. This gives the firm an incentive to lower their emissions.
Give an example of pollution permits being used? (Case study)
-The EU commission trading system (ETS) is a tradable pollution permit scheme, with permits called emission allowances.
-These allowances (of greenhouse gas emissions) are distributed between the EU's member governments, who in turn allocate their allowances to firms.
-Firms in the ETS are allowed to invest in emission-saving schemes outside of the EU ago offset their own emissions. For example, a U.K firm could invest in low-carbon power production in India to offset some of it's emissions in the UK.
Advantages of pollution permits?
-Reduce pollution to an acceptable level, as they encourage firms to be more efficient and pollute less.
-Firms causing low levels of pollution will benefit from these schemes,-They can sell permits, allowing them to invest more and expand.
-Governments can use any revenue, e.g. from fines, to invest in other pollution reducing schemes.
-Schemes internalise the externality of pollution.
Disadvantages of pollution permits?
-Optimal pollution level can be difficult to set- Too high- firms have no incentive to lower their emissions. Too low- new firms might not be able to start up at all, or existing firms may relocate.
-Pollution per,it schemes create a new market- thus, there may be market failure.
-High levels of pollution in specific areas may still exist, and this would still be harmful to the environment.
-Regulatory capture if too many per,it's are sold.
Extension of property rights.
-More ownership over the environment, so owners can charge producers and consumer for using the property and sue if permission hasn't been granted.
-Negative externalities have been internalised by the extension of property rights, as a value has been put on the property.
-For examples, if a chemical company pollutes a river it must increase it's prices in order to pay compensation. Money raised by charging the polluter can be used to reduce the effects of the negative externality.
What are the problems associated with extending property rights?
-It can be difficult. For example, EU rules allowed boats from other EU countries to fish in UK waters, stopping the allocation of property rights over these waters by the UK governments.
-Externalities can affect more than one country. For example, deforestation in Malaysia could impact the whole world by contributing to climate change, but the UK can't extend property rights to Malaysia.
-It's difficult for the owners of a property to put a a value on its use.
-There are often difficulties in tracing the source of the environmental damage. For example, a chemical leak into a river could kill fish in a farm a great distance from the source of the leak. Hence, may not have the information to demand compensation for the firm responsible.
What is government information provision?
-They try to provide information on the full costs and benefits off goods and services. This information is given to try to help consumers make rational choices and prevent market failure from asymmetric information.
-Examples include: School and hospital performance league tables, compulsory food labelling for most foods, advertising campaigns encouraging healthy eating and health warnings on cigarette packs.
-Provision of information will impact the demand for goods. Government will try and increase demand for merit goods and decrease demand for demerit goods.
-Effectiveness of government information provision can be questioned. For example, the growing obesity problem in the UK suggests that the government's healthy eating campaigns aren't having a significant impact on the public.
What are the advantages of nationalisation?
-Governments can ensure a nationalised industry better provides the goods and services the country needs.
-Governments can set the output and prices of an industry at a level that most benefits society.
-Governments can pay public sector workers a fair wage.
-Nationalised industry has greater economies of scale than an industry populated by several private firms.
Why do nationalised industries tend to be inefficient?
-They're not driven to reduce costs and make profit.
-There's little incentive for a nationalised firm to aft prudently, as the firm knows governments and tax payers will bail them out if they get into trouble.
Explain what is meant by government failure?
-Government failure is when government intervention causes a misallocation of resources in a market.
-Government failure is often an unintended consequence of an intervention to correct a market failure.
Example of government failure?
-Local authorities can charge for non-household waste disposal, e.g. some county councils charge for the disposal of DIY waste. This is an attempt to force waste producers to internalise the externalities of waste disposal.
-However, there's evidence that this has led to an increase in fly-tipping. The fly-tipping produces negative externalities for local residents.
-In this instance the intervention that aimed to reduce the negative externalities linked to waste disposal has resulted in the production of it her unintended negative externalities.
How does government intervention cause market distortions?
-Income taxes act as a disincentive to working hard- if you increase your earnings by working hard them you'll have to pay more income tax.
-Maximum and minimum prices can lead to the distortion of price signals. For example, producers will overproduce a product if they'll receive a guaranteed minimum price for it and flood the market with surplus goods.
-Subsidies may encourage firms to be inefficient by removing the incentive to be efficient.
How can government bureaucracy interfere with the way the market works?
-Governments has lots of rules and regulations, often referred to as the red tape.
-Red tape can interfere with the forces with supply and demand,- it can prevent markets from working efficiently.
-For example planning controls can create long delays on construction projects. If these delays affect housing developments then this could restrict supply for the housing market.
How are conflicting policy objectives a source of government failure?
-If Governments introduces stricter emission controls for industry, this would contribute towards its environmental objectives.
-However, it may increase costs for firms and reduce their output, causing unemployment and a fall in economic growth.
-Politicians are constrained by what is politically acceptable. For example, it's unlikely the UK government would ban the use of private cars to reduce greenhouse gases because of the idea's political unpopularity.
How can government failure be caused by inadequate information?
-Asymmetric information means it is difficult to assess the market failure. For example, an incorrect evaluation of a market failure might lead to taxes or subsidies being set at a inefficient level.
-Governments may not know how a population wants resources to be allocated. Some economists would argue the the price mechanism is better way of allocating resources.
-Governments don't know how consumers will react. For example, discouraging under 18s to drink alcohol, may lead to alcohol being viewed as desirable and increase drinking by this age group.
-Firms covered by regulatory bodies, such as utility companies, can sometimes influence the decisions of the regulator to ensure that the outcomes favour the companies and not the consumer.
What is CAP (Common Agricultural Policy)?
-Main aim of CAP is to correct market failure caused by fluctuating prices for agricultural products.
-To achieve this CAP uses measures such as subsidies and buffer stocks. They also use import restrictions on goods from outside the EU, e.g. Tariffs.
-The CAP has resulted in distortions in agricultural markets- it has encouraged over supply, leading to a misallocation of resources.
What problems have CAP caused?
-CAP encourages increased output as farmers are guaranteed a minimum price for all that they produce. Increased output results in environmental damage from a greater use of intensive farming methods and chemical fertilisers.
-Minimum price: resulted in oversupply of agricultural products, which have to be bought and stored by government agencies at great expense. Governments have sold these stocks at low prices outside the EU, negatively affecting global farmers who can't compete with the low prices.
-Increased food prices caused by the CAP are particularly unfair on poorer households who spend a large proportion of their income on food. Arguably, welfare gains to farmers brought about by CAP, are smaller than the size of the welfare loss to consumers.
-CAP makes exports from non-EU countries less competitive, as products from non-EU countries are subject to import tariffs.
Case study on government intervention into the housing market, by setting maximum rents?
-Maximum rents are used by the government to protect tenants from excessive rental charges. However this causes a shortage of rental properties as there is excess demand for them.
-The excess demand for rental properties could lead to a shortage of available properties and cause a black market to develop. In a black market people will end up paying more than the maximum rent level.
-Shortage of rental properties can also impact the supply of workers. People may not be able to find somewhere to rent near where they work.
How may governments provide subsidies for public transport?
-Bus and train journeys may be subsidised to reduce car usage and pollution levels.
-Subsidies do not always lead to an increase in passenger numbers. Bus transport is often viewed as an inferior good , so even if it's cheaper demand may not increase.
-Allocation of resources to public transport services that don't increase their usage and don't cause a reduction in pollution can be seen as a misallocation of resources and lead to a net welfare loss.
EU Fishing quotas Case Study.
-Fish quotas were introduced by the EU, in an attempt to make sure fish stocks remain stable in European waters.
-Fish quotas have been heavily criticised:
-Fish stocks are depleting even with quotas in place. This can indicate that quotas are too high and overfishing still takes place.
-Fishing boats that exceed their quotas often throw large amounts of dead fish back into the sea-these dumped fish are known as 'discards'.
-There has been poor monitoring of fish catches. Means fishing boats have been overfishing and it hasn't been detected.
-Problems with EU fishing quotas have led to a need for reform. One proposed change is called landing obligation. This means everything the fisherman catch must be kept on board and be counted against their quotas. However this is likely to be difficult to police, it would be a huge task to check every fishing boat hasn't discarded any fish at sea.
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