Microeconomics - Market failure

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Terms in this set (...)

Market failure
the failure of the market to allocate resources efficiently. Market failure results in allocative inefficiency, where too much or too little of goods or services are produced and consumed from the social optimum,
MPC
marginal private costs. Refer to costs to producers of producing one more unit of a good.
MSC
marginal social costs. Refer to costs to society of producing one more unit of a good
MPB
marginal private benefits. Refer to benefits to consumers from consuming one more unit of a good.
MSB
marginal social benefits. Refer to benefits to society from consuming one more unit of a good.
Allocative efficiency is achieved when...
MSC=MSB
A negative externality is created when social costs are _____ than social benefits
greater
A positive externality is created when social costs are ___ than social benefits
lower
Negative externalities of production (3)
refer to external costs created by producers.
MSC>MSB at Pm.
MSC is to the left of MPC(S).
example of a negative production externality is...
pollution
Ways to correct negative production externalities...(3)
-government regulations
-imposing a tax
-tradable permits
How do government regulations reduce negative production externalities? (3)
-limit the emission by setting a maximum level
-limit the quantity of output
-require polluting firms to install technologies
How do taxes work to reduce negative production externalities? (3)
shifts the supply curve up so MSC = MSB, reducing output. The tax is equal to the external costs. Provides incentive to change.
How do tradable permits work to reduce negative production externalities? (4)
-permits are bought and sold in a market
-demand for permits increases as output increases
-Incentive to reduce emissions to sell permits
-Reduces pollution, moving MSC down to MPC, increasing optimum output.
How do tradable permits work to reduce negative consumption externalities?
Permits to pollute are traded in a market, creating incentives to pollute less to sell permits.
Supply of tradable permits is...
perfectly inelastic (limited supply)
In general, correction of negative production externalities involves...
shifting MPC towards MSC, decreasing quantity produced to Qopt
Negative production externalities diagram
MSC shifted left, split from S
Negative externalities of consumption (3)
refer to external costs created by consumers.
MSC>MSB at Pm.
MSB is to the left of MPB(D)
example of a negative consumption externality is...
smoking
Demerit goods...(2)
are considered to be undesirable for consumers, but are over provided by the market. Creates external costs.
Ways to correct negative consumption externalities...(2)
-government regulations
-imposing a tax
How do government regulations reduce negative consumption externalities?
Restrictions and advertising have the affect of decreasing demand
How do taxes work to reduce negative consumption externalities?
Decreases supply so that if the tax = the external costs, MPC + tax intersects MSB at Qopt.
In general, correction of negative consumption externalities involves...(2)
-decreasing demand and shifting MPB curve towards MSB
-decreasing supply to Qopt
Negative externalities of consumption diagram
MSB has shifted left, split from D
Advantages of market-based policies (4)
-internalises the externality
-taxes on emissions is better than taxes on output as it is an incentive to reduce emissions
-taxes reduce emissions at a low cost
-incentives to consumers
Disadvantages of market-based policies (3)
-difficult to decide/quantify externality (technical difficulties)
-tradable permits: how to decide what is the maximum level (cap)
-some consumption externalities have inelastic demand
Advantages of government regulation (2)
-simple and practical
-force instead of incite
Disadvantages of government regulation (5)
-doesn't internalise the externality
-no market based incentives
-cost to government to implement
-advertising might not be effective
-doesn't completely nullify the externality
Positive externalities of production
refer to external benefits created by producers.
MSB>MSC at Pm
MSC(opt) is to the right of MPC(S)
example of a positive production externality is...
research and development
Correction of positive production externalities involve
shifting the MPC curve downward toward the MSC curve through direct government provision or by subsidies. For allocative efficiency to be achieved, the quantity produced and consumed must increase to Qopt as price falls to Popt.
Positive externalities of consumption
refer to external benefits created by consumers.
MSB>MSC at Pm
MSB(opt) is to the right of MPB(D)
example of a positive consumption externality is...
consumption of education
Correction of positive consumption externalities involve
either increasing demand and shifting the MPB curve towards the MSB curve through legislation or advertising;
or increasing supply and shifting the
MPC curve downward by direct government provision
or by granting a subsidy.
Merit goods
are held to be desirable for consumers, but are under provided by the market
Ways to correct positive production externalities (2)
-direct provision
-subsidies
Ways to correct positive consumption externalities (4)
-legislation
-advertising
-direct provision
-subsidies
Public goods (2)
are non-rivalrous and non-excludable
Private goods (2)
are rivalrous and excludable
Rivalrous
consumption reduces availability for someone else
Excludable
it is possible to exclude people from using the good (price mechanism)
Examples of public goods
police force, national defence, research, non-toll roads...
Examples of private goods
most goods, eg food
Free rider problem
occurs when people can enjoy the use of a good without paying for it
How does the lack of public goods indicate market failure?
There is an underallocation of resources to the production of public goods. Firms want to produce excludable and rivalrous goods to make a profit, so there is no incentive to produce public goods.
Some problems with direct government provision of public goods
-which public goods should be provided?
-how much of the goods?
-limited funds mean opportunity cost
-difficulty in calculating economic criteria as there is no price mechanism for public goods
-surveys can work, but unreliable
Common access resources
resources that are not owned by anyone, do not have a price and are available for anyone to use without payment. They are rivalrous and non-excludable
Examples of common access resources
ozone layer, air, fish in open seas
Describe sustainable resource use
resources should be used at a rate that allows them to reproduce themselves so that they do not become degraded or depleted
Why are common access resources overused and how does this threaten sustainability?
CARs are rivalrous and non-excludable, meaning that they can be depleted but anyone can use them as there is no pricing mechanism. This means that people take advantage of this and overuse CARs, leading to serious environmental degradation
Two main threats to sustainability
-overuse of common access resources (eg fossil fuels)
-over-exploitation of the land in poor countries
How does over-exploitation of the land in developing countries threaten sustainability? (4)
Lack of modern technology, scarce resources, lack of access to credit means no improvements to sustainability, high birth rates
Government responses to threats to sustainability (4)
-legislation
-carbon tax
-cap and trade schemes
-funding for clean technologies
Asymmetric information
refers to situations where buyers and sellers do not have equal access to information and results in misallocation of resources. Can go both ways
Example of asymmetric information
When the buyer knows more about their health than the seller of life insurance
Government responses to asymmetric information (3)
legislation, regulation, provision of information
Monopoly power definition
is the ability of a firm to control the price of a product
How does monopoly power lead to welfare loss? (4)
-higher price leads to
-social surplus is less than maximum
-underallocation of resources to the good
-production does not take place at lowest possible cost
Government responses to monopoly power (4)
-legislation
-regulation
-nationalization
-trade liberalisation