61 terms

Economics- Market Failure

Define allocative efficiency
When consumer satisfaction is maximised. Scarce resources are used to produce products that consumers actually want i.e. demand equals supply.
Define productive efficiency
When production takes place using the least amount of scarce resources i.e. production lies on the PPC.
Define economic efficiency
When both allocative and productive efficiency are achieved. Consumers get what they wanted and the fewest number of resources were used.
Define market failure
When a free market fails to achieve economic efficiency (i.e. both allocative and productive efficiency). Markets fail to take into account of external costs and external benefits.
What are the 3 reasons markets fail (without explanation)?
1. Information failure
2. When stakeholders lose out
3. When products are not made despite there being a demand for them
Define information failure
When a lack of information can result in consumers and producers making decisions that do not maximise welfare.
Give 2 examples of information failure
• Consumers are not aware of the benefits/harmful effects of a product.
• When persuasive advertising pushes up consumption levels when it is not in the best interest of consumers.
Define asymmetric information
Information not equally shared between 2 parties.
Give 3 examples of asymmetric information
1. Healthcare- doctors have more medical knowledge than us. We rely on them to give us proper care when we are ill.
2. Consumer purchases- when we buy a product the seller is likely to know more than us. Our purchase may be a bad choice as a result.
3. Insurance- as the purchaser you know a lot more about your behaviour than the insurer. The seller relies on your honesty in deciding whether to sell you a product.
What is meant by a third party?
Those not directly involved in making the transaction decision.
Social cost equals...
Private cost + External cost
For economic efficiency to be achieved what should the market price reflect?
Social cost (not just the private cost)
Social benefit equals... Would the socially optimum price be higher or lower than the free market price?
Private benefit + External benefit
Socially optimum price is lower than the free market price.
What is meant by internalising an external cost?
When you add the external cost to the private cost. To do this you put a tax on the product to shift the MPC towards the MSC and the external cost is now reflected in the market price (assuming tax is exactly the correct amount).
Why is internalising an external cost very difficult?
It requires shadow pricing (attempting to put a monetary value on external costs). This procedure is complex and subjective (normative economics).
What is meant by a negative externality?
The cost of a transaction to a third party. The social cost of an activity is greater than the private cost.
What is meant by a positive externality?
The benefit of a transaction to a third party. The social benefit of an activity is greater than the private benefit.
Define merit goods
Consumers don't realise the benefit of these goods (they lack the information) so are often under-produced and under-consumed if left to market forces. An example of a merit good is education. Positive externalities arise from its consumption.
Define demerit goods
Goods that are more harmful than consumers realise e.g. cigarettes. They would be over-produced and over-consumed if left to market forces. Negative externalities may arise from them.
Define public goods
These are goods that have the features of non-rivalry and non-excludability and as a result would not be provided by the free market. It is impossible to charge consumers directly for it.
Define non excludability
Where it is not possible to provide a good/service to one person without it thereby being available for others to enjoy. This refers to the free rider problem.
Define non rivalry
Where consumption of a good/service by one person will not prevent others from enjoying it.
Define quasi public goods
Goods that have some, but not all the features of a public goods (non-excludability & non-rivalry).
Define direct tax
Taxes placed on the incomes individuals and businesses e.g. income tax, corporation tax.
Define indirect tax
Taxes placed on the sale of goods and services e.g. VAT, excise duties.
Define progressive tax
As your income rises the proportion paid in tax rises e.g. income tax.
2 advantages of progressive taxes
Helps distribute income from rich to poor (this boosts spending) and it could be considered 'fair'.
Disadvantage of progressive tax
Acts as a disincentive to work.
Define regressive tax
The proportion of income paid in tax falls as your income rises e.g. VAT.
Advantage of regressive tax
Gives an incentive to gain promotion
2 disadvantages of regressive taxes
Worsens inequality between rich and poor and it is considered 'unfair'.
What is meant by the term 'no direct hypothecation with taxes'?
No revenue from a specific tax is earmarked for certain expenditure.
4 advantages of using indirect taxes to correct market failure
1. They REDUCE OUTPUT of products with negative externalities (quantity falls).
2. They RAISE the PRICE of these products. The price paid for the product now matches the social cost of production.
3. Revenue can be used for the provision of MERIT goods.
4. REVENUE can be used to fix the market that is being taxed e.g. tax on fuel used to fund £5000 cash back on purchase of electric cars.
3 disadvantages of using indirect taxes to correct market failure
1. Difficult to determine how much the tax should be. SHADOW PRICING is a highly subjective and complex process (normative economics).
2. Many demerit goods have INELASTIC demand- it doesn't reduce consumption as much as intended. This also means producers pay very little of the tax. This could be considered 'unfair' considering they produce the good/service.
3. Indirect taxes are REGRESSIVE. It takes up a small proportion of the rich's income and they may not be put off buying the product. Market failure continues.
4 depends on points for indirect taxes correcting market failure
1. Size of tax
2. How accurate information is on how much the tax should be
3. Price elasticity of demand for the product.
4. Could you do something else? Regulation, advertisement etc. could be more effective.
Define subsidy
A direct payment made by the government usually to producers of goods and services, but sometimes also so consumers. Its purpose is to reduce production costs to reduce the price in a market and increase output/consumption of the good or service compared to the free market equilibrium.
3 advantages of using subsidies to correct market failure
1. Increased supply leads to a lower price (more able to buy product) and greater quantity traded of products with positive externalities.
2. Improves allocative efficiency.
3. Increases consumer surplus (especially if demand is price inelastic). There will be a bigger difference between the market price and the price consumers are willing and able to pay (demand).
5 disadvantages of using subsidies to correct market failure
1. Difficult to determine how much the subsidy should be (i.e. SHADOW PRICING is a highly subjective and complex process).
2. If PED<1 price may drop, but consumption of the desirable product may not increase by much.
3. The OPPortunity COST of the spending on the subsidy e.g. reducing debt.
4. May make firms INEFFICIENT. The business has less incentive to lower costs if the subsidy will do it for them. This can be very damaging to the long run competitiveness of an industry.
5. May not be spent on increasing provision of product.
6 depends on points for using subsidies to correct market failure
1. Size of the subsidy (not enough/too much).
2. Accuracy of information on how large the subsidy should be (for shadow pricing).
3. PED for product.
4. Depends what the firm spends the money on e.g. debt spending does not increasing output of the goods.
5. Is it the best policy to use? Could direct provision of the good which is free at the point of use be better, especially in a market with large external benefits?
6. Short term or long term.
Define regulations
Controls set by the government to correct market failure, not involving the direct use of the price mechanism.
Advantages of using regulation to correct market failure.
Regulations aim to achieve the optimum scale of an activity outside the price mechanism. They attempt to reduce consumption of products with external costs and increase production and standards of goods with external benefits. (Then perhaps analyse the type of regulation). EXTRA FROM MARKSCHEMES INCLUDE: cheap and easy to impose, rapid effect, backed up with fines to make an incentive to comply.
5 disadvantages of using regulation to correct market failure.
1. Costs and difficulties of enforcement (opportunity cost).
2. Hard to judge what an 'optimum level' of consumption is. It requires accurate information about the actual source of the external costs and the scale of them.
3. No incentive for further improvements after standard set.
4. May cause consumers to turn to the black market, which could cause more damage.
5. Business costs rise with an impact on competitiveness.
4 depends on points for using regulation to correct market failure
1. Stringency of regulation- too low and the benefits the polluter receives are greater than the external costs. Too high and there is an incentive to dodge regulations, potentially in a harmful way.
2. Quality of information- informs the stringency of regulation.
3. How easy is it to enforce?
4. Are other policies better?
What are tradeable permits?
A market based means of correcting market failure, particularly pollution. They allow the owner of the permit to undertake a particular amount of an action. The total number of permits is strictly controlled to keep the activity at low levels. The permits can then be traded. If a firm achieves a lower level of pollution than stated in the permits it can sell unused/partly used permits to someone else.
Example of use of tradeable permits
European Trading Scheme (ETS)
o Aim- cut CO2 emissions by 30% in the next 10 years.
o Firms sold carbon trading credits, each worth 1 tonne of CO2 emissions.
o Each permit costs €15 and there is a €100 fine for every tonne over limit.
o Pollution is checked by examining energy use and then converting it into an appropriate CO2 emission level.
Describe briefly the graphs to use for tradeable permits
Perfectly inelastic supply of permits. MPB/MPC curves.
4 advantages of using tradeable permits to correct market failure
1. They limit the amount of a harmful activity created by a firm. There is a PHYSICAL LIMIT on it because of the limit on the supply of tradeable permits.
2. The cost of the permit increases the firm's costs. Price matches the social cost of production resulting in external COSTS BEING INTERNALISED. This resolves allocative efficiency, now there is no longer overproduction of a 'harmful' good.
3. They give an incentive to become MORE EFFICIENT. This is because you can sell permits and reduce costs. This is a market based solution.
4. Selling permits raises REVENUE for the government. This revenue could then be used to subsidise investment into greener production methods etc.
5 disadvantages of using tradeable permits to correct market failure.
1. It is hard to calculate the number of permits there should be. SHADOW PRICING is subjective.
2. If the PRICE ELASTICITY OF DEMAND for the good is inelastic, there will only be a small fall in demand from polluting products. (L4+ however, significant revenue is raised, so its effectiveness depends on what the objective was in the first place. Was it to raise revenue or reduce pollution?).
3. It is expensive for the government to ENFORCE the permits. For example, it may be hard to accurately attribute pollution to one particular firm and then you must consider the opportunity cost of the money spent enforcing.
4. Should permits be TRADEABLE? For example, if one firm becomes very efficient another firm may just buy these permits and the overall level of pollution remains the same.
5. The increase in BUSINESS COSTS caused by the tradeable permits may reduce UK competitiveness. (L4+ it depends if the permits are internationally applied).
5 depends on points for using tradeable permits to correct market failure
1. How accuracy when determining the supply of permits.
2. How much incentive is there to reduce pollution? (I.e. the price of permits).
3. Price elasticity of demand (depends on objective- see above).
4. How well enforced is it?
5. Is there a better method e.g. subsidy to invest in greener technology?
Intro for info provision essay
Information provision is needed when poor or misleading information fails to take account of the full social costs and benefits of making a decision. This leads to poor decision making that doesn't maximise welfare. This is corrected by the government providing information and guidance to the private sector as to what consumers should know.
3 ads of info provision to correct market failure
1. Can reduce demand for products with large external costs (e.g. cigarettes).
2. Can increase demand for products with large external benefits (e.g. apprenticeships).
3. Information can be passed from one generation to another.
3 disads of info provision to correct market failure
1. Difficult to decide the correct level of intervention needed (light touch may fail to get the message across).
2. May not appeal to the target market in the right way. Thought is needed to capture the eye of those needing the information and to instigate a response.
3. Opportunity cost of information provision.
3 depends on for info provision to correct market failure
1. Quality of the advertisement (depends on how much money available).
2. Elasticity of demand for the product needed to be influenced. An inelastic demand curve is hard to shift left.
3. Other policy more successful?
Define govt provision
The government supply of goods or services in the public sector and it is paid for through taxes.
Define nationalisation
The transfer of business ownership from the private to public sector.
How does government provision work?
Government provision leads to a fixed amount of supply for a good/service. It is fixed by the government's budget for each area. It is provided free at point of use often leading to an excess of demand for the product.
3 ads of govt provision correcting market failure
1. Increased supply ensures external benefits are fully realised.
2. Government provision is more equitable as it is often free at the point of use. This does not prevent low income groups from accessing the benefits of these goods. It is also funded by tax revenue where a large amount is raised by progressive methods (income tax mainly), therefore taxing higher income groups more.
3. The government can prioritise areas of importance and ensure these are covered.
6 disads of govt provision correcting market failure
1. It is difficult to decide the correct level of government provision in order to match external benefit (SHADOW PRICING).
2. Government provision can be INEFFICIENT as there is no profit motive to drive public sector providers to be cost effective. Also limited/no competition.
3. Successive governments have DIFFERENT PRIORITIES and can cause undue change on public sector services. This can demotivate workers within the sector and limit long term effectiveness.
4. Does it need to be FREE FOR ALL? Pay unless you can't afford it.
5. Long TIME LAG between deciding provision is required and it existing.
6. OPPORTUNITY COST of provision.
3 depends on points for govt provision correcting market failure
1. How well areas managed? Compare the inefficient public sector services of the past and greater accountability in education leading to greater efficiency.
2. Quality and quantity of funding- a rise in real terms will enable the supply of a higher standard service. However, there are debt problems and it also doesn't ensure money is spent wisely.
3. Other policies better? Should the government assist the private sector rather than being the sole supplier? Subsidies or tax cuts better?
3 ads of privatisation
1. Increases efficiency because there is a profit motive and greater competition.
2. Raises revenue for the government through the sale and taxation of the firm. Also, to funding is needed so more can be spent on the previous opportunity cost.
3. Quality may improve (firm has to be competitive and profits are reinvested in the firm).
3 disads of privatisation
1. Resource allocated based on who is willing and able to pay, not necessarily who requires it. Under-consumption by low income groups in particular- unfair?
2. Supply of a good/service may fall if it is not profitable, yet it may have large social benefits.
3. Quality may suffer if the focus on profits instead of needs.