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Markets, Market Failure and Government Intervention
Terms in this set (90)
What are the factors of production?
Land, labour, capital and entrepreneurship
What are the factor incomes?
Rent, wage/salary, interest and profit
What is the basic economic problem?
We live in a world of unlimited wants but limited resources, as a result, scarcity exists.
What are the types of economies? and explain them
FREE MARKET ECONOMY (here households own resources and allocate resources through the price mechanism). MIXED ECONOMY (where some resources are owned by the government (public sector) and some resources are owned by the private sector). COMMAND ECONOMY (where the government own all resources e.g. Korea)
Define opportunity cost
Opportunity cost is the cost of any activity measured in terms of benefits of the next best alternative forgone.
What is a PPF and what does it assume?
The production possibility frontier shows the potential combinations of output available in an economy given a fixed state of technology and the limited resources available. If drawn concave, it assumes that not all resources in the economy are as productive in one use as compared to another.
Whats the point on a PPF called?
What is productivity and what methods of production increase it?
Productivity measures output per input per time period e.g. output per person per hour. It can be increased by specialisation or devision of labour.
What is specialisation? And why's it good?
occurs when we concentrate on a particular product or task. (it could be specialising in a particular occupation, e.g. doctor, or firms specialising like software at microsoft or countries specialising e.g. Barbados and bananas. If everyone specialised on what they were most productive at, there would be an increase in productivity per person.
How do you calculate productivity?
output/no. of workers
What is devision of labour?
Where the production of a good is broken up into many separate tasks each performed by one.
Other ways to increase productivity?
1)Specialisation/devision of labour 2)Through automation and computerisation 3)Through education and training 4)Setting targets 5)A motivated workforce 6)Providing incentives for increased research and development 7)Encouraging foreign investment to British firms are forced to be more competitive 8)Less business regulation and red tape from the government 9)Improving the country's infrastructure 10)making markets more competitive
Advantages and disadvantages of specialisation
(Pros: higher output and lower costs) (cons: Boredom for workers engaged in repetitive tasks which may make them less productive, and a breakdown in the chain of production can cause chaos).
What are the three main economic agents?
Workers, Firms, Government
Three important functions of prices within a market?
Signalling function (the price of a good is a key piece of information to both buyers and sellers in the market. Decisions about buying and selling are based on those signals)... Rationing or Allocative function (one function of price in a market is to allocate and ration scare resources. Resources are rationed to those willing to pay a high enough price)... Incentive function (prices act as an incentive for buyers and sellers, high prices encourage sellers to produce and lower prices encourage consumers to buy goods)
What are complements?
Complements are goods in joint demand. By buying one good, a consumer will also be likely to demand another good. E.g. tennis racket and tennis balls
What are substitutes?
A substitute is a good which can be replaced by another good. E.g. coke and pepsi
What is composite demand?
Composite demand exists when a good or service has alternative uses.
What is joint supply?
Joint supply occurs when two goods are by-products. i.e. the production of one good naturally leads to the production of another. E.g. leather and beef
What is market failure?
Market failure arises when the equilibrium price and output levels in a market are socially undesirable and/or create inefficiency.
What are the main types of market failure?
Monopoly power, merit/demerit goods, externalities, public goods, factor immobility, Inequality and information failure
Explain Market failure associated with market power
Pure monopoly exists when there is a single supplier in the market. As a result, it is not subject to the competitive pressure of market forces. It can therefore set its own price , leading to a breakdown of the price mechanism. The monopolist will restrict output to raise prices. The impact of this is to increase producer surplus and reduce consumer surplus and choice. Market failure arises as the equilibrium price and output levels under monopoly are socially undesirable and monopoly decisions (i.e. lower output higher prices) do not allocate resources efficiently.
Draw monopoly market failure on a diagram...
What are externalities?
Externalities are defined as third party spillover effects that arise in consumption or production of goods or services.
What are the types of costs
PRIVATE COSTS-the cost of any activity to a consumer or firm.
EXTERNAL COST- a negative third party spiller over effect which arises in production or consumption (e.g. car pollution)
SOCIAL COST-the cost of any activity to society. It therefore includes all private and external costs
What are the types of benefits?
PRIVATE BENEFITS-the satisfaction or pleasure gained from consumption or production of a good or service. EXTERNAL BENEFIT- a positive third party spill over effect which arises in production or consumption (e.g. education)
SOCIAL BENEFIT - the benefit of any activity to society. It includes all private and external benefits.
Social optimum level of production and consumption
Markets work most efficiently when all private and external costs and benefits are taken into account. the market will then produce at the socially optimum point where social costs = social benefits
Market failure with negative externalities
If social cost is greater than private cost, then an external cost or externality is said to exist. This leads to the level of output being greater than the social optimum point (where social costs = social benefits. The market fails because consumers or producers do not take the effects of externalities into their calculations. A good with negative externalities will tend to be underpriced and overproduced/consumed in a free market. As a result, market failure occurs.
Draw a negative externalities graph...
What else might cause negative externalities?
Negative externalities may occur because of the absence of clearly defined property rights - for example, who owns the are we breathe? If an asset is un-owned nobody has an economic incentive to protect, thus leading to over use of common land, fish stocks etc... which can leads to long term permanent damage to the stock of natural resources.
What is it also known as?
Tragedy of the commons
Market failure with positive externalities using the NHS as example
While the individual who is treated gains a private benefit, there is a far greater social benefit (e.g. becoming a more productive worker, less sick days etc). As a result, a positive externality exists or external benefit exists. Market failure occurs because because a good with positive externalities will tend to be under produced/consumed and prices do not accurately reflect the costs and benefits to society.
Draw a positive externalities graph
What are merit and demerit goods?
MERIT GOODS are goods which are socially desirable but are under provided in a market economy e.g. education and healthcare.
DEMERIT GOODS are foods which are socially undesirable and are underpriced and over provided by in a market economy.
Why does market failure occur with merit goods?
Merit goods (such as education) would be substantially under provided in a free market economy because the social benefits are greater than the private benefits. As a result they are consumed below the socially optimum level and thus the market fails.
Draw a merit goods graph
Why might these goods be under consumed?
The social benefits are far greater than the private benefits and so consumer don't consume the required amount... They may underestimate the private benefits (example of information failure)...May disc out the benefits because they occur largely in the future...
Why does market failure occur with demerit goods?
Consumption/production of these demerit goods generates negative externalities which are not accounted for by the price mechanism. market failure occurs as there is over consumption/production of demerit goods.
Why are these goods over consumed/produced?
Consumers under-estimate the private costs (long-term effects) of consuming these goods and discount them as they occur largely in the future (an example of information failure)
What are public goods?
Public goods are goods not provided by the market, as a result the market fails. Public goods are non-excludable (you cannot prevent anyone else from consuming that good) and non-diminishable (this means it does not run out as more people consume the good) Examples include: flood defence, nation defence, street lighting etc...
Why are they not provided by the free market?
Free rider problem - no consumer would pay for a public good that could be consumed for free if another household decided to purchase it. As a result, no public good would be provided if left to the private sector.
What are quasi or non-pure public goods?
Quasi-public goods are products that are public goods in nature, but do not fully exhibit the features of non-excludability and non-rivalry (non-diminishable) e.g. roads and beaches
What is factor immobility?
Resources should be reallocated when prices change(e.g. due to changing demand), but some resources are not mobile between uses and this results in market failure.
Types of factor immobilities and examples? explain why the market fails
Occupational immobility (structural unemployment) example could be the miners, once the mines close they had no transferrable skills and thus we left unemployed. Geographical immobility, high train fairs to work in London or family ties that shop workers from going into high demanded areas. Capital immobility, such as when banks fail to provide sufficient affordable funds to allow businesses to expand.
Where would this point be on a ppf curve?
Why does market failure occur with inequality?
The level of wealth and income equality are socially undesirable. The richest fifth have two thirds of the wealth.
What is information failure?
Information failure occurs when there are information gaps that can often lead to a misallocation of resources.
Examples of information failure?
Misunderstanding the true benefits/costs of a product... Complex informations (such as when to buy house)... Inaccurate or misleading information (e.g. persuasive advertising can lead to higher demand than what is optimal)... Addiction (drugs addicts may be unable to stop consumption)
Whats the other type of information failure?
Asymmetric information (asymmetry of information). This occurs when either buyer or seller knows more information that the other party. It distorts people's incentives to buy and sell goods and services at the right prices and as a result can lead to inefficiencies and market failure.
What is government intervention?
Government intervention is used to correct market failures arising from an inefficient resource allocation or a lack of equity (fairness).
Problems of government intervention in markets?
Mis-timing (by the time they intervene the issue may have changed and thus the solution will be wrong), Political pressure, politicians short-termism views, difficult to quantify the problem, lack of information on extent of the problem
What is government failure?
Government failure may occur if there are negative consequences to their policies to address market failure (it may lead to a deepening of the failure or a new failure). Example, smoking ban leading to high demand for outside heaters which is bad for environment.
How do government intervene with demerit goods and negative externalities?
Indirect taxation and regulation
What is it? Types of indirect taxations explained with examples
Indirect taxes are a tax imposed on expenditure by government. They are designed to raise the firm;s costs and therefore cause an upwards shift of the supply curve. It aims to increase the firm's costs so that it will take into account the external costs it generates. Examples: unit tax (specific tax) such as air passenger duty, and Ad Valorem tax (percentage tax) such as VAT.
What are the pro's of taxation?
Very effective at adjusting price and output levels to a more socially desirable position... Also they raise substantial revenue for the government which helps fund public services.
What are the con's of taxation?
It has a regressive impact as it affects the poorest most... Negative externalities are difficult to measure... If demand is inelastic it won't have much of an impact... Producers may relocated to countries with lower taxes...
Ways to solve monopoly's?
What are regulations?
Government sometimes seek to tackle market failures by putting legal restrictions (regulations) on the behaviour of firms and consumers.
How do they work?
Government could enforce environmental standards to tackle production causing pollution or ban spoking in public places to discourage consumption of cigarettes. Or monopolies fix prices government can intervene with a series of fines and even jail sentences.
Pro's of regulation?
Limit activity associated with negative externalities
Con's of regulation?
Regulations must be enforced and this carries a high administrative cost and thus an opportunity cost... It's hard to know how much you should regulate as externalities are hard to measure... firms may find it very costly (inefficient) to meet regulations e.g. pollution levels... There are other effect methods that could be used such as indirect taxation.
Methods of solving demerit goods or information failure
Pro's of awareness campaigns?
1)Effective at bridging the information gap and discouraging consumption of demerit goods 2)reduces demand at all price levels
Con's of awareness campaigns?
1)Government cost and thus opportunity cost
2)Evidence suggests that campaigns have a limited impact, we've become numb to them
Methods of solving market failure with merit goods and positive externalities?
Subsidies or state provision
What are subsidies and how do they work?
Subsidies are payments made to producers by government, which effectively reduce costs and encourage them to increase output. Producers then pass on this subsidy to consumers through lower prices and thus encourages consumption.
Pro's of subsidies?
1)Reduces price and increases output to a more socially desirable point
2)Increase in external benefits associated with output
3)subsidies have a progressive impact, the poorest benefit most
4)If demand is elastic the impact will be greater
Con's of subsidies?
1)Difficult to measure, gov. can only hope to approach social optimum
2)Government subsidies may support firms who are inefficient or wasteful
3)Costly to the tax payer
Government intervention to solve public goods?
What is state provision?
The state sometimes tackles market failures by paying for them entirely (making them free of charge), as if left to the free market (especially public goods) they would not be provided due to the free rider problem.
Draw the diagram of state provision
Pro's of state provision?
1)Increases consumption of merit goods thus producing more positive externalities
2)If demand is elastic state provision is more effective
Con's of state provision?
1)Expense to the tax payer, opportunity cost
2)Could lead to inefficiency in government run organisations as there is no competition
3)Difficult to measure positive externalities making setting provision at the right level hard
4)If government decided to hire private sector firms, the increase in competition could lead to a fall in quality.
Whats a price ceiling?
A price ceiling or maximum price is set by government for which the good/service's price can not exceed. It is only effective if set below the equilibrium price.
Draw a price ceiling diagram
Pro's of a maximum price
1) Makes a good cheaper/more affordable
Con's of maximum price
1)Excess demand cannot be cleared thus supplies must be rationed
2)Could lead to more activity in the black economy
Evaluative point of maximum prices
1)Must be set below equilibrium, if about it has no impact
2)It depends on the elasticities of demand and supply
3)Depends on where it is set, the lower it is set the greater the shortage is
What are minimum prices? With examples
A minimum price is a price floor below which the price cannot fall. To be effective the minimum price has to be set above the equilibrium price. Examples include minimum wage, alcohol and agricultural goods.
Draw minimum prices on a graph
Pro's of minimum prices
1)Increases producer surplus, revenues and profits
2)Discourages consumption of demerit goods
Con's of minimum prices
1)Subject to whether fairness is improved- as consumers have to pay higher prices, regressive impact
2)Excess supply has to be bought up by the government (intervention buying), often excess supply (food) is destroyed or dumped which is wasteful.
Evaluative points of minimum prices...
1)It depends upon where the minimum price is set, if set below equilibrium it has no impact.
2)The higher it is set, the greater the impact
3)It depends on the elasticity of demand and supply of the good
How does government solve externalities such as pollution?
What are pollution permits and how do they work?
Pollution permits are quotas on CO2 emissions, they are distributed between polluting firms who then may only produce so much goods so as not to exceed this limit. It is a market based system designed to reduce emissions over time and all firms are incentivised to clean up polluting using the price mechanism. Permits are reduced over time, forcing companies to become more environmentally friendly. They can be traded between companies. It uses the market to reduce external costs and correct market failure.
Pro's of pollution permits
1)The price mechanism is used to "internalise the externality" i.e. make the polluter pay
2)Environmentally friendly firms or countries may sell their permits to those who cannot meet the required levels, therefore the desired level of pollution is met
3)It can easily be controlled and changed as required
Con's of pollution permits
1)Scheme is open to hacking/corruption etc...
2)It's very difficult to measure the desired level of pollution therefore difficult to measure how many permits should be distributed
3)Not all industries take part e.g. shipping
4)Cost of administrating the scheme
5)There may be alternatives e.g. regulation
How do government intervene to solve factor immobility?
The government intervenes by improving information flows e.g. Job centres and training schemes.
Con's of doing this?
Administrative costs and opportunity cost
How does government solve market failure associated with inequality of income and wealth
1)The tax system (progressive taxes, tax allowances, tax credits, inheritance tax etc.)
2)The benefits system
3)Provision of merit goods (e.g. nhs, education)
4)Subsidies for higher education/ema/housing
6)Minimum prices for agricultural goods- raising farm incomes
7)maximum prices (for food in foreign places)
THIS SET IS OFTEN IN FOLDERS WITH...
Chapter 13: Consumer Theory
Economics-Chapter 7 Market Structures
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