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Market Failure and Government Intervention

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Christina Lim

on 22 August 2012

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Transcript of Market Failure and Government Intervention

Scarcity Choice Opportunity cost Price and
output determination DD and SS
(Price mechanism) a) What and how much to produce b) How to produce c) For whom to produce Efficiency Equity Allocative efficiency Productive efficiency Assumptions: a) Perfectly Competitive Market
b) No externalities
c) No public goods perfect info
perfect mobility
perfect knowledge when assumptions fail Market Failure Definition: Market fails to allocate resources efficiently CAUSES CURE/
POLICIES/
MEASURES 1) Presence of externalities 2) Demerit goods 3) Merit goods 4) Public goods 5) Imperfect information positive negative Externality occurs when a transaction between two parties has an effect on third parties. It affects the third party not through the market mechanism but via some other indirect effect on thier welfare. occurs when third parties who are not consuming or producing the good are affected adversely occur when third parties benefit from consumption of a good Definition Explain for every additi0nal unit of output produced, an external cost is imposed on third parties, known as Marginal External Costs (MEC) Example factory discharge waste and other pollutants into river
water become unfit for concumption + no clean drinking water
negative externality imposed on residents Diagram - Negative exgternalities cause a divergence between MSC and MPC

- Producers --> max. own profit, they will only consider private benefits and costs
- They will not take into account the MEC imposed on others. Thus, producers only produce where MPC=MPB, where market eqm is at Q.
- Society will take into account all costs and benefits, thus social eqm is at MSC=MSB, at output Q*

- With presence of -ve externalities, market eqm output Q > social eqm output Q*
- Overproduction/ overconsumption of output QQ*
- Total social benefit is given by area ___
- Total social cost is given by ___
- This leads to deadweight loss of area ___
- Due to this dwl, output Q is socially inefficient as welfare of society is now below its social optimal point.
- The market has failed to acllocate resources efficiently Definition Explain Example Diagram immunisation against diseases
these people receive higher benefits in terms of higher resistance to diseases and better health status
positive externality imposed on families, neighbours and people around them
less risk of such diseases spreading through the population - Positive externalities cause a divergence between MPB and MSB

- Consumers --> concerned with self interest, only willing to pay for the direct benefit
- They will not take into account MEB agined by others. Thus consumers consume where MPB=MPC, where market eqn is at Q.
- Society will take into account all costs and benefits, thus social eqm is at MSC=MSB, at output Q*

- With presence of +ve externalities, market eqm output Q < social eqn output Q*
- Underconsumption/ underproduction of QQ*
- If additional QQ* units are produced,
total social benefit is given by ___
total social cost is given by ___,
and there would have been a net gain.
- But by not producing QQ* units, deaweight loss of area __ is thus incurred
- Output is socially inefficient as welfare of society is now below social optimal point.
- Market is said to have failed to allocate resources efficiently. ignorance or lack of information on either the producer or the consumer externalities or the impact on third party Explain - those who consume them do not recognise or understand the "true" consequence of their actions
- due to ignorance, irrationality, irresponsibility, a "wrong" demand of the good is generated.
- the demand is reflected by "perceived" demand.
- the goods will be consumed in excessive amounts Example - a teenager who smokes may think that he will never incur the various ailments linked to smoking, and thus fail to take that into consideration when he smokes.
- as the immediate benefits of smoking are high and he is unlikely to incur any significant costs in the short term,
- he will smoke more than what is privately and socially optimal Diagram Explain - a demerit good may be one with significant negative externalities, and it imposes external costs on third parties
- tend to be over-consumed/ over-produced when left to market forces Diagram (same as negative externality) - Demerit goods cause a divergence between MPB and MSB
-Due to ignorance/ irrationality, consumer tend to consume at the perceived marginal value of the good, MPB, instead of at the true marginal value, MSB

-Thus consumers consume where MPB=MPC, where market eqn is at Q.
- However, social equilibrium is at Q* where MSC=MSB.

- With presence of demerit goods, market eqm output Q > social eqn output Q*
- Overconsumption/ overproduction of QQ*

- Additional QQ* units are produced,
total social benefit is given by ___
total social cost is given by ___,
and there would have been a net loss.
- Output is socially inefficient as welfare of society is now below social optimal point.
- Market is said to have failed to allocate resources efficiently. significant consumer ignorance externality Explain - due to ignorance, those who consume the goods misunderstand the true benefits which the good confer
- the demand is reflected by "perceived" demand.
- due to a lack of precise info, the effective demand will be lower than than the level that is socially desirable and if left tot he market forces, the good is underproduced or underconsumed. Example - education
- insurance
- healthcare Explain CRITERIA:
- Non-excludable


- Non-rivalry - total market failure
- because available to everyone to consume regardless of who pays
- therefore will never be supplied under the free market system impossible/ very costly to prevent someone who has not paid from having access and consuming the good the consumption of a good by one person does not diminish the amount available for another person to consume (MC for providing for an additional user = 0) Example - National defence - problem of free rider
- if consumers can be free riders and are unwilling to pay, there will be no effective demand.
- no demand and price signals to guide producers under free market -> nothing produced.
- therefore, if production of public goods is left to free market, there will be no production by private firms and total market failure occur Imperfect info Factor immobility ASSYMETRIC INFO
- occurs when one side of the market has better info than the other
- info available to both party differs - when potential buyers or sellers have limited info about sth or understanding of what they wish to sell or buy
- many reasons MORAL HAZARD
- when one person is performing some task on behalf of another person (if action of agent cannot be monitored, they would put in less effort/ undertake more risk)
- when the parties to a contract change their behavious as a consequence of the contract THEREFORE lack of trust between buyers and sellers means a mutually advantageous trade cannot take place --> no market THEREFORE free market becomes inefficient as a result of factors being too slow to react to DD&SS OCCUPATIONAL IMMOBILITY
- occurs when there are barriers to the mobility of labour between different sectors of the economy
- result in factors remaining unemployed/ used in ways not economically efficient GEOGRAPHICAL IMMOBILITY
- occurs when there are barriers to people moving from one area to another to find work 1. family and social ties
2. financial costs
3. huge regional variation in house prices
4. differences in cost of living eg. in sheet metal industry/heavy engineering
-> workers difficult to regain re-employment in a different sector
-> job-specific skills
-> mismatch between skills
-> leads to structural unemployment

==> wastage of resources -> market failure Free market these are extra benefits enjoyed as a spillover by third parties due to extra consumption of the good and it is known as marginal external benefits (MEB) Diagram - Merit goods cause a divergence between MPB and MSB
- Due to ignorance/ irrationality, consumer tend to consume at the perceived marginal value of the good, MPB, instead of at the true arginal value, MSB

-Thus consumers consume where MPB=MPC, where market eqn is at Q.
- However, social equilibrium is at Q* where MSC=MSB.

- With presence of merit goods, market eqm output Q < social eqn output Q*
- Underconsumption/ underproduction of QQ*

- If additional QQ* units are produced,
total social benefit is given by ___
total social cost is given by ___,
and there would have been a net gain.
- But by not producing QQ* units, deaweight loss of area __ is thus incurred
- Output is socially inefficient as welfare of society is now below social optimal point.
- Market is said to have failed to allocate resources efficiently. Explain - a merit good may be one with significant positive externalties
- it confers external benefits on third parties
- under-consumed/ under-produced when left to market forces Diagram (same as positive externality) 1) Assign property rights Explain A property right is the exclusive authority to determine how a resource is used, whether that resource is owned by the government or individuals :( NOT FEASIBLE when there are many parties involved as :

- cannot decide on amount of compensation for each party
- monitor each firm (so that they cannot cheat) --> cost
- negotiations fail --> legal action --> legal costs
- equity problem 2) Taxation Tax on production/ output Tax on pollution Explain The government makes the producer bear the negative externalities/ internalise the external costs of his economic activity by imposing a tax equal to MEC, causing MPC to converge with MSC. Diagram :) :( - output --> easy for government to monitor and enforce - taxed based on output --> reduce output to reduce pollution --> no incentive to try a cleaner production method Explain Taxes levied on firms based on $X per unit of pollution generated or
the tax levied can be varied to limit the pollution generated by the industry to an acceptable level. Diagram :) :( - reduce pollution using cheapest way possible - allow the more polluting firms to continue polluting
- difficult to determine the socially optimal level of pollution
- difficult to determine the correct tax rate 3) Tradable pollution permits Explain Tradable pollution permits are based on property rights.
The government, on behalf of its people, owns the right to pollute the atmosphere in its country. The government then decide on the total allowable level of pollution and subdivided it into smaller amounts of which corresponding permits are issued. These permits are then auctioned off to thie highest bidders, allowing the market to decide who gets them.
Firms which acquire the permits acquire the right to emit the given quantity of pollution. property rights -> gvnt determine totaly allowable pollution -> auction the permit -> left to market forces to decide who gets the permit :) :( - pollution level can be fixed at socially acceptable level
- reduce pollution using cheapesy posible way - difficult to determine the socially optimal level of pollution 4) Legal regulations Explain Governments impose direct regulation in order to influence firms' or consumers' behaviour.
It is a form of command economy measure that do not merely raise or lower prices but also compel firms and consumers to moderate their actions as a result. Example - imposing standard to limit externalities generated
--> emission standards on automibile and factories that emit polluting
gases

- limit the ownership of goods with detrimental social effects
--> guns

- limiting use of certain goods

- banning (when amt of externalities generated is very severe)
--> drug taking, prostitution :) - easy to understand, implement and monitor :( - high monitoring costs
- lack of incentive to do better 5) Public education Explain Resources could be allocated to eduate the public about the negative effects generated by externalities or even the true costs of consuming certain goods. Example - campaigns to reduce wastage of plastic bags, CFC bases goods etc :) :( - reduce production by reducing the demand for the good - require longer time
- difficult to influence peoples' mindsets Managing Negative externalities
and Demerit goods Managing Positive externalities
and Merit goods 1) Subsidy Explain - The government helps to increase production levels by granting subsidies to lower the costs of production.
- Real target is output Diagram :) - continual operation of market mechanism
- subsidies can be adjusted according to the magnitude of externalities
- subsidizing good practices give firms incentives to adopt more good practices :( - hard to determine divergence between MPB and MSB
- take a long time for full benefits to realise
- budget deficit
- promote inequity 2) Vouchers Explain - Government issue vouchers which can be used to purchase specified merit goods such as certain kind of healthcare or education.
- Households spend the vouchers -> producers claim the cash equivalent from the government
- Prices not lowered, but goods are now more affordable as vouchers can help consumers offset the price.
- Encourage consumption to a socially optimal level :) - goods are more affordable as the vouchers help consumers to offset part of the price --> encourage consumption up to sociable optimum level
- equity 3) Direct provision Explain Where goods are directly supplied by the government
and provided free of charge.
Seen as basic human rights. :) :( - state run --> non-profit --> benefit citizens (education)
- reduce prob of asymetric info (private hospital) - no profit motive --> lack incentive to minimise cost --> productively inefficient
- no market pricing --> mismanagement occur --> misallocation of resources and poor quality of services
- over-consumption of zero-priced goods (graph) -> may lead to greater social inefficiency as compared to a purely free market outcome 4) Grants Explain - The lump sum subsidies to institutions and households.
- do not affect marginal costs
- authorities set targets regarding the level of output and the quality of service as a prerequisite for obtaining grants to ensure socially optimal outcome is attained Managing public goods 1) Government provision :( - x-efficiency
- raise tax for the provision --> welfare loss Managing imperfect information 1) Signalling Explain Refers to the seller's attempt to reveal information about what they have to sell in order to make themselves more attractive to the buyer. 2) Co-payment Example - advertising by firms to indicate high quality of product sold Explain Creating of insurable risks by the use of co-payment.
In such cases, the insured person pays an excess before claiming the insurance payout so that they still prefer one state over the other, but the insurance still offers some of the pain. Managing labour mobility Reduce occupational mobility 1. Training schemes --> boost human capital of employees --> new skills + skills that can be transferred from one occupation to another --> a more flexible response in labour DD and SS

2. Subsidise training programmes by private firms to raise skill level

3. Raise totaly spending on education Reduce geographical mobility 1. Reform hosing market
-> improve SS
-> reduce cost of rented properties
2. Specific subsidies for people moving into areas where there are shortages of labour Negative externalities occur when third parties who are not consuming or producing the goods are affected adversely. This adverse effect/ external costs can be in the form of _____________. These are the extra costs generated as spillover on third parties by extra production of good, known as Marginal External Cost. These marginal external costs cause a divergence between MSC and MPC. A merit good is usually desirable for a society but when left to market, it will be under-consumed due to consumer ignorance of external benefits, irrationality and irresponsibility. These benefits can be in the form of _________. Central Problem of Economics - Because resources are limited and human wantes are unlimited, all societies face the problem of scarcity.
- Scarcity refers to a situation in which the resources available for producing output are insufficient to satisfy all the wants.
- Everytime a scarce resource is used to satisfy all the wants, an alternative want goes unsatisfied.
- Scarcity necessitates choice.
- Scarcity forces a society to choose between the competing uses of the limited resources, which give rise to the central economic problem. Scarcity Unlimited human wants Limited wants (factors of production) Choice Oportunity cost Resource allocation 3 basic economic questions of resource allocation - Making rational choice:
equate the marginal benefit and the marginal cost of acquiring that additional stuff.
- Marginalist principle,
marginal benefit must be > marginal cost
=> total benefits > total cost Opportunity cost measures the cost of using the resourcesfor a certain purpose, in terms of the next best alternative forgone. 3 economic systems WHAT and HOW much to produce HOW to produce For WHOM to produce Centrally Planned (Command) Economy Mixed Economy Free Market Economy A system that relied exclusively on government direction and co-ordination. All the economic decisions are made by a central authority. Firms produce and household consume only as directed. A system in which resources are allocated partly via the price mechanism and partly by the government. Production is still carried out under private enterprises but the government steps in to regulate when necessary. A system that relies totally on market forces for the allocation of resources. All economic decision are made without the central government planning or directives. All economic agents such as households, forms and resource owners seek to promote their own self-interest. All economies face the problem of scarcity and choice.
To use resources efficiently, different economies adopt different economic systems to make decisions. An economic system aims to provide answers to the 3 economic issues. - This is determined jointly by firms and consumers through the signalling role of prices and the profit motive.
- The price of a good reflects the value placed on it by the customers. Consumers indicate their tastes and preferences to firms by the price that they are willing and able to pay for the goods.
The more urgent the demand for the good, the higher the price that consumers are willing to pay in order to get it.
- Producers seeking to maximise profits would only produce goods which consumers demand. The higher the price of a good, the more the producers will supply that good.
- In this way, the price acts as a signal telling the producers what to produce and how much of a good to produce, and thus this determines the allocation of resources among various goods. - The profit-motive of the producers will mean firms tend to choose the least cost method of productioins.
- Firms are guided by signals they receive regarding relative factor prices. - The free market distributes the output produced according to consumers' willingness and ability to pay. (according to their purchasing power) Land |Rent Labour |Wages Capital |Interest Entrepreneurs |Profit -mineral deposits
-forests
-rivers -lawyers
-productions workers
-medical staff -risk taker
-organusers
-innovators fixed (once)
circulating (time and again) -machinery -goods in warehouse
-ingredients in kitchen Price mechanism Demand and Supply Demand Supply Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period. Supply is the willingness and ability of a firm to offer a good for sale at a given price in a given time period. Relationship between quantity demanded and price Relationship between quantity supplied and price Factors affecting demand curve Factors affecting supply curve 1. Income substitution and effects of a price change 2. Law of diminishing marginal utility The law of demand states that there is an inverse relationship between price and quantity demanded, ceteris paribus. When price of a good falls, consumers can maintain current consumption with less expenditure --> ability to pay has risen. The resulting increase in real income is used by consumers to buy more of this product.

When price of a good falls, the product now become relatively cheaper than an alternative good and consumers will switch their spending from alternative good to this good Utility is the satisfaction that consumers derive from the goods they consume.

Marginal utility is the additional satisfaction that consumers derive from consuming an additional unit of good per period of time.

Law of diminishing marginal utility states that as more and more units of a good are consumed per period of time, the marginal utility derived from the consumption of each successive unit will decrease. Change in taste and preference Level and distribution of income Change in population and population structure Price and availability of related goods Expectation of future price chanes The more desirable people find the good, ceteris paribus, the more of it they will demand at any price.
Changing tastes are affected by a variety of influences including changes in advertising, fashion, new information through hearsay or the press. As people's income rises, their ability to pay for such goods increase and this will cause their demand for most goods to rise. These are normal goods.

When people get richer, the demand for these goods will fall, and they are then called inferior goods. Substitute Complementary A rise in the price of a substitute good will cause a rise in the demand for this good as people switch away from the substitute.

An increase in the availability of substitutes will lead to a decrease in the demand for a good and vice versa. A fall in price of complementary goods will increase quantity demanded and hence, the demand for the good in joint demand will increase as well.

An increase in the availability of complementary goods will cause the demand for the good in joint demand to increase. A rise in the general population will cause the demand for most goods and services to rise, assuming that the purchasing power per head does not decline as a result of a population increase.

As the population structure of a country change, demand for certain goods and servies change as well as they have different need/ tastes/preferences. The law of supply states that there is a direct relationship between price and quantity supplied, ceteris paribus. 1. Firms adopt the cheapest solution first, before moving on to more expensive ones.


2. Law of diminishing marginal returns As firms supply more, they are likely to find that beyond a certain level of output, costs rise more and more rapidly.
Thus, in order to cover the increasing marginal cost, firms are only able to offer more units of output for sale if the price of the goods rises. The marginal cost of production Changes in the production of related goods Nature, random shocks and other unpredictable events. Expectation of future price changes change in price of variable inputs change in technology organisational changes government policy An increase in the marginal cost of production will reduce supply and cause the supply curve to shift vertivally upwards. -wages
-raw material
-labour etc. Rise in price of variable inputs cause marginal cost of production to rise. Every extra unit of output made will cost more than before. Technology advances will reduce the costs of production.
Eg. advances in computer technology have caused production processes to become more automated and efficient, lowering production costs. -mergers |reduce duplication of work
-downsizing |reduce staff to cut cost
-more flexible employment practice Various cost savings can be made by reorganising productionprocesses to make them more efficient, reducing costs of production. -tax |marginal costs rises
-subsidy |production costs lowered Joint supply Competitive supply When one good is produced, another good is produced as well. When different goods require similar factors of production. Adverse weather, industrial dispute, financial or banking crisis disrupt production and reduce supply.
The ability and not willingness to supply would have been altered. Government intervention in the market and its effect on welfare Free market brings about efficient allocation of resources.

Assumptions:
a) Perfectly Competitive Market
b) No externalities
c) No public goods when assumptions fail allocative inefficiency market failure ALLOCATIVE EFFICIENCY Allocate resources in such a way that it is impossible to make someone better off without making someone else worse off. EQUITY Fairness in the distribution of income or output among individuals. free market -> price mechanism distributes output to consumers on the basis of their willingness and ability to pay -> household income depend on factors of production it owns and their prices -> vary significantly from household to household -> uneven distribution of income -> unequal access to goods and services -> government intervention -> create a more equitable and fairer distribution of income and output Indirect Taxation An indirect tax is a compulsory levy imposed on goods and services by the government. The producer or retailer has the legal responsibility to pay the tax to the government. Uses:
1. Discourage consumption of a good
2. Obtain tax revenue to finance other form of expenditure 2 types:
- Specific tax:
a tax levied as a FIXED amount per unit sold, irrespective of price.
- Ad valorem tax:
a tax levied as a PERCENTAGE of the selling price of the good. An indirect tax has the effect of increasing the marginal cost of production.

Supple curve shift leftwards as cost of production increases.

This is because for the firm to produce the same quantity of output before the tax, it must now receive a price that allows it to fully recoup the tax it has to pay. EFFECTS WELFARE EFFECTS If the initial equilibrium output was allocative efficient, the imposition of an indirect tax would result in a welfare loss. - Assume that the initial equilibrium output Q1 is allocative efficient.
- An indirect tax is now imposed which adds to the MC of the firms, causing supply to shift to S1. The fall in supply causes the equilibrium price to rise to P2, and the equilibrium output to fall to Q2.
- This results in a fall in quantity by Q1Q2 units, resulting in a deadweight loss of area aeb because for each of the Q1Q2 units, MSB > MSC which means that there could have been a net welfare gain if those units were produced. However, since it was not, it results in a welfare loss. Subsidy A subsidy is a payment made by the government to producers to encourage the production of certain goods or services, but it is nto made in exchange for any goods or services. Uses:
1. Encourage overall consumption of a good
2. Help the poor afford it and reduce problem of income inequality EFFECTS A subsidy has the effect of decreasing the marginal cost of production. * zero pollution graph ADVERSE SELECTION
- when one party has more info than the other, and the subsequent action by the other party would be seen as adverse.
- eg. car market, credit cards, insurance explanation is opposite to that of taxation,
-a unit subsidy equal to MEB is given blah blah
- lower cop --> increase supply preferred over state provision due to more productive efficiency
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