Market Failures and Government Interventions, 2.1 to 2.4

• The economic assumptions:

  1. Consumers' aim is to maximise their satisfaction.
  2. Businesses' aim is to maximise their profit.
  3. Governments' aim is to maximise welfare.
• Market failure is when the market equilibrium leads to an inefficient allocation of resources. This means that the market either produces more than is desirable or not enough that would be desirable for society's welfare.
• When there is market failure, governments need to intervene using subsidies, taxes, information, laws, and regulation to ensure society's welfare is maximised.
• Private costs are the costs of consumers and producers when consuming or producing a product.
• External costs are costs to a third party of the consumption or production of a good or service.
• A third party is anyone that is not the consumer nor the producer.
• Examples of external costs of production:

  • Pollution
  • Congestion
  • Environmental damage
• social costs = private costs + external costs
• Regulations are rules and limits on what firms can do.
• Pollution permits are documents which specify how much a firm is allowed to pollute when producing.
• Administration costs are the costs of enforcing a policy.
• Government interventions to correct overproduction from negative externalities:

  1. Indirect taxation.
  2. Regulation.
  3. Fines.
  4. Pollution permits.
• Private benefit is the benefit of an economic activity to the consumer and the producer of that activity.
• External benefit is the benefit to a third party.
• social benefits = external benefits + private benefits
• Negative externalities cause a market failure of overproduction.
• Private benefit is the benefit of an economic activity to the consumer and the producer of that activity.
• External benefit is the benefit to a third party. A third party is anyone who is neither the consumer nor the producer.
• social benefits = external benefits + private benefits
• Positive externalities cause a market failure of underconsumption.
• Government interventions to correct underconsumption from positive externalities:

  1. Subsidies.
  2. Regulation.
  3. Public provision of goods and services.
• Public goods are goods which are non-excludable and non-rival.
• Non-excludable means that once the good is provided for one person, you can't exclude others from consuming it.
• Non-rival consumption means that more people consuming the good doesn't diminish the quality that each consumer gets.
• Non-excludability and non-rival consumption of public goods creates the free-rider problem.
• Free-rider problem refers to the fact that with public goods people can consume it without paying for it. There is no way for businesses to exclude those who don't pay and all consumers enjoy the same quality.
• Firms don't want to supply public goods as they can't make profit from supplying them. This is why the government needs to intervene, so people have access to public goods.
• Government intervention for public goods:

  1. Public provision of public goods.
• Negative externalities lead to overproduction because private costs are lower than social costs, so producers make more than is socially optimal.
• Positive externalities lead to underconsumption because private benefits are lower than social benefits, so consumers buy less than is socially optimal.