market failure and govt intervention test

• Examples of How Government Intervention Corrects Market Failure

  • Regulation
  • Subsidies
  • Minimum price
  • Maximum price
• Regulations for markets with negative externalities

  
• Regulations for markets with positive externalities

  
• Maximum price diagram

  
• Minimum price diagram

  
• Subsidy diagram

  
• Regulation


  Seeks to modify firms/consumers behavior to reduce market failure (associated with demerit goods or negative externalities). Can also lead to firms being fined for non-compliance
• Advantages of regulation


  • Reduces consumption/production of the goods up to the social optimum and eliminates welfare loss
  • Reduces over-allocation towards demerit goods (and vice versa with merit goods)
  • Reduces asymmetry of information (e.g. calorie information on junk food and cigarette packaging) and aim to reduce demand to the socially optimum level leading to an efficient allocation of resources
  • Can place a limit on an activity and therefore total associated negative externalities (e.g. pollution limits)
  • Easy to understand and potentially quite quick to implement
  • Can be used in conjunction with other policies
• Disadvantages of regulation


  • Must be enforced and have a high admin cost (opportunity cost?)
  • Hard to judge the optimal levels and thus the best they can hope for is a movement towards the social optimum
  • Regulation forces companies to cut levels to the legally allowed level. Some firms may find it inefficient and costly to cut levels. This can lead to illegal behavior to circumvent the rules
  • Raises business costs and reduces competitiveness
  • Risk of regulatory capture – restrictions may not be tough enough and the regulations ends up working in interest of producer instead
• May be superior policies available or a multi faceted approach
• Subsidies


  Effectively reduces producer costs and encourage them to increase output (on merit goods; those with positive externalities)
• Advantages of subsidies


  • Corrects market failure by correcting under-consumption of positive externalities and / or merit goods, producing
  • Increases positive externalities and reduces the welfare loss
  • Reduces price (progressive impact) and increase output to socially more efficient levels
  • May protect / increase jobs
• Disadvantages of subsidies


  • Hard to judge the optimal levels and thus the best they can hope for is a movement towards the social optimum
  • Subsidies may support firms that are inefficient and wasteful
  • Expense to the taxpayer – there is also associated opportunity cost
  • Limited impact if ped is inelastic
  • Producer may not fully pass on benefits to consumer
• Maximum price


  A price ceiling designed to ensure a good is affordable (due to lack of fairness) to all. Effective when set below equilibrium price e.g. rent controls
• Advantages of maximum price

  • Fall in prices makes consumption more affordable due to an expansion in demand
  • Consumer surplus increases and leads to progressive impact
• Disadvantages of maximum price

  • Fall in prices reduces producer surplus and can lead to lower investment
  • Unintended consequences: (even greater shortage of housing; quality of housing and maintenance might fall, "black market" created as excess demand/shortage cannot be cleared, so consumer surplus may not increase by as much as thought; rents may rise in areas without rent controls)
  • Authorities must spend money to discourage black markets
• Depends on where max. price is set: At/above equilibrium has no impact, Greater impact the lower the max price is set or when ped & pes is elastic (develop point fully giving min. 2-3 examples)
• Subjective whether max. price improves fairness (more affordable for consumers but greater shortages, black markets, etc.)
• Minimum price


  A price floor below which the market price cannot fall. Used to tackle goods with negative externalities (e.g. alcohol). Should increase the price which will lead to a contraction in demand
• Advantages of minimum price

  • Should increase the price and lead to contraction in demand , reducing output closer to the social optimum
  • It internalizes externality
  • Reduced demand should also reduce the number of externalities
  • Increased prices mean increased producer surplus and revenues
• Disadvantages of minimum price

  • Risk of black markets and smuggling (e.g. minimum price of alcohol). The government will have to spend more on enforcement
  • Have little impact ped is inelastic
  • For agricultural goods authorities need to purchase any excess supply to prevent price falling below min. price (expense & opp. cost, as money could have been spent on other projects)
  • Once purchased, the excess supply likely to be destroyed as most agricultural products are perishable (wasteful)
• Depends where min. price is set: At/below equilibrium has no impact, Greater impact the higher max price is set, or when ped & pes is elastic (develop point fully giving min. 2-3 examples)
• Subjective whether min. price improves fairness (e.g. for alcohol, consumers pay higher prices than they would in the absence of government intervention)