1.7 market failure

• Market failure definition 


  Occurs when there is an insufficient allocation of resources due to the free market forces failing to allocate scarce resources at the socially optimal level leading to social and economic welfare loss
• public good


  has non rivalry and non excludability e.g street lights
• merit goods


  a good which is underprovided by the market mechanism (d +s)
• demerit goods


  A good which is overprovided by the market mechanism (d + s)
• what is the free rider problem

  • when a good is consumed without paying
  • The free rider problem would occur if the provision of public goods was left to the market mechanism
• how doe governments intervene to correct market failure for merit and demerit goods?

  • taxation
  • subsidies
  • regulation
  • information
• IMPACT of tax


  who sets the tax
• INCIDENCE of tax


  who ends up paying for the tax
• Ad valorem tax


  A tax imposed on an item based on its assessed value

  • the diagram shows that the tax at each point gets bigger so the price gets bigger at each point

  
• externalities definition 


  The effect to the third party of an economic decision, occurs when producing or consuming a good
• how to calculate marginal social cost 


  MSC = MPC + EC
• how to calculate marginal social benefits


  MSB =MPB + EB
• negative externality


  an externality that arises from either production or consumption and that imposes an external cost
• positive externality


  an externality that arises from either production or consumption and that provides an external cost.
• marginal private cost


  the cost of producing an additional unit of a good or service that the consumer of that good or service received.
• external cost


  the cost of producing an additional unit of a good or service that falls on people other than the producer.
• external benefit


  the benefit from an additional unit of a god or service that people other than the consumer enjoy.
• Marginal social cost


  The marginal cost incurred by the entire society, by the producer and by everyone else on whom the cost falls and is the sum of marginal private cost and marginal external cost.
• public provision


  the production of a good or service by a public authority that receives its revenue from the government.
• subsidy


  a payment made by the government to a producer.
• negative consumption externality

  • overconsumption
  • MSC > MSB
  • causes overpricing

  
• negative production externality

  • overproduction
  • MSC < MPC
  • causes under pricing

  
• positive consumption externality

  • underconsumption
  • MSB > MSC
  • causes under pricing

  
• positive production externality

  • underproduction
  • MSC < MSB
  • causes over pricing

  
• Negative externality solution

  • gov intervenes and sets a tax- this is known as internalising the externality
  • This reduces production/ consumption to the socially optimum level
• evaluation of using tax to reduce consumption/ production of demerit goods

  • if demand is inelastic- reduction would be small
• solution to underconsumption/ underproduction of merit goods


  gov could subsidise the good (e.g give money to uni students to pay for education at university)
• evaluation for using subsidies to increase consumption of merit goods

  • opportunity costs linked- gov could spend on other public services
• regulation definition 


  Using legislation to create a regulatory free work for firms to comply with
• extension of property rights definition

  • transferring resources from those who create pollution to those who suffer from it
  • Externalities often occur because there is an absence of property rights. (e.g nobody owns a lake so nobody cares when it is polluted)
• tradeable pollution permits

  • a permit issued, so the firm is able to pollute up to a certain quantity
  • If a firm does not use up all its permit, they can sell it to other producers providing incentive to reduce pollution
• minimum price control 


  • The minimum price that the product can be sold at, set by the government
  • used in agricultural markets to ensure fair pay for farmers to guarantee supply for food products
  • set above the equilibrium
• Buffer stock definition

  A buffer stock scheme is a government plan to stabilise prices in volatile markets by buying up supplies of the product when there is excess supply and selling stocks onto the market when supplies are low.
• buffer stock example 1

  • a flood may cause a shortage in the market for wheat
  • supply for wheat falls (S shifts left)
  • buffer stock schemes have this wheat stored and sell it onto the market
  • this pushes supply right until the equilibrium (target) price is achieved
• buffer stock example 2

  • excessive supply of wheat (glut in supply)
  • supply rises (S shifts right)
  • prices are pushed down
  • buffer stock scheme can buy and store the wheat
  • this causes an increase in the demand for wheat pushing prices back up to the equilibrium (target) price
• maximum price control definition 


  • The government intervenes and set a maximum price designed to Keep the price low/ limit the price
  • set below the equilibrium
• Monopoly definition 


  There is only one firm in the market
• assumptions of a monopoly market structure

  • the firm is the market
  • unique product sold
  • demand is very inelastic (no available substitutes)
  • monopolist is the price maker- can charge high prices
• negatives of monopolies

  • can charge higher prices than the competitive free market prices turning consumer surplus into extra profit
  • no competition so monopolies dont take into account customer service
• positive impacts of monopolies

  • trade balance could improve (MACRO)
  • large size markets makes it easier to compare and trade demand