Market Failure Government intervention in markets Definition When

Market Failure Government intervention in markets

Definition When the free market mechanism leads to a misallocation of resources in the economy, either completely failing to provide a good or service or providing the wrong quantity.

Market failure 1. 2. 3. 4. 5. 6. 7. Negative externalities Positive externalities Merit & demerit goods Public goods Monopoly Immobility of the factors of production Unequal distribution of income and wealth

Negative externalities Also regarded as the external cost. When the consumption or production of a good or service causes costs to a third party, where the social cost is greater than the private cost.

Negative externalities 1 Costs that spill over to third parties of a market transaction.

Negative externalities in production Where the social cost of production exceeds the private cost The existence of negative Costs and benefits S 2 (MSC) S 1 (MPC) P 2 E 2 P 1 E 1 externalities in production creates a divergence between the private and social costs of production. The private costs of any action are those incurred by the individual decision maker while the social costs of the corresponding action are ALL the conceivable costs associated with the action. D (MSB) Q 2 Q 1 Quantity Production needs to be reduced.

Negative externalities in consumption Where the social cost of consumption exceeds the private cost Costs and benefits S (MSC) E 1 P 1 D 1 (MPB) P 2 E 2 D 2 (MSB) Q 2 Q 1 Quantity The existence of negative externalities in consumption creates a divergence between the private and social costs of consumption. The private benefits of any action are those incurred by the individual decision maker while the social benefits of the corresponding action are ALL the conceivable benefits associated with the action. Consumption needs to be reduced.

Positive externalities Also regarded as the external benefit. When the consumption or production of a good or service results in a third party benefit, where the social benefit is greater than the private benefit.

Positive externalities 2 Benefits that spill over to third parties of a market transaction.

Positive externalities in production Where the social benefit of production is greater than the private benefit The existence of positive Costs and benefits S 1 (MPC) P 1 S 2 (MSC) E 1 P 2 E 2 externalities in production creates a divergence between the private and social costs of production. The private costs of any action are those incurred by the individual decision maker while the social costs of the corresponding action are ALL the conceivable costs associated with the action. D (MSB) Q 1 Q 2 Quantity Production needs to be increased.

Positive externalities in consumption Where the social benefit of consumption is greater than the private benefit Costs and benefits S (MSC) E 2 P 1 E 1 D 2 (MSB) The existence of positive externalities in consumption creates a divergence between the private and social costs of consumption. The private benefits of any action are those incurred by the individual decision maker while the social benefits of the corresponding action are ALL the conceivable benefits associated with the action. D 1 (MPB) QDS 1 QDS 2 Quantity Consumption needs to be increased

The reasons for government intervention • The free market mechanism is a very powerful tool for determining how resources are allocated. The government may choose to intervene in the price mechanism largely on the grounds of wanting to change the allocation of resources and achieve what they perceive to be an improvement in economic and social welfare. The main reasons for policy intervention are : • To correct market instances of market failure. • To achieve a more equitable distribution of income and wealth. • To improve the performance of the U. K economy both domestically and on the international front.

The 3 main forms of government intervention 1. Government legislation, regulation and deregulation 2. Financial intervention (taxation and subsidies) 3. Closing the information gap

1. Forms of government intervention Laws Regulation Deregulation

Forms of government intervention • Laws (Legislation) to prohibit certain activities. This could be to limit the consumption of demerit goods • Regulation (putting rules in place) may involve the governments setting standards of conduct for businesses e. g. the sale of alcohol or output levels for monopolies. • Deregulation (removing rules) sees the government removing controls with the view of increasing levels of competition and the benefits that are said to go with such a change in market structure.

Government legislation A ban on smoking in public Costs and benefits S (MSC) E 1 P 1 D 1 (MPB) P 2 E 2 D 2 (MSB) Q 2 Q 1 Quantity • Laws to prohibit certain activities. This could be to limit the consumption of demerit goods • Rules and regulations on where smoking is and is not permitted • The result being a reduction in the consumption of this demerit good to a more socially optimum level.

Regulation of businesses selling demerit goods Costs and benefits S (MSC) E 1 P 1 D 1 (MPB) P 2 • Regulation may involve the government setting standards of conduct for business e. g. the sale of alcohol and opening hours E 2 D 2 (MSB) Q 2 Q 1 Quantity • The result being a decrease in the consumption of the good and the negative externalities that go with its consumption.

Negative externalities in production Regulation Where the social cost of production exceeds the private cost Tradeable permits and carbon trading Costs and benefits S 2 (MSC) S 1 (MPC) P 2 E 2 P 1 E 1 D (MSB) Q 2 Q 1 Quantity Tradable Permit System. A tradable permit system is a tool that allows the market to direct (typically) environmental efforts where a market does not naturally exist. The tradable permit system can be thought of as a three-step process to reduce pollution emissions. 1. Assess the impact of pollution 2. Set limits 3. Develop a market where permits to be traded between those below and those above their permit levels

Regulation 1. Assess the needs • A system by which carbon allowances can be bought and sold. • Country A would trade its surplus with country C Country Carbon emissions needed (tons) Carbon emissions allocated (tons) Deficit / surplus (tons) A 10 15 +5 B 15 15 0 C 20 15 -5

2/3 Set limits & trade permits • The sum total of allowances can be less than the current total emissions from the individual businesses / countries. • Total sum needed 45 tons. • Total sum allocated 40 tons. Country Carbon emissions needed (tons) Carbon emissions allocated (tons) Deficit / surplus (tons) A 10 12 +2 B 15 13 -2 C 20 15 -5

Reduce limits over time The sum total of allowances can be reduced over time. Total sum allocated 2008, 42 tons. Total sum allocated 2009, 39 tons. This can have a number of effects. • • Countries will look to reduce emissions as purchasing permits can be expensive. Countries may look to reduce emissions in order to create surlpuses to trade these potentially expensive permits. Country Carbon emissions allocated (tons) 2008 Carbon emissions allocated (tons) 2009 Carbon emissions allocated (tons) 2010 A 12 11 10 B 13 13 12 C 17 15 14

Problems with carbon trading as a way of tackling global warming (evaluation) • The ‘cap and trade’ system gives a right to emit. That is, find a surplus producer, purchase their permit/s and continue to pollute rather than look to reduce emissions through efficiencies and climate friendly innovation. • Misjudging the level of permits can have major implications on the price of the permits. Too high and their price falls having little effect on reducing emissions and too low sees their price rise with potentially negative effects on the local and global economies. • A fixed allotment of permits makes no adjustment for the business cycle. Emissions will vary with economic activity.

Government legislation Deregulation of bus services Costs and benefits S 1 (MPC) P 1 S 2 (MSC) E 1 P 2 E 2 D (MSB) Q 1 Q 2 Quantity • Deregulation sees the government removing controls with the view of allowing firms to enter the market, increased levels of competition and the benefits that are said to go with such a change in market structure. • The result being an increase in the production and consumption of this good or service and the positive externalities associated with it.

2. Financial Intervention Taxation

Negative externalities in production Taxation Where the social cost of production exceeds the private cost Additional or higher taxes on demerit goods Costs and benefits S 2 (MSC) S 1 (MPC) P 2 E 2 P 1 E 1 D (MSB) Q 2 Q 1 Quantity Effect of Taxes on Supply and Demand. Taxes reduce both demand supply, and drive market equilibrium to a price that is higher than without the tax and a quantity that is lower than without the tax. require the Tax authorities usually require the seller to be legally responsible for payment of the Excise duties or VAT (value added tax).

The imposition of a tax on suppliers of a demerit good (a good/service with an inelastic PED) S 2 Price Tax imposed e. g. 20 p (P 2 -P 3) S 1 E 2 Amount of tax passed onto customer e. g. 17 p (P 1 -P 2) P 2 P 1 Amount of tax absorbed by the business e. g. 3 p (P 1 -P 3) E 1 P 3 D 1 Quantity Q 2 Q 1

The net effect of a tax on suppliers of a demerit good • Demand for the demerit good falls by a smaller percentage than the percentage tax rise. • Government revenues increase. • ‘Overall, the tax has not had the effect of discouraging a significant number of consumers away from the consumption of the demerit good, but does yield large tax revenues. ’

2. Financial Intervention Subsidies

Forms of Government Intervention A subsidy to suppliers of a good or service with positive externalities Costs and benefits S 1 (MPC) P 1 S 2 (MSC) E 1 P 2 E 2 D (MSB) Q 1 Q 2 Quantity • A subsidy is a sum of money paid to suppliers in order to lower the cost of production. This should lower the price of goods and services, in this case one that provides positive externalities. The effect is to boost production and or consumption. • The result being an increase in consumption to exploit the positive externalities that go with its production and/or consumption.

Using carbon tax revenues to subsidise environmentally friendly production and consumption (inelastic supply curve) S 1 Price S 2 E 1 P 2 E 2 P 3 D 1 Subsidy provided e. g. 20 p (P 1 -P 3) Amount of subsidy passed onto customer in the form of lower prices e. g. 8 p (P 1 -P 2) Amount of subsidy kept by the business as an increase in profits e. g. 12 p (P 2 -P 3) Quantity Q 1 Q 2

A subsidy to suppliers of a good or service with positive externalities (a good/service with an elastic PES) • The net effect Price Quantity

The net effect of a subsidy on suppliers of a good or service The price of the good or service falls Demand rises Supply of the good or service rises A proportion of the subsidy is passed onto consumer. A proportion is kept by the business in the form of profit. • ‘Overall, the subsidy has the effect of encouraging an increase in demand supply. • The more elastic a PES, the greater will be the increase in supply and consumption of the good with positive externalities. ’ • •

2. Financial Intervention Price Ceilings and Price Floors

Financial intervention : maximum prices (price ceiling as the price will NOT rise above the ceiling) Costs and benefits S (MSC) E 2 P 1 E 1 D 2 (MSB) The existence of positive externalities in consumption creates a divergence between the private and social costs of consumption. The private benefits of any action are those incurred by the individual decision maker while the social benefits of the corresponding action are ALL the conceivable benefits associated with the action. D 1 (MPB) QDS 1 QDS 2 Quantity Consumption needs to be increased

Financial intervention : maximum prices (price ceiling as the price will NOT rise above the ceiling) p • • Price ceilings aim to encourage demand. A price set below the free market equilibrium price. Prices cannot rise above this level. The lower price sees demand move along the demand curve to Dc. The lower price sees supply move to Sc. pe A situation of excess demand is created. Examples include, council housing, NHS pc prescriptions and university tuition fees. s e Price ceiling . d Sc QDSe Dc Excess demand Qds

The case for and against setting a price ceiling (maximum price) For Against To allow those on low incomes to enter the market Distorts the workings of the free market To promote the consumption of certain goods and services Encourages consumers into the market that could otherwise afford the free market price To protect consumers against monopoly power Suppliers may leave the market due to incentive function of lower prices Excess demand is created potentially leading to ‘secondary’ or ‘black markets’ Can lead to a ‘two tier system’ within the market Governments are likely to pay a subsidy to suppliers to encourage supply. This is likely to come from taxes

Financial intervention : - minimum prices (price floor as the price will NOT fall below the floor) The existence of positive Costs and benefits S 1 (MPC) P 1 S 2 (MSC) E 1 P 2 E 2 externalities in production creates a divergence between the private and social costs of production. The private costs of any action are those incurred by the individual decision maker while the social costs of the corresponding action are ALL the conceivable costs associated with the action. D (MSB) Q 1 Q 2 Quantity Production needs to be increased.

Financial intervention : - minimum prices (price floor as the price will NOT fall below the floor) • • p Price floors aim to encourage supply A price set above the free market equilibrium price. Prices cannot fall below above this level. The higher price sees supply move to Sf. pf The higher price sees demand move pe along the demand curve to Df. A situation of excess supply is created. Examples include agriculture (The Common Agricultural Policy and Fair Trade). s Price floor e . d Df QDSe Excess supply Sf Qds

The case for and against setting a price floor (minimum price) For Against Encourages production in markets where incentives may be low Distorts the workings of the free market Supports incomes where supplies may not be able to negotiate a ‘fair’ price. Suppliers may increase production without their being the necessary demand Excess supply of perishable goods can lead to waste Can lead to inflated prices and a loss of welfare to society Can lead to over reliance and difficult to withdraw once market conditions have changed Governments may subsidise the difference between pe and pf through increased taxation.

Financial intervention : - minimum prices (price floor as the price will NOT fall below the floor) Costs and benefits S (MSC) E 1 P 1 D 1 (MPB) P 2 E 2 D 2 (MSB) Q 2 Q 1 Quantity The existence of negative externalities in consumption creates a divergence between the private and social costs of consumption. The private benefits of any action are those incurred by the individual decision maker while the social benefits of the corresponding action are ALL the conceivable benefits associated with the action. Consumption needs to be reduced.

Financial intervention : - minimum prices (price floor as the price will NOT fall below the floor) • • p Price floors aim to discourage demand A price set above the free market equilibrium price. Prices cannot fall below above this level. The higher price sees supply move to Sf. pf The higher price sees demand move pe along the demand curve to Df. A situation of excess supply is created. Examples would include all demerit goods that are subject to additional taxes. s Price floor e . d Df QDSe Excess supply Sf Qds

The case for and against setting a price floor for demerit goods For Against Discourages production in markets where incentives may be high Distorts the workings of the free market Discourages consumption in markets where negatives externalities exist Suppliers may increase production without their being the necessary demand Can lead to inflated prices and a loss of welfare to society Disproportionately effects lower income groups where consumers may not be able to able afford the good.

2. Financial Intervention Price stabilisation Buffer stocks

Definition An intervention system that aims to limit fluctuations in the price of commodities by the release and purchase of the commodity in question.

Price volatility, agricultural markets and government intervention • Agricultural and commodities markets are subject to unpredictable weather patterns and have relatively inelastic demand supply conditions. • As a result these markets are notorious for their price volatility. • This instability can lead to unpredictable incomes for farmers and their families. Price volatility is a particular concern in developing countries where they are heavily dependant on ‘cash crops’. • Agricultural and commodities supply the secondary sector and price volatility can impact on the price of staples. • Governments may seek to stabilise this volatility in agricultural and commodities order to brings markets in order to eliminate this uncertainty.

Buffer stocks and excess supply • A positive change in the determinants of supply causes the P supply curve to shift to the right giving S 2 • Supply rises from QS 1 to QS 2 • QD remains unchanged at QD 1 • This creates a situation of excess supply (more supply than demand) • The excess supply puts pressure on P 1 prices to fall. • The authorities (government) purchase the excess QS 2. • The excess supply is eliminated. • Equilibrium is restored at E 1. S 1 S 2 E 1 D 1 QDS 1 QS 2 QDS

Buffer stocks and excess demand • A negative change in the determinants of supply causes the P supply curve to shift to the left giving S 2 • Supply falls from QS 1 to QS 2 • QD remains unchanged at QD 1 • This creates a situation of excess demand (more demand than supply) • The excess demand puts pressure P 1 on prices to rise. • The authorities (government) release buffer stocks onto the market at lower prices to satisfy excess QD 2. • The excess demand is eliminated. • Equilibrium is restored at E 1. S 2 S 1 E 1 D 1 QD 2 QDS 1 QDS

3. Closing the information gap

Closing the information gap (information failure) Where market failure occurs as a result of consumers suffering a lack of information about the costs and benefits of products available in the market place. The government can have a role in helping consumers and producers value the ‘true’ cost and/or benefits of a good or service.

Merit Goods Definition A good that would be under-consumed in a free market, as individuals do not fully understand the benefits that derived from the consumption of that goods Examples § Health care § Education § Vaccinations § Screening for cancer § Eye tests § Dental care § Fruit § Vegetables § Exercise

Closing the information gap (promotional campaigns on the benefits of healthy eating and exercise) • Improved information on healthy living to counter S (MSC) the risk of growing obesity and associated health risks. Costs and benefits E 2 P 1 E 1 D 2 (MSB) D 1 (MPB) QDS 1 QDS 2 Quantity • The result being an increase in the take up of activities that improve health and promote the positive externalities that go with its consumption.

Demerit Goods Definition Goods that are typically considered to be ‘bad’ for one. Such goods would be over-consumed in a free market, as it brings less overall benefit to consumers than they realise. In addition to this, consumption may well lead to external costs that are not taken account of. Examples § Alcohol § Cigarettes § Gambling § Drugs § Chocolate ? § Fast foods ? § Fizzy drinks ? § High heeled shoes ?

Closing the information gap (promotional campaigns on the dangers of smoking) Costs and benefits S (MSC) E 1 P 1 D 1 (MPB) P 2 E 2 D 2 (MSB) Q 2 Q 1 Quantity • TV commercials , print media and compulsory labelling of cigarette packages with health warnings to reduce smoking. • The result being a reduction in the consumption of this demerit good to a more socially optimum level.