Economics 2 - Module 1 - Unit 3 & 4

Unit 3 - Market Failure

The key functions of the Market: To allocate scarce resources in the light of unlimited wants To signal to buyers and sellers that market conditions have changed To incentivise buyers and sellers to respond to changes in the market Market failureMarket failure is the consequence of the market failing to allocate scarce resources so the economic welfare of consumers is maximised rather than the few. Market failure implies that some consumers are being made worse off because of how the resources are being allocated.Market failure is the sign that scarce economic resources are being misallocated.

Costs and BenefitsProduction and consumption generates costs and benefits which can be either private or social:1. Private cost - this represents the cost to the producer or consumer. For the producer, this is the cost of producing a good, plus an element of profit - this determines the price, which is the cost to the consumer.2. Private benefit - this is the benefit to the producer or consumer. For the producer, this can be derived from higher revenue. For a consumer, the private benefit is derived from the consumption of a product or service.3. Social cost - this represents the negative consequence for society arising from the production and consumption of an economic good e.g. car production and consumption can cause deaths, accidents, congestion, CO2 pollution etc.4. Social benefit - this represents the positive consequence for society arising from production and consumption of an economic good e.g. car production and consumption creates employment for workers and other services like maintenance and fuel. The market price is determined by the interaction of buyers and sellers who base their decisions on their private costs and benefits. This is how the market misallocates scarce resources.

ExternalitiesThese are the external costs and benefits generated in either production or consumption of a good which are not paid for by the producer or consumer but by society. Externalities can therefore be either positive or negative. The market can choose to ignore externalities because producers and consumers don't pay for them or benefit from them.5. External cost - this is the cost generated in production and/or consumption that is not paid for by the producer or consumer but by a third party in society.6. External benefit - this is the benefit generated in consumption or production that is not enjoyed by the consumer or producer, but is enjoyed by a third party in society.The social cost is the private cost and external cost combined. This represents the true value of the cost to society of an activity.The social benefit is the private benefit and external benefit combined. This represents the true benefit to society of an activity.Externalities exist if the private costs and benefits of an activity diverge from the social costs and benefits of that economic activity.

Negative externalities in production

This means that the marginal social cost exceeds the marginal private cost of production. The market equilibrium A is greater than the social equilibrium B, which shows that the good is being overproduced and consequently over-consumed e.g. fossil fuels. ABC represents the welfare loss to society, which represents the negative externalities in production e.g. CO2 pollution. Society would prefer a lower level of fossil fuel production because of the external costs being generated. This can be achieved by fossil fuel production firms switching to renewable energy, which can be made possible by the government providing subsidies.

Positive externalities in production

This means the marginal private cost of production exceeds the marginal social cost. The social equilibrium B is greater than the market equilibrium A, which shows that the good is being under-produced and consequently under-consumed e.g. improving quality of staff training. ABC represents the welfare gain to society, which represents the positive externalities in production e.g. higher pay - more taxes. Society would prefer a higher level of production because of the welfare gain. However, improving the quality of training staff is expensive and so many firms will ignore this because they may not enjoy the private benefits.

Negative externalities in consumption

This means that the marginal private benefit exceeds the marginal social benefit of consumption. The market equilibrium B is greater than the social equilibrium A, which shows that the good is being overproduced and consequently over-consumed e.g. alcohol. ABC represents the welfare loss to society, which represents the negative externalities in consumption e.g. violence, vandalism etc. Society would prefer level of alcohol production and consumption because of the external costs being generated. To lower consumption, the state could increase taxes on alcohol.

Positive externalities in consumption

This means that the marginal social benefit of consumption exceeds the marginal private benefit. The social equilibrium B exceeds the is greater than the market equilibrium A, which shows that the good is being under produced and consequently under-consumed e.g. cycling. ABC represents the welfare gain to society, which represents the positive externalities in consumption e.g. healthier, less pollution etc. Society would prefer a higher quantity of the good or service because f the external benefits being generated. For a higher quantity to be supplied, the government could subsidise a firm to encourage production.

Private goods and Public goodsA market will only supply goods for which the private benefit outweighs the private cost, so that the good can be sold for a price that exceeds the cost of its production, and can therefore generate a profit.Private goods - these have the 2 basic characteristics:1. Rivalry - consumption by one person will reduce the supply available to another.2. Excludability - the benefit of the good is limited to the paying consumer, and free riders are excluded from enjoying the benefits.For example: if you purchase a ticket to see Southampton play at St. Mary's, you reduce the supply of tickets available(rivalry) and only you can enjoy the benefits (excludability).Public goods - these have the 2 basic characteristics:1. Non-rivalry - consumption by one does not limit the supply available to another - provision for one means provision for all.2. Non-excludability - no-one can be excluded from enjoying the benefits, in particular free-riders.Free rider conceptThis is a consumer who enjoys the benefit of consumption without having to contribute to the cost.The market will not provide public goods because they will not be able to exclude free-riders and make a profit. Therefore, public goods are provided by the state because they generate private and external benefits. Most public goods are known as quasi public goods because as well as having elements of non-rivalry and non-excludability, free-riders can be excluded from enjoying the benefits of consumption if necessary e.g. a toll on a bridge.

Merit goods and Demerit goodsMerit goods - A merit good is a good that can be provided by both the market and the state:The market will provide a merit good because it has the characteristics of a private good (rivalry and excludabilty), and therefore the market can charge consumers for it and generate a profit. Because of this incentive, a merit good will be under-provided by the market from society's point of view.The state will provide a merit good because it generates external benefits in its consumption for society, implying the marginal social benefits exceed the marginal private benefits e.g. education.Merit goods vs. Private goodsA merit good is different to a private good because it generates significantly greater positive externalities for society and is therefore considered desirable for human consumption.Examples of merit goods - Education / Healthcare / Pensions* / Housing / Television / Transport / Lawyers.*There are 3 different types of pension:1. State pension - Paid for by national insurance contributions.2. Occupational pension - Paid for by employer, based on time spent and money earned during occupation.3. Private pension - Paid for by your private insurance company or with a bank.Demerit goods - A demerit good is a good supplied by the market that the state deems is undesirable for private consumption: They generate negative externalities in their consumption.For example: smoking - There are numerous negative externalities generated by smoking, such as bad health, poor hygiene, social undesirability, passivity and premature death.Unfortunately, the market ignores the external costs when setting the price of demerit goods, which is why private benefits exceed social benefits implying external costs exist.From society's point of view , a demerit good will be over-produced and consequently over-consumed.Examples of demerit goods - Alcohol / Smoking / Gambling / Speeding / Drugs.The government will attempt to reduce the consumption of demerit goods, on the basis that producers and consumers lack the information to realise the external costs and benefits. The government will use methods such as taxes, legislation and negative advertising.

Monopoly and Monopoly Power

Monopoly Power - The extent to which a supplier is able to influence the price charged to its consumers in the market.In theory: the definition of monopoly power is a market structure where one firm supplies all output without any competition. So in theory, monopoly power is having 100% market control e.g. water companies who are the sole suppliers in their area.In practice - A firm is considered to have a monopoly position if it has 25% of the market share. This is because they aren't many firms who dominate the market completely. e.g. Microsoft, as they have a dominant position in the PC market but not complete control.The demand for monopoly goods is inelastic because there are a few acceptable consumer substitutes. Consequently, the supplier can charge a higher price to gain a significantly higher revenue. The greater the market share, the greater the inelasticity.

Sources of monopoly power1. Legal barriers - In some markets, the state will limit the number of firms e.g. the mobile phone market is legally limited to 5 companies - T-Mobile + Orange (EE), O2, 3 and Vodafone. The reason for legal barriers is that they allow the firms to operate efficiently, considering they are large and have high costs. Furthermore, by only having a few suppliers in the market, they can adopt economies of scale and increase productive efficiency, and charge the lowest possible prices.2. Economies of Scale - Economies of scale is the name given to the advantages that firms can only exploit as they grow in size and operate on a larger scale. The effect of these economies is that they allow the firm to increase their output while reducing their average costs of production, because the increase in output is greater than the increase in production costs.

The economies of scale are:1. Technical - capital equipment which is modern, up-to-date and advanced and more cost effective.2. Specialisation - the result of division of labour of a large workforce, resulting in increased productivity.3. Purchasing - the benefits of bulk buying at lower costs per unit.4. Financial - lower costs of capital charged by financial providers, lower interest rates charged by banks etc.5. Risk bearing - having the finance and resources to take risks e.g. investing in new products and markets.6. Marketing - being able to afford larger scale marketing e.g. TV advertising and internet advertising.

A small firm has to have a higher average cost AC1 to cover its cost of production. A larger firm with a greater output can set a lower price to cover its costs per unit AC2.

3. Unfair Competition - Once in a dominant position, economies may use unfair competition and illegal actions to maintain their monopoly power. For example:- Supermarkets have been accused of forcing suppliers to accept lower prices or force losing their contract.- Microsoft - they have threatened computer hardware manufacturers to install their software or face consequences.4 - Natural Barriers - Natural barriers occur when firms legally manage to gain control of all the resources for production, preventing any competition. e.g. Oil companies gaining exploration rights of all the oil in the area.

Advantages of monopolies Monopolies can increase productive efficiency by exploiting economies of scale, thus allowing them to operate at a lower cost compared to smaller operators. For example, water suppliers who are the sole suppliers of water services in their area are able to exploit economies of scale to produce their goods at the lowest possible cost. Monopolies can increase allocative efficiency by charging lower prices to their customers. They can do this by avoiding duplication , which may otherwise occur with a greater number of suppliers. Monopolies have the resources available to be more inventive and innovative. Research and development in areas such as pharmaceuticals, technology and energy are extremely risky and expensive, and only affordable by large firms who can exploit economies of scale.

Disadvantages of Monopoly Power1. Barriers to entry mean that consumers have a lack of choice. Therefore, the demand is highly price inelastic, and consumers - particularly those on lower incomes - will be made worse off, as they will not be able to afford these goods.2. Consumers pay more than they would in competitive markets, resulting in a loss of allocative efficiency.3. Lack of competition means monopolies have less incentives to lower prices, resulting in a loss of productive efficiency.4. Diseconomies of scale - as a business grows in size, it may become too large to run inefficiently.

Diseconomies of scale imply: It will become harder to communicate with staff Controlling operations will become more challenging Staff will start lacking motivation and productivity As a result, productive efficiency is decreased and average costs start to rise. The firm then has to raise prices to maintain profits, which leads to lower demand.

Market Imperfections

Economic efficiency is maximised when one individual can be made better off, without making another worse off. This implies that suppliers are:1. Productively efficient - they use all the resources available, and operate at the lowest cost possible.2. Allocatively efficient - the goods produced are affordable, and therefore sold for the lowest possible price.Factor Immobility - when a factor of production is not working to its full potential. For example: Land is immobile because it requires planning permission and a lot of time. Labour is immobile because of unemployment and lack of productivity or motivation. Capital is immobile because of depreciation and lack of its use. Enterprise is immobile because sometimes, risks don't always pay off. Factor immobility is a form of market failure. For example, labour is not maximised because unemployment exists, which means that there are people who are not contributing to the economy but instead benefiting from welfare. The opportunity cost of this is that less money is spent on better alternatives such as education.Imperfect Knowledge - Economic agents lack the necessary information to make rational decisions. For example: The market underprovides merit goods such as education because it only seeks to make a profit and ignores the positive externalities to society. Education provided by the state is free, and is therefore abused because some students ignore the private and external benefits. Alcohol is a demerit good over-provided by the market, and over-consumed by consumers who ignore its private and external costs. Therefore, imperfect knowledge is an example of market failure because economic agents ignore the external benefits of merit goods and external costs of demerit goods.Wealth - This is the result of income, which is attained from 3 basic sources: Employment, Welfare and Investment.There are 2 different forms of wealth: Physical - Tangible possessions such as property, cars or jewellery. Monetary - Monetary investments such as cash, bank accounts, shares and pensions. There are 3 factors that can increase wealth: Rising income from work. Rising value of investments. Wealth is an example of market failure because it is unevenly distributed.

Unit 4: Government Intervention in the Market

Recap of market failure>The misallocation of scarce resources resulting in externalities.>Examples of market failure - Pollution, oiling, education, unemployment, smoking, monopoly, poverty, choice.Rationale for Government Intervention To maximise economic efficiency by making one person better off without making another worse off. In the absence of government intervention, scarce resources will be misallocated. The market generated positive and negative externalities which result in some goods being over or under produced. Merit goods will be underprovided by the market who ignore their external benefits in consumption. Demerit goods will be over-provided by the market who ignore their external costs in consumption. The market does not provide public goods because they lack the mechanism to prevent free-riders Market imperfection such as monopolies, factor immobility and imperfect knowledge means that the market produces less goods at higher prices. Income inequality means that some consumers are excluded from the market because they lack market power. In the absence of government intervention, there may be higher levels of unemployment, crime and poverty and possibly anarchy. Methods of Government Intervention1. The use of indirect taxesAn indirect tax is a charge added by the government which increases the market price of a good to a customer, for example an excise tax or V.A.T.. The incidence of tax is used to measure how much indirect tax is paid by the producer, and how much is paid by the consumer.

The effect of an indirect tax will be to shift the supply curve to the left, meaning that less will be supplied at each existing price. The unit tax is represented by the shift from S to S+tax. P-P1 is the amount of tax paid by the consumer. P-X is the amount of tax paid by the producer. Higher taxes imply that the quantity traded for the good will decrease. The greater the incidence of tax, the more tax the consumer will have to pay. The greater the inelasticity of demand, the greater incidence of tax. Hence, if demand is perfectly inelastic (|), the incidence of taxation falls entirely on the consumer.

2. The use of subsidiesA subsidy is a sum of money paid by the state to the producer to encourage a lower market price and a higher quantity traded, so the supply curve will shift to the right.

A subsidy will increase supply, and this will be shown as the supply curve shifting to the right (outwards). The reason for this is to show that the producer is now able to supply a higher quantity Q2 at a lower price P2. The unit subsidy is equivalent to the shift in the price from P2-P3*. The price decrease available to the consumer is represented by P1-P2. *P3 will be greater than P1, and meet with Q2 at the curve S pre subsidy.

Minimum and Maximum prices

3. The use of price controlsThe government will use price controls because the prices set by the market may may not be allocatively efficient - this may be because it is either set too high or too low, or it fluctuates in the short term. The government uses 3 forms of price control - maximum prices, minimum prices and buffer stock schemes.

Minimum price

A minimum price is set by the state above the market price This is order to protect the incomes of primary producers such as agriculture and commodity For example - farmers, whose produce is vulnerable to factors such as weather or competition - which cause prices to fluctuate Minimum prices create excess supply, implying there is a surplus in the market.

Maximum price

A maximum price is set by the state below the market price This is in order to keep the prices affordable for the least well-off For example - a maximum prices on council houses so that people on low income can afford them Maximum prices create excess demand, implying there is a shortage in the market.

Buffer stock systemThe rationale for buffer stock schemes: The free market price of primary products can fluctuate significantly over the short term because supply and demand for these goods are price inelastic - therefore, a change a demand or supply causes a significant fluctuation in the market price. Price fluctuation creates instability in the market, making it difficult for producers to predict future incomes. The buffer stock scheme is a form of state intervention to help stabalise both prices and incomes for suppliers.

How the buffer stock scheme works1.The authorities will set a target floor and ceiling price: The ceiling price is represented by P3 The floor price is represented by P2 2. If the market price falls below the floor price to P1, authorities will intervene by buying up the surplus stocks.3. If the market price rises above the ceiling price to P4, authorities will sell surplus stocks in order to depress the price.

If surplus stock is bought by the state, there a number of things that can happen to it: It can be stored It can be destroyed It can be sold to other countries It can be provided as overseas assistance.

However, every option has a disadvantage: Storage is expensive and has an opportunity cost for the state Destroying food surpluses is unethical in a world devastated by poverty Selling it to other countries at low prices can undermine domestic producers It is argued that giving the food as aid could lead to a dependency culture.

Limitations of the buffer stock scheme:1. It is difficult for members to agree on prices, especially if they are set too high with the incentive to maximise profits.2. Buffer stock schemes are expensive to operate because of the high costs of storing maintaining stocks.3. If there are persistent surpluses that have to keep getting bought up, the scheme members may go bankrupt.4. Agreements are vulnerable between members and non-members as selling below the intervention price to make profits comes at the expense of other members.5. Setting a price above the free market price means that consumers are being made worse off because they are paying higher prices.

4. Regulation (legislation)This is the use of legislation to legally command and restrict consumers on how they behave in producing and consuming goods and services.

5. State provision of merit goods and public goodsThis is where the government provides merit goods and public goods that they believe will cause a long-term benefit to society.

Government failureThe reason for government intervention is to correct market failure - the misallocation of scarce resources. The purpose of government intervention is therefore to maximise economic efficiency - make one individual better off without making another worse off.However, government intervention may not always be economically efficient, as it may not improve resource allocation compared to a free market. Government failure implies that the cost of government intervention outweighs the benefit. There are 3 basic reasons for government failure:

1. Inadequate informationGovernments will base their decisions on the best information available. However, they are not always able to gather all the information necessary, and so inadequate information leads to inappropriate decisions.

2. Conflicting objectivesThe government will set a range of objectives it wishes to achieve, but every decision will have an opportunity cost. For example, imposing excise taxes on tobacco to reduce consumption will encourage a growth in the illegal market.

3. Administrative costsGovernment policies to correct a market failure will have a financial cost, and sometimes this cost may outweigh the benefit altogether. For example, in order to reduce unemployment the government introduced a range of training schemes. However, many people enrolled into these schemes to avoid having to look for work, and many eventually found jobs they would have got even if they didn't participate in the training scheme. Another example is that a third of all students drop out of their higher education courses, and this results in a waste of economic resources which was devoted to their education.