Notesale: Turn your study into money

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Consequences of a price floor on
stakeholders
Þ   Consumers get higher prices
Þ   Producer sell at higher selling prices; this
breeds inefficiency and it is a
misallocation of resources
Þ   Government may need to increase
spending on solving the consequences
(opportunity cost) by storing, destroying or
selling the surplus abroad (dumping) or by
increasing demand through the
advertisement or restriction of imports of
the same good through protectionist
policies (thus increase demand for
domestic products)

Market failure – situation in which market
forces fail to allocate resources efficiently and
the community surplus is not maximised
...

Demerit good is a good that has a negative
externality on a third party
...
Examples include cigarettes and
alcohol
...
This results in
their under provision/under consumption in
the free market
...

Types of market failure
1
...

There are four types of externalities:
•  
•  
•  
•  

Negative externality of production
Negative externality of consumption
Positive externality of production
Positive externality of consumption

Negative externalities – an external cost
borne by society when producing or
consuming a good/service;
Negative externality of production (e
...

cement industry emitting pollutants into the
atmosphere)
MSC

C/B

MPC
Size of externality

MSB=MPB
0

Qo

Qm

Q

1
...


3
...


2
...


4
...


3
...


5
...


4
...


6
...


5
...

6
...

Negative externality of consumption (e
...

fuel taxis emitting pollution)

MSC=MPC

C/B

1
...
This would
raise production costs and prices as well as
inducing the firm to limit output to the
optimal level of the good
...

However, it is difficult for the government
to estimate the size of the externality and
the necessary tax to reduce market failure
...

2
...


Size of
externality

MSB
0

Solutions to market failure caused by
negative externalities

Qo

Qm

MPB
Q

1
...

2
...


3
...
These are licenses that
allow a firm to produce a fixed amount of
pollution, and are tradable in the free
market
...

However, a maximum acceptable level of
pollution is hard to establish
...


4
...

Governments may attempt to change the
practices of consumers and of firms by
increased awareness of the external costs
of certain activities they undertake
...

Positive externality of production

MPC

C/B
5
...

Governments may directly regulate the
behaviour of consumption of demerit
goods
...


MSC

Size of
externality

MPB = MSB
Qm

Qo

Q

1
...

2
...

3
...
  In the diagram, the market quantity (Qm) is
less than the optimal quantity (Qo), which
means there is an under-allocation of
resources that causes market failure
...
  The indicated triangle shows the welfare to
be gained if the use of good A would
increase to the optimum quantity (Qo) and
the distance between the MPC and MSC
shows the size of the externality
...
g
...
  Legislation and direct provision
(consumption)
...
This is the
case with state education and public
hospitals
...
This is the
case with education (which is compulsory
up to a certain age) and in some countries,
with vaccinations
...

3
...


1
...

2
...

3
...

4
...

5
...

Solutions to market failure caused by
externalities
1
...

The government may give a subsidy equal
to the estimated size of the external
benefit
...

However, estimating the proper size of a
subsidy is not easy, and may not
completely eliminate market failure
...
  Lack of public goods – A good is
considered a public good if it is nonexcludable and non-rival, meaning that the
consumption of the good does not decrease
the amount available for others
...

Free rider problem leading to market
failure
Þ   No consumer would pay for a good that
could be for free if another household
decided to purchase it
...

Þ   This suggests they could enjoy a “free
ride”, meaning using the good/service
without having to pay for it
...

Solution to market failure caused by lack of
public goods –The government may directly
provide public goods, which are usually
financed through taxation
...
  Common access resources –Resources
that lack ownership, and which are
difficult to exclude other people from
using them
...
Examples include forestry
and fisheries
...
  Asymmetric information – Market
failure may occur when one party in an
economic transaction possesses more
information than the other party
...


Þ   Governments improving the information
flow
...
g
...


How does common access resources lead to
market failure?

Þ   Legislation – governments may establish
minimum standards of information

The depletion or degradation of common
access resources poses a threat to
sustainability and therefore leads to market
failure
...


Market failure by common access resources
can be illustrate with a negative externality of
consumption diagram
...
  Abuse of monopoly power – Firms with
monopoly power are able to restrict output
below the competitive ideal and charge
higher prices leading to a welfare loss
...


Solutions and responses to threats to
sustainability
Þ   Legislation - Governments can ban or
limit the amount of pollution firms can
produce, as well as controlling production
methods
...

Þ   Carbon taxes and cap and trade
schemes would limit the amount of
pollution produced
...
International treaties and
agreements may be created to respond to
threats to sustainability
...


Solutions to abuse of monopoly power
Þ   Legislation and regulation - enforcing
competitive laws that include:
•   No mergers or acquisitions that
increase the monopoly power of any
firm
•   Tax or fine firms found guilty of anticompetitive practices or even breaking
them down into smaller independent
firms
...

Þ   Nationalisation



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