Economic Issues: An Introduction DE3A 34 Outcome 3 Topic 11 The Role of Government in Market Failure

Market Failure  Market failure occurs when free markets, operating without any government intervention, fail to deliver an efficient allocation of resources.  In the market system, the price mechanism is used to transmit information from consumers to producers.

Market Failure  For a market to work efficiently various conditions must be met. 1. Producers must be willing and able to respond to changes in demand. 2. There must be no barriers to entry and exit. 3. Perfect mobility in the factors of production, and, 4. Costs and prices must reflect social costs and benefits.

Market Failure  Market failure occurs because of either:· 1. Productive inefficiency where firms are not maximising output from given factor inputs. The lost output from inefficient production could have been used to satisfy more wants and needs· 2. Allocative inefficiency where resources are misallocated and producing goods and services and resources can be put to a better use so that a higher level of wants and needs can be satisfied

Market Failure Markets can fail because of: 1The existence of externalities (e.g. pollution & training) causes private and social costs and/or benefits to diverge. 2Imperfect information means merit goods are under produced while demerit goods over produced. 3Imperfect Markets. Markets cannot make a profit from producing public goods and demerit goods. The concentration of power in markets results in market dominance and abuse of monopoly power.

Market Failure 4Imperfect Competition. Monopoly/Oligopoly power in the market place. 5Factor immobility such as the geographical & occupational immobility of labour causes unemployment hence productive inefficiency· 6Short termism. Private sector entrepreneurs will put short term gain ahead of long term benefits. This may result in over production of consumer goods and a lack of investment in long term capital goods and growth.

Market Failure 7Equity (fairness) issues. Markets can generate an 'unacceptable' distribution of income and social exclusion where people on low income - the relatively poor - are denied access to essential goods and opportunities considered 'normal' by a society e.g. food, clothing, housing, and education.  Bized Bized  Market Failure – Virtual Developing Country

1Externalities  Externalities are the unintended spill over effects on third parties of economic activity.  The economic actions of consumers and producers can often affect third parties (other people).  Generally producers and consumers only take into account the private costs and benefits of production or consumption – how they themselves are affected – and ignore any unintended spill over effects on third parties (someone not directly involved) of their decisions.  For example Victorian factory owners paid little attention to the side effects of manufacture: smoke noise and pollution.

1aNegative Externalities  Negative externalities occur when production or consumption inadvertently impose costs on third parties e.g. 1. Smokers ignore the unintended but harmful impact of ‘passive smoking’ on non-smokers. 2. Acid rain from power stations in the UK can damage the forests of Norway.  Further Study Materials  Bized Bized

1bPositive Externalities  Positive externalities exist when third parties benefit from the spill over effects of production or consumption e.g. 1. Friends benefit when a consumer connects a home computer to the internet – they can now send messages. 2. A well kept garden gives pleasure to passers-by and increases the value of a neighbour’s house.

Externalities and Market Failure  All economic agents produce and/or consume.  There is a cost to all economic activity. We use resources to produce goods and services.  For all economic activity there is a cost and benefit to society.  Externalities explains the difference between our individual needs and desires and societies needs and desires.

Social Costs  Social costs refer to the total cost to society of a product i.e. the cost to first parties and costs inadvertently imposed on third parties.  Social costs are found by adding together the private and external costs of a given economic activity: Private Costs + External cost = Social Costs Cost to individual consumers or firms of their economic activity Cost to others of individual consumers or firms economic activity Total cost to society of a given economic activity Cost to first parties - individuals Cost to third parties - others Total Cost to society - everyone

Social Benefits  Social benefits refer to the total benefit to society from a good i.e. the benefit to individuals and any beneficial unintended spill over effects on third parties.  Social benefits are found by adding together the private and external benefits of a given economic activity. Private Benefits + External benefits = Social Benefits Benefits to individual consumers or firms of their economic activity Benefits to others of individual consumers or firms economic activity Total benefits to society of a given economic activity Benefits to first parties - individuals Benefits to third parties - others Total benefits to society -everyone

Further Study  Externalities and Market Failure  Bized – Virtual Economy Bized

2Information Failure  Consumers and producers require complete information if they are to make efficient choices.  Imperfect information means consumer or producers (economic agents) cannot accurately value the ‘true’ cost and/or benefit of a good or service.  Information failure occurs when economic agents have inaccurate, incomplete, uncertain or misunderstood data and so make potentially ‘wrong’ choices.

2Information Failure  Consumers and producers make economic decisions based on available information.  Perfect information allows them to make informed choices.  Imperfect or misunderstood information can result in ‘wrong’ choices.  Private and social costs and benefits diverge so that the equilibrium and allocatively efficient level of output are different and markets fail.  Imperfect information can be caused by:

2Information Failure 1. Misunderstanding over the true costs or benefits of a product. E.g. drugs and higher education 2. Uncertainty about costs and benefits e.g. should young workers buying into pension schemes when we can only guess at economic conditions in 40 years time? 3. Complex information e.g. choosing between makes of computers requires specialist knowledge of hardware. Do I buy an Apple or PC computer? 4. Inaccurate or misleading information e.g. some advertising may ‘oversell’ the benefits of a product 5. Addiction e.g. drug addicts may be unable to stop consumption of harmful substances

3Imperfect Markets  In a free market economy goods and services will only be provided if firms can ensure they will receive payment for them.  They will then provide whatever quantity is the most profitable. In doing this, they take account only of the costs and benefits to them.

Market Failure  If there are external costs or benefits, they will not take account of these.  This may mean that they don't provide the socially optimal level of output.  Public goods and merit goods are goods that would either not be provided at all or would not be provided in sufficient quantity, for these reasons.

Merit Goods  A merit good is a product, such as education, that the government believes consumers undervalue because of imperfect information.  A merit good is ‘socially desirable’ and ‘better’ for a consumer than the consumer realises e.g. measles inoculation  The decision as to what constitutes a merit good is highly controversial. Who is to say that consumers undervalue products because of 'information failure'? Governments?

Public Goods  A good which is both non-rival and non-excludable is called a public good:  Non-rival means an individual's consumption of the good does not reduce the amount of the product available to other consumers  Non-excludable means once the good is provided, others cannot be excluded (stopped) from benefiting from the product.

Public Good  Public goods are non-excludable. Once the product is provided, other consumers cannot be excluded (stopped) from benefiting from the good e.g. a lighthouse.  This means some consumers may avoid payment and become free riders i.e. benefit without contributing to the cost of provision.  Because public goods are non-excludable, profit- seeking firms will not provide them. The non- excludability of a public good encourages some consumers to avoid payment and become free riders.  Firms cannot collect all the revenue needed to supply the public good and make a normal profit.

Public Good  Markets cannot provide the incentives needed to supply essential services such as policing and national defense and so there is allocative inefficiency.

Demerit Goods  Demerit goods - A product, such as alcohol, which consumers may overvalue but which the government believes may be harmful for consumers.  In this case the government can ban their consumption or reduce it by taxation and by providing information about their harmful effects.  Further Materials  Merit and Public Goods  Bized Bized

4Imperfect Competition  More often than not, power lies with producers rather than consumers.  This imperfect situation in the market place results in monopolists and oligopolists who are able to restrict output, raise prices and produce where price exceeds marginal cost.  They can also prevent new producers entering the market thereby preventing full adjustment to changes in consumer demand occurring.

4Imperfect Competition  This abuse of power will again lead to an inefficient use of resources and is deemed not to be in the “public interest”.

Government Intervention  Governments intervene in markets in an attempt to correct market failure.  We shall look at how governments intervene.

Government Intervention Governments intervene into the market:  To correct shortages or surpluses  To provide when the market does not or can not  To regulate and correct where there is perceived inequality or inefficiency  To protect individuals and groups in society and provide a safety net for those unable to help themselves  To reduce poverty  To influence property rights

How does government intervene? 1. Taxation – to redistribute and provide incentive or disincentive effects 2. Subsidies – to encourage production/consumption 3. Regulation – guides, codes of practice, legislation, independent regulators 4. Identifying property rights – ownership of property, e.g. intellectual property, granting of patents, etc. 5. Direct provision of goods and services – health, education, etc.

Taxation  Governments will tax goods and services for various reasons.  Overall taxation is the main source of income for a government, however tax can also be used to influence supply and demand.  Taxes can be Direct, placed on income or wealth, or Indirect, placed on goods and services.

Direct taxes  Direct taxes are taxes on income.  The main direct tax in the UK is income tax.

Indirect taxes  Indirect taxes are taxes on expenditure. Examples of indirect taxes in the UK include VAT and taxes on alcohol, tobacco and petrol.  Indirect taxes can be specific or ad valorem. Specific A specific tax is a fixed-sum tax, e.g. 2p per unit. E.g. Tax paid on Wine and Spirits. Ad valorem This is a percentage tax, e.g. Vat. Tax rises with the price of a product.

Indirect Taxes  A specific tax will cause a parallel shift in the supply curve to the left.  An ad valorem tax will cause a non-parallel shift in the supply curve.  The tax is an extra cost of production and will therefore reduce supply at any given price.  Ensure you work through the Taxation and Subsidies presentation to explain these shifts in the supply curve.

Specific Tax

Ad Valorem Tax

Reasons for Imposing Indirect Taxes 1. Raise revenue 2. Discourage consumption and output  If demand is elastic, responsive to changes in price, taxation will decrease consumption and output.  Elastic demand will also reduce revenue to the government.

Indirect Taxes  Indirect Tax  Revision Notes  Bized Bized

Subsidies  Subsidies may be regarded as negative taxes.  They normally take the form of a payment by governments to producers.  The effect of a subsidy is to reduce the costs of supplying a product.  A subsidy is essentially a simple idea; give a producer an incentive to produce more than they would normally do.  The typical approach is to give the producer a certain amount of money per unit of production.

Subsidies  In terms of demand and supply, a subsidy will lower the cost of production allowing the producer to supply more at any given price.  This will shift the supply curve to the right.

Specific and Ad Valorem Subsidies  A subsidy can again be either specific or ad valorem.  A specific subsidy is a fixed sum payment. This causes a parallel shift in the supply curve to the right.  An ad valorem subsidy is a percentage subsidy. This causes a non-parallel shift in the supply curve to the right.

Specific Subsidy

Ad Valorem Subsidy Price Quantity S1 S2 0 Q1 P1 Q D P Amount of subsidy

Reasons for Giving Subsidies  A subsidy may be given to assist the poor, to help producers and/or to encourage consumption and output of goods and services with positive externalities (good for society at large).  Subsidies can be given to consumers as well as producers. This will increase demand for a product, demand curve moves to the right.

Subsidies and Taxation  Presentation  Subsidies and Taxation Subsidies and Taxation  Activity  Bized Bized  In the news  Bized Bized

Activity  Government Intervention into Markets  Bized Bized  Government Failure  Bized Bized