DHS Y5 H2 Economics Content Clinic 2 (Market Failure)

H2Economics:ContentClinic2 KeyDefinitions:1.Marketfailureoccurswhenthefreemarketisunabletoallocateresourcesefficiently.2.Productiveefficiencyoccurswhenthe maximumpossibleamountof outputis beingproducedfromagivenamountofresources.3.Allocativeefficiencyoccurswhentheproductionofonecombinationofgoodsandservicesmaximisessociety’sutility.4.Publicgoodsaregoodsthatexhibitthe3 characteristicsofnon-rivalry, non-excludabilityandnon-rejectability.5.Non-rivalryoccurswhentheconsumptionof a goodbyoneormoreconsumersdoesnotreducethequantityavailableforotherstoconsume.6.Non-excludabilityoccurswhenit is impossibletoexcludenon-payersfromconsumingthegoodonceitisproduced.7.Non-rejectabilityoccurswhenconsumersareunabletorefuseconsumptionofagoodonceitisproduced.8.Negativeexternalitiesare negativespill-overor third-partyeffectsgeneratedfromtheconsumption/productionofagood/service.9.Positiveexternalitiesare positivespill-overor third-partyeffectsgeneratedfromtheconsumption/productionofagood/service.10.Thirdpartiesarepeoplewhoarenotdirectlyinvolvedin themarkettransaction.(i.e.familymembers,friends,thegovernment,employers)11.Imperfectinformationoccurswhenthereisincompleteorinaccurateinformationavailabletosociety.12.Asymmetricinformationoccurswhenonepartyhasmoreinformationthantheother.13.Factorimmobilityrefersto theinabilityof factorsof productionto shiftfromoneusetoanotherduetogeographicaloroccupationalboundaries. KeyConcepts:a)SourcesofMarketFailure: PublicGoods Diagram: N/A(Missingmarket) Explanation: 1.Free-riderproblem● Non-excludability:Non-payersableto enjoythegood→ Noonewillingtopay→Waitforotherstopay→Noexpressionofdemand● Non-rivalry:Quantityavailabledoesnotdiminishwhennon-payersfree-ride→Free-ridershipcontinuestoperpetuity2. Efficientpricetochargeis0(Non-rivalry)● Non-rivalry:Quantityavailabledoesnotdiminishwhennon-payersfree-ride→MCofoneadditionaluserofthegoodis0,onceit hasbeenproduced→Allocativelyefficientpricetochargeis0 →Goodshouldbemadeavailabletoanyonethatderivespositivemarginalbenefit→ Noprofit-drivenfirmswillingto supplythegood→Nosupply Inefficientallocationofresources: Noallocation

NegativeExternalities Diagram: Perspective:ConsumptionORProduction Explanation:7Steps:1. Establishfree-market/privateequilibrium(MPC=MPBatQp )2. Stateassumptions(AssumeMEB=0)3. Explaindivergence(MSCaboveMPC)4. Establishsociallyoptimalequilibrium(MSC=MSBatQs )5. Identifyinefficientallocationofresources(Qp >Qs )6. Derivedeadweightloss(Netsocialcostsincurred)7. Linktomarketfailure Inefficientallocationofresources: Over-allocation PositiveExternalities Diagram:

Perspective:ConsumptionORProduction Explanation:7Steps:1. Establishfree-market/privateequilibrium(MPC=MPBatQp )2. Stateassumptions(AssumeMEC=0)3. Explaindivergence(MSBaboveMPB)4. Establishsociallyoptimalequilibrium(MSC=MSBatQs )5. Identifyinefficientallocationofresources(Qp <Qs )6. Derivedeadweightloss(Netsocialbenefitsforgone)7. Linktomarketfailure Inefficientallocationofresources: Under-allocation ImperfectInformation(Underestimation) Diagram: Perspective:Consumption Explanation:Lackofaccurate/completeinformationon fullextentof privatebenefits→Under-estimationof privatebenefits→DivergencebetweenMPBperceived andMPBactual →Under-allocationofresources→Deadweightloss→Marketfailure Inefficientallocationofresources: Under-allocation

ImperfectInformation(Overestimation) Diagram: Perspective:Consumption Explanation:Lackofaccurate/completeinformationon fullextentof privatebenefits→Over-estimationof privatebenefits→DivergencebetweenMPBperceived andMPBactual →Over-allocationofresources→Deadweightloss→Marketfailure Inefficientallocationofresources: Over-allocation AsymmetricInformation(AdverseSelection) Diagram: N/A Perspective:Consumerinformation<Producerinformation Explanation:Consumershavelessinformationonqualityofthegood/service→Consumersare unableto differentiatebetweenhigh-qualityand low-qualitygoods→Consumerslowerthepricetheyare willingto payduetopossibilityofreceivinga lower-qualitygood/service→ Producersof higher-qualitygoods/servicesunwillingtoenterthemarket Inefficientallocationofresources: Noallocationforhigher-qualityproduct AsymmetricInformation(MoralHazard) Diagram: N/A Perspective:Consumerinformation>Producerinformation Explanation:Consumershavemoreinformationontheirfuturebehaviour→Consumersengageinhigher-riskactivitiesduetothecostsfullybornebyanotherparty→Higherlikelihoodofinsurancepayout→Unprofitableforinsurer→Exitmarketinextremecases

Inefficientallocationofresources: Noallocation FactorImmobility Diagram: Perspective:Producer Explanation:OccupationalImmobility:Barriersto mobilityof factorsof productionbetweenindustriesanduses→ Workersnothavingtherightskillsto allowthemtotransferbetweenjobsGeographicalImmobility:Lackof willingness/abilityof factorsof productiontomovebetweenandwithincountriesStructureof theeconomychanges→Changestoskillsandknowledgetoperformjobs→Factorimmobilityleadstostructuralunemploymentoffactorsofproduction→Opportunitycostofoutputforgone Inefficientallocationofresources: Under-allocation(Unemployment)

b)GovernmentIntervention IndirectSpecificTax Diagram: Explanation:Indirecttax imposedon producers,equalstotheMECatQs → Dueto theincreasedmarginalcost, producersreducesupplyofthegood/service→Priceincreases→Thetaxispartiallytransferredtotheconsumers,causingthemto“internalise” the externalities→MPCincreasesfromMPCto MPC+tax→ConsumersnowconsumeatQp’whichisequaltoQs,thesociallyoptimallevelofoutput→Efficientallocationofresources→Deadweightlossiseliminated→Nomarketfailure Aim: Decreaseconsumption/production IndirectSpecificSubsidy Diagram: Explanation:Indirectsubsidygrantedto producers,equalstotheMEBatQs →Duetothe

decreasedmarginalcost, producersincreasesupplyof thegood/service→Pricedecreases→MPCdecreasesfromMPCtoMPC-subsidy→ConsumersnowconsumeatQp’whichisequaltoQs,thesociallyoptimallevelofoutput→Efficientallocationofresources→Deadweightlossiseliminated→Nomarketfailure Aim: Increaseconsumption/production ClosingtheInformationGap(PublicEducation/Legislation) Diagram: N/A Explanation: 1. PublicEducation:Governmentprovidesaccurateandcompleteinformationto consumers/producers→ Increase/decreaseMPBperceived to MPBactual →Consumers/producersnowconsume/produceat Qp’,equalsto Qs →Efficientallocationof resources→ Deadweightlosseliminated→ Nomarketfailure2. Legislation:Governmentmandatesthe disclosureof informationbyproducers→SameasPublicEducation Aim: Increase/decreaseconsumption/production DirectProvision(FreeDirectProvision) Diagram: Explanation:Goodisprovidedfreetotheconsumersbythegovernment→MPCequalsto0→ConsumersnowconsumeatQp’whichisequaltoQs,thesociallyoptimallevelofoutput→Efficientallocationofresources→Deadweightlossiseliminated→Nomarketfailure Aim: Increaseconsumption

Standards(Quota) Diagram: Explanation:MaximumoutputbyproducersinthemarketiscappedbythegovernmentatQs →OutputfallsfromQp toQp ’ whereit equalsQs , thesociallyoptimaloutput→Efficientallocationofresources→Deadweightlossiseliminated→Nomarketfailure Aim: Decreaseproduction Ban Diagram: Explanation:Production/Consumptionof thegoodis prohibitedbythegovernment→Outputsetat0 →Consumers/Producersnowconsume/produceatQp’whichisequaltoQs,thesociallyoptimallevelofoutput→Efficientallocationofresources→Deadweightlossiseliminated→Nomarketfailure Aim: Decreaseconsumption/production

Cap-and-Trade(TradablePermit) Diagram: N/A Explanation: 1. MaximumoutputbyproducersinthemarketiscappedbythegovernmentatQs →OutputfallsfromQp toQp ’ whereitequalsQs , thesociallyoptimaloutput→ Efficientallocationof resources→ Deadweightloss iseliminated→Nomarketfailure2. NumberoftotalpermitsisdecidedbythegovernmenttoachieveQs .3. Producersareabletotradewithotherfirmsforpermits/quotasshouldtheyrequiremore→Allowsforfreemarketforcestotakeplace→Priceofpermits/quotasdeterminedbyforcesofdemandandsupply Aim: Decreaseproduction CompulsoryConsumption Diagram: N/A Explanation:Governmentmandatestheconsumptionofagood/service Aim: Increaseconsumption