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MARKET FAILURE
Complete Failure: fail to produce completely (Public…
MARKET FAILURE
- Complete Failure: fail to produce completely (Public Goods)
- Partial Failure: fail to produce in sufficient amount (All others)
GOVT GOALS
MF when any one goal is not achieved
- Pdtive efficiency
- Allocative Efficiency
- Equity
Efficiency
- Productive Efficiency: resources being utilised at full capacity and potential; society cnot produce one more good without reducing that of another
- All pts on PPC are productive efficient
- Allocative Efficiency: resources are allocated to production of a mix of G&S that maximises societal welfare
- A single pt on the PPC, MSB = MSC
- Consr surplus: Difference between total amt that conrs are W and A to pay for a G&S and the total amt they actually pay (i.e. top half triangle of eqm)
- Prodr surplus: Different between total amt that prodrs are willing and able to sell for a G/S and the total amount they actly receive (bottom half)
Equity
- Achieved when the distribution of economic welfare is considered fair by society
Inequity
- Society decides what, how much and for whom to produce through the Px mechanism, this leads to unequal dist. of resources to ppl bc
- In free mkt, rich has access to wider range and greater qty of G&S
- This is a prob of inequity bc there are certain goods that society deem that everyone must have access to, e.g. healthcare
- Since free mkt allocates resources such that the poor do not have enough $$ to pay for healthcare, there is inequitable distribution of resources (and hence ine. dis of econ welfare) and hence MF
Inequity: Causes
- Unequal incomes from labour
- Wage is the price for one's lbr, and is determined by DD and SS
- Mkt conditions vary across industries, occupations and abilities, hence individual wage differ
- Unequal dist. of income
- Incomes from ownership of capital (or resources)
- One also obtains income from capital resources they own
- e.g. landlords collect rent on land, investors earn from investments
- As they earn income simply by owning resources, the rich accumulate wealth and income gap widens
Inequity: Solutions
Taxes, Subsidies & Grants, Price controls, Social securities
- Taxes
- Progressive tax e.g. PIT, tax on capital and wealth,
- Aims to tax the rich proportionately more than poor to promote equity
- SG: Wkrs that earn little Y pay little to no tax
- Subsidies & Grants
- Subsidies: Lower COP and increase SS, lowers eqm Px of G&S
- Subsidies provided for necessities e.g. education, healthcare, making them more affordable for poor
- These necessities take up larger prop. of Y for poor, hence subs have equalising effect
- Grants: Lower cost of consumption and increase DD
- Increase eqm qty, govt usually provide grants for necessities
- Distribution limited through means testing; determines if their circumstances satisfy criteria
- Grants redistribute income from rich to poor (through taxation)
- Price Controls: A max./min. for the Px of a G/S
Bad bc distortionary in nature!
They distort the proper functioning of the price mechanism, resulting in shortages or surpluses that must be bought up by the govt
- Price Ceilings: Maximum permissible price a pdr can legally charge; only effective if it's below eqm P
- Imposed on G that gov deem as basic necessities and the existing Px is excessively high
- To keep Px low and affordable to conrs, promote equity. Also, conrs can retain their PP despite fall in Yd
- Results in shortage (show in diag.) which leads to:
- Rise of black mkt: G&S sold in violation of govt.
- In black mkt, Px is set even higher than Pe, which is countereffective to govt intentions
- Blanket approach: lowers P for even high-Y ppl who don't need it
Price Floors: Min. permissible price a pdr can legally charge; effective only if set above eqm P
- Usually set to protect the poor's income
- e.g. agricultural price floor protect farmers' income; international govts setting Px floors help boost and stabilise farmer Ys
- e.g. Min. wage legislation; protects workers by guaranteeing a decent age to all workers
- Distorts lbr mkt!
- Price floor diagram: Qss of wkrs > Qdd of wkrs; leads to unN (surplus)
- Similar conseq. to shortage, e.g. barbers open their own "illegal" shop in HDB
- SG has no min wage!
Social Securities
- Benefits provided by govt. for ppl who cannot earn Y for themselves; unN benefits, invalidity benefits
- Major drawback: It reduces incentive to work; workers can be discouraged from gaining better qualifications or doing OT, unN may be discouraged from seeking jobs
- Economic efficiency may be reduced
Conflict of Goals
- Equity vs Efficiency: subsidies distort prices in mkt and Px controls hinder Px mechanism from working effectively to allocate resources; equity increases at the expense of efficiency
- SG: No min wage bc we believe lbr resource is critical to our survival as a small cty, must maximise the efficiency of wkforce even at a cost to equity
Externality Framework
- "Positive externalities are positive spillover effects of C/Pn on persons other than conrs or prodrs themselves. The 3rd parties do not pay to enjoy the external benefits."
- Give example of a mkt (Healthcare, Education, etc.). Explain MPB in context.
- Explain MEB and 3rd party in context
- "Due to presence of MEB, MSB > MPB"
- "Assuming no negative externalities," Draw diagram
- "In an unregulated mkt, mkt o/p is at Qm where MPB = MPC as individuals only take into acc their priv. benefits and costs when C/P."
7. "However, socially opt. o/p level occurs at Qs, where MSB = MSC and societal welfare is maximised."
8. "As Qm<Qs, there is underC/P of XX, leading to a deadweight loss to society of area ABC"
Cause 1: Externalities
Positive: positive spillover effects of Pn/Cn on persons other than conrs and prodrs themselves. 3rd parties do not make payment to enjoy the external benefits
- e.g. Healthcare: MPB=Personal wellbeing, MEB=disease prevented from spreading to them, w/o paying for the medical bill
- e.g. Education: MPB=individual's intellect, pdtivity and earning capacity, MEB=Raise pdtivity of colleague through sharing of knowledge, builds skilled lbr force that benefits society
Solutions:
- Grants
- $$ that govt gives to conrs to spend on a certain G&S.
- e.g. educational grants, scholarship, bursaries, Edusave
- Increase MPB; when grant = MEB, MPB coincides with MSB, Qm = Qs, external benefit internalised
- Legislation
- Implemented to increase DD for goods that have +ve ext.
- e.g. legislate compulsory education for 10 yrs in SG
- Moral Suasion
- Through campaigns and advertisements, persuade individuals to consume more of the gds that have +ve ext.
- Subsidies
- Given to prodrs to increase SS by lowering COP, lowering price and hence increasing consumption (Qm)
- e.g. subsidising of private Uni such that education is at a lower fee
- Govt supplement Production
- Govt directly provides the G&S, e.g. healthcare and education to supplement private pdrs
- Increases SS, lowers Px, increase Qm
Limitations
- Difficult to estimate level of MEB, over/underestimation leads to over/underCn
- High govt spending leads to strain on govt budget, may lead to higher taxes or reduced spending in needy areas; having adverse effects on nation
- Legislation requires administrative costs in monitoring. If these costs>benefits, not economically viable
- Moral suasion: effectiveness not guaranteed (passive method)
NOTE
- Govt-financed heatlhcare by govt. can lead to moral hazard!
- One person takes up more risks bc the cost is borne by govt., hence less less incentive to take good care of own health
- Can also say lead to over con. of healthcare due to not having to pay, hence large burden on govt.
- But can go the other way round: may incentivise ppl to do more health checkups, cause they don't have to pay
Negative: Harmful side effects of Pn/Cn on persons other than conrs and prodrs. 3rd parties are not compensated for external costs
- e.g. Production process: pollution causes respiratory problems to residents, they must foot their own medical bills and are not compensated
- e.g. Drinking: Individual health problems, societal implications
Solutions
- Pigouvian (Indirect) taxes
- Increases COP, more ex to produce. If tax = MEC, MPC shifts upwards and coincides with MSC, Qm = Qs
- External cost internalised
- Tax revenue can be used to pay for external damages from the pdtn of the G
- Tax also serves as impetus for firms to use pollution-reducing devices or conduct R&D for env. friendly methods
- Cap-and-trade
- Govt sets a cap on total amount of a pollutant that can be emitted by all firms (Qs) in the form of emission permits
- Firms can trade permits
- When firm decides if buy/sell permit, cost-benefit analysis required
- Sell if: Price of permit > private cost involved in reducing the firm's emission volume; meaning this firm uses more efficient methods of pdn
- Buy if: Price of permit < private; for firms that need to emit more carbon
- Legislation:
- Can curb activities that give rise to MEC, e.g. legislate the max. lvl of pollution a factory can emit
- Extreme form: Banning of product
- Nationalisation: Take firms with -ve ext. into public ownership, allowing the govt to producing Qs
- e.g. SGPools is state-owned, designed to curb illegal gambling in 60s
- Moral Suasion
- Convincing conrs to voluntarily reduce consumption
- e.g. Anti-smoking/gambling campaigns
Limitations
- Administrative cost of collecting tax + Unable to estimate amt of tax to impose; furthermore problem may stem from overseas e.g. Indonesian slash-and-burn farmers and haze in SG
- Difficult to charge each firm its own tax rate since each firm pollutes at different levels
- Not gd as different industries face more difficulties in reducing pollutants. Hence should adopt c and t
- Good, as firms that sell their permits can reduce emissions at a lower cost (bc they receive payment for their permit)
- Encourages firms to invest in reducing pollution
- Further govt intervention not needed; permits are managed by DD and SS forces
- But difficult to estimate no. of permits issued; diff to measure amt of carbon emitted
- Volatility in permit Px may discourage green investment as ppl uncertain whether future payoff will justify the adoption of green tech.
- Volatility in permit Px may occur if it's oligo, larger firms may buy up a large no. of permits, pushing up permit price to drive competitors out; in such case tax may be better bc all firms must pay regardless of mkt power
- Administrative costs in monitoring + no incentives for firms to lower their external costs
- Does not allow reduction in pollution to be achieved at min. cost as diff firms have diff costs of reducing pollution
- Govt. may not have adequate resources and expertise to produce the G&S
- Removal of profit incentives makes firms less conscious of reducing COP and less willing to innovate
- No guarantee of success of campaigns; LT and passive
EV
- Depends on type of cty
- 1st world cty w/ extensive research system has no problem determining the correct amt of tax
- Furthermore, taxes make use of self-adjusting Px mechanism to allocate resources, which is less disruptive to econ. than legislation/nationalisation which are blunt tools
- Moral suasion is LT
- Hence tax is good bc more immediate effect and uses mkt mechanism
More EV
- Tax on nec. like electricity not eff. bc PED<1, power plants and firms need them, few close subs
- Since PED<1, firms can easily pass on increase in COP to conrs as higher el. bills
- As Qdd will not fall substantially
- Hence govt has to impose v high tax to yield the desired fall in Qdd
- Which may affect the industry's COP, Px competitiveness and X comp.
- Furthermore inequity for low Y
Merit and Demerit Goods: due to imperfect info. and externalities
- They show two types of MF!
- Explain only ext. if no time, but useful to show both.
- If not, can also explain mkt dominance, asymm. etc
Merit Goods
- Good that is deemed desirable by the govt and perceived to be under-consumed
- Undercon. because individs. underestimate the private benefits and disregard +ve ext.
- e.g. Immunisation; brings MPB and MEB but some fail to appreciate them due to ignorance or complex info
e.g. Healthcare, Education
Demerit Goods
- Deemed undesirable by the govt and perceived to be overcon.
- Overcon. because individs. overestimate private benefits and disregard -ve ext.
- e.g. smoker does not have enough info on harms of smoking hence over-estimate MPB and ignore external cost to ppl arnd him
Cause 2: Public Goods: Non-excludable and non-rival
- Non-rival: The con. of one good by one does not diminish the amt available for con. by others
- Non-excludable: Impossible or prohibitively expensive to exclude any non-payers from using it
- e.g. national defence: protects all citizens equally, regardless of whether they pay taxes
- Other e.g.s: Street lighting, Lighthouses, Police force
Complete MF
Implications
- Non rivalry
- Due to non-rival nature, the MC of serving an additional user is zero. W/ zero MC, allo.efficiency is achieved only when the good is provided to all who want it at P=0. Any non-zero Px will discourage some users from enjoying the good; causes reduction in society's total welfare
- Non-excludability
- Due to non-E nature, those who do not pay for the good also get to enjoy it. Since non-payers can also consume the good, no one will be willing to pay for the G (free ridership)
- Since no profit-seeking pdr will be willing to produce a good at zero Px, free mkt will not produce the gd, though conrs want it
Hence, govt intervenes by directly providing public goods to ensure AE. Paid through taxes
However, govt. not enough info to decide how much of public good to produce; w/o px mechanism it's hard to ascertain the exact level
Cause 3: Market Imperfections
- Market Dominance
- Factor Immobility
- Information Failure
Factor Immobility
- Pdrs face constraint in allocating the use of resources
- Hence cannot make pdtion decisions that lead to AE outcomes; MF
Geographical Immobility
- Resources cnot be easily transferred from one place to another, due to high cost of moving/poor transport system/language barriers
- Not a big issue in SG
Occupational Immobility
- Resource cnot be easily transferred from one use to another; lack of edu/skills
Prices in a free mkt coordinate the movement of resources, directing them from abundant mkts to those that are scarce
- Due to factor immobility, these resources may not be able to be allocated to where they are required
Mkt Dominance
- For oligos and monos:
- Due to high BTE, they have high mkt power and can restrict o/p and set higher P than MC, which will lead to MF
- Bc of few no. of sellers, there are few close subs, causing PED<1, and DD to be downward sloping
- They will pdc at profit max. op where MR=MC, causing P to be at P1
- At this op, P > MC: means that the value that society places on the last unit of good is higher than the OC incurred in producing it
- Leads to DWL of ABC (ref. to diagram on A. inefficiency in pg 072)
- Expln overpdn, etc.
- AE would be achieved by increasing op and lowering Px to that of a PC mkt structure (show on diagram)
Solutions
- ref. to pg 116: note that lump sum will not cause P=MC!
- Consider competition policies, introducing contestability into the mkt
- And also Px regulation via MC pricing:
- Set price where MC = AR, not when MC = MR
- This cause P=MC, now firm will pdc at higher op and lower Px
- Conrs better off, they enjoy lower Px
- AE, societal welfare maximised
EV
- Only sustainable if the firm is able to still make normal/super profits aft MC pricing
- According to diagram, they will be earning sub, meaning they may be driven out of industry in the LR
Information Failure
Econ. agents must have good qly and complete info to make efficient choices and decisions abt what to C and P
- Note: Gds can show both imperfect and asymmetric info!!
- Asymmetric Info
- Arises due to diff in amt of info made available to pdr/conr involved in a transaction
- Pdr have > info than Conr or vice versa
- MF bc fail to pdc good in sufficient amt
Note: Asymm. must clearly show 2 parties, with 1 withholding info for their benefit
- and this need to withhold arises due to 2 types of goods/consumers, 1 higher qly than the other
- Moral Hazard: Where conr takes greater risks than normal bc the costs that would result would not be borne by themselves (e.g. insurance). This makes the event insured more likely to occur (this is just a bad cons. of insurance)
- Can also say the person might overconsume healthcare services due to this insurance
Pdr > Conr: Used cars
- Pdr know more abt qly of pdt than conrs
- Used car dealers have more info than buyers regarding condition of cars
- To profit(their benefit), they have incentive to withhold info. abt the condition of cars
- Buyers cannot distinguish between high and low qly cars, only willing to offer avg P for used cars bc they may be buying a low qly car
- At this Px, sellers w/ high qly cars unwilling to offer their cars for sale
- Mkt adversely selects against high qly cars in favour of low qly
- Uninformed party, the buyers, have to choose from an adverse selection of cars
- Presence of low qly cars in this selection means buyers will further lower Px offered
- Subsequently reduces no. of high qly cars put up for sale
- Extreme case: No high-qly cars put up for sale
- MF bc asym. info led to "thin mkt", some high qly cars sold but less than if there were perfect info
- MF bc less than optimal no. of good qly cars sold
Same can be applied for healthcare mkt:
- doc have more knowledge abt medical procedure than patient, withhold to earn more profit and make patient undergo more procedure than necessary; misperceived MPB, overcon
Conr > Prodr: Health Insurance
- Conr knows more about their own family history, risks and insurance needs than insurance company
- High risk conr have incentive to withhold info so company will agree to insure them
- Sellers cannot disinguish between high and low risk, hence they offer an avg Px as they may be getting high risk indiv.
- At this px, low-risk not willing to purchase although high risk willing to
- Mkt adversely selects against low, in favour of
high
- Presence of high-risk indiv in the mkt forces insurance comapny to raise avg price
- Further reduces no. of low-risk conr willing to purchase
- Extreme: no low-risk willing to buy
- MF as less than optimal no. of low-risk buying insurance
SOLUTIONS
1. Govt intervention to reduce Info Gap
A. Forcing sellers disclose info abt the pdt: e.g in mkts for used cars, financial services etc., sellers are legally obligated to explain benefits, risks and charges to the buyers
Statutory guidelines that require sellers provide clear and understandable info e.g. Agri-Food and Veterinary Authority of SG (AVA) legislate all pre-packed fd pdts be labelled w ingredients, content and source. -Explain reduce info gap, less MF-
B. Protection for Conrs: against defective goods (Lemon Law): if fail to meet standards of qly, sellers required to repair/refund w/in 6 mths
C. MoneySense; national financial literacy programme to help conrs better understand financial, insurance and investment pdts to make informed decisions
Range of govt policies recommended to complement each other
2. Pdr/Conrs driven by self interest to reduce MF(uninformed take action to be more informed)
- Car buyers will try to obtain more info abt qly by engaging their own trusted mechanic/ going online to research (sgcarmart.com). This saves time and effort in gathering info, helps them distinguish betwn lemon and plum
- Car dealers use "signalling" to give info abt qly of their car to conr (thru ''moneyback" guarantees/warranties); attract them to offer higher Px. Encourages high-qly cars to be sold rather than adversely selected against
- Insurance company require conrs for full body checkup/punishment for not disclosing health truthfully, prevents sellers from choosing from ad selection of high risk
- Insurance company provide group coverage for employees of an org; get broader base of conrs w/ mix of high and low; prevents ad selection + increased cost of insuring
LIMITATIONS
- Cost of laws: enforcement, administration in ensuring the labels are accurate and checking that firms comply
- Failure of public education by moral suasion
- Government failure; time lags from red tape and bureaucracy may lead to greater inefficiency and DWL. Info from govt may also have gaps
- Imperfect Info
- In certain mkts, there may be missing or incomplete info
- If conrs act on such imperfect info, they may make erroneous choices, leading to A inE and MF
- e.g. Ignorance (smoking, gambling, healthcare), uncertainty about future, complex info (tech. pdts), misleading info (ads), missing or incomplete info (GM food label)
- e.g. Misleading info leads to conr overestimating PB of pdt, leading misperceived MPB>actual MPB. Qm>Qs, overconsumption and deadweight loss and MF
EXAMPLES:
- Complex info: technically complex pdts like car; technical specifications too complex/ insurance: financial and legal details too diff to be understood by layperson
- Incomplete/Missing info; Apparently simple pdts (food items), never disclose ingredients, health labels, ppl can get allergy
- Also can have ignorance of LT effects
SOLUTIONS
- Provide more info for conrs to make more informed decisions
- Less ignorant abt health consequences
- Public education campaigns, TV shows e.g. HPB raise public awareness of healthier fud choices and reading fud labels
BUT
- moral suasion through such means is passive, no guarantee of success (contingent on conr's response)
Cause 4: Government Failure
- When govt interventions fail to correct MF
- Bc govt possess imperfect information due to lack of info on information about C, B or effects
- e.g. unable to measure external benefits of education accurately
- Don't know what level of subsidies to provide, over/undersubsidise education