4.1.8 – Market Mechanism, Market Failure & Gov Intervention in Markets

    67 – how markets and prices allocate resources

    Competitive Markets
    • competitive markets exist under certain conditions
    o when theres large numbers of buyers and sellers (consumers
    and producers)
    o when no single consumer or producer can influence the
    allocation of resources by the market or the price a good or
    service can be bought at
    • in a competitive market its assumed that consumers and producers act rationally
    • producers compete to provide consumers with what they want (at lowest possible price) to maximise profit
    Price is the Main Way of Allocating Resources in Market Economy
    1. value a good or service is exchanged for is known as price.
    o Changes in demand and supply change price and quantity sold – this is known as the price mechanism
    2. The price mechanism has 3 functions:
    o Acts as an incentive to firms – higher prices make them increase production to raise profits
    o Acts as a signalling device – changes in price show changes in demand and supply so signals
    o Acts to ration scarce resources – high demand for a good/service if limited supply cause price to be high
    3. The price mechanism is used to allocate the resources used to produce goods or services and has pros & cons – Meaning of Market Failure

    Market Failure Occurs when a Market Leads to a Misallocation of
    Market failure occurs when a market allocates resources inefficiently
    • A market fails when the price mechanism fails to allocate scarce resources efficiently so society suffers
    • Market failure is a common problem and governments often intervene to prevent it
    Market failure can be Complete or Partial
    • during complete market failure no market exists (missing market)
    o national defence is an e.g. of a missing market as theres no market which allocates it. So, governments
    must intervene and provide it
    • When the market functions, but price or quantity supplied of good/service is incorrect. Theres partial market
    o healthcare if left to the market is a partial failure, as people couldn’t afford treatment needed. So,
    governments must intervene and provide free healthcare
    Factors that lead to Market Failure are:
    1. Public goods
    2. Imperfect Information
    3. Inequality in income and wealth
    4. Externalities
    5. Merit and demerit goods – Public Goods, Private Goods & Quasi-Public Goods

    Public Goods are Consumed Collectively
    • They have two main characteristics
    o Non-excludable – people can’t be stopped consuming
    the good even if they haven’t paid
    o Non-rivalrous – one person benefiting from the good doesn’t stop others benefiting, so public goods
    have zero marginal cost – no additional cost to extending the good to one more person
    • Examples of a public good are street lighting, lighthouses
    Private Goods are the Opposite of Public goods
    • Private goods are excludable and they exhibit rivalry
    o Biscuits are private goods as eating one means someone else can’t eat one
    • People have a choice if they want to consume private goods. Most goods are private goods
    Public Goods Can Have Characteristics of Private Goods
    Goods that show some characteristics of public goods are known as quasi-public goods:
    ▪ Roads have the characteristics of a public good but tolls can make a road excludable and congestion can
    make the road rivalrous as theres a limit to number of people benefiting from road at one time
    New technology can change a good From Public to Private
    ▪ Television broadcasts were non-rivalrous and excludable but the invention of digital technology has meant
    channels can be encrypted so If you want a certain channel you have to pay for it
    Public Goods Are Under-Provided By The Free Market
    ▪ The Non-Excludability of Public Goods leads to the FREE RIDER PROBLEM
    o when it’s impossible to stop someone benefiting from public good even if they didn’t pay towards it
    ▪ the price mechanism can’t work as consumers wont pay for goods they can get for free
    ▪ this causes everyone to wait and see who will pay for public good, but then it wont be provided
    ▪ It’s difficult to set price of a public good as you have to work out their value to consumers
    ▪ producers overvalue benefit of public good to get higher price, consumers undervalue it to get lower prices
    ▪ As firms are reluctant to supply public goods it this will cause market failure so governments provide it
    o Positive externalities are public goods and consumed by those that don’t pay
    Some Parts of Environment are Public Goods
    ▪ Air for example is non-rivalrous and non-excludable and can’t be bought or sold.
    ▪ Clean and dirty polluted air cost the same, so if clean air becomes scarce its price won’t rise as its consumption
    can’t stop
    ▪ This is a free rider problem. The benefit of not polluting the air, or cleaning the air aren’t restricted to those who
    have paid for the clean air by choosing not to pollute, or choosing to clean the air.
    ▪ Therefore, in a free market, its unlikely that anyone will either choose not to pollute, or to clean up the pollution
    they make
    ▪ This is an example of the tragedy of commons – people acting in their own best interest will overuse a common
    resource without considering that it will lead to depletion or degradation
    Governments intervene to stop depletion or degradation of common resources – Positive and Negative Externalities in Consumption and Production

    Externalities affect Third Parties
    • Externalities are the effects of producing/ consuming a
    good or service has on third parties that aren’t producing
    or consuming the good/service
    • Externalities can be positive or negative and can occur in production or consumption

    Market Failure occurs because Externalities are Ignored
    • Private cost – cost of doing something to either a consumer or a firm (supply curve)
    • External cost – caused by externalities e.g. dropping litter has an external cost to council to employ binman
    • Private cost + External Cost = Social cost (the full cost to society for good/service)
    • Private benefit – benefit gained by consumer or a firm by doing something e.g. buying a car for enjoyment
    • External benefit – caused by externalities e.g. investment in new equipment may create external benefits of
    needing less electricity
    • Private Benefit + External Benefit = Social Benefit (full benefit received by society)
    o Market failure occurs because in free market the price mechanism only considers private costs and
    benefits but not external costs and benefits

    Externalities can be Shown Using Diagrams

    ▪ This is an example of negative externalities from production
    • Marginal private cost (MPC) = cost of producing the last unit of a good
    • MSC= Marginal private cost + External costs
    o If the curves parallel then the external costs per unit produced are constant
    o If the curves diverge then external costs per unit increase with output
    ▪ curves may diverge due to pollution
    • This is an example of negative externalities from production
    • marginal private benefit (MPB) is the benefit of consuming the last unit of a good
    • MSB= MPB + external benefit
    o If the curves parallel then the external benefits per unit produced are constant
    o If the curves diverge then external benefits per unit increase with output
    ▪ curves may diverge for vaccinations as theres less chance for others to
    get the disease

    Equilibrium Point may be Different to the Socially Optimal Point
    • when S=D theres equilibrium in a free market
    • in a free market, externalities aren’t taken into account as producers only consider
    their private costs and benefits
    • So equilibrium occurs at Qe,Pe
    • However, the socially optimum level of output is where MSC=MSB (Q1, P1)
    o this would give the maximum benefit from positive externalities
    o this would cover the cost of any negative externalities

    Ignoring Positive Consumption Externalities Lead to Under consumption

    • if there are no negative externalities MPC=MSC
    • in a free market only private benefits are considered so causes underproduction and under pricing
    • Area between MSC and MSB which is A,B,C is the welfare gain – gain to society lost by
    ignoring externality
    o E.g couple of examples of services with positive consumption externalities
    ▪ Education – better educated workforce more productive raising output
    ▪ Healthcare – healthier workforce will be more productive and take less
    time off work increasing economic output

    Ignoring Negative Consumption Externalities Lead to Overconsumption

    • If theres no negative externalities MPC=MSC
    • in a free market only private benefits are considered so causes overproduction and over pricing – mores
    consumed and sold at higher price than is desirable for society
    • Area between MSC and MSB which is A,B,C is the welfare loss – loss to society by
    ignoring externality
    ▪ E.g. drivers ignore negative consumption externalities with driving cars
    like pollution and congestion

    Ignoring Negative Production Externalities Lead to Overproduction

    • if there are no positive externalities then MPB=MSB
    • Therefore, in a free market only private costs are considered so causes overproduction and underpricing of good
    – so more is produced and sold at lower price than is desirable for society
    • Area between MSC and MSB which is A,B,C is the welfare loss – loss to society caused
    by ignoring externality
    o E.g of negative production externalities
    ▪ Chemical factory may ignore negative externalities produced
    ▪ Therefore output will be higher than the socially optimal level

    Ignoring Positive Production Externalities Lead to Underproduction

    • if there are no positive externalities then MPB=MSB
    • Therefore, in a free market only private costs are considered so causes
    underproduction and overpricing of good – so less is produced and sold at higher
    price than is desirable for society
    • Area between MSC and MSB which is green is the welfare gain – gain to society lost
    by ignoring externality
    o E.g. employees will ignore positive production externalities in paying to
    train their employees like benefits to society with having more skilled

    A lack of Property Rights Cause Negative Externalities
    • Absence of property rights can cause production and consumption externalities and
    market failure.
    o E.g. factories dumping waste into river wouldn’t be accountable for pollution if nobody had rights over river
    • Extending property rights means these externalities could be accounted for.
    o E.g. a water company can allow, charge for or refuse permission for others to pollute river
    • The absence of it leads to overuse of scarce resources and environmental damage

    Negative Externalities
    Governments tax goods with negative externalities e.g. tobacco, petrol, alcohol
    • They may use several indirect taxes on one item like cigarettes
    • The taxation is to pay for the externality the good produces e.g. tax from alcohol can be used to pay for
    additional police time to deal with alcohol crime
    • Another example of specific tax is landfill tax which aims to reduce impacts of environmental market failure:
    o Firm and local authorities are charged environmental tax for waste disposal
    o The tax encourages recycling or more efficient machines reducing negative externalities
    o The tax can however lead to illegal waste disposal – Merit and Demerit Goods

    Merit Goods Benefit Society Demerit Goods Do the
    • Merit goods have Greater social benefits than private
    o Merit goods consumption is beneficial to
    individuals and society as a whole due to
    positive externalities from there
    consumption, but people are unaware of the full benefits that merit goods provide
    o Examples of merit goods include health care and education
    • Merit goods are under consumed for two main reason:
    o The positive externality that merit goods provide are ignored and production and consumption will be
    below the socially optimal level.
    ▪ E.g. producers and consumers won’t consider wider benefits to society of a good education
    o Due to imperfect information, consumers don’t realise the full benefits that merit goods provide
    ▪ E.g. lack of information about severity of health problems so demand for health care isn’t as high
    • Demerit goods have greater social costs than private costs
    o Demerit goods consumption is harmful to society due to negative externalities from their consumption
    o Examples of demerit goods are cigarettes and heroin
    • Merit goods are over consumed for two main reason:
    o The negative externality that demerit goods provide are ignored and production and consumption will
    be above the socially optimal level.
    ▪ E.g. producers and consumers won’t consider wider disadvantages to society of cigarettes
    o due to imperfect information consumers don’t realise the harm that demerit goods provide
    ▪ lack of information about effects of a drug on health so demand is higher than it should be
    1. classifying whether a good is a merit or demerit good it’s based on value judgement (based on opinions)
    2. not all goods with positive externalities are merit goods
    3. not all goods with negative externalities are demerit goods

    The Market Underprovides Merit Goods & Overprovides Demerit Goods
    Merit goods Generate Positive Externalities

    • if left to the free market price and quantity demanded would be P,Q where MPB
    crosses MSC/MPC.
    • The market equilibrium is below the socially optimum level of consumption where
    • The area ABC is the welfare gain lost from under consumption/ under production
    • To increase consumption government could introduce subsidy to lower price
    Demerit goods Generate Negative Externalities
    • if left to the free market price and quantity demanded would be P,Q where MPB
    crosses MSC/MPC.
    • The market equilibrium is above the socially optimum level of consumption where
    • The area ABC is the welfare loss from over consumption/ over production
    • To decrease consumption government could introduce taxes to raise prices
    Short-Term Decision-Making Affects Consumption Of Goods
    • When individuals take short-term approaches to decision-making, it can lead to under consumption of merit
    goods or overconsumption of demerit good
    1. People often consider the short-term benefits of costs
    2. Long term private benefits of merit goods are greater their short-term private benefits and the long term private
    costs of demerit goods are greater than their short term private costs
    3. short term benefits of paying towards a pension are less than the benefits of receiving that pension when retired
    4. short term costs of buying cigarettes are much less than the long term costs e.g. serious smoking-related illness
    Governments Can Intervene In Markets For Merit and Demerit Goods
    1. the failure of the free market to supply the socially optimal levels of merit and demerit goods is why
    governments intervene supply.
    2. Governments can directly provide certain goods or services or can use taxes and subsidies to decrease or
    increase consumption of certain goods or services to socially optimal levels
    3. Government have lots of information regarding costs and benefits of goods and services to individuals and
    society as a whole.


    Governments Use Indirect taxes To Affect Supply
    These are placed on purchase of goods and services. The purpose of indirect taxes is to:
    1. Generate tax revenue for a government
    2. Discourage consumption of ‘harmful’ products
    3. Encourage consumption of ‘good’ products
    • Theres two types of indirect tax
    o Specific taxes – these are a fixed amount charged per unit of a good, regardless of its price
    o Ad valorem (VAT) – these are charged as a proportion of the price of a good. So a 20% tax on price of
    good means for a £10 product its £2 and for a £100 product its £20
    • These taxes cause shifts to the left
    • The amount of the tax producers and consumers receive depends on PED

    • Governments pay subsidies to encourage production and consumption of goods and services with positive
    • It shifts the supply curve as more is produced
    • The proportion of the subsidy producers and consumers benefit from depends on PED and PES

    Advantages to Subsidies

    Benefit of goods with positive externalities is internalised
    • Subsidies can change preferences as the goods cheaper
    and more affordable increasing demand
    • Positive externalities are still present in e.g. windfarms

    Disadvantages to Subsidies

    Difficult to put monetary value on the benefit of the
    positive externalities
    • Any subsidy has an opportunity cost – as it might be
    better spent on something else
    • Subsidies may make producers inefficient and reliant
    • Effectiveness of subsidies depends on elasticity of
    • May be lower quality goods than imported goods

    Subsidies and Indirect Taxes
    • Subsidies and indirect taxes can affect consumers and producers
    o Governments sometimes provide subsidies to encourage demand for a good
    o A subside is money paid by government to producer of a good to make it cheaper than it would be otherwise
    • Governments can also place a tax on a good (indirect taxes) to reduce the demand for a good e.g. cigarettes
    o Increased Tax on a good discourage people from buying the good as the market price rises
    • Taxes and subsidies lead to shifts in supply and this causes price to change causing movement on demand curve
    Benefit on Subsidies
    • Subsidies increase supply right and decrease price of goods and services. This causes demand to increase
    • The benefit of subsidies is received by both producers and consumers
    • The amounts gained by producer and consumers are dependent on the price elasticities of demand and supply
    • market is in equilibrium at P,Q before subsidy is granted
    • the subsidy causes supply to shift to S1 so price falls to P1
    • cost of subsidy is entire shaded box this is split into :
    o consumer gain = fall in price from P to P1 so pay less for good
    o producer gain = receive extra revenue from government which they keep
    price inelastic demand = consumer gain is larger than producers from subsidy
    price elastic demand = producer gain is larger than consumers from subsidy

    Effects of Indirect Tax
    • increase in taxes reduce supply left as the price of a good increases. This causes demand to decrease
    • Tax affects both producers and consumers of a good
    • The amounts given by producer and consumers are dependent on the price elasticities of demand and supply
    • with no taxation the market is in equilibrium at P1, Q1
    • the tax causes supply to shift to S1+tax so price rises to P2
    • government revenue from tax is the entire shaded box this is split into:
    o consumer burden = they pay more for good than if tax wasn’t in place
    o producer burden = they pay some of the revenue to government
    price inelastic demand = consumer have greater tax burden
    price elastic demand = producer have greater tax burden

    State Provision
    Governments Directly Provide Some Goods And Services
    • Governments use tax revenue to pay for certain goods and services so are free when consumed
    o E.g. in UK is NHS, State Education, Waste Disposal Street Lighting and Defence (police and fire services)
    • State provision can come directly from the government or they purchase the good or service from a private
    sector and provide it to the public for free. For e.g. dental practices
    State Provision Overcomes Market Failure
    • Governments might provide things to increase consumption of merit goods like
    o Education – learn new skills and educated in a range of things
    o Health – less of the workforce with health issues so theres a more productive and efficient output
    • Free provision of services reduces inequalities in access e.g. due to differences in wealth
    • It also redistributes income – most of money for services comes from wealthier persons income tax
    • The level of state provision is a value judgement made by government – they decide how much of a good or
    service to provide depending on importance to society
    State Provision Has Disadvantages
    • State provision means less incentive to operate efficiently due to no price mechanism
    • State provision may fail to respond to consumer demands as it lacks motive of profit to determine supply
    • The opportunity cost of state provision of goods and services is that other goods and services can’t be supplied
    • State provision can reduce individual’s self-reliance
    Health Care Is a Merit Good That is Sometimes Provided By Governments
    • The government funds the NHS so society benefits from positive externalities of health care
    o E.g. consumption of health care contributes to a healthier and happier population so less days off work
    • Drawbacks to State Provision of health care by NHS:
    o Demand is greater than supply for the NHS causing waiting lists
    o Hospitals and clinics can be wasteful of resources, like money and unused prescriptions
    o The NHS may not respond to wants and needs of patients
    o The NHS can reduce patients’ self- reliance – can remove incentive for patients to deal with medical
    issues themselves– Market Imperfections

    Symmetric Information
    • This means buyers and sellers have equal and perfect knowledge on price,
    cost, benefits, availability of goods
    • The symmetric information allows efficient allocation of resources but rarely exists
    o As buyers don’t have time to get full information on price before buying a product
    Asymmetric Information
    • This involves lack of perfect/imperfect information in a market
    • Usually, sellers have more information than buyers e.g. car salesman
    • Sometimes buyers may have more information than sellers e.g. antiques collector
    • Moral hazard happens when people take risks as they won’t suffer the consequences themselves if it goes wrong
    o E.g. Home insurance providers have a lack of information on how the individual acts in terms of security
    Information Failure Causes Market Failure
    • Imperfect information means merit goods are under consumed and demerit goods are overconsumed
    • Imperfect information affects their consumption for e.g.
    o Consumers don’t know full personal benefit of merit goods
    o Consumers may lack information to decide which good or service is right for them
    o Consumers may not know how harmful demerit goods are
    o Advertising for demerit good cover any health dangers
    • Information Failure means merit goods are under produced and demerit goods are overproduced creating
    misallocation of resources and market failure
    • Imperfect information affects their production for e.g.
    o Pension providers have greater knowledge of schemes available than clients – this can lead to them
    selling unnecessary schemes or more expensive schemes than needed
    o Doctors have greater knowledge of medicine so may recommend more expensive care than required
    o Information on a good/service may be complex to understand e.g technical differences between a

    Monopolies cause Market Failure and the Misallocation of Resources
    • Monopolies restrict output causing deadweight loss which is a market failure
    o So, they may not reach economies of scale
    o They will have higher production costs compared to other
    competitive monopolies as they have less incentive for innovation
    o Market failure is caused as monopolies restrict choice to consumers

    Immobile factors of production
    1. Immobile factor of production is one not easily moved to another area of the economy
    2. Land is an immobile factor of production – can’t be moved from one location to another
    3. A lot of capital is mobile (e.g. computers) but some is immobile due to its size
    4. Land and capital can become immobile due to human action
    • e.g. farmer may choose not to change crops grown on land despite climate changes
    Labour Immobility Can be Geographical or Occupational
    • Labour is mobile if workers can move from one job to another. This can be between occupations or
    geographical areas. But theres reason why labour can be immobile:

    Reasons for geographical immobility:
    ➢ Large house prices, rent and cost of living differences between areas make it difficult for workers to
    move location to obtain work
    ➢ High costs may be involved in moving house
    ➢ A reluctance to leave family or friends
    ➢ A dislike of change
    ➢ Imperfect information about jobs available in other areas
    ➢ Lack of transport to move from one area to another
    Reasons for occupational immobility:
    ➢ Lack of education, skills and training to do different job
    ➢ Lack of work experience
    ➢ Lack of required qualifications (e.g. dentists require a BCS degree)
    Immobile Factors of Production cause Market Failure
    1. Immobile factors of production mean inefficient use of resources (resources unused or underused).
    This inefficiency means market failure
    2. Theres limit to how much government can tackle immobile factors of production.
    a. They can’t move land or force relocation
    3. However, they can improve labour immobility for example
    • To improve geographical immobility can offer relocation subsidies or mortgage relief to make move
    to new area more affordable for workers
    • Government could offer incentives for building more homes in area
    • To improve occupational mobility governments could provide more training programmes,
    improving peoples skills – Competition Policy

    • The part of the governments microeconomic policy
    and industrial policy which aims to make imperfect
    markets more competitive. It comprises policy toward monopoly, mergers and restrictive trading
    Three Parts of UK Competition Policy
    • Monopoly Policy – investigates pure monopolies and mergers
    • Competition and Markets Authority – screen UK economy for evidence of monopoly abuse
    o Alternative Approaches by CMA to the Problem of Monopoly
    ▪ Breaking up all monopolies
    ▪ Price controls to restrict monopoly abuse
    ▪ Taxing monopoly profits
    ▪ Privatising Monopolies
    ▪ Deregulation and Removing Barriers to Entry
    • Merger Policy – overlooks takeovers and mergers creating a new monopoly
    European Union Merger Policy
    • Prevents and control EU mergers – Public Ownership, Privatisation, regulation and deregulation

    Privatisation Improves Efficiency
    1. A publicly owned firm is owned by the government. The firm/ industry
    will act in the best interests of consumers – so prices tend to be low and output high. (possible as no
    profits need to be made)
    2. However, these firms are inefficient as they lack competition which leads to market failure
    a. Governments might increase competition by privatisation
    3. Privatisation is the transfer of the ownership of a firm/industry from a public to private sector
    a. This leads to more efficiency as it creates free market competition
    b. Private firms have shareholders so maximisation of profits is needed to keep shareholders
    4. Privatisation covers a number of different things, for e,g,
    a. Sale of public firm e.g. royal mail privatised through sales of shares
    b. Contracting out services – gov pays firm to carry out work on its behalf (cleaning gov buildings)
    c. Competitive tendering – private firms bid/compete to get a contract to provide a service for gov
    d. Public private partnership (PPPs) – private firm + government work together to build or provide
    and service for the public
    i. PPP example = M&S set up a 5-year partnership with Somerset County Council Waste
    Partnership. So M&S fund the council to collect waste so improves recycling service but
    M&S can use the recyclable plastic for its products

    Government regulation comes in various Forms
    1. Regulations are rules enforced by authority (government) and are backed up by legislation (laws)
    o They are used to control the activities of producers and consumers
    2. Regulations are used to try and reduce market failure and its impacts. They can help in various areas:
    o Reducing the use of demerit goods and services e.g. banning / limiting sale of such products
    o Reducing the power of monopolies through price caps
    o Providing some protection for consumers and producers from problems arising from
    asymmetric information
    3. With the right legislation, firms or individuals who don’t follow the regulations can be punished (fines)
    o For e.g. the clean air act and Environmental Protection Act limits damage to the environment
    Regulations can be difficult to set
    1. Governments find it hard to work out what is correct. For e.g. they may set acceptable pollution too low or high
    2. Theres a need for regulation in some areas to be worldwide not just one country. For e.g. regulation to control
    greenhouse gases
    3. Following excessive regulations can be expensive and may force firms to close or move to another country
    4. Monitoring compliance with regulations can be expensive for a government and if the punishment for breaking
    regulation isn’t harsh enough, then it may not be a deterrent and change behaviours

    Some Regulations are set To Encourage Renewable Energy Usage
    • UK government introduced Renewable Obligation Certificates to encourage use of power generated from
    renewable energy sources (wind, solar etc)
    • Electricity suppliers are given a minimum percentage of power that must come from renewable sources
    • Companies that generate the renewable energy get a ROC which link to amount of renewable energy generated.
    • Suppliers that fall short of target percentage of power from renewable sources pay a financial penalty. This
    money is then distributed between suppliers that did reach target
    • This means removing or reducing regulations. It removes some barriers to entry so can be used to increase
    competition in a market especially monopolistic markets, tackling market failure
    • Deregulation is used with privatisation as it reduces barriers to entry
    • Examples of deregulation in UK include the deregulation of directory enquiries.
    o BT, was a private firm at the time it was deregulated to allow other firms to enter the market

    Government Failure
    Government Intervention can cause Misallocation of Resources
    1. Government intervention can lead to resources being
    misallocated and a net welfare loss
    2. Government failures often an unintended consequence of an
    intervention to correct a market failure
    3. When looking at government failure it should be considered to
    the market failure its attempting to correct
    a. Local authorities can charge for some forms of non-household waste disposal e.g. for DIY waste
    b. However, this leads to an increase in fly-tipping, causing negative externalities for local residents (e.g.
    visual pollution caused by discarded items) and requires resources to clear up fly-tipping
    c. So the intervention aimed to reduce waste disposal negative externalities has produced other
    unintended negative externalities
    Government Intervention may Cause Market Distortions
    Gov intervention cause market distortions rather than removing them
    There are several example of this:
    • Income taxes can be disincentives to work hard, as earning more from working harder means more tax paid
    • Gov price fixing, such as maximum and minimum prices can lead to distortions of price signals.
    o For e.g.
    • Subsidies may encourage firms to be inefficient by removing incentive to be efficient

    Government Bureaucracy can Interfere with the Way Markets Work
    • Governments have rules and regulations (red tape) to prevent market failure
    • Enforcement of these rules and regulations is known as bureaucracy. Excessive bureaucracy leads to gov failure.
    • Red tape can interfere with supply and demand – reducing efficiency of markets e.g. Planning controls take ages
    o So, lots of red tape causes time lags so governments can’t respond quickly to needs or producers &
    • Bureaucracy can lead to lack of investment and prevent economy working at full capacity and create growth
    Conflicting Policy Objectives Cause Gov Failure
    • Attempts to achieve one policy can have negative impact on another
    o For e.g. stricter emission controls for industry to help environmental objectives. But this increases firms
    inputs and reduces output. This will cause unemployment and reduce economic growth
    • Governments often favour short term solutions as they are under pressure to solve issues quickly
    o For e.g. increasing capacity of UK road network will help short term congestion, but may increase road
    usage in long term
    Gov Failure can be Caused by Inadequate Failure
    1. Imperfect or asymmetric means it is difficult to access extent of market failure, so the gov cant put a value on
    the gov intervention needed to correct failure.
    o E.g. incorrect valuation of a market failure could lead to laxes or subsidies being set at inefficient levels
    2. Gov don’t know how population want resources to be allocated (better left to free market)
    3. Gov don’t know how consumers will react
    o E.g. campaigns to reduce under 18s drinking may lead to alcohol consumption being more desirable
    Administrative Costs can Cause Government Failure
    1. Government measures to correct market failure, like policies regulations, can use lots of resources (high costs)
    2. Some government interventions require policing, which can also be expensive
    a. For e.g. pollution permit schemes must monitored emissions of firms to check they aren’t exceeding
    There are Some Other Causes of Government Failure
    • Some other reasons for gov failure are

    Examples of Government Failure

    Common Agricultural Policy (CAP) was set up to help Farmers
    • CAP is to correct market failure cause by fluctuating prices for agricultural products
    o So provides reasonable stable prices for farmers
    • To achieve this CAP uses things like subsidies and buffer stocks. Also import restrictions on goods from outside
    EU. For e.g. tariffs are placed on imported goods

    The CAP scheme has some problems:
    o CAP encourages increased output at farmers are guaranteed minimum price by the government
    o Large amounts of wasted food products when perishable (have sell-by date) goods have to be destroyed
    o Theres a cost to taxpayers for getting rid of excess agricultural products
    o CAP can cause conflict between countries as exports from non-EU countries are less competitive
    o Increased food prices caused by CAP are unfair on poorer households who spend larger proportion of
    income on food
    • CAP encourages oversupply leading to misallocation of resources. This causes a net welfare loss to society
    • In recent years prices have moved closer to market price as part of EU reforms of CAP, but theres still problems
    Governments May Intervene in Housing Markets By Setting Maximum Rents
    • Price controls like maximum rents protect tenants from excessive rental charges
    • The downside of control of rent prices is that it can cause shortages of rental properties.

    Problems caused by Maximum Rents are an example of Government Failure:
    o Excess demand of rental properties leads to shortage of supply and causes black market to develop
    ▪ Black market will cause people to pay more than govs maximum rent level
    ▪ Black market tenants may also not offer a good service to their tenants
    o Shortage of rental properties also impacts supply of workers as workers can’t find accommodations near
    the firm to rent, so firms can’t attract staff
    Government Provide Subsidies To Public Transport
    • Bus and train journeys may be subsidised to reduce car usage and pollution levels
    • Subsidies don’t always lead to increases in passenger numbers (bus transport is inferior good) so even if it’s
    cheaper demand might not increase
    • Allocation of resources to public transport that doesnt raise usage or reduce pollution can be seen as a
    misallocation of resources and leads to net welfare loss
    Road Congestion Schemes Reduce Negative Externalities with Traffic
    • They reduce external cost linked to road congestion and the pollution it creates. These are AKA road pricing
    • The scheme works by charging people for a road where congestion is a problem
    o Charge is set at level that results in socially optimum level of traffic, but getting this right is difficult
    • Getting it wrong has impacts
    o If the price is too low then it will have limited impact on traffic levels
    o If the price is too high then too few cars will use the area covered by charge (reduced trade in area)
    • Road congestion charges may unfairly impact on poorer people, putting them off using a car
    Fishing Quotes were Introduced to Help make Fishing More Sustainable
    • Fishing quotas were introduced to make sure fish stocks remain stable in European waters.
    • They aim to prevent overfishing, which has negative impacts on fish populations, by setting limits on amount
    of fish that can be caught
    • The fishing quota system has been criticised and has a few key problems
    o Fish stocks depleted even with quotas
    o Fishing boats who exceed quotas often throw dead fish back into sea also known as discards
    o Theres poor monitoring of fish catches, so overfishing hasn’t been detected


    Price Controls
    Governments can set Maximum Price (price ceiling) for Goods or Services
    • a maximum price is set to increase consumption of merit good.
    o For e.g. government may set maximum rent price so the cost of renting a property of affordable
    • If max price is above equilibrium price it will have no effect
    • If its below equilibrium it will cause excess demand and shortage in supply
    • A goods PES and PED has a big effect on amount of excess demand

    Governments can set Minimum Price (price floor) for Goods or Services
    • Minimum price are often set to make sure suppliers get a fair price (done for several agricultural products)
    • If minimum price is set below market equilibrium, it will have no effect
    • If its set above equilibrium price, it will reduce demand and increase
    supply leading to excess supply
    • To make minimum price for a good work the government must purchase
    the excess supply at the guaranteed minimum price. The goods bought by
    government will be stockpiled or destroyed
    • Gov expenditure would then be A,B,Q1,Q2
    • A goods PES and PED has a big effect on amount of excess supply
    • Minimum price are a good way to reduce monopsony power as they
    provide a guaranteed price for suppliers so the monopsony buyer can’t negotiate lower and lower prices

    Buffer Stocks
    Buffer Stocks are Used to Stabilise Commodity Prices
    1. Prices in commodity markets (especially agricultural products) can be very unstable
    2. Buffer stocks schemes aim to stabilise prices and prevent shortages in supply
    a. Only work for storable commodities like wheat anf fuel
    3. Maximum and minimum prices are set on commodities by government
    4. If market price for product goes below price floor, the government buys it and stores it in stockpiles. Demand
    increases and the price is brought up to an acceptable level
    5. If market price for product goes above price ceiling, the government buys it and stores it in stockpiles. Demands
    increased and the price is brought up to an acceptable level

    Buffer Stocks Often Aren’t Successful
    In theory, income from selling the product at the set maximum price should pay for purchases at the set
    minimum price and the running of the scheme. However, buffer schemes often don’t work due to:
    • If minimum price is too high, so scheme will spend excessively purchasing stocks to maintain minimum price
    • If theres a run of good or bad harvest, then scheme may buy excessively or run out of stock
    • Storage and security of stockpiles is expensive
    • Producers may overproduce as they will get guaranteed minimum price
    Creating massive stockpiles = waste of resources






    Please enter your comment!
    Please enter your name here