Microeconomics AS Part 5


Information Failure

This is when consumers lack, or fail to utilise properly, the information available about the benefits or harm derived from consumption. This creates a case for government intervention if they think they know better, and can correct the information failure. For example:

  • False or misleading advertising from firms
  • Consumers not informed of all costs and benefits of consumption
  • Consumers fail to take notice of costs and benefits
  • Lack of education
  • Denial or ignorance of facts ('It won't happen to me')
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Merit Goods

A merit good is one that consumers underestimate the benefit (or overestimate the harm) they will get from consumption . This creates a welfare loss from underconsumption, and often creates negative externalities for specific groups of people.

The informed demand of consumers will be greater than the uninformed demand, and so the quantity exchanged is lower than the quantity that would be best for society. This shows allocative inefficiency in the market.

Because of this inefficient resource allocation of resources, there is a market failure.

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Demerit Goods

A demerit good is one that consumers overestimate the benefit (or underestimate the harm) they will get from consumption . This creates a welfare loss from overconsumption, and often creates negative externalities for specific groups of people.

The uninformed demand of consumers will be greater than the informed demand, and so the quantity exchanged is higher than the quantity that would be best for society. This shows allocative inefficiency in the market.

Because of this inefficient resource allocation of resources, there is a market failure.

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Excludability and Rivalry in Consumption

Market economies are based on private ownership of products, and market transactions (buying and selling) involve the exchange of property rights - you are exchanging your right of ownership of one product (or money)  for another product.

Excludability is the ability of a firm to excude people who have not paid from consumption of their product. This is one of the reasons for the existance of the legal system.

A product is rivalled in consumption means that consumers are competing for a limited supply of the product - i.e. a noirmal product. One person's consumption of a product reduces the amount available for others.

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Public Goods

Public goods are neither excludable or rivalled in consumption.

They are non-excludable because the consumption of them cannot be prevented by those who have not paid. These generate a lot of positive externalities, as consumers' economic welfare is being increased without having paid for the product.

They are also non-rivalled in consumption because one person's consumption of them does not have any effect on the supply available for others.

Examples of public goods include national defence, street lighting and flood defences, however pure public goods are quite rare. The degree of excludability and rivally is more relevant.

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Public Goods 2

If profit-orientated private firms will not provide pure public goods, this is an example of market failure as the market is failing to provide for the wants of consumers. The government must intervene and provide the resources for public use. This is done by taxation - a compulsary charge for the provision of public goods.

If parts of the public good can be made excludable, there may be opportunities for private firms to provide the public good. This is what is happening at the moment with the NHS in the UK.

For example, a lighthouse would have been considered a public good because they are non-excludable and are non-rivalled in consumption.

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Government Intervention

The main reasons for policy intervention are:

  • To correct for market failure
  • To achieve a more equitable distribution of income and wealth
  • To improve the performance of the economy

Governments intervene for different reasons depending on the reason for the failure of the market:

  • Information failure - the government intervene because they think they know better, and can correct the information failure.
  • Externalities - these reduce or increase the social welfare of consumers, and so governments try to minimise or maximise these
  • Merit/demerit goods - governments act to influence the distribution of these in order to increase the social welfare of consumers
  • Public goods - the government act to fund the provision of public goods to increase the economic welfare of consumers
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Indirect Taxation

A tax is a compulsary payment to governement for which no good or service is recieved directly in return. Taxes used by governments to correct market failure are indirect taxes, which are a tax on spending on a specific product. It can either be a specific (fixed amount) tax or an ad valorem (% based) tax. They can be used for any of the 3 interventional objectives, and are levied onto companies, therefore act by shifting the supply curve to the left.

Specific taxes are more common, and can be shown graphically by a leftward shift in the supply curve, for which the price difference between the two curves at each level of output is equivalent to the amount of the tax. This is because companies need higher pices to make a sufficient profit, in order to cover the revenue lost through the tax.

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Indirect Taxation 2

When the supply curve shifts, the price directly above the original level of output on the new curve will be the price at which producers will wish to sell their products, however this point represents excess supply, and so will not be sustained.

Ceteris Paribus, the market should return to equilibrium at:

  • Price: Original price plus tax
  • Quantity: Point where new supply and demand curves intersect

The area between the new price, new EQ point, new price minus the tax and quantity supplied at this point represents the revenue raised by the tax. The net revenue for firms is the area underneath this.

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Surplus and Burden of Taxation

The effectiveness of a tax can be analysed by looking at the relative porducer and consumer surpluses before and after the tax, and the region by which they have changed.

This can further be analysed by investigating upon whom the burden of the tax falls:

  • The nominal burden is whoever legally pays the tax, i.e. the firm.
  • The effective burden is who is really paying the tax

If demand is relatively price elastic, less of the burden can be passed to consumers as they will respond the the increase in price with a greater decrease in demand, reducing revenue for the firm. The producer is forced to take most of the burden.

Moreover, if demand is relatively inelastic, firms can pass more of the price of the tax onto consumers as they will respond less, proportionately, to the price increase. The consumers are taking more of the burden.

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Surplus and Burden of Taxation 2

The producer burden is also determined by elasticity - in this case the price elasticity of supply.

As price elasticity of supply increases, firms are more able to adjust their supply of rpoducts, and so are less affected by the tax. They do not take much of the burden. Conversely, if PES is low, firms are not able to adjust supply, and so they are forced to absorb more of the burden.

The consumers will take most of the burden when demand is inelastic and supply is elastic (Demand will change little, supply can change greatly).

The firms will take most of the burden when demand is elastic and supply is inelastic (An increase in price will greatly reduce demand, supply unable to adjust)

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A subsidy is a payment from government to encourage production and/or consumption. They are usually paid to producers in order to reduce their costs and increase output.

There are two types of subsidy:

  • Lump sum - A fixed amount, usually used for capital investment or research and development
  • Output-related subsidy - Related to the number of units sold, a set amount is given per unit 

A subsidy will make both parties better off directly, however the subsidy is paid for by:

  • Taxation (direct or indirect)
  • Cutting spending/diverting resources elsewhere
  • Borrowing money
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Benefit from Subsidies

The nominal benefit of a subsidy is whoever is legally entitled to the subsidy, i.e. the firms or producers.

However, the benefit can be broken down into consumer and producer benefit:

  • Consumer benefit is the total value by which prices fall, and can be calculated by multiplying the units exchanged by the fall in price.
  • Producer benefit is the total value of the subsidy producers keep, and is calculated by multiplying the number of units exchanged by the amount of the subsidy kept by firms for each unit.
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Benefits from Subsidies 2

The value of benefits from subsidies are determined by the relative elasticities of demand and supply:

  • Relatively inelastic demand means prices have to fall by a considerable amount in order for demand to increase, therefore the subsidy will be more to the benefit of the consumer
  • Relatively elastic demand means prices do not have to change by much in order for demand to increase, meaning producers can retain more of the subsidy
  • Relatively inelastic supply means firms will be able to benefit more as they are usually unabel to respond that well to price change, meaning supply can increase more than usual
  • Relatively elastic supply means firms will benefit little from the subsidy, as they are usually able to respond to price change anyway.

The maximum benefit for consumers is when supply is elastic and demand is inelastic;

The maximum benefit for producers is when supply is inelastic and demand is elastic.

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Regulation is the use of rules, standards and laws to influence behaviour of both firms and consumers, and to influence the allocation of resources. In a sense, all forms of government intervention are regulations as they are enforced by legislation.

There are 4 categories of regulation, and the relevant categories of a regulation should always be identified:

  • Government (local or national) regulation - rules set out by government itself
  • Self/Voluntary regulation - a market (or set of firms within it) setting their own rules by which they promise to abide. Often preffered to government regulation as it allows markets to avoid the influence of government and encourages a market system
  • Positive regulation - a regulation that states something that must be done in order to comply with the law and avoid prosecution (incurring costs for the firm)
  • Negative regulation - a regulation that bans s certain practice, either completely or partially from happening in a market.
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Regulation Evaluation

Since regulations are a broad group of intervention techniques, each one must be evaluated individually:

Enforcement: This is the way in which governments enforce a regulation. The resource cost of enforcement must be considered, as must the opportunity cost of using these resources for this purpose. Also, the clarity of the regulation must be considered - a regulation with many loopholes and clauses will cost more to enforce as it must be applied to each individual case.

Unintended consequences: By imposing a regulation, it is possible that there will be side effects on other markets, and so the markets for the complementary and substitute products must be considered. Also, by imposing regulations, this can sometimes lead to the formation of black markets, which are impossible for governments to regulate.

Generally, regulations are quick, and will be observed by most law-abiding people and firms. They are also quite cheap to implement, but only the sanctions for breaking them will raise revenue for the enforcer. These sanctions must act as an effective deterrant, otherwise the regulation will be broken.

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Tradeable Pollution Permits

TPP are based on the idea of countries agreeing to set limits on pollution. These limits are broken down into small permits, which allow holders to pollute a certain amount. These permits can be traded if firms have too few or too many for their production process - ineffect creating a market for carbon.

The ides is that by contniuing to use methods of production that pollute, firms will incur costs that are unsustainably high, and so should invest in cleaner production techniques in order to cut costs.

Over time, the market is 'squeezed' by the removal of some permits from circulation, meaning the market price for these permits is made to be very high.

However, they will only work if the cap holds and is enforced, and if firms see it in their best interests to stop polluting. In theory, it doesn't matter who is actually doing the polluting, as long as it doesn't exceed the cap, everyone signs up, and it affects all industries.

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Problems with TPPs

Global warming is a public bad, i.e. its effects are neither excludable or rivalled in consumption. This creates a free rider effect as some countries, markets or firms will not contribute as they believe that as everyone else will, they don't need to. This craetes a problem as all countries need to agree on the cpas in order for them to be effective.

Since these schemes will increase costs for most firms, the overall price level will increase, leading to inflation.

Enforcement must be strict and effective in order for general pollution levels to fall.

It can be argued that this policy could be a distraction from policies that are more practicla and can be implemented immediately.

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