Market Failure and Government Failure

Includes questions on cost benefit analysis as well as gov. + market failure 

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What is cost-benefit analysis?
A method attempting to establish whether a project carries a net social benefit (i.e. social benefit more than social costs) in order to improve allocation of resources
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How is cost benefit analysis undertaken? (5 steps) - 2 on this card
1)identify costs + benefits... includes both private costs and benefits and external costs and benefits to third parties 2)attach monetary value to each cost and benefit
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2 on this card
3)find social benefit and social cost using that... a)Social benefit= private benefit + external benefit b)Social cost= private cost + external cost 4)subtract social cost from social benefit to find net social benefit.
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Final step
5)look at alternative uses for the resources to establish if the project is the best use of the resources
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What 8 problems are there with CBA? should be able to explain each (6 on this card)
1)difficult to identify all costs and benefits 2)difficult to put a monetary value on costs/benefits 3)may not cover everyone affected 4)distributional consequences 5)valuing the environment is difficult 6)valuing a human life is difficult
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last 2
7)can take up different attitudes towards risk e.g. Precautionary principle / free-market principle 8)Very difficult to value costs/benefits that might not occur
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How can we decide whether to carry out CBA?
Depends on how useful the information it provides is, relative to the cost of undertaking CBA- (CBA itself= administrative cost-potential source of gov. failure if doesn't provide useful info)
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How can we increase the value of the information provided by the CBA..? (4 ways- 3 on this card)
1)ensure cba is carried out independently + its assumptions aren't biased by political considerations 2)state clearly where it hasn't been possible to place a monetary value 3)state clearly assumption made in valuing costs and benefits
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4th way
4)conduct a sensitivity analysis, looking at effect of outcome of CBA if its assumptions are varied e.g. ask diff. teams of economists to conduct separate CBAs (will make diff. assumptions but hopefully arrive at similar conclusion
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What is a real-world example of how cba could've saved social costs/money
In 1970s, British + French gov. spent billions on Concorde project- chose not to do CBA. It closed down in 2003 as costs were greater than expected and revenue less than expected... likely carried huge social cost- could've been prevented with CBA
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What is market failure?
when a market fails to reach an optimal allocation of resources for society due to the market mechanism performing unsatisfactorily
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Give 5 examples of environmental market failures... (3 on this card)
1)resource depletion- negative externality w. future generations being 3rd party 2)resource degradation- natural resources less productive than before (same 3rd party as (1)) 3)Public good aspects of environment- e.g. gov int. needed for clean air
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(2 on this card)
4)Negative externalities- pollution= overprovided 5)Positive externalities- planting trees= under produced
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Give 4 methods of government intervention that could be used to correct environmental market failure such as pollution
1)Taxation- making polluter pay 2)Pollution permits 3)Extending property rights 4)Regulation
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How would taxation work?
-negative externality internalised by increasing private cost of production (MPC shifts upwards towards MSC) - SHOULD BE ABLE TO DRAW DIAGRAM
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What are the advantages of environmental taxation? (4)
1)Increases private cost 2)promotes allocative efficiency 3)contracts demand for product 4)government rev. generated
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What are the disadvantages of environmental taxation? (6)
1)Difficult to place values 2)International competitiveness hindered 3)Regressive effect on distribution of income 4)hard to know what type of tax 5)more efficient alternatives 6)affect on consumer welfare- reduces output and raises prices
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What might a more efficient alternative be to taxes?
Use of direct subsidies to encourage greater innovation in designing cleaner production technologies
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Give 3 ways a government could regulate pollution
1)set a quota it believes to correspond to social optimum 2)impose a ban on certain pollution generating activities 3)fine firms that do not conform to standards
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Why is this method not the best one? (3 reasons)
1)can be expensive 2)doesn't generate any tax revenue that could be used to support environmental improvement schemes 3)doesn't compensate those adversely affected
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What is the "tragedy of the commons"
When commonly used resources such as seas and air are not privately owned, so no person or organisation takes responsibility if they're overly exploited
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How does government correct this?
By extending property rights- if fully assigned, parties can negotiate at low cost with one another- efficient solutions to problems will be found without need for regulatory authorities to make artificial judgements
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Give an example
Water companies can seek compensation from firms/individuals who pollute rivers
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Evaluate this method
There are equity considerations e.g. who gets to own the river? it will affect the distribution of wealth
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How can these equity problems be avoided?
gov could auction off property rights- gains revenue!
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What happens in the absence of property rights? (3 things)
1)opportunism 2)misuse of scarce resources 3)over-use of resources
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What do pollution permits do?
Give businesses the right to emit a given volume of waste or pollution into the environment
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Ideally where would the number of permits issued correspond to?
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Give 4 advantages of this method (3 on this card)
1)More efficient way of reaching desired level of pollution 2)externality internalised 3)trade schemes of caps can address international dist. of income- poor countries allocated sufficient permits- can sell them to richer countries
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4th advantage
4)creates incentive for firms to reduce their emissions so that they're able to profit from the scheme
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GIve 4 disadvantages (3 on this card)
1)Requires judgment to be made about optimal level of pollution- not sufficient info to do this accurately 2)new market in pollution permits could lead to market failure 3)rich companies can just buy more permits and pollute more
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4th disadvantage
4)difficult to know how many permits to issue- if too many issued, fall in price and makes it uneconomical to invest in clean technologies 5)gov. could become 'captured' + pressured into issuing permits or favour important firms
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When are pollution permits most likely to be successful? (give 5 circumstances- 4 on this card)
1)when pollutant measurable 2)when large number of participant firms who're sufficiently sophisticated to deal with trading at auctions 3)transaction costs of permits low 4)strict enforcement
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5th circumstance
5)if cost of buying extra permits is high enough to create incentive to reduce emissions- otherwise will just continue to pollute
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What are pure public goods?
Goods which are non-excludable (cannot be restricted to just those who have paid) and non-rival (consumption by one household will not reduce availability to others)
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What are non-pure public goods (Quasi goods)? Give an example
Ones with elements of both public and private goods... public in nature but don't exhibit fully features of non-excludability and non-rivalry. e.g. road network in UK could be made excludable via a system of electronic road pricing
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How could this example also be rivalrous?
If roads are congested
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Why would no public goods be provided if left to free-market mechanism?
No individual consumer would pay for a product that could be consumed for free if another household decided to purchase it
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How can technical change lead to markets efficiently providing goods previously regarded as non-excludable and non-rivalrous?
Through excludability of traditional public goods.. e.g. encryption allows broadcasters to sell individual access to their programmes or costs of electronic road pricing has fallen dramatically
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How can it create new public goods?
E.g. streetlights
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In what ways can the government prevent missing markets from occuring?
1)direct provision 2)extending property rights e.g. charging for road usage
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What is imperfect information?
Occurs when one party to a transaction has more/better information than the other party.
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In most cases...
... seller knows more than the buyer e.g. car salesmen / estate-agents
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Why might it lead to market failure?
1)lemon market theory 2)frictional unemployment- unaware of jobs available 3)merit goods underconsumed, demerit goods overconsumed
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What is the lemon market theory?
When there a good quality goods and defective goods (lemons) in a market, but the buyer does not know if a good is a 'lemon' prior to purchase- assumes it is of average quality and hence only pays an average price for it
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What is the result of this?
The average value of a product tends to go down, even for those products of perfect quality
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If the process continues...
..the quality of the goods will decline (Gresham's Law), and eventually the market may disappear altogether (because it becomes unprofitable to sell the goods)
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What 2 main reasons do governments intervene in markets?
1)to correct market failure 2)to improve macroeconomic performance
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Give the 4 main categories of their intervention (should know what type of int. lies in which category)
1)provision 2)financial 3)regulation 4)information
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What is government failure?
When gov. intervenes in market but causes a loss of economic welfare rather than a gain.
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What is the public choice theory?
If a government failure is thought to be intentional, as gov. acting in its own interest rather than to maximise welfare
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Give an example of this
e.g. biofuels in US costed alot to subsidise in US, and lead to soil acidification and biodiversity loss as well as rising food prices (less supply of land to grow food)- gov. do it for votes
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Why does gov. failure occur? (5 main reasons- 3 on this card)
1)self-interest 2)conflicting objectives e.g. equity-efficiency trade-off 3)unintended consequences- e.g. increasing benefits to improve poverty leads to lack of incentive to work 3)inadequate info.
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2 on this card
4)regulatory capture- acts in interest of producer rather than consumer 5)high administrative costs-e.g. competition policy
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Other cards in this set

Card 2


How is cost benefit analysis undertaken? (5 steps) - 2 on this card


1)identify costs + benefits... includes both private costs and benefits and external costs and benefits to third parties 2)attach monetary value to each cost and benefit

Card 3


2 on this card


Preview of the front of card 3

Card 4


Final step


Preview of the front of card 4

Card 5


What 8 problems are there with CBA? should be able to explain each (6 on this card)


Preview of the front of card 5
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