The market mechanism, market failure and government intervention in markets

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The price mechanism
Determines the market price,Allocates resources in a free market economy-solves economic problem-price moves resources to where demanded/shortage,removes resources from where there is surplus
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The three main functions of the price mechanism
Rationing, Incentive and Signalling
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The Rationing function of the price mechanism
Scarce resources-price increases due to the excess of demand-discourages demand and consequently rations resources
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The Incentive function of the price mechanism
Encourages a change in behaviour, high price- encourage firms to supply as more profitable
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The Signalling function of the price mechanism
Price acts a signal to consumers and new firms entering market,Price changes show where resources are needed in the market,High price-signals firms to enter the market because it is profitable-encourages consumers to reduce demand and leave market
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Invisible hand in the price mechanism
Can signal what the cost of purchasing a good is to a consumer and signal to producers to tell them what revenue they will receive
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Advantages of the price mechanism
Allows consumers to gain sovereignty in market-enables them to choose what is bought and sold,Generally the free market allows for an efficient allocation of resources
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Disadvantages of the price mechanism
Impersonal method of allocating resources,Could be undesirable in some markets,Inequality in income and wealth-does not consider distribution,Ignores equality,Under provision of public and merit goods-requires gov intervention
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Market failure
Misallocation of resources(resources not allocated to the best interests of society),Could be more output,Economic and social welfare is not maximised
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Types of market failure
Externalities,The under-provision of public goods,Information gaps,Monopolies
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How are externalities a form of market failure?
Cost or benefit a third party receives from an economic transaction outside of the market mechanism,Negative-Consumption of demerit goods,Positive-Consumption of merit goods
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How is the under-provision of public goods a form of market failure?
Public goods-non-excludable and non-rival - under provided by free-market because of free-rider problem
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How are information gaps a form of market failure?
Perfect information is assumed - rarely case in reality - imperfect information leads to a misallocation of resources
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How are monopolies a form of market failure?
Consumers have little choice - often overcharged - under-consumption - misallocation of resources since consumer needs and wants are not fully met
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How are inequalities in the distribution of income and wealth?
Unequitable distribution in income and wealth - income is flow of money - wealth is stock of assets - can lead to negative externalities such as social unrest
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Complete market failure
Missing market - market does not supply the products at all
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Partial market failure
Market produces a good, but it is the wrong quantity or the wrong price - resources are misallocated
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Private goods
Rival and excludable
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Quasi (non-pure) public goods
Characteristics of both public and private goods - partially provided by the free market
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Example of how technological change can be excludable
Television broadcasting - available to those willing and able to pay for them
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Public goods
Missing from free market but offer benefits to society, Non-excludable,Non-rival - free rider problem, Provided by governments-funded using tax revenue-quantity provided will be less than socially optimum quantity
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Why are public goods underprovided by the public sector?
Free rider problem - people who do not pay for the good still receive benefits, firms don't make profits, Difficult to measure value consumers get so hard to put a price,Consumers-undervalue benefit-pay less,Producers overvalue-Charge more
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Why are public goods non-excludable?
By consuming the good, someone else is not prevented from consuming the good as well
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Why are public goods non-rivalry?
Benefit other people get from the good does not diminish if more people consume the good
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The tragedy of the commons
Refers how individuals prioritise personal gain over the well-being of society,When resources are held in common it means that no one owns the resource but everyone can assess it, e.g. Air-no one owns but everyone uses it-air pollution-market failure
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What is an externality?
The cost or benefit a third party receives from an economic transaction outside of the market mechanism,the extent of market failure depends on a value judgement-hard to determine cost of externality
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Negative externalities
Cost suffered by third party-Caused by demerit goods-information failure since consumers not aware of LR implications of consumption-usually overprovided,e.g.cigarettes and alcohol
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Positive externalities
Benefit enjoyed by third party-Caused by merit goods-information failure since consumers not aware of LR benefits of consumption, e.g. healthcare/education
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Private costs
Producers-rent.cost of capital/labour,insurance,transport,raw materials-determines how much will be supplied-could refer to the market price which the consumer pays for the good
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Social costs
Private costs + external costs, external costs are the difference between private costs and social costs
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Property rights
The exclusive authority to determine how a resource is used. In the case of a private property right, the owner of private property has the right to prevent other ppl from consuming
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Marginal private cost
The cost of producing the last unit of a good - supply curve
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Marginal social cost
Marginal private cost + external cost
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What is the difference between the MPC and the MSC curves?
The external cost - negative externalities
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What does it mean when MSC and MPC diverge from each other?
External costs increase disproportionately with increased output
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When do externalities exist?
When there is a divergence between private and social benefits/costs
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Why are negative externalities likely to result in over-production?
MPB=MSB as no positive externalities,In a free market only private costs are considered,So output would be MPB/MSB=MPC-Overproduction and under pricing,MSC>MSB-Welfare loss from ignoring externalities
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Negative production externalities diagram
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Positive consumption externalities diagram
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Why are positive externalities likely to result in under-production?
MPB=MSB,Only private costs considered,Output would be MPB/MSB=MPC-Underproduction and overpricing-Potential welfare gain-the gain to society lost by ignoring externalities
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What is the socially optimal point of equilibrium?
MSB=MSC, however in a free market equilibrium is where MPC=MPB (Supply=Demand)
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Marginal private benefit
The benefit to someone of consuming the last unit of a good - Demand curve
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Negative consumption externalities diagram
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Positive production externalities diagram
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Why are positive production externalities likely to result in under-production?
MPB=MSB,Only private costs considered,Output would be MPB/MSB=MPC-Underproduction and overpricing-Potential welfare gain-the gain to society lost by ignoring externalities
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What is the socially optimal point of equilibrium? What is the socially optimal point of equilibrium?
MSB=MSC, however in a free market equilibrium is where MPC=MPB (Supply=Demand)
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Marginal private benefit
The benefit to someone of consuming the last unit of a good - Demand curve
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Negative consumption externalities diagram
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Positive production externalities diagram
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Why are negative consumption externalities likely to lead to over consumption?
MPC=MSC,MPB>MSB,Only private benefits considered,Output would be where MPB=MPC/MSC-Causes overconsumption and overpricing-Welfare loss as a result of ignoring externalities
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Why are positive consumption externalities likely to lead to underconsumption?
No negative externalities,MPC=MSC,Only private benefits considered,Underconsumption and underpricing,Potential welfare gain possible due to ignoring externalities
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Why does the absence of property rights lead to externalities in both production and consumption and hence market failure?
Markets become inefficient when there are no property rights,Free riders can have unlimited access-exploitation of the good,Moral hazard assumes someone else will pay the consequence for a poor choice-scare resources overused/exploited/environmental
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What does the classification of merit and demerit goods depend upon?
A value judgement
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Merit goods
SB>PB, positive externalities from consumption,Imperfect information-people unaware of full benefits,Underconsumed,Can be rejected by consumers
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Why are merit goods underconsumed?
Positive externalities ignored,Production and consumption below socially optimal level,Imperfect information-may not know full benefits
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Demerit goods
SC>PC,Harmful,Unaware/don't care about harm,Harmful effect on society due to negative externalities,Overconsumed
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Why are demerit goods overconsumed?
Negative externalities ignored,Production and consumption above socially optimum level,Imperfect information-don't always realise the harm,inelastic demand
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Merit good diagram
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Demerit good diagram
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Imperfect information
Leads to market failure,Information is missing so an informed decision can't be made,Consumers might pay too much or too little and firms might produce the incorrect amount
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Symmetric information
Consumers and producers have perfect market information - efficient allocation of resources
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Asymmetric information
Consumers and producers have perfect market information - leads to market failure as there is a misallocation of resources
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Why can the existence of monopoly or monopoly power lead to market failure?
Imperfect information/Asymmetric information, consumer can be exploited by paying a higher price for less,Missallocation of resources,Good underconsumed,Needs not fully met,Loss of allocative efficiency
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Principal-agent problem
Agent makes decision for the principal, but the agent is inclined to act in their own interests-Objectives which might conflict-Might choose to make personal gain
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How can information be made more widely available?
Advertising and government intervention
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Competition policy
Aims to increase competition in a market-improve allocation of resources,reduce deadweight welfare loss,protect the interest of consumers and improve efficiency,prevent monopolies
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What do the European commision and the UK's Competition and Markets Authority (CMA) look out for to prevent monopolies?
Mergers/takeovers, Agreements between firms (Cartels,Collusion),The opening of markets to competition-Privatisation,Financial support from governments
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What can the European Commission and CMA do to prevent monopolies?
Block mergers and impose fines on firms guilty of anti-competitive behaviour
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What regulating body regulates the water industry in the UK?
OFWAT
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What regulating body regulates the communication industry in the UK?
OFCOM
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What regulating body regulates the gas and electricity industry in the UK?
OFGEM
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What is the effectiveness of competition affected by?
Information available-if reliable:improve efficiency/allocation/fairness-if imperfect:gov failure, Also depends on the costs involved
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What are regulating bodies at risk of?
Regulatory capture
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How can governments intervene using competition policy?
Privatisation, Regulation and Deregulation
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How do governments use privatisation to increase competition in markets?
Publicly owned monopoly can be privatised to open it up to competition and force it to respond to market signals-Public monopoly could just become a private monopoly who are less likely to act in the best interests of the consumer
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How do governments use regulation to increase competition in markets?
Prevent a firm from gaining monopoly power or to increase competition by reducing the monopoly power a firm already has-Price caps,Monitor prices,Regulations to ensure standards,Regulate profits by imposing windfall taxes,Performance taxes-penalty
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How do governments use deregulation to increase competition in markets?
Market more contestable-Easier for new firms to enter-Increases competition-price falls closer to MC and output increases
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Price caps
Put put a max on the price increase that firms can charge their customers-provide an incentive for firms to increase efficiency,consumers benefit from improved services
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How do the CMA regulate the PPI market?
List of requirements for firms when selling PPI-providing information about right to cancel and costs-prevent future mis-selling,help consumers make informed decisions,increase competition
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How does the European commission regulate mobile phone roaming charges?
Lack of competition led to excessively high charges-Used price caps to significantly reduce data roaming charges-All member states must comply-Firms can offer lower prices than the caps to compete with each other
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Public ownership of firms and industries
Publicly owned firm is owned by the government
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Advantages of public ownership of firms and industries
Usually acts in best interest of consumer(don't have to make profit),low prices,high output,
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Disadvantages of public ownership of firms and industries
Tend to be inefficient,lack competition-market failure
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Privatisation
The transfer of the ownership of a firm/industry from the public sector to the private sector-Sale of public firms,Contracting out services,Competitive tendering,Public Private Partnerships
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Competitive tendering
Private firms compete to gain a contract to provide a service for the government
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Public Private Partnerships
Private firm works with a gov - Private Finance Initiative (PFI)
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Advantages of the privatisation of state-owned enterprises
Increased competition improves efficiency and reduces x-inefficiency,Improves resource allocation,PFIs enable the building of important facilities and mean lower taxes in SR,Gov gain rev from selling firms
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Disadvantages of the privatisation of state-owned enterprises
Privatised public monopoly likely to become private monopoly-extra measures need to be taken,Less focus on safety/quality,Might need regulating,PFI will cost more in LR than it's worth-Gov debt and higher taxes for future gen
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Regulations
Rules that are enforced by an authority and they're usually supported by legislation-used to control undesirable behaviour-can be punished with appropriate legislation
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Examples of regulations
Reducing the use of demerit goods and services-banning or limiting,Reducing the power of monopolies-price caps,Providing protection from problems arising from asymmetric info-Sale of Goods Act
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Advantages for the regulation of markets
Can generate positive externalities,Reduce use of demerit goods,Reducing power of monopoly,Protection from asymmetric info
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Disadvantages for the regulation of markets
Difficult to police, High administrative costs, Black market,Could raise costs for firms who might pass that onto consumers
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Deregulation
Removing or reducing regulations-removes some barriers to entry-increase competition-used alongside/as part of privatisation
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Advantages for the deregulation of markets
Improves resource allocation-more contestable-prices fall closer to MC-Output increases,Used with privatisation to prevent public monopoly becoming priv one,Improves efficiency by reducing 'red tape' and bureaucracy
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Disadvantages for the deregulation of markets
Difficult to deregulate some natural monopolies-expensive to build and maintain/only need for one of them,Deregulation can't fix other market failures-negative externalities/consumer inertia/immobile FoP,Less safety/protection for consumers
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Consumer Inertia
Resistance to change by consumers
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Regulatory capture
A form of government failure, happens when a government agency operates in favour of producers rather than consumers
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What are the two types of indirect tax?
Specific - fixed amount charged per unit, Ad valorem - proportion of the price of a good
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Specific indirect tax diagram
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Ad valorem indirect tax diagram
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Why do governments tend to tax?
Indirect taxes on goods with negative externalities - internalise the externality-make prod/cons cover costs of externalities-make rev more gov-offset effect of externalities
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What does the amount of tax passed onto the consumer depend upon?
PED - if inelastic most or all of the extra cost is likely to be passed on to the consumer
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Advantages of indirect taxation
Cost of externality internalised,May reduce demand/production of good-reducing effects of negative externalities,Revenue gained from the tax can be used by the gov to offset the externalities
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Disadvantages of indirect taxation
Difficult to put a monetary value on the 'cost' of externalities,Inelastic PED,Increase cost of prod-reduce international competitiveness,Firms relocate,Money raised may not be spend reducing effects,Inequality ^-affects poor more
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Indirect taxes
Taxes on expenditure, increase cost of production-supply less,Increases market price and demand contracts-discourage the prod/cons of a demerit good
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Subsidies
Encourage the prod/cons of good/service with positive externalities, increases supply-shifts right,Reduce negative externalities,Con/prod both gain
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Subisidy diagram
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What does the proportion of the subsidy producers and consumers benefit from depend on?
The elasticity of the supply and demand curves
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Advantages of subsidies
Benefit of goods with positive externalities is internalised,Price of good reduced,Subsidies can change preferences-more affordable,Positive externalities still present,Subsidies can support a domestic industry-exploit EoS and become competitive int
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Disadvantages of subsidies
Difficult to put a monetary value on externality,Opportunity cost,May make producers inefficient and reliant on subsidies-less incentive,Effectiveness depends on PED,Subsidised goods may not be as good as those replaced
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Maximum pricing
Increase consumption of a merit good or to make a necessity more affordable,has to be set below eq,leads to excess demand/shortage supply-rationing
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What effects the amount of excess demand when a maximum price is set by a government?
PES and PED
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Maximum pricing diagram
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Minimum pricing
Set to make sure suppliers get a fair price, EU's CAP,Has to be set above eq,Reduces demand,Increases supply-excess-gov must purchase the excess supply at min price-stockpiled/destroyed
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EU's CAP
European Unions Common Agricultural Policy - involves the use of a guaranteed min price for many agricultural products
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What effects the amount of excess supply when a maximum price is set by a government?
PES and PED
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Minimum pricing diagram
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Advantages of maximum pricing
Increase fairness-more ppl ability to purchase, Prevents monopolies exploiting consumers
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Disadvantages of maximum pricing
Demand will be higher than supply-some ppl won't be able to buy,Rationing scheme to allocate,Black market
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Advantages of minimum pricing
Producers have a guaranteed min income which will encourage investment,Stockpiles can be used when supply is reduced or as overseas aid
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Disadvantages of minimum pricing
Consumers will be paying a higher price,Resources could be used elsewhere-inefficient allocation of resources,High opportunity cost,Destroying excess is a waste of resources
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Buffer stocks
Aim to stabilise prices and prevent shortages in supply-can only work for storable commodities,Max and Min price are set,The income from selling the product at max price should fund purchases at min price/operational costs
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What happens when the market price for a product goes below the price floor in a buffer stock scheme?
The government buys it and stores it in stockpiles. Demand is increased and the price is brought up to an acceptable level
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What happens when the market price for a product goes above the price ceiling in a buffer stock scheme?
The government sells the product from it's stockpiles. Supply is increased and the price is brought down to an acceptable level
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Buffer stock diagram
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Why aren't buffer stocks often successful?
Min price set too high-spend excessively purchasing stocks to maintain this min price,Run of good or bad harvests-scheme may buy successively/run out of stock,Storage/security expensive,Deteriorate,Producer overproduce - guaranteed min price - waste
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State provision
Use tax rev to pay so goods/services largely free-NHS,Education,Waste disposal,Fire,Police,Public goods-defence/street lighting
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How can state provision overcome market failure?
Increase the consumption of merit goods,Free provision-reduce inequalities,Redistribute income,Level of state provision is a value judgement however
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Disadvantages of state provision
Less incentive to operate efficiently-lack of the price mechanism,May fail to respond to consumer demand-lacks profit motive,Opportunity cost,State provision can reduce individual's self-reliance
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Tradable pollution permits
Gov set optimal lvl of pollution and allocate permits that allow firms to emit a certain amount of pollution over a period of time,Firms may trade their permits if low emissions-sell its permits to firms who pollute more,Uses market mechanism
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EU emissions trading system
Tradable pollution permit scheme, with permits called emissions allowances, which are distributed between the EU's member governments, who in turn allocate these allowances to firms,Each yr no of allowances reduced-incentive to lower emissions
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What happens to a firm if they exceed their pollution allowances?
Will be fined unless they buy extra allowances to cover any extra emissions
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Advantages of tradable pollution permits
Good way to try reduce pollution-encourages efficiency and to pollute less,Firms causing low lvls of pollution benefit-sell permits-invest more and expand,Gov gain revenue from fines,Internalises the externality of pollution
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Disadvantages of tradable pollution permits
Optimal lvl difficult to set,Gov failure,Creates a new market where market failure can occur,High lvls of pollution in specific areas still exist,Admin costs to gov/firms
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What could happen if the optimal pollution level is set too high?
No incentive to lower emissions - gov failure
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What could happen if the optimal pollution level is set too low?
New firms might not be able to start up, existing firms might choose to relocate - gov failure
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Extension of property rights
Tackles market failure arising from absence of property rights,Can charge cons/prod for using the property and sue if permission hasn't been granted
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Advantages of extending property rights
Negative externalities internalised,Money raised reduce effects of externalities,Improve management of resources so they'll last longer,Negative externalities more carefully monitored and regulated,Fixes market failure arising from absence of PR
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Disadvantages of extending property rights
Difficult for gov to extend property rights, EU rules vs UK gov, Externalities can affect more than one country,High costs of suing an individual/company,Difficult for owner to put a value on its use,Difficulties in tracing source of environme damage
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How can governments intervene to help consumers make well-informed decisions?
Provide information on the full costs/benefits - try to help consumers make rational choices and prevent market failure caused by asymmetric info,Effectiveness often questioned-growing obesity problem-healthy eating campaign unsuccessful
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Examples of government-provided information
School and hospital performance league tables,Compulsory food labelling,Health warnings on cigarette's,Advertising campaigns to encourage healthy eating
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Advantages of nationalisation
Needs better provided,Set output/price most benefits society,Easily regulated-best interest of consumers,Public sector workers fair wage,Greater EoS,Pay suppliers fair prices
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Disadvantages of nationalisation
Tend to be more inefficient - not driven to reduce costs and make profit, little incentive to act prudently-moral hazard-firm will know gov and tax payers will bail them out
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How can governments increase competition by promoting small businesses?
Providing tax breaks, Subsidies for small firms, Helping entrepreneurs get the investment,Reducing regulations and 'red tape' - leads to greater consumer choice and lower prices
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Government failure
Government intervention can lead to resources being misallocated and a net welfare loss - unintended consequence
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Examples of government intervention causing market distortions rather than removing them
Income taxes can act as a disincentive to working hard, Governmental price fixing-distortions of price signals, Subsidies may encourage firms to be inefficient by removing the incentive to be efficient - reliance
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Red tape
Rules/regs that exist to prevent market failure, the enforcement of these is bureaucracy,Red tape can interfere with supply/demand-prevent efficiency, Causes time lags-int competitive disadvantage,Lack of investment/not full capacity
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Government failure caused by conflicting policy objectives
Certain policy objs may have negative effect on another,e.g.-stricter emission controls contribute towards environ objs but could ^ costs/reduce output-unemployment/fall in GDP,Politicians constrained-politically acceptable,Gov favour ST solutions
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Government failure caused by inadequate information
Imperfect/asymmetric-difficult to asses extent of market failure-hard to put value on intervention needed,May not know how population want resources to be allocated,Don't always know how consumers will react
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Government failure caused by administrative costs
Some gov interventions require policing-expensive ,Measures to correct market failure can use large amount of resources-high costs
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Examples of government failure
Subsidies to public transport, Road congestion schemes, Fishing quotas, Max rents in housing markets, CAP to help farmers
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Problems caused by the Common Agriculture Policy (CAP) that could lead to government failure
Environmental damage from increased output,Great expenses from oversupply-sold internationally-negatively affecting those outside EU,Waste/perishable,Increase food prices-inequality,Cost to taxpayer to rid excess,Conflicts w other countries,High OC
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Problems caused by government intervention in the housing market by setting maximum rents that could lead to government failure
Can cause shortages of rental properties, Excess demand - Black market - consumers likely to pay more than max lvl and may not be as good,Not be able to find somewhere to rent near work - labour immobility
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Problems caused by government intervention in subsidising public transport that could lead to government failure
Subsidies don't always lead to increases in passenger numbers-inferior good-travelling by car preferable for reasons of privacy/convenience,Allocation of resources that don't increase usage don't cause reduction in pollution - net welfare loss
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Problems caused by road congestion schemes that aim to reduce externalities linked with traffic that could lead to government failure
Hard working out socially optimum level - too low will have ltd impact on traffic lvls, too high then too few cars will use the area -reduced trade for businesses, under-utilisation,congestion in other areas, Unfair impact on poorer motorists
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Problems caused by fishing quotas that were introduced to help make fishing more sustainable that could lead to government failure
Fish stocks are depleting even with quotas - set too high and overfishing still in place, Fishing boats that exceed their quotas throw large amounts of dead fish back into sea,Poor monitoring of fish catches
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Rationing, Incentive and Signalling

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The three main functions of the price mechanism

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Scarce resources-price increases due to the excess of demand-discourages demand and consequently rations resources

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Card 4

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Encourages a change in behaviour, high price- encourage firms to supply as more profitable

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Card 5

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Price acts a signal to consumers and new firms entering market,Price changes show where resources are needed in the market,High price-signals firms to enter the market because it is profitable-encourages consumers to reduce demand and leave market

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