Chapter 3: Market failure and government intervention.

 
As we know that the main aim of market is to produce the best ( efficiency ) allocation of scare resources. In an ideal situation market does it, but in practice markets do not always work in this way. In this case we have the term market failure.
Market failure occurs where the free market mechanism (the system by which the market forces of demand and supply determine prices and the decisions made by customers and firms) fails to achieve achieve economic efficiency. Using simple words, during this process market is failing to produce the best use of scarce resources.
Lets talk about efficiency. There are two recognizable types of efficiency: allocative efficiency (we looked before) and productive efficiency. Economists explain productive efficiency as a process when everything that is produced is produced using the least amount of scare resources. Both terms (allocative efficiency and productive efficiency) are parts of economic efficiency.
What does it mean? Economic efficiency is a process where both allocative productive efficiency are achieved. There also the opposite term of efficiency. Inefficiency. This means any situation where economic efficiency is not achieved (resources are not used in the best possible way)
Information failure.
As we know all people, when they are making decisions what product buy or what product don’t buy, are using some sources of information about particular product (advertisement, for example). So information is very important for people while they are making decisions. We have to remember that almost in all cases people think rational, so they are thinking about advantages and disadvantages of buying something new. Lets have a look on this using some examples.
We can conditionally divide all goods into two groups (merit goods and demerit goods). You have to remember that difference between this two groups of goods is that demerit goods have bad influence for society (for example, cigarettes).
- merit goods

As we can see on the graph without information people would by less than with information. If people will know that product is good (for example, healthy food), they will buy it.

- demerit goods

We can notice from this graph that with information (about how goods are harmful) people would by less.

Speaking about information failure we also should to pay attention on asymmetric information. This means that information nit equally shared between two parties. Lets have a look on partical examples for better understanding:
Health care. When you visit your doctor with illness, you do not have the same medical knowledge as your doctor. You rely on the doctor’s experience and competence to give you treatment you need.
Insurance. When applying for travel or car insurance, as a purchaser you know far more about your circumstances (particular situation) than the company that is selling the insurance.
In these examples we can see that the lack of information has distorted how the market allocates resources.

Externalities.
All production has influence (sometimes positive, sometimes negative). In Economics this calls externality, that means an effect whereby those not directly involved in taking a decision are affected by the actions of others. The group of people, that is affected by others without taking decisions, calls third parties. Lets look at example just for better understanding.
Suppose a new airport was built. Noise from planes is negative influence (externality) on people (third parties) who live in this area.

Lets look at costs and benefits of externality.
There are three types of costs and benefits:
1) Private costs and benefits. In the case with airport, private costs are costs incurred by firm(airport) and privet benefits are directly received by airport. Private costs are the costs incurred by those taking particular action. Private benefits are the benefits directly accruing to those taking a particular action.
2) External costs and benefits. In the case with airport, people who live on the flight path of the airport will experience additional noise pollution problems. They may be forced to soundproof their homes at their own expenses trough no fault or doing of their own. An external benefits could be if some frights transfer to the airport from elsewhere, resulting in less noise pollution for those people who live near airport.
3) Social costs and benefits. You have to remember that external and social costs and benefits are not the same. For example, in the case of airport, the social cost could include cost of increased CO2 pollution, and social benefit might include the additional jobs for people who live in this area (near airport).

Negative externalities.
Negative externality exists where the social cost of an activity is greater than the private cost. Here some examples:
Chewing gum. This can poses major problems in all towns and cities. Westminster Council claims to spend over 100,000 pounds annually removing gum from its streets.
Illegal dumping of waste. The private cost to those dumping such things is minimal (unless they are found out!); the external cost has to be covered by those, such as local councils, responsible for maintaining the environmental.
Each of these situations we can show on the graph below.

The price is P and the quantity bought and sold is Q. At this price the supply curve only takes into account the private costs of a given action. If the external costs is also accounted, the supply curve would shift to the left, to S1. The result would increase in price to P1 and fall in equilibrium quantity to Q1. The problem with negative externality is that there is over-production of Q-Q1 and that the price is lower than it should be. Too many scare resources are being used.

Positive externalities.
Positive externality exists where the social benefit of an activity exceeds (is greater than) the private benefit.
Lets have a look at the graph below.

At the price P the private benefit are not taken into account. If they are, the demand curve will shift to the right and, as a result, the market equilibrium would be at the price P1 and quantity Q1. Where the market fail to operate in this way, there is under-production. This is shown by the difference between Q1 and Q. Too few scarce resources are being used, hence the market failure.

As you remember, we have looked on two types of goods (merit and demerit) before. There is also another group of goods.

Public goods.
Public goods are goods that are collectively consumed and have characteristics of non-excludability and non-rivalry. There are two types of public goods:
1) non-excludability – situation existing where individual consumers cannot be excluded from consumption. Free rider – someone who directly benefits from the consumption of a public good but who doesn’t contribute (develop) towards its position.
2) non-rivalry – situation existing where consumption by one person doesn’t affect the consumption of all others.
Economists also notice a further type of public good – quasi-public good (goods having some but not all of the characteristics of a public good)

Government intervention to correct market failure.
The government can intervene into market by two ways (methods):
1) by manipulation of the market mechanism – subsidies, indirect taxation and the provision of information.
2) by direct provision and various forms of regulation and control.

TAXATION
There are two types of taxes:
- direct taxes, such as income tax, corporation tax and national insurance contributions, all of which are taxes on the incomes of individuals and firms.
- indirect taxes, such as value added tax (VAT) and excuse duties, that tax the sale of certain products, council tax and business rates are charged locally on the ownership of houses and business premises.

SUBSIDIES
Subsidy is a direct payment made by government to producers of a good or service or, in some cases, to its consumers. This company is aimed to reduce the cost and increase level of production and consumption. Lets have a look on some examples:
- subsidies to producers . payments to train-operating companies to operate franchised service, payments to local bus companies to run loss-making services in rural areas, etc.
- subsidies to consumers . the winter full payment to people aged 60 and over, the educational maintenance allowance for 16-18-years-olds in further education,etc.
Lets look on the graph below, that shows us the effects of introducing a subsidy.

As we can see that in almost all situations introducing a subsidy involves an increasing in supply (supply curve shifts to the left)

Regulations, standards and legal controls.
The best way of understanding this topic is looking through some examples in our book.

Tradable permits.
Tradable permits are the permits that allows owner to emit a certain amount of pollution and that, if unused or only partially used, can be sold to another polluter.
The graph below shows how, in theory, the price of permit is determined. As we see that supply of permits (S) is constant(vertical straight line). So if demand will change from D to D1 only prices will change (from P to P1).

Role of government in information provision.
Lets have a look at some examples to understand exactly how the government plays role in information provision:
- health warnings on cigarette packets
- advice on the maximum number of units of alcohol that should be consumed
- improved labeling on food products, such as the ‘traffic light’ system that indicates fat, sugar and salt content
- advice on the consumption of junk food and on links to child obesity.