Real-world issue 2

Real-world issue 2: When are markets unable to satisfy important economic objectives—and does government intervention help?

Conceptual understandings

  • The market mechanism may result in socially undesirable outcomes that do not achieve efficiency, environmental sustainability and/or equity.

  • Market failure, resulting in allocative inefficiency and welfare loss.

  • Resource overuse, resulting in challenges to environmental sustainability.

  • Inequity, resulting in inequalities.

  • Governments have policy tools which can affect market outcomes, and government intervention is effective, to varying degrees, in different real-world markets.

  • Key concepts: scarcity, choice, efficiency, equity, economic well-being, sustainability, change, interdependence, intervention.

2.7 Role of government in microeconomics

  • Reasons for government intervention in markets

    • Influencing market outcomes in order to:

      • earn government revenue

      • support firms

      • support households on low incomes

      • influence level of production

      • influence the level of consumption

      • correct market failure

      • promote equity.

  • Main forms of government intervention in markets

    • Price controls: price ceilings (maximum prices) and price floors (minimum prices)

    • Indirect taxes and subsidies

    • Direct provision of services

    • Command and control regulation and legislation

    • Consumer nudges (HL only)

    • Diagram: showing the following measures and the possible effects on markets and stakeholders

      • Price ceiling (maximum price)

      • Price floor (minimum price)

      • Indirect tax

      • Subsidy

    • Calculation (HL only): the effects on markets and stakeholders of:

      • price ceilings (maximum prices) and price floors (minimum prices)

      • indirect taxes and subsidies.

  • Government intervention in markets—consequences for markets and stakeholders

2.8 Market failure—externalities and common pool or common access resources

  • Socially optimum output: marginal social benefit (MSB) equals marginal social cost (MSC).

  • (MSB = MSC): allocative efficiency; social/community surplus maximized

    • Positive externalities of production and consumption and welfare loss

    • Merit goods

    • Negative externalities of production and consumption and welfare loss

    • Demerit goods

    • Common pool resources

      • Characteristics: Tragedy of commons, rivalrous but non-excludable

      • Unsustainable production creating negative externalities

  • Diagram: allocative efficiency

  • Diagram: showing market failure due to:

    • negative externalities of production

    • negative externalities of consumption

    • positive externalities of production

    • positive externalities of consumption.

  • Calculation (HL only): welfare loss from a diagram

  • Government intervention in response to externalities and common pool resources including:

    • Indirect (Pigouvian) taxes

    • Carbon taxes

    • Legislation and regulation

    • Education—awareness creation

    • Tradable permits

    • International agreements

    • Collective self-governance

    • Subsidies

    • Government provision

  • Diagram: showing government responses to externalities

    • Indirect (Pigouvian) taxes

    • Carbon taxes showing effects on the market of a particular polluting industry

    • Subsidies

    • Legislation and regulation

    • Education

  • Strengths and limitations of government policies to correct externalities and approaches to managing common pool resources including:

    • challenges involved in measurement of externalities

    • degree of effectiveness

    • consequences for stakeholders

  • Importance of international cooperation

    • Global nature of sustainability issues

    • Challenges faced in international cooperation

    • Monitoring, enforcement

2.9 Market failure—public goods

  • Public goods

    • Non-rivalrous, non-excludable

    • Free rider problem

  • Government intervention in response to public goods

    • Direct provision

    • Contracting out to the private sector

2.10 Market failure—asymmetric information (HL only)

  • Asymmetric information

    • Adverse selection

    • Moral hazard

  • Responses to asymmetric information

    • Government responses: legislation and regulation, provision of information

    • Private responses: signalling and screening

2.11 Market failure—market power (HL only)

  • Perfect competition–many firms, free entry, homogeneous products

  • Monopoly—single or dominant firm, high barriers to entry, no close substitutes

  • Imperfect competition

    • Oligopoly—few large firms, high barriers to entry, interdependence

    • Monopolistic competition—many firms, free entry, product differentiation

  • Rational producer behaviour—profit maximization (HL only)

    • Total revenue - Total costs (TR -TC)

    • Marginal cost = Marginal revenue (MC=MR)

    • Abnormal profit (AR > AC)*

    • Normal profit (AR = AC)*

    • Losses (AR < AC)* (* AR = Average revenue, AC = Average cost)

    • Calculation (HL only): profit, MC, MR, AC, AR from data

  • Degrees of market power

    • Meaning of market power

    • Perfect competition—no market power—firm as price taker

      • profit maximization:

        • in the short run

        • in the long run

      • Meaning of allocative efficiency, necessary conditions

      • Imperfect competition—varying degrees of market power—firm as price maker

    • Diagram: perfectly competitive firm as price taker where *P = D = AR = MR

    • Diagram: perfectly competitive firm showing:

      • abnormal profit

      • normal profit

      • losses

    • Diagram: equilibrium in perfectly competitive market with reference to allocative efficiency when P = MC or MB = MC, maximum social/community surplus.

    • *P = Price, D = Demand

  • Monopoly

    • Profit maximization

    • Allocative inefficiency (market failure)

    • Welfare loss in a monopoly in comparison with perfect competition due to restricted output and higher price

    • Natural monopoly

    • Diagram: market power where AR > MC

    • Diagram: monopolist showing:

      • abnormal profit

      • normal profit

      • losses

    • Diagram: price/quantity comparison of a monopoly firm with a perfect competitive market. Also showing welfare loss under the monopoly.

    • Diagram: natural monopoly

  • Oligopoly

    • Collusive versus non-collusive

    • Interdependence, risk of price war, incentive to collude, incentive to cheat

    • Allocative inefficiency (market failure)

    • simple game theory payoff matrix

    • Price and non-price competition

    • Measurement of market concentration – concentration ratios

    • Diagram: collusive oligopoly acting as a monopoly

  • Monopolistic competition

    • Profit maximization:

      • in the short run

      • in the long run

    • Less market power due to many substitutes—more elastic demand curve compared with monopoly

    • Allocative inefficiency (market failure)

    • Less inefficiency, more product variety

    • Diagram: monopolistically competitive firm showing:

      • abnormal profit

      • normal profit

      • losses

    • Diagram: monopolistic competition (with a more elastic demand curve compared to a monopoly)

  • Advantages of large firms having significant market power, including:

    • Economies of scale including natural monopolies

    • Abnormal profits may finance investments in research and development (R&D), hence innovation

  • Risks in markets dominated by one or a few very large firms

    • Risks in terms of output, price, consumer choice

  • Government intervention in response to abuse of significant market power

    • Legislation and regulation

    • Government ownership

    • Fines

2.12 The market’s inability to achieve equity (HL only)

  • Workings of free market economy may result in an unequal distribution of income and wealth

  • Diagram: showing the circular flow model to illustrate why the free market results in inequalities

Inquiry—possible areas to explore (not an exhaustive list)

  • The impact of a price floor or price ceiling in a chosen market.

  • The impact of a government policy to correct market failure resulting from externalities.

  • How different communities approach the managing of a common access resource.

  • The impact of a price war or of price fixing on stakeholders of a selected industry.

  • The risks of increasing monopoly power and abuse in a selected industry (for example, technology).

  • Examples of government intervention in response to abuse of market power.

  • How government intervention to correct a market failure (other than externalities) affects different stakeholders.

  • How a country’s economy could thrive without depending on the overuse of finite resources and still meet people’s needs.

Theory of knowledge questions

  • What knowledge criteria should government policy makers use to make choices between alternative policies?

  • The idea of environmental sustainability suggests that people should avoid destroying resources today so as not to penalize future generations. Is it possible to have knowledge of the future?

  • Microeconomic theory is based on the assumption of rational consumer choice and rational self-interest. Yet the principle of collective self-governance suggests that people also behave cooperatively. What assumptions do economists make about the roles of reason and emotion? Are these assumptions justified?

  • How can we know when a problem is sufficiently large to justify government intervention?

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