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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