Ans. A market failure takes place when –
Free markets allocate resources inefficiently. The production in an economy is not Pareto optimal as shown on the PPF graph. At A the production is inefficient and at X it is impossible with the current resources. Market failures can take place in all these situations –
1. There is a lack of merit goods such as food in the economy which leads to market failure.
1. There is overprovision of demerit goods which could harm society. For example – drugs, cigarettes etc.
1. There is a lack of public goods as private firms are not ready to produce them as they are not profitable.
1. There is a huge income gap. The rich are too wealthy and the poor are very poor.
1. There is environmental degradation or any negative externality which causes a market failure.
1. There are too many monopolies formed all of which exploit consumers by charging unrealistic prices.
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Economics Project – Market Failure
Research Question 2 – How does the government deal with market failures?
Ans. The government can take the following steps –
1. Taxation – Income tax, sales tax and other ad valorem taxes help generate government revenue to provide merit and public goods. Taxes can be imposed on the production of demerit good to reduce production. Taxes can also be imposed on firms which pollute the environment causing negative externalities.
1. Subsidies – Payments from the government to firms are given to encourage the production of merit and at times public goods. For example – food for everyone, public transport, post service etc.
1. Legislation and Regulation – If taxes and subsidies fail to work then the government can use the law and imply regulations. The government could limit or ban the production of demerit goods such as cigarettes as well as heavily penalise firms which do not comply with the eco – friendly standards set by the government.
1. Tradable Permits – These are used to control the total greenhouse emissions of an economy. The government calculates how much CO2 can be emitted and divides this among all the firms. Some firms might not want high permits and might sell some of theirs. Others might buy from them as they are unable to cut down on their greenhouse gas emissions.
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Economics Project – Market Failure
Research Question 3 / 4 – How effective is the use of taxation and subsidies? What are the opportunity costs?
Ans. The efficacy is as follows –
Uses of taxes –
1. Raises revenue for the government which is spent on providing public goods such as defence and merit goods such as food for the poor. It can also be used to offset the interest on national debt.
1. Environmental taxes help reduce pollution and other negative externalities. Landfill taxes, plastic bag taxes etc. are new taxes which reduce social costs. Demerit taxes help to reduce the production of demerit goods which are harmful for society such as cigarettes.
Causes for inefficacy of taxes and opportunity costs –
1. Most demerit goods have an inelastic demand. Thus, the producers can pass on most of the burden of the tax on the consumers by hiking the prices. However, as the demand is inelastic it does not react much to the rise in price and thus the quantity consumed remains the same thus defeating the main purpose of taxation.
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1. The government does not have proper information when setting the level of environmental taxes as social costs cannot be easily equated to monetary values. Also, firms may commit fraud by reducing pollution when checks take place and polluting the environment liberally at other times.
1. High taxes on companies may cause higher unemployment. As the profit margins of private firms decreases they would tend to cut down on costs and thus might make some of their labour force redundant.
Uses of subsidies –
1. To reduce inflation as this causes prices to rise. Due to inflation many low – income households are unable to purchase basic necessities such as food and clothing. The subsidies help bring the prices of these goods down.
1. Encourages provision and consumption of merit goods which lead to positive externalities or social benefits. It ensures that there is no under provision and under consumption of merit goods. Food for everyone can be merit good.
1. Maintain or increase the revenue of producers during tough times such as a recession or economic downturn. Subsidies help producers raise their profit margins and would therefore save them from getting bankrupt during a recession.
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Causes for inefficacy of subsidies and opportunity costs –
1. Subsidies tend to distort the market prices as at times only certain industries and firms are given subsidies. This can lead to misallocation of resources and can end up in a market failure itself.
1. Subsidies provide arbitrary assistance. If a certain firm is favoured by the government it will be given more subsidies. Furthermore, fraud can take place as subsidies can be allocated unwisely.
1. The financial cost of the subsidies can at times be too high. This leads us to think whether that much government revenue could be put to another use such as defence or street – lighting. This is a major opportunity cost of giving subsidies.
1. The ones who pay for the subsidy, consumers (taxpayers) might not always benefit from the subsidies and thus the ones who pay are not always the ones who benefit thus making subsidy payments unfair.