III. Government Intervention in the Price System.

A. Market Failure (Define and List)

a. An economic term that encompasses a situation where, in any given market, the
quantity of a product demanded by consumers does not equate to the quantity
supplied by suppliers. This is a direct result of a lack of certain economically ideal
factors, which prevents equilibrium.
b. Examples of market failure
i. Where there are externalities present in a market
ii. Where merit goods have to be provided because the market will fail to
provide them
iii. Where public goods are provided by the government, again because the
free market will fail to do so

B. Externalities (Define and include private and social costs)

a. A consequence of an economic activity that is experienced by unrelated third
parties. An externality can be either positive or negative.
b. Private cost
i. Those costs involved in an action that accrue to the decision maker
c. Social costs
i. Are all of the related costs associated with that action

C. Negative Externalities (Define and include private and social costs)

a. An external cost
i. A private and social costs are not always equal
ii. This is what causes externalities to exist in an economy
iii. The social costs exceed the private costs of a decision

D. Positive Externalities (Define and include private and social benefits)

a. Private and social benefits
i. The social benefits are all of the benefits that accrue from that decision
ii. The private benefits are those that accrue solely to the decision maker
iii. These are not always equal
b. An external benefit
i. The social benefits of a decision may exceed the private benefits

E. The Problem Created by Externalities

a. They will lead to an inappropriate amount of the product involved being
produced: the free market will lead either to too much or too little production
b. Because the social cost is different from the private cost, the price will be at a
different price than the actual equilibrium and the amount of money to rectify the
negative externality will be large
c. Social cost vs private cost leads to a problem with the supply line
d. Social benefit vs private benefit leads to a problem with the demand line
F. The Cost-Benefit Approach (How is this used to solve the problem? How does it differ
from private sector methods of appraisal?)
a. Identifies various causes and consequences of market failure
b. Major projects may produce important and controversial side effects, in particular
where there are substantial costs and benefits which fall upon people and
communities who have no direct connection with the project
c. Spillover Effects
i. The production of a new development may cause the surrounding
community to be polluted
ii. Those not involved in the project are effected
d. Attempts to quantify the opportunity cost to society of the various possible
outcomes or sources of action
e. Differs from the private sector in the following ways
i. It seeks to include all of the costs and benefits, not just the private ones
ii. Has to impute shadow prices on costs and benefits where no market price
is available

G. The Framework of Cost-Benefit Analysis (What are the four stages? What are the
difficulties?)
a. The stages
i. The first stage is to identify all of the relevant costs and benefits arising
out of any particular project
1. there are problems establishing external costs and benefits
2. these are often controversial and not easy to define in a discrete
way and have the added difficulty that it is not always possible to
draw a physical and geographical cut off
ii. The second stage involves putting a monetary value on the various costs
and benefits
1. This is straightforward
2. However, often a monetary value has to be placed for something at
which there is not market value
3. A human life costs how much?
iii. The third stage applies in situations where projects have longer-term
implications which stretch well into the future
1. employ statistical forecasting techniques, sometimes of a very
crude nature, to estimate costs and benefits over many years
iv. The final stage
1. is where the results of the earlier stages are drawn together so that
the outcome can be presented in a clear manner in order to aid
decision making
b. The difficulties
i. Which costs and benefits should be included
ii. How to put monetary values on them

H. Merit goods, de-merit goods and information failures (Define each and give examples)
a. Merit goods
 i. Goods or services (such as education and vaccination) provided free for
the benefit of the entire society by a government, because they would be
under-provided if left to the market forces or private enterprise.
b. De-Merit goods
i. A good which is considered unhealthy or damaging in some way. A
demerit good can be physically harmful (cigarettes), mentally harmful
(gambling), or morally harmful (prostitution). In many cases, demerit
goods are subject to additional taxes in an effort to reduce consumption;
these taxes are frequently known as sin taxes.
c. Information failures
i. A result of merit and demerit goods
ii. Consumers do not perceive quite how good or bad a particular product is
for them
iii. Either they don’t have the right information or lack some relevant
information
d. Value Judgments and paternalism
i. Value Judgments
1. if a society is able to say to consumers what is good and bad for
them, then we are accepting that society knows best and has some
right to make such judgments
ii. Paternalism
1. It is acceptable for us to say that society can judge what is, or is
not, good for a person regardless of what that individual may
believe.
iii. This makes society be able to decide what is a merit and an demerit good
e. The Problems
i. Their existence will cause an inappropriate amount of the products
concerned to be produced
ii. Merit Goods
1. will be under produced in a free market
iii. Demerit goods
1. will be over produced in a free market
f. The Health Care Market
i. We go to the doctor to gain the necessary information and make a decision
based upon the information we are given
ii. This works as long as the doctor does not give us deliberately incorrect
information
1. We would proceed to make an undesirable choice about possible
treatment
2. This will cause a misallocation of resources

I. Public Goods. (Define and explain the characteristics required)

a. A different type of good from a merit or demerit that may cause the market to fail
b. The characteristics
i. It must be non-excludable
1. it must be provided to all consumers
 ii. It must be non-rival
1. the use of it must not diminish the benefit for others to use the
good
c. The Problem
i. The market may fail to produce them at all
ii. Although there is consumer demand, the free market has no mechanism
for guaranteeing its production
iii. Free Riding problem
1. Once a consumer has purchased the product, all other consumers
cannot be prevented from benefiting from that product
2. A lighthouse
iv. Existence of such goods may mean that scarce resources are not used in a
way that would be desirable

J. Government intervention. (Why should the government intervene? What are the two
justifications?)
a. Justification is usually market failure or the desire to achieve a fair or equitable
distribution of resources in the economy
b. Market Failure
i. Occurs when markets do not allocate resources efficiently
c. Equitable distribution
i. Concerned with ensuring that all members of society have fair access to
goods and services
d. When governments attempt to achieve this aim it must be recognized that there is
also the possibility that they will fail and create rather than remove distortions

K. Methods of government intervention. (List and explain the four methods)

a. Regulation
i. Used to control the quality and quantity of goods and services that are
produced and consumed
ii. For example. May regulate the sale of certain drugs by making them only
available on prescription from a qualified doctor
iii. May not only apply to the quantity and quality of goods and services sold
but may also refer to the prices
b. Financial Intervention
i. Examples such as taxes and subsidies
ii. Influence production, prices of commodities, incomes or the distribution
of wealth in an economy
iii. Tax instruments may also vary
iv. Governments also provide the finance that is needed to produce a good or
service
1. It does not necessarily mean it has to produce the product too
c. State production
i. Also called nationalized industries
ii. Industries such as the electricity, coal mining and railway industries are
owned and managed entirely by the state in many countries
 iii. Finding some goods produced by both the state and the private sector is
also vary common
1. Education and health care are good examples
d. Income and other transfers
i. Used by the government as a means of redistributing income or
transferring income from one group in society to another group
1. Example: people in work to those who are retired
ii. May be used to cover the unexpected loss of income when a person is not
working due to illness or unemployment

L. The impact of government intervention on markets. (Explain and use GRAPHS)

a. Public goods
i. Need to be financed by the government but they do not necessarily need to
be produced by the government
ii. The government will decide upon the optimal amount of defense
expenditure and raise revenue through taxation to fund it
1. The problem is choosing the best way to raise the funds necessary
iii. Methods of raising funds
1. Tax individuals according their ability to pay tax
2. The government takes a larger percentage of income in tax from
the rich than the poor
3. Called a progressive tax system
b. Externalities
i. Setting standards and regulation
1. Governments frequently use regulation to overcome market
failures caused by externalities
2. The environment
a. The government might intervene by setting standards
which restrict the amount of pollution that can be legally
dumped
b. Need to regulate and inspect the company to make sure that
these restrictions are enforced
ii. Financial intervention – Taxes
1. A tax would be imposed on the individual or firm that causes an
externality
2. The external costs are then internalized
3. The government intervenes and imposes a tax which is equal to the
marginal external cost
iii. Financial intervention – Subsidies
1. Caused by external benefits or positive externalities
2. Considerable debate over which is the best method of government
intervention
iv. Maximum price controls and price stabilization
1. Governments use legislation to enforce maximum prices for:
a. Staple foodstuffs, such as bread, rice, and cooking oil
b. Rents in certain types of housing
 c. Services provided by utilities, such as water, gas, and
electricity companies
d. Transport fares where a subsidy is being paid
2. A price ceiling production is not sufficient to satisfy everyone who
wishes to buy the product
a. As price cannot rise, the available supply has to be
allocated on some other basis
b. The most likely way is by means of queuing
3. Price stabilization policies, especially in agricultural markets, are
designed to lessen the effects of unplanned fluctuations in supply
4. A producer’s association or a government-backed marketing board
regulates supply by releasing stocks on to the market in order to
stabilize farm incomes
5. By releasing buffer stocks at times of shortage or by purchasing
excess stocks at times of surplus production, prices can be
stabilized at a predetermined level

Cost-Benefit analysis – a technique for assessing the desirability of a particular project, taking
into account all of the respective costs and benefits

De-merit goods – any good that has negative externalities associated with it, such as passive
smoking or the excessive consumption of alcohol

Externalities – a situation where a third party is affected, negatively or positively, by the

decisions or actions which are taken by others

Income transfer - it is a method of transferring income, such as welfare to persons.

Market failure - Market failure is a concept within economic theory wherein the allocation of
goods and services by a free market is not efficient. That is, there exists another conceivable
outcome where market participants' overall gains from that outcome would outweigh their losses
(even if some participants lose under the new arrangement).

Merit goods – goods such as health care and education which have positive externalities
associated with them and where there is likely to be under consumption without government
intervention

Nationalized industry - lso spelled nationalisation, is the process of taking an industry or assets
into the public ownership of a national government or state.[1] Nationalization usually refers to
private assets, but may also mean assets owned by lower levels of government, such as
municipalities, being transferred to the public sector to be operated by or owned by the state.

Negative externality - A negative externality occurs when an individual or firm making a

decision does not have to pay the full cost of the decision. If a good has a negative externality,
then the cost to society is greater than the cost consumer is paying for it.
Non-excludable – a characteristic of public goods whereby it is impossible to stop all from
benefiting from the consumption of that good

Non-rival – another characteristic of a public good, this time referring to a situation where as
more people consume a give good, the benefit to those already consuming is no diminished

Paternalism - refers to an attitude or a policy reminiscent of the hierarchic pattern of a family

based on patriarchy.

Private benefits – the benefits which directly accrue to an individual consumer or firm

Private costs – costs which are directly incurred by the owners of a firm or an individual carrying
out a particular activity

Progressive tax - a tax by which the tax rate increases as the taxable base amount increases.
Progressive" describes a distribution effect on income or expenditure, referring to the way the
rate progresses from low to high, where the average tax rate is less than the marginal tax rate.

Public goods – goods which possess the combined characteristics of non-excludability and non-
rivalry.

Shadow price - the change in the objective value of the optimal solution of an optimization
problem obtained by relaxing the constraint by one unit – it is the marginal utility of relaxing the
constraint, or equivalently the marginal cost of strengthening the constraint.

Social benefits – the total benefits accruing to the community as a whole from a particular action

Social costs – the total costs borne by the community as a whole from a particular action

Spillover effects - externalities of economic activity or processes upon those who are not directly
involved in it. Odours from a rendering plant are negative spillover effects upon its neighbours;
the beauty of a homeowner's flower garden is a positive spillover effect upon neighbours.

State production – See nationalization

Subsidies – a payment made by government to producers or consumers to reduce the market

price of a good or service

Taxes - is to impose a financial charge or other levy upon a taxpayer (an individual or legal
entity) by a state or the functional equivalent of a state such that failure to pay is punishable by
law.

Value judgment - an assessment that reveals more about the values of the person making the
assessment than about the reality of what is assessed