The Market Failure Revision and Resits

Unit 2882: Market Failure and Government Intervention – Resit work book
ECONOMICS RESIT – MARKET FAILURE (UNIT 2)
LESSON 1 – COMPETITION AND EFFICIENCY
What is Market Failure?
Markets fail when they fail to be efficient.
Q: There are three types of efficiency, what are they?
1. ……………………………………………………………………………
2. ……………………………………………………………………………
3. ……………………………………………………………………………
A perfect market (perfect competition) achieves all three types of efficiency. Unfortunately
such markets only exist in text books. The markets that we see and experience in reality
(monopoly, oligopoly and monopolistic) all fail to be perfect for one reason or another.
Q: Should anything be done about this?
A: The fact that such markets aren’t efficient is a powerful argument for governments to
intervene to correct the failure and make the market efficient. Even Adam Smith suggested
that the state should curb some of the activities that firms undertake.
Q: How does competition lead to efficiency?
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Pareto Efficiency
A concept developed by the economist Vilfredo Pareto (1848-1923) in his Manuel D'Economie
Politique (1909).
Pareto efficiency exists when no-one can be made better off with out making someone else
worse off. We can relate this concept to the PPF:
If a resource allocation is Pareto efficient, for a given set of tastes, resources and
technology, it is impossible to move to another resource allocation to make someone better
off without making someone else worse off. Therefore all points on the PPF (production
possibility frontier) are Pareto efficient because to achieve more of one good an amount of
the other must be sacrificed and those who consumed the first good will lose out and
therefore not be better off.
Butter
PPF
c A
Y
X
d B
Guns
f g
Pareto efficient points:
Point(s) ……………………………………………………………….is/are Pareto efficient, given the level of technology
and resources, there can be no improvement because more guns and butter cannot be achieved.
Also know as Pareto optimal – with current resources and technology the economy cannot move
away from such points without making some sections of society worse off. In fact all points on
the ………………………………………………………………………………………… are Pareto optimal.
…………………… and ………………………. are both Pareto inefficient points as more guns and butter could
be produced if more resources were used or used more efficiently.
Pareto efficient movement:
A move from A to B is Pareto inefficient - for this economy must sacrifice cd units of butter to
achieve fg units of guns. Gun consumers are made better off at the expense of butter
consumers. Therefore, this cannot be a Pareto efficient move.
A move from X to Y is Pareto efficient as more guns and butter are produced. Therefore both
gun producers and consumers and butter producers and consumers are better off.
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Productive Efficiency
Occurs when a firm produces at it lowest average cost (average or unit cost is TC÷Q).
Therefore productive efficiency deals with altering the combination of factor inputs to produce
that combination which will give the lowest average cost – the optimal factor combination.
Unit costs Productively efficient output at

minimum LRAC, i.e. the best
factors combination given the
technology and factor prices. LRAC
Q Quantity
Exam Practice: ‘Market failure government services and government failure’,

question (a)
(i) Define the term productive efficiency. [2]

(ii) Identify and explain one reason why a monopoly, such as a local hospital,
might not achieve productive efficiency. [3]
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Allocative Efficiency
Allocative efficiency occurs when the welfare or benefit of society is maximised. It is

concerned with whether resources are used to produce the goods that consumers wish to buy.
This occurs at the level of consumption where MSB = MSC and in certain circumstance where
P=MC.
MSC is
MSB is
MPC is
MEC is
MPB is
MEB is
MSC =
MSB =
Marginal social costs and benefits can be used together to show the concept of allocative
efficiency.
Costs/benefits
MSC
p* A B
MSB
Quantity
q1 q* q2
At q1 MSB > MSC - value to society of the last unit consumed is more than it costs, therefore if
more were to be consumed overall society will benefit. Area A is benefit that could be gained if
consumption increased (A = producer + consumer surplus). As society misses out on gaining A
when it produces at q1, triangle A is known as a dead-weight loss to society.
At q2 MSB < MSC - value to society of last unit is less than its cost, therefore consume less (P
rises and MC falls). Area B is disbenefit to society that will be lost if consumption fell. It
shows the excess of costs over benefits and therefore the welfare or dead-weight loss to
society.
At q* MSB = MSC - gains maximum benefit without increasing costs. This is the social optimum
or socially optimal level or output or allocatively efficient level or output.
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If the market mechanism works all costs will be reflected in the firm's MC curve and all
benefits will be reflected in the D curve – there will be no positive or negative externalities (no
MEC and MEB). Therefore MSC = MC and MSB = D. Market clearing (D = S) will therefore be
the social optimum. In this case the allocatively efficient level will be where P = MC. P is read
form the demand curve and MC from the MC curve.
Costs/benefits
MC
p*
MPB = D
Quantity
q*
If P = MC in all markets then nobody can be made better off. Therefore an allocatively
efficient allocation of resources is also PARETO OPTIMAL. Therefore all points on a PPF
are Pareto efficient, allocatively efficient and productively efficient.
Exam Practice: ‘The problem of global warming’, question (b) (i)
Define what is meant by allocative efficiency. [2]
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LESSON 2 – INEFFICIENCY 1; EXTERNALITIES AND MERIT/DEMERIT GOODS
Negative Externalities
Q: How do you define negative externalities?

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Q: Give some examples of negative externalities.
1 1
1 1
1 1
1 1
1 1
Exam Practice: ‘Government and the environment’, question (a) (i) and (ii)
(i) Define what the term externality. [2]
(ii) From the article, identify two examples of a negative externality. [2]
Q: How do we represent this on a diagram?

Costs/benefits
Quantity
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Q: What is the market outcome when negative externalities exist?
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Q: What policies exist to deal with the problem of negative externalities?
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State provision; the state could take-over the production of the good/service (known as
nationalisation) and choose to produce where MSB = MSC. As the government is not constrained
by profit it can make decisions to maximise the welfare of society. Governments have the
resources to measure the extent of the negative externality and estimate the level of output at
Q*, it can then produce the socially optimal amount.
Advantages Disadvantages
• An fair solution as the • Nationalisation is politically unpopular and will take time and
government acts in resources, there is an opportunity cost for tax payers.
society’s interests. • Government owned industries are often productively
• Q* is achieved. inefficient as they have no competition.
Example: Nuclear power generation.
Regulation; rules laid down by the government in order to reduce the behaviour that leads to
the production of the negative externality. If the rules are broken there is usually a system of
fines to pay or in extreme situations a prison sentence. There are many examples of UK
regulations:
• Maximum pollution levels (do exist in the 1989 Environmental Protection Act). This is
monitored by the Environment Agency. Firms are fined if they break the law.
• Limits on noxious emissions from car exhausts – to pass the MOT.
• Forbid some pollution creating activities (smoke free zones).
• Planning regulations (planning permission) ensure that any significant development is not
environmentally damaging.
• Enforce the use of pollution reducing equipment. Using the example of car use, can it be
controlled or limited by some means (any ideas? Brain storm class – better public transport,
tolls, bus lanes, tax on petrol, tax on car purchases, city centre charging, park and ride,
etc.).
Regulation is difficult as the government must be able to assess the cost of complying with the
regulation and the benefits to society from reduced pollution. The regulation will only be optimal
if the marginal cost of the regulation is equal to the marginal benefit from the reduced pollution.
Note that in the case of a negative externality an outright ban is a bad policy as there are
benefits gained from the polluting behaviour and therefore there is an optimal level of polluting
behaviour.
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• Easy to • If fines are set too low firms will continue to pollute – pay the fine and
understand benefit from revenue.
and to • It is difficult for the government to fix the right level of regulation to
change, if ensure efficiency (q*). The government need to weigh the value of the
necessary. negative externalities and the benefit that society would receive from
• Relatively their reduction against the costs of implementing the regulation.
cheap to • Regulations do not discriminate between the different costs of
enforce. reducing negative externalities. Some firms find this less costly than
• Q* is others and it would be therefore more efficient for such firms to
achieved. engage in pollution reducing activity.
Extending property rights – internalising the externality; eliminating the externality by

bringing it back into the framework of the market mechanism. Allocating the ownership of the
externality (the property rights) to an individual or individuals.
In the UK this is achieved through the courts; the sufferers of pollution have the right to sue
the polluters for compensation. Firms should therefore curb their polluting behaviour until the
costs of paying compensation = the benefit gained from the production that caused it (revenue).
• The state does not have to • If compensation levels are set too low firms will
assess the cost of pollution. continue to pollute – pay the compensation and benefit
This is done by property from revenue
owners who have a much • The legal process may take years – as those who have
better idea. suffered must prove it.
• There is a direct transfer of • Even the owner’s assessment of the value of the damage
resources from the polluter done by pollution is a guesstimate and they have an
to those who have suffered. incentive to overvalue. Different people will value the
• Q* is achieved. same thing differently.
Extending property rights – permits to pollute; this involves extending property rights over
the externality to the third parties or the creators of the externality. An example of this is
pollution permits – firms have the property right to trade the permission to pollute. The G8
(most economically developed nations) want to implement a global system of pollution permits.
Permits to pollute are usually administered by the state or state appointed agency – an impartial
body. There are several stages to the imposition of such a system:
• The government/agency calculates the optimal level of pollution, i.e. the quantity of pollution
there will be when q* is achieved.
• Permits are produced that allow firms to pollute up to a certain quantity, e.g. 1 permit = 500
cubic metres of pollution.
• The government allocate the permits to firms based on their size.
• Trading is allowed; those firms who find it cheap to cut their pollution will do so and sell
their permits to other firms (for more than the cost of reducing pollution) who don’t. Those
firms that buy permits do so because the cost of a permit is cheaper than the cost of
cleaning up their production activities.
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• Q* is achieved. • Initial set up costs.

• The outcome is • Monitoring costs – to ensure firms stick to the levels of
productively efficient pollution outlined in the permits.
– it reduces pollution • The state must initially decide the ‘acceptable’ level of
at the least cost to pollution. Externalities are very difficult to value and
society as it uses the therefore it is unlikely that the government will accurately
market to allocate the assess q*.
permits.
The green tax/carbon tax/emissions tax; by taxing pollution or polluting behaviour we make
the polluter bear the cost of their pollution (make the polluter pay). Consumers and firms find
that taxes will increase prices and costs. Therefore MPC can be brought into line with MSC – at
higher prices less is demanded and produced and the optimal output is reached. Such taxes are
referred to as ‘green taxes’ or ‘carbon taxes’ (car emissions) or ‘pollution taxes’.
A simple tax on car users to shift the MPC to the left – therefore equating MPC with MSC. The
value of the unit tax is the vertical difference between the two curves. Such a tax is known as a
Pigouvian tax as it improves economic efficiency. The primary aim of a Pigouvian tax is not to
raise revenue but to correct an externality.
Costs/benefits
MSC
MEC = tax per unit
MPC
p* A
MSB
Quantity of car journeys

q* qa
Problems:
• Does the government really have a good enough knowledge of costs and benefits to do this?
• How do we measure and quantify external costs such as pollution and green house effects?
• What do we tax? car purchases, petrol, road usage, etc.
• Politically unpopular.
• Transfers the polluting behaviour to another country that doesn’t have the tax, rather than
reducing total level of pollution.
• May discourage firms from locating in the UK as their costs will be higher. Already many
haulage firms are registering in other EU countries to avoid the VED and the tax on fuel.
This reduces UK GDP and economic growth. Economies will only be willing to implement such
a tax if there was a ‘level playing field’ i.e. other economies were doing the same thing.
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Positive Externalities
Q: How do you define positive externalities?
The benefits that members of society experience indirectly, as a third parties (not involved in
the decision), due to the decisions of individuals within society to consume or produce an extra
unit of a good or service. They are known as positive ‘spill-over’ effects. They occur when
MSB>MPB.
Q: Give some examples of positive externalities.
• Positive multiplier effects. • Socially responsible behaviour.

• Improvement to infrastructure. • Improved living standards.
• Education. • Improved factors of production.
• Furthering the knowledge of mankind (scientific
discoveries).
Exam Practice: ‘Government and the environment’, question (a) (iii)
From the article, identify two examples of a positive externality. [2]
Q: How do we represent this on a diagram?

Costs/benefits
Quantity
Q: What is the market outcome when positive externalities exist?
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Q: What policies exist to deal with the issue of positive externalities?
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The solutions are the same as those for negative externalities and the same problems occur:
State provision; the state provides libraries in the UK for example.
Regulation; the state has rules regarding the amount of schooling and education that each child
must receive. The state has even specified what children should learn (the National curriculum).
Equally, minimum standards for any good or service could be laid down. (Problems? Cost, free
riders, etc).
Internalise the externality; this is a much more difficult activity for external benefits than it
is for costs. A cost can be imposed through fines and compensation in the court, a benefit
cannot. However, firms can be ordered to undertake certain activities to benefit the
environment and the local community. If the externality occurs between two firms (such as the
bee keeper and the orchard owner) merging the firms would be one way to internalise the
externality.
Subsidisation; a subsidy is an amount of money paid by the government to a firm for every unit
of output that it produces. Subsidise the production of the good with a subsidy per unit of S.
This will reduce unit costs and therefore at each level of output marginal cost will be lower
MSCs. MSC will be equated with MPB at the socially optimal level. As the price is lower at Ps
there is greater consumption.
In the UK the government will subsidise research by universities and firms. Such research will
have many benefits in the forms of cures for diseases and extending human knowledge. The
government also subsidises public transport.
Costs/benefits
MSB
MPC = MSC
MPB = D
MSCs
P A S
Ps
Quantity of nice gardens

qa q*
Consider:
• How does the state know q*?

• Opportunity cost of the subsidy – what else could the money have been spent on?
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Merit and Demerit Goods
Merit goods (and bads or demerit goods) are goods that society thinks everyone ought to have
(ought not to have) regardless of whether they are wanted by each individual. When the state
behaves in this way it is known as paternalism. Therefore merit goods tend to be under-
provided by the market mechanism and demerit goods are overprovided.
There are two reasons for the occurrence of merit and demerit goods:
(i) Individuals lack perfect information about the effects of such goods and therefore make
decisions based on less than perfect information. For example individuals are unable to
make rational decisions when the cost occurs today, but the benefit occurs in 20 years
time (education), therefore demand is too low. Conversely, for merit bads the benefit may
occur today, but the cost in 20 years time (smoking) therefore demand is too high.
(ii) Merit Goods may also be positive externalities (merit bads may be negative externalities).
The social benefit of such goods is greater than the private benefit. Thus there is a
market for the goods but they will not be produced in great enough quantities to reach the
optimal output for society (q*). Examples of merit goods are education, health care, etc.
Costs/benefits/price
Costs/benefits/price
Quantity Quantity
Lacking perfect information Externalities
How Can We Reach the Socially Optimal Level?
1. Use the same methods as you would for positive or negative externalities.
2. Information provision
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Problems
1. How do we accurately identify MSB and therefore identify the socially optimal output?
2. Once produced, how do we ensure people consume the good?
3. Is providing information enough? Consider cigarette smoking.
Homework:
• Government and the environment – Qd (i), (ii) and (iii)

• The National Health Service – Qa (i) and (ii)
• Problem of global warming - Qa (i) and (ii), d (i) and (ii)
• Tackling the problem of the countryside - Qa (i) and (ii),
Qd (i) and (ii)
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LESSON 3 – INEFFICIENCY 2; PUBLIC GOODS AND MARKET DOMINANCE
What are public goods?
A public good has two important properties that differentiate it from a private good and
influence the amount of the good that will be provided by the market.
1. Non-excludability; ……………………………………………………………………………………………………………………………………..
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2. Non-rivalry; ………………………………………………………………………………………………………………………………………………..
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Examples are radio and terrestrial television broadcasts, defence and street lighting. Radio
broadcasts are an example of an optional public good in that you can choose how much you
consume and defence is non-optional.
This is in contrast to a private good. Private goods are both rival and excludable; if consumed by
one person, cannot then be consumed by anyone else and the amount left for others will be
reduced. (Brainstorm such e.g. as food, clothes, etc.)
Exam Practice: ‘The market for higher education’, question (b) (i) and (ii)
(i) Explain two characteristics of a public good. [4]
(ii) Explain one reason why higher education is not a public good. [4]
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Many goods have one or other of the characteristics above, but not both, therefore they
possess some of the nature of public goods, but cannot be said to be pure public goods. Such
goods are referred to as quasi-public goods.
EXCLUDABLE NON-EXCLUDABLE
RIVAL Private goods Quasi-private good
NON-RIVAL Quasi-public good Public goods
As a general rule to above table can be used, however a good is said to be a quasi-public good if
it is closer to a public good than a private good.
A good example may be a sandy beach. Such a beach is available to all those who wish to use it.
It appears to be non-excludable. However, it is possible to conceive ways of excluding
consumers and privately owned beaches achieve this. Equally the beach is non-rival up to a point.
If you are the first there on a sunny day, it does very little to your enjoyment if a few more
people arrive to enjoy the benefits. However, there may well come a point at which this is no
longer the case. As the beach becomes crowded, space limited, and other people’s conversations
and music become ever more audible, enjoyment may perceptibly reduce; thus the beach has
become rival.
Q: Why is road space another example of a quasi-public good?
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Exam Practice: ‘Tackling the problems of the countryside’, question (b)(iii)
Explain why beauty spots in the countryside can be described as quasi-public goods. [4]
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Government policy for public goods
There are two basic ways to bring about this outcome:
1. Co-operation; possible but unlikely due to the non-exclusive nature of the product. There
will always be the possibility of a free-rider. For example, residents of a particular street
may decide to provide street lighting. Each individual must pay £100 per year. Once the
system is up and running, there is an incentive not to pay as you cannot be excluded from
consuming the light (unless the other residents put your eyes out!). In addition with a good
such as defence, the numbers of consumers are so great that co-operation is impossible.
2. Government provision; which also solves the problem of the large numbers of consumers
involved. But of course, it brings with it its own problems - can the government accurately
identify q*?
Market Dominance
What does market dominance mean? Perfect competition results in a long run equilibrium
where P = MC (allocative efficiency) and firms produce at the minimum point on their AC curves
(productive efficiency). Any other forms of competition do not do this. Monopoly and oligopoly
are situations where there is none or very little competition and one or a few large firms
dominate the market. This removes the incentive to be efficient, reduce costs and gain market
share over the competition. In such markets survival of the biggest, not necessarily the fittest
occurs; prices are higher and output lower than under perfect competition.
Problems Benefits
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Government policy
1. Tax abnormal profits; and redistribute them throughout society. This may improve
equity, but it does not bring output nearer to the socially optimal level as it does not
affect costs. E.g. windfall tax on privatised utilities.
2. Price controls; impose a maximum price set to MSC. The regulatory bodies of the
privatised utilities do this. However, there is still the problem of knowing exactly where
the cost and revenue curves are and therefore q*. This becomes a problem if MSC is
lower than unit cost, at this price the monopolist will make a loss and have no reason to
carry on producing.
3. Nationalisation; to change the goals of the firm. The nationalised industry will produce at
the point where P = MC, because it does not need to profit maximise. This usually occurs
with a natural monopoly. The industry's loss is subsidised by government revenue from
other sources such as taxation. The reason behind the nationalisation of rail and the
public utilities in the past.
4. Breaking up the monopolist; into competing units. This may be effective where the
monopolist has a large number of plants each operating at MES. If MES is high the
welfare gains from doing this is negligible. In the USA there is a series of anti-trust laws,
which effectively ban monopolies and will break up monopolists. Microsoft is involved in
just such a battle at the present moment.
5. Regulation to reduce barriers to entry and prevent anti-competitive practices;

regulation means controlling the quality and quantity of products in a particular market or
markets though legal means. Anti-competitive behaviour includes activities such as
cartels, price-fixing, forcing firms to supply whole ranges and not competitors, etc. In the
UK this is the role of the competition authorities (Competition Commission, Office of Fair
Trading and Industry Regulators). The competition authorities monitor the behaviour of
large firms in order to prevent anti-competitive practices and abuse of monopoly power.
They can do this through ordering the removal of barriers to entry, introducing
contestable markets and setting rules and standards for the operation of firms.
There are several problems with regulation:
• Monitoring costs; in terms of acquiring information and acting upon it may be higher
than the benefits received after legislation.
• Regulatory capture; a situation where the regulator gradually comes to identify with
the interests of the firm it regulates, eventually becoming its champion, not its
watchdog. (See Competition Authorities handout.)
• Credibility of regulators; the regulators make seek to encourage the monopolist to

invest by promising light regulation. But once the investment is made and costs are
sunk, the regulator faces the temptation to tighten controls. Foreseeing all of this,
the monopolist never invests in the first place. Regulation discourages investment;
the very thing it wants to improve in many cases.
H/W: The National Health Service (e) (i) and (ii), Market Failure, public services and
government failure (a) (iii). Externalities and Market Failure Q(d) (i) and (ii). Taxing
Pollution Q(b) (i) and (ii).
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LESSON 4 – GOVERNMENT INTERVENTION: CBA
What is CBA?
CBA is the monetary evaluation of the social costs and benefits involved in a particular capital
project. CBA takes a long and a wide view:
• Social costs include private and external (positive and negative externalities) costs and
benefits (briefly explain, students should generate examples).
• Capital project refers to a long-term investment projects.
• Long view – recognises the long-term nature of infrastructure projects and seeks to include
all costs and benefits over the life of the project. In the case of road it could be anything
up to 50 years.
• Wide view – values all costs and benefits, not just private ones.
Why undertake CBA?
1. It enables spending priorities to be determined by central and local government in relation

to the limited funds that are available. The government will therefore choose the project
that has the greatest positive difference between benefits and costs as this project will
bring the greatest net benefit to society. This is exactly what the DETR do in the case of
roads.
2. The government will have social objectives that can be accounted for in CBA by giving their
value a greater weight. The government is not constrained by the profit motive and will take
into account both the positive and negative externalities of its actions. In this way the
social optimum (allocatively efficient outcome) may be reached.
3. A CBA can be used as the basis for wider public discussion and debate in such forums as
public enquiries. It can be the starting point for a discussion of the issues and will support
the government’s case for either building or not building a road, an airport, etc. – depending
upon the outcome of the CBA.
4. Public and quasi-public goods will not be provided by the market. When the state provides
public and quasi-public goods it needs a method of deciding if such projects are worthwhile.
Commercial methods of investment appraisal are unavailable because insufficient revenue
will be raised in the provision of these goods to cover costs. Therefore the government
uses CBA to determine whether or not it is worthwhile going ahead with a project.
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Would a private firm undertake CBA?
We would not expect private firms to use CBA because the method involves assessing external
costs and benefits that by definition have no direct financial impact upon the firm. We assume
that private firms follow a profit motive and therefore when considering capital projects they
will assess the commercial rate of return only. The cost of the project compared to the revenue
they will receive from it. This is known as investment appraisal. However, there may be some
circumstances when a private firm will undertake a CBA (brainstorm ideas):
• Legal requirement.
• Public image – to get a pressure group or local residents on side.
• In order to get planning permission quicker.
• In order to receive Government or EU funding for a project.
What are the stages of CBA?
CBA is a decision-making technique. It enables an organisation to decide upon whether or not to

undertake a capital or infrastructure project. It is also quantitative – it converts costs and
benefits to numerical values. Most CBAs follow five stages:
Stage 1: Identify all costs (capital, maintenance and external costs) and benefits (both private
and external).
Stage 2: Put a money value on all costs and benefits.
Stage 3: Values are weighted after an assessment of risk and uncertainty.
Stage 4: Discount values for time to calculate the net present value.
Stage 5: Make a recommendation based on the outcome.
How is the CBA decision made?
1. To decided whether or not to go ahead with the capital project.
• If costs > benefits then don’t go ahead.

• If benefits > costs then proceed.
2. Where there are several projects to be considered CBA can be used to rank them in order
of desirability. With the biggest positive difference between costs and benefits being the
most desirable as it produces the greatest welfare gain to society.
Valuing positive and negative externalities
Complete the tables below by inserting ideas of how to value the externalities.
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Negative Description Monetary Value

Externality
Noise Aeroplanes, lorries and certain types of • The cost of sound proofing and
pollution production in particular cause a high level of double glazing on properties
disturbance. Noise over long periods becomes disturbed by the noise.
very unwelcome to the ears. Prolonged exposure • The cost of medical bills incurred
to this noise can disrupt lifestyle, increase by those suffering stress due to the
stress, make it difficult to relax, make it noise.
difficult to sleep, etc. • Value of lost productive time if
days are lost at work (hourly wage
multiplied by no. of hours lost.
Air pollution Production processes and traffic produce
gaseous emissions from exhaust and venting
systems. Cars running on petrol produce CO2
emissions that increase the greenhouse effect
and lead towards global warming. Lorries, running
on diesel, may be greener, but their emissions
increase nitrous oxide that contributes towards
acid rain and stone oxidation in
buildings/monuments.
Water Certain production processes require water for
pollution cooling, which is take from local waterways and
returned to them at high temperature. Other
industries produce liquid waste that is released
into waterways. Indirectly, waterways can be
polluted through use of chemical pesticides and
herbicides. Rain will leach these substances into
ground water that feeds waterways. Such
pollution destroys ecosystems.
Visual A road, air terminal, railway, industrial site, mine,
intrusion quarry may devalue a view in a particular urban or
rural landscape. It is difficult to enjoy an
historic building with cars whizzing round.
Additionally residents may obtain less enjoyment
- their environment is now less peaceful.
Blight Whole areas become desolate and vandalised as
they are by-passed or simply too near industries
and/or busy roads for people to choose to live
their. Houses are left vacant and easy targets
for vandals, remaining houses are targets for
burglary, this is one of many causes of urban
decay.
Accidents Road-traffic accidents in particular cost society
in terms of productive lives and damaged
resources.
Congestion Added time to journeys therefore there is loss

of productive time or leisure time, increased fuel
and running costs, reduced vehicle productivity,
similar costs to users and operators of public
transport. In 1989 it was estimated by the CBI
that the costs of congestion to industry were
£15 bn per year.
20
Positive Description Monetary Value

Externality
Local Certain activities undertaken by firms and • Change in local incomes.
multiplier other organisations can indirectly attract • Increase in the profit of firms.
effects industry to an area, which will lead to the
creation of local employment opportunities
and higher local incomes. A new airport for
example will create jobs and business for local
firms: car hire, catering, hotels, etc.
Improved The higher incomes created by the above

living multiplier effects lead to better living
standards standards. Individuals are able to buy more
goods and services which improves their living
conditions and lifestyles. Choice is widened.
In addition to this, higher incomes produce
higher tax revenues. Therefore the
government has more money to spend on
public goods and services, such as health,
education, infrastructure and social services –
this will lead to further improvements in the
standard of living.
Educational Certain activities undertaken by firms and

effects other organisations for their own benefit may
lead to new discoveries which increase the
sum of human knowledge. Scientific
discoveries can lead to improvements to
future living standards.
Improved If the activities of firms lead to

factors of improvements in the workforce through
production training or improvements in the capital stock
through investment in technology then the
country as a whole will benefit. The quality of
the factors of production has improved which
pushes the PPF outwards and leads to
potential higher incomes. In addition to this,
such productivity improvements will reduce
costs and improve UK competitiveness. This
could lead to improvements in the balance of
payments.
Social By educating and training people, creating

effects jobs and improving living standards firms and
other organisations can have a positive effect
upon society. The better off an individual is
the less likely they are to engage in anti-
social behaviour. There is a direct link
between crime and poverty (of course, we
must acknowledge that poverty is not the only
reason for anti-social behaviour and the
majority of those suffering from poverty are
law abiding).
21
What are the limitations of CBA?
• Considering which costs and benefits should be included. Some costs and benefits have long
term and geographically long reaching effects – it is difficult to mark a cut off point. E.g. do
we still consider the benefits that a road will bring to users in 50 years time? And how
accurate would our estimate of those benefits be? A local retail development may affect
towns and villages in the region for miles around – how far do we go? Do we only consider the
effect on people in the immediate vicinity?
• The subjective nature of putting monetary values on certain external costs and benefits.
This includes a lot of guesswork as to the magnitude of the externalities. There are also
problems separating the externalities from the effects of particular activities. E.g. acid
rain is caused by many different activities how can we correctly identify the proportion of
acid rain that each firm produces?
• Many public sector projects are controversial because of their affect on local communities.
Therefore, such projects are often rejected for political reasons and in the face of local and
pressure group opposition, the outcome of the CBA is immaterial to the final decision.
H/W: Tackling the problems of the countryside Q(e) and New houses in the UK Q(d).
22
LESSON 5 – GOVERNMENT INTERVENTION: OTHER
Governments intervene in the economy for several reasons:
1. To correct market failure.

2. To influence the macro-economy.
3. For reasons of social justice or equity.
We’ve looked at the first of these and macroeconomics deals with the second.
Equity
Through questioning bring out the answers to the following questions and write them on the
board:
1. What is equality? – The condition of being the same as or equal to others in society.
2. What is inequality? – The degree to which the distribution of economic welfare generated
in an economy differs from that of equal shares amongst its inhabitants. Some text books
use the ‘distribution of income and wealth’.
3. What is equity? - Fairness.
4. What is horizontal equity? – The identical treatment of identical people or groups in
society.
5. What is vertical equity? – The different treatment of different groups in society in order
to promote greater equality.
6. What is social justice? – Ensuring that inequalities in society are not great, usually through
the redistribution of income and wealth.
7. What are the objectives of social justice? – The elimination of poverty (minimum living
standards); reduction of unacceptable inequalities in income and wealth; equality of
opportunity (equal access to certain goods and services, regardless of income - seen as basic
human rights such as education, healthcare, housing and transport); the protection against a
sudden and unexpected loss of income.
8. How does the government achieve such objectives? – Through the tax and benefits system
and government provision of certain goods and services. In the UK we know this as the
‘Welfare State’.
9. Why doesn’t the government aim for complete equality? – Difficult to achieve and
measure, but mainly because the market system needs some inequality to work – inequality is
the main incentive to produce. In competition there will always be winners and losers.
The government use the welfare state to help it achieve equity and social justice. In particular
taxation and state benefits are used to redistribute income and other resources towards the
poorer sections of society. The government also provides certain goods and services free of
charge in order to allow equal access to them irrespective of income levels.
23
PROGRESSIVE TAXATION:
PROPORTIONAL TAXATION:
REGRESSIVE TAXATION:
Example:
TYPE OF TAX SYSTEM:
Income Tax Paid % of income paid Tax Paid % of income paid

in tax in tax
Person A £10,000 £2,000 £500
Person B £50,000 £3,000 £4,500
Tax Paid £5,000 £5,000
MEANS TESTED BENEFIT:
UNIVERSAL BENEFIT:
BENEFITS ‘IN KIND’:
24
Government Failure
Defined: when government intervention leads to a net welfare loss compared to the free market
solution. E.g. imposing a tax on a polluting activity that reduces consumption so the actual output
is further away from Q* than the market outcome.
MPC2
Costs/benefits
MSC
TAX
MPC1
p* A A = original welfare loss

B
B = government failure welfare loss
p
MSB
Quantity of polluting
q gov q* qa activity
failure
Why does government failure occur?
Ã Political reasons – the coal and steel industries were subsidised for a long time before they
finally failed, the government did this as they provided jobs and votes.
Ã Lack of perfect information - about external costs and benefits, therefore no real
knowledge of Q*.
Ã Corruption – politicians may be bribed or simply follow a course that will maximise their own
welfare if they own companies or have been promise lucrative contracts and jobs when they
retire.
Ã Short-termism – UK politics has a cycle of 4/5 years between elections. It is argued that
governments will introduce populist policies before elections to win votes irrespective of
their long term consequences.
Ã Regulatory capture - a situation where the regulator gradually comes to identify with the
interests of the dominant firm it regulates, eventually becoming its champion, not its
watchdog. Therefore the anti-competitive and inefficient practices of market failure are
allowed to continue.
H/W: The National Health Service Q(c), Market Failure, public services and government
failure Q(c) and Q(d).
25

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Unit 2882: Market Failure and Government Intervention – Resit work book

ECONOMICS RESIT – MARKET FAILURE (UNIT 2)

LESSON 1 – COMPETITION AND EFFICIENCY

What is Market Failure?

Markets fail when they fail to be efficient.

Q: There are three types of efficiency, what are they?

Q: Should anything be done about this?

Q: How does competition lead to efficiency?

Pareto efficient points:

Point(s) ……………………………………………………………….is/are Pareto efficient, given the level of technology

the ………………………………………………………………………………………… are Pareto optimal.

Pareto efficient movement:

Unit costs Productively efficient output at

Exam Practice: ‘Market failure government services and government failure’,

(i) Define the term productive efficiency. [2]

Allocative efficiency occurs when the welfare or benefit of society is maximised. It is

Exam Practice: ‘The problem of global warming’, question (b) (i)

Define what is meant by allocative efficiency. [2]

Q: How do you define negative externalities?

Q: Give some examples of negative externalities.

(i) Define what the term externality. [2]

Q: How do we represent this on a diagram?

Q: What policies exist to deal with the problem of negative externalities?

Example: Nuclear power generation.

Extending property rights – internalising the externality; eliminating the externality by

• Q* is achieved. • Initial set up costs.

Quantity of car journeys

Q: How do you define positive externalities?

Q: Give some examples of positive externalities.

• Positive multiplier effects. • Socially responsible behaviour.

Exam Practice: ‘Government and the environment’, question (a) (iii)

From the article, identify two examples of a positive externality. [2]

Q: How do we represent this on a diagram?

Q: What is the market outcome when positive externalities exist?

Q: What policies exist to deal with the issue of positive externalities?

State provision; the state provides libraries in the UK for example.

Quantity of nice gardens

• How does the state know q*?

Lacking perfect information Externalities

How Can We Reach the Socially Optimal Level?

2. Once produced, how do we ensure people consume the good?

3. Is providing information enough? Consider cigarette smoking.

• Government and the environment – Qd (i), (ii) and (iii)

What are public goods?

(i) Explain two characteristics of a public good. [4]

RIVAL Private goods Quasi-private good

NON-RIVAL Quasi-public good Public goods

Q: Why is road space another example of a quasi-public good?

Exam Practice: ‘Tackling the problems of the countryside’, question (b)(iii)

There are two basic ways to bring about this outcome:

5. Regulation to reduce barriers to entry and prevent anti-competitive practices;

There are several problems with regulation:

• Credibility of regulators; the regulators make seek to encourage the monopolist to

Why undertake CBA?

1. It enables spending priorities to be determined by central and local government in relation

What are the stages of CBA?

CBA is a decision-making technique. It enables an organisation to decide upon whether or not to

Stage 2: Put a money value on all costs and benefits.

Stage 3: Values are weighted after an assessment of risk and uncertainty.

Stage 5: Make a recommendation based on the outcome.

How is the CBA decision made?

1. To decided whether or not to go ahead with the capital project.

• If costs > benefits then don’t go ahead.