Archive for the 'Market failure' Category

Jan 08 2013

Income Inequality and Asymmetric Information as Market Failures – student animations

The following animations were made by this year’s grade 12 IB Economics students when they were studying market failure in the 11th grade. They are meant to show scenarios that demonstrate two types of market failure that may arise in society: asymmetric information and income inequality.

Watch the videos and answer the questions that follow.

Income Inequality:

Discussion Questions: After watching your assigned video, answer the questions that follow

  1. In the animation you watched, what was the “market” that was being discussed?
  2. According to the dialogue, how does a market failure lead to the existence of income inequality?

Information Asymmetry

Discussion Questions: After watching your assigned video, answer the questions that follow

  1. In the animation you watched, what was the “market” that was being discussed?
  2. How did asymmetric information between the buyer and seller in the market lead to a market failure?

4 responses so far

Jan 08 2013

Income inequality as a Market Failure

The prevalence of income inequality in free market economies indicates that inequality may be the result of a market failure. Those who are born rich are more likely to become rich, while individuals who are born poor are more likely to live a life of relative poverty. In a “free” market, it is believed, all individuals possess an equal opportunity to succeed, but due to a mis-allocation of resources in a purely market economy, this may not always be the case.

The resources I refer to here are those required for an individual to escape poverty and earn a higher income. These include public and merit goods that those with high incomes can afford to consume, while those in poverty depend on the provision of from the state, including:

  • Good education
  • Dependable health care
  • Access to professional networks and the employment opportunities they provide

Whenever a market failure exists, it can be argued that there is a role for government in regulating the market to achieve a more optimal distribution of resources. When it comes to income inequality, government intervention typically comes in the form of a tax system that places a larger burden on the rich, and a system of government programs that transfer income from the rich to poor, including welfare benefits, unemployment benefits, healthcare for low income households, public schools and support for economic development in poor communities.

Many politicians and some economists like to argue that income inequality is not as evil as many people make it out to be, and that greater income inequality can actually increase the incentive for poorer households to work harder to get rich, contributing to the economic growth of the nation as a whole. Allowing the rich to keep more of their income, in this way, leads more people to want to work hard to get rich, as they will be able to enjoy the rewards of their hard work.

Another common argument is that higher income inequality leads to social and economic disruptions that can slow economic growth and bring an economy into a recession or a depression, since the middle and lower income groups in the nation will not benefit from a relatively equal share of the nation’s output, and over time will see their living standards drop and their overal productivity and contribution to national output decline.

The debate over inequality and what government can or should do about it is at ther root of many other economic debates today. A recent study by the Political Economy Research Institute of the University of Massachusetts, Amherst, provides support for those who support the second argument above. Here are some of the main discoveries from the study, “Searching for the Supposed Benefits of Higher Inequality: Impacts of Rising Top Shares on the Standard of Living of Low and Middle-Income Families”.

Discoveries of the study:

Some believe that increasing inequality leads to more growth, others argue that it leads to less growth.

A more interesting question is whether rising income inequality leads to a higher standard of living for everyone in society, or whether standards of living decline for those in the middle as the percentage of total income earned by the top 10% increases.

The study found that the higher the percentage of income earned by the top 10%, the incomes of those in the middle and bottom of the income distribution actually decreases. Not just the percentage of total income, but the actual incomes of these groups falls as the rich get richer.

The popular belief is that reducing taxes on the rich increases the amount of investment in the economy, creating more jobs and helping increase incomes of the middle and lower income households. This theory is sometimes referred to as “trickle down” economics, as the increased incomes and wealth at the top will “trickle down” and raise the incomes of the rest of society as well.

However, actual data shows that a 10% increase in the share of total income earned by the top 10% of income earners leads to a 2% decline in the incomes of households in the middle of the income distribution (based on data for the period between 1979 and 2005).

It’s not just that the rich get richer and the poor get poorer, rather that the rich getting richer makes the poor (and the middle income earners) poorer. This is a breakthrough discovery.

Possible explanations:

  • The rich contribute to growth abroad, rather than at home: Rich households’ higher incomes allow them to consume more domestic output and imported goods and services, but it also allows them to save more, which sometimes translates into more investment. But more investment does not always translate into domestic economic growth, since investment is now global. A rich American saving more does not mean American firms will have access to cheaper capital, as domestic savings may fuel investment in emerging markets or elsewhere abroad. Foreign investment resulting from savings among rich Americans counts as a leakage from America’s circular flow of income, leaving less income within America for the middle and low income earners. Essentially, much of the income earned by the rich is saved abroad, contributing to employment and growth overseas, reducing incomes of the middle class at home.
  • Reduced support for the provision of public goods: When examining living standards, more than just income must be considered, but also access to education, provision of health care and other public goods such as public safety and security. Richer households are less interested in things like public schools and social welfare programs, as they do not rely on these for their own well-being. Therefore, the richer the top 10% become,  the greater their incentive to work against efforts to fund public education, public health and public safety. The underprovision of these social welfare enhancing goods by govenrment further widens the gap between the living standards of the richest and the middle class. Economist Robert Reich refers to this phenomenon as “the secession of the successful”.
  • Wage competition reduces incomes in the middle: Business owners, who make up a large percentage of the richest households in America, increase their own incomes to the extent that they can drive down the wages they pay their employees. In this way a higher share of national income is enjoyed by a smaller proportoin of society. The minimum wage has barely increased over time, and workers have less bargaining power as fewer workers than ever are members of labor unions; this has allowed business owners to pay lower wages over time, concentrating an increasing share of national income in business profits, and less and less in wages for workers.

In the video below, the study’s author shares some of the findings discussed above. Watch the video and respond to the discussion questions that follow.

Discussion Questions:

  1. Summarize the argument against a government taking measures to redistribute its nation’s income to reduce the level of inequality between the rich and the poor.
  2. Summarize the argument for a government reducing inequality.
  3. Popular belief holds that “a rising tide lifts all boats”. In other words, if the total income of a nation is increasing, it does not matter if the rich are enjoying a larger percentage of the higher income than the poor and middle, because everyone is likely to be better off than if total income were not growing at all. Does the study discussed above support this popular view? Why or why not?
  4. What measures can a government take to assure that higher national income leads to higher standards of living for everyone in society, including the middle class and the poor? Why might the highest income earners be opposed to such attempts by government?
  5. Should government intervene to reduce the level of income inequality in society?

90 responses so far

Nov 21 2012

IB Economics Podcast Assignment – Market Failure Commentary

As IB SL and HL students, you will be required to write, record and post one podcast written and performed by you and a classmate. The purpose of this project will be to strengthen and enhance your ability to explain economic theory, apply it to current real-world issues and evaluate the effectiveness of economic theory to explain what is occurring.As these skills are required to write a successful IB Economic Internal Assessment, the process of producing the podcasts will strengthen the performance of students on their IAs.

Before reading the rest of the assignment details, listen to the three podcasts below. The first is an introduction to the IB Internal Assessment and this podcast assignment from Mr. Hauet. The second is an example of the type of analysis you may do in an IB Economics podcast from me. The third is a podcast by a Digital Journalism student in which she investigates the negative externalities of the meat industry.

The Assignment:

Students will work in pairs and sign up to produce a podcast on a real world market failure.

For example, you may choose to do your story on an industry you are aware of that creates water pollution:

  • Research the industry and find examples how it creates water pollution.
  • Investigate the external costs imposed by this industry on the environment and human health.
  • Gather data from studies that have already been conducted on industry’s contributions to water pollution.
  • Interview individuals or find others’ written or audio/visual accounts of the social, environmental, or health impacts of water pollution.
  • Investigate solutions to water pollution that have been implemented in different communities or nations.
  • Propose solutions to the specific examples of water pollution you have investigated.

Any audio editing program may be used to produce your podcast. You may find the following recommendations useful:

Podcast Requirements:
Part 1 – Introduction
  • An intro accompanied by music – the intro should be a hook such as a section from an interview or a clip from a news program. The music should not be copyrighted and therefore must be taken from sites such as Jamendo or produced by yourself (Garage Band is great for this)
  • An brief  introduction to the topic of the podcast
  • A fact, economic indicator or story that happened recently that may interest your listeners.This is your “hook”.
Part 2 – Analysis
  • Summarize the issue. This should include the cause of the market failure, what it means for the economy, the environment, society or human health, and what is being done about it.
  • Application – How can economic theory inform our understanding of the market failure you have chosen to research.
  • Analysis– Does economic theory support the findings from your research and what is said in the interview? Why or why not? In a written commentary, diagrams would be a crucial part of analysis. Since this is audio, you can describe the concepts that the diagram you could use illustrate.
  • Interview – The podcast must include at least one interview with someone who can provide additional insight into the market you have chosen to research. You may interview someone yourself, or you may use an excerpt from an interview you found in your research (perhaps on YouTube).

Part 3 – Evaluation

  • Evaluation – What are the short and long run implications of the market failure on society, the environment or human health. What are the possible solutions to your market failure? How are different stakeholders effected? Is one solution better than another and why?
  • Conclusions – Bring the podcast to a close by discussing the implications of the issue in other areas. Can this issue be fixed and if so what are the future implications? Be sure to end just as you started, with some nice music that suits the topic.

Bibliography: As this assignment will involve original research, you are required to produce a bibliography. It should be formatted properly. You may use EasyBib to help you with the formatting of our bibliography.

Examples:

Here are some examples of economics podcasts from Planet Money. Your podcast should be similar in its production to these.

Samples of last year’s student podcasts:

Your final product will be assessed using similar criteria for the internal assessment and will include the following:

  1. Terminology – Terminology appropriate to the topic is used throughout the podcast – 2 marks
  2. Application – Relevant economic theories are applied throughout the podcast – 2 marks
  3. Analysis – There is effective economic analysis within the context of the topic and interview – 3 marks
  4. Evaluation – Judgments are made using sound evidence and appropriate reasoning – 4 marks
  5. Podcast Requirements – The podcast is presented in a highly effective manner, including a clear introduction with music, clear audio, at least one interview, a conclusion with music, and a bibliography formatted in MLA style. – 3 marks

Total – 14 marks

2 responses so far

Nov 01 2012

Has the Baby Market Failed?

The tools of economics can be applied to almost any social institution, even the decision of individuals in society whether or not to have children. All over the rich world today, potential parents have decided against having babies, the result being lower fertility rates across much of Europe and the richer countries in Asia, including Japan, South Korea and Singapore. Lower fertility rates have some advantages, such as less pressure on the country’s natural resources, but the disadvantages generally outweigh the benefits.

The story below, from NPR, explains in detail some of the consequences of declining fertility rates in the rich world, and identifies some of the ways governments have begun to try to increase the fertility rates.

The problem of declining fertility rates can be analyzed using simple supply and demand analysis. In the graph below, we see that the marginal private cost of having children in rich countries is very high. The costs of having children include not only the monetary costs of raising the child, but the opportunity costs of forgone income of the parent who has to quit his or her job to raise the child or the explicit costs of child care, which in some countries can cost thousands of dollars per month. Marginal private cost corresponds with the supply of babies, since private individuals will only choose to have children if the perceived benefit of having a baby exceeds the explicit and implicit costs of child-rearing.

The marginal private benefit of having babies is downward sloping. This reflects the fact that if parents have just one or two children, the benefit of these children is relatively high, due to the emotional and economic contributions a first and second child will  bring to parents’ lives. But the more babies a couple has, the less additional benefit each successive child provides the parents. This helps explain why in an era of increased gender equality, families with three or more children are incredibly rare. The diminishing marginal benefit experienced by individual couples applies to society as a whole as well, therefore the market above could represent either the costs and benefits of individual parents or of society at large.

Notice, however, that that the marginal social benefit of having babies is greater than the marginal private benefit. In economics terminology, there are positive externalities of having babies; in other words, additional children provide benefits to society beyond those emotional and economic benefits enjoyed by the parents. The podcast explained some of these external, social benefits of having children: a larger workforce for firms to employ in the future, more people paying taxes, allowing the government to provide more public goods, more workers supporting the non-working retirees of a nation, and more competitive wages in the global market for goods and services. Higher fertility rates, in short, result in more economic growth and higher incomes for a nation.

When individuals decide how many children to have, they make this decision based solely on their private costs and benefits, since the external benefits of having more babies are enjoyed by society, but not necessarily by the parents themselves. Therefore, left entirely alone, the “free market” will produce fewer babies (Qe) than is socially optimal (Qso).

So what are Western governments doing about low fertility rates? The podcast identifies several strategies being employed to narrow the gap between Qe and Qso. In Australia households receive a $1000 subsidy for each baby born. In Germany mothers receive a year of paid leave from work. Here in Switzerland mothers get three months of government paid leave and $200 a month subsidy to help pay for child care after that. Each of these government policies represents a “baby subsidy”. In the graph above, we can see the intended effect of these policies. By making it more affordable to have children, governments are hoping to reduce the marginal private cost to parents, encouraging them to have more children, which on a societal level should increase the number of babies born so that it is closer to the socially optimal level (Qso).

Unfortunately, as the podcast explains, it appears that parents are relatively unresponsive to the monetary incentives governments are providing. This can be explained by the fact that the private demand (MPB) for babies is highly inelastic. Even if the “cost” of having a baby falls due to government subsidies, parents across the Western world are reluctant to increase the number of babies they have.

As we can see in the graph above, a subsidy for babies reduces the marginal private cost of child-rearing to parents. But the MPB curve, representing the private demand for babies, is highly inelastic, meaning the large subsidy has minimal effect on the quantity of babies produced. Without the subsidy, Qe babies would be born, while with the subsidy only Qs are born, which is closer to the socially optimal number of births at Qso, but still short of the number of births society truly needs.

The “market for babies” in rich countries is failing. Because of the positive externalities of having children, parents are currently under-producing this “merit good”. One of two things must happen to resolve this market failure. Either the marginal private costs of having babies must fall by much more than the government subsidies for babies have allowed, or the marginal private benefit must increase. Either larger subsidies are needed, or some moral revival aimed at encouraging potential parents to consider both the private and social benefits of having children when making their decisions.

Don’t you love economics? We make everything seem so logical! And like they say, it all comes down to supply and demand!

Discussion Questions:

  1. What makes low fertility rates among parents in the rich world an example of a “market failure”?
  2. What are the primary reasons fertility rates are lower in the rich world than they are in the developing world?
  3.  What are the economic consequences of lower birth rates? What are the environmental consequences of lower birth rates? Should government be trying to increase the number of babies born?
  4. Why have government incentives for parents to have more babies failed to achieve the fertility rates that government wish they would achieve?
  5. Do you believe that government can create strong enough incentives for parents to have more babies? If not, what will become of the populations of Western Europe and the rich countries of Asia given today’s low fertility rates? Should we be worried?

75 responses so far

Nov 01 2012

“Cap & Trade” – An introduction market-based approaches to pollution reduction

Inside Obama’s Green Budget – Forbes.com

Some say that Global Warming may be the greatest market failure of all. This podcast was originally broadcast in January of 2007 while George Bush was still in office. The commentator claims that global warming is “nothing but one giant market failure”, arguing that the United States therefore must get serious about tackling the problem.

The allocation of resources towards carbon emitting industries has almost undoubtedly contributed to the warming of the planet over the last half century. Only recently have governments begun taking active measures to reduce the impact of industry on the environment through greater regulation of polluting industries, employing corrective taxes in some instances and market-based approaches to pollution reduction in others.

US President Barack Obama, unlike his predecessor, appears to be serious about correcting the “market failure” represented by global warming:

Obama’s budget, announced Thursday, looks to fund a host of new energy programs, from carbon sequestration to electric transmission upgrades. It would also provide the EPA with a $10.5 billion budget for 2010, a 34% increase over the likely 2009 budget. Nineteen million dollars of that would be used to upgrade greenhouse gas reporting measures.

The Interior Department would get $12 billion for 2010. The agency would use part of the money to asses the availability of alternative energy resources throughout the country.

Funding comes from elaborate carbon “cap and trade” program, which puts a price on emitting pollution and is the core of Obama’s plans. Starting in 2012, the government would sell permits giving businesses the right to emit pollution, generating $646 billion in revenue through 2019.

During those years, the number of available permits would gradually decline, forcing businesses to buy the increasingly scarce, and costly, rights to pollute on an open market. Obama hopes that the rising cost of permits will encourage businesses to invest in clean technologies as a cheaper alternative to meeting pollution mandates, helping to cut greenhouse gas production to 14% below 2005 levels by 2020.

Below is a diagram that illustrates precisely how the Obama cap and trade plan is meant to work. Notice that between 2012 and 2020 the cost to firms of emitting pollution will increase dramatically, while at the same time the total amount of carbon emissions in the US economy will fall due to regular reductions in the number of permits issued to industry.

market-for-pollution-rights_1

The Obama cap and trade scheme is not the first experiment with such a market based approach to externality reduction:

Europe established such a market in 2005. But some E.U. governments allocated too many credits at the outset, causing the value of some permits to fall by half and making it relatively easy for large polluters to simply buy credits rather than cut emissions. Overall emissions grew in 2005 and 2006. In 2008, E.U. emissions dropped 3%; 40% of that drop was attributed to the carbon trading scheme.

Europe’s cap and trade program took a few years before it began having any noticeable impact on the emission of carbon by European industry. While unpopular among the firms who are forced to pay to pollute, the fall in emissions in Europe shows that a market for carbon may be effective in forcing firms “internalize” the costs of carbon emissions, which until now have been born by society and the environment in the form of the negative effects of global warming.

Discussion Questions:

  1. Why do you think tradeable pollution permits are more politically viable than a direct tax on firms’ carbon emissions?
  2. Why did Europe’s carbon emission permit market fail to reduce emissions over its first couple of years of implementation?
  3. Is making firms pay to pollute a good idea in the middle of a recession? Do you think that we should even be worrying about the environment when millions of people are losing their jobs and entire industries are struggling to survive?

60 responses so far

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