IB ECONOMICS EXAM ESSAYS

Question 4: Market forces as believed to be the most efficient way to

allocate scarce resources, explain the role prices play in this process and the
areas where the market fails do its proposed job. Evaluate the policies
government can implement to solve such areas of market failure. How can
knowledge of Elasticities help government when designing a TAX policy?
Answer:
It is known there are a number of factors that prevent markets from
allocation resources in an optimal manner. When this occurs the community
surplus is not maximizes and we say that this is a market failure. When
markets fail governments are often expected to intervene in order to attempt
to eliminate the market failure and move towards the optimal allocation of
resources. In the following paragraphs the types of market failure will be
developed.
Public goods, which are of benefit to society, will not be provided at all in a
free market (a non-intervened market) since they are non-excludable
(impossible to stop other people consuming it once it is provided) and nonrivalrous (it does not prevent two persons from consuming it at the same
time). This makes it pointless for private firms or individuals to provide these
type of goods.
Merit goods are goods considered to provide positive benefits for both the
people that use them and society as a whole. These goods will be
underprovided and therefore under-consumed. Government may try to
reduce both types of market failure by either providing the public goods
themselves or subsidizing private firms covering all the costs to provide the
good. However this would have an opportunity cost for the government.
On the contrary, demerit goods which are considered bad for people and
society will be over-provided and so, over-consumed. Governments will
attempt to reduce the supply of these goods by either making them illegal or
banning them completely or taxing them.
Externalities occur the production or consumption of a good or service has
a positive or negative effect upon a third party. When they exist, the Marginal
Social Cost (MSC) does not equal the Marginal Social Benefit (MSB), and so it
is considered a market failure and inefficient allocation of societys resources.
Negative externalities of production such as environmental problems, for
example, occur when the marginal social cost of the production is higher than
the marginal private cost. This could be solved by taxing the firm to raise its
MPC towards the point of social efficiency or either legislating or banning the

polluting firms. However this could cause job losses or affect the price of a
merit good.
Positive externalities of production occur when the marginal private cost
of the firm is greater than the marginal social cost. Subsidizing the firms that
offer training, for example, or offering the training through the state would be
a solution though it would imply an opportunity cost for the government.
Negative externalities of consumption occur when the marginal social
benefits are lower than the marginal private benefits, for example, smoking.
One possible solution could be banning cigarette smoking totally although
that would affect the Tabaco industry as to employment. The government
could also provide education about its dangers although it would have an
opportunity cost as well. Imposing indirect taxes on cigarettes is also often
considered though the government should be aware of the inelastic demand
that cigarettes have due to their addictive effect on their consumers.
Applying a tax on a price inelastic good or service would be useless since a
raise in its price would not mean a lower demand for the good. Consumers
might be willing to pay any price for cigarettes and so will continue
consuming them.
Possible externalities of consumption occur when the consumption of a
good or service provides external benefits to third parties, for example,
health care or education. The Marginal Social Cost occurs to be greater than
the Marginal Private Cost. The government could subsidize the supply of
those services or use positive advertising could to encourage people to
consume them; although this would have an opportunity cost.
One last area in which the market fails is in the threat to sustainability
that the production and consumption of some goods and services provoke.
Sustainability exists when the consumption needs of the present generation
are met without reducing the ability to meet the needs of future generations.
Common access resources are typically natural resources which are very
difficult to exclude people from using them. This often leads to their overconsumption which eventually leads to the depletion of the resource. Poverty
and economic growth also result in environmental problems such as overexploitation of land, soil erosion, land degradation, and deforestation.
Another threat to sustainability occurs with the heavy global demand for fuels
used for transport. This means fuels are over-produced and over-consumed,
adding to the fact that when they are used and burned they emit
greenhouse gases known to be damaging for the planet causing climate
changes. Governments often response to these threats by setting economic
incentives to reduce emissions or agreements; subsidizing the development
of clean technologies (use of renewable sources of energy) or offering tax

credits to firms that invest in clean technologies. However, once again this
solution would have an opportunity cost for the government.
To conclude it could be said that although market forces as believed to be
the most efficient way to allocate scarce resources, there are various areas in
which the market fails doing this job correctly such as: the lack of public
goods, the under-supply of merit goods and the over-supply of demerit goods;
the existence of externalities and the threats to sustainability. There are
however various possible solutions that the government may carry out
although many times they imply an opportunity cost.