OCR Economics- Markets in Action

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JUNE 2013- Discuss whether regulation is the most effective solution

to the market failure arising from information failure.
(L1)Regulation is a non-market based form of government
intervention that comprises of laws, rules, and standards that
dictate how consumers and producers should behave. It aims to
correct market failure by overruling the market mechanism.
Information failure occurs when a lack of information results in
consumers and producers making decisions that do not maximise
welfare. It occurs when consumers are unaware of the harmful
effects or underestimate the private benefits of consumption of a
product. Market failure occurs when economic efficiency is not
achieved.
(L2) Regulation can be used to correct market failure such as
sunbedding, consuming alcohol, cigarettes, drugs etc. e.g.
Implementing legislation whereby U18s are not allowed to sunbed.
Making health warnings on cigarette and alcohol packaging
compulsory and banning drugs completely enforced by severe
punishments.
Firstly, regulation is the most effective solution to the market failure
arising from information failure because it is able to achieve
allocative efficiency. Firstly, setting a clear standard to firms will
place a cap on production and restrict quantity supplied. E.g.
Consumers are not fully aware of the harmful effects arising from
sunbedding. Therefore imposing a limit for consumers on how many
times they can use the sunbed each week will cause quantity
supplied will decrease from QQ1(SOLO).
Graph showing effects of of vertical S(physical cap)

(L3B1) Secondly, regulations such as a ban on junk food adverts

showing on TV before 9pm will act as a solution to the market failure
arising from information failure amongst children. When less
children watch advertisements that perceive junk food as beneficial,
there will be a decrease in demand due to a decrease in taste and
fashion for junk food. Price will decrease from (PP1). Quantity
demanded will decrease from QQ1(SOLO).
Graph of D shifting inwards

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(L3B2) This reduction in overconsumption/production to the SOLO

will ensure that allocative efficiency is achieved and market failure is
solved. Also, welfare of the consumers will be maximised from these
types of regulation as they have proper information and can make
fully informed decisions.
(L4+judgement) Conversely, regulations are ineffective as they are
costly and difficult to enforce. E.g. ensuring that all consumers who
sunbed are U18. Government has to hire workers to prevent people
who disobey the law. The opportunity cost of the government
spending on enforcement is the provision of merit goods such as
education, healthcare and improved infrastructure. This is unlike a
tax, which is able to generate additional tax revenue to spend on
merit
goods.
Regulation
may
fail
to
reduce
overconsumption/production to the SOLO. So allocative efficiency is
not achieved and market failure is not solved. The welfare of
consumers may not be maximised.
Also, a black market/shadow economy for regulated products may
arise. E.g. Drugs are banned and therefore there is a massive illegal
market for drugs. This causes difficulty for the government to
control the distribution of the banned product, which results in the
government spending even more on enforcement and crime
prevention. It will not solve overconsumption/production and reduce
output to the SOLO. Allocative efficiency will not be achieved and
market failure arising from information failure will not be solved and
welfare will not be maximised. However, black market would be less
likely to occur if people were also educated through information
provision.
(L4) Finally, if consumers do not respond as expected to the
information provided then regulation would fail to solve market
failure. E.g. Government forces cigarette companies to print pictures
of consequences of smoking such as lung cancer and rotten teeth
onto cigarette boxes to make consumers aware of harmful effects
but
consumers
still
choose
to
smoke
cigarettes.
Overconsumption/production will not be reduced to the SOLO and
allocative efficiency will not be achieved. Market failure arising from
information failure will not be solved as welfare is still not

OCR Economics- Markets in Action

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maximised.
Another alternative would be information provision, which aims to
provide information to consumers and producers so that decisions
maximising their welfare will be made. e.g. The government can
educate the public so they are fully aware of the harmful effects that
arise from smoking. This may be more effective than regulation as
people will gain a full understanding of the consequences they will
face from consumption of a demerit good such as drugs and
cigarettes. A black market/ avoidance will be less likely as opposed
to regulation and this will eliminate overconsumption and
production, so that quantity demanded will be at the SOLO.
Allocative efficiency will be achieved and market failure will be
corrected.

The weight of the evidence suggest that regulation is not the most
effective form of government intervention to reduce market failure
arising from information failure unless the punishments set are at
the correct level.
This is because a shadow economy will be encouraged for regulated
goods so overconsumption/production will not be reduced to the
SOLO.I believe that the most effective form of intervention is
information provision whereby consumers fully understand the
consequences of their actions in order to maximise their welfare.

OCR Economics- Markets in Action

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JUNE 2014- Discuss whether indirect taxation is the most effective

policy measure to correct market failure arising from negative
externality of production.
Indirect taxation a market-based form of government intervention. It
is a tax levied on specific goods and services. Market failure occurs
when
economic
efficiency
is
not
achieved.(economic
efficiency=allocative e.+productive e.). Negative externalities occur
when social cost of an action outweighs the private costs and leads
to market failure.
Indirect taxes are used to reduce overconsumption/production of a
good or service. E.g. VAT, road tax, excise duties. Taxation can be
effective at corrective market failure arising from negative
externalities. Negative externalities occur because consumers and
producers fail to take into account full social costs of their actions.
Price is therefore too low which results in overconsumption and
overproduction causing negative externalities e.g. air pollution.
Causes allocative inefficiency because too many resources are being
allocated towards the production and market failure is not corrected.
An indirect tax will increase cost of production for a firm.
Inward shift of S curve

OCR Economics- Markets in Action

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This leads to a shift in supply curve from S S1. Price will increase
from PP1 and quantity demanded/supplied will be reduced from
QQ1, which is the SOLO. This corrects overconsumption/production
and allocative efficiency is achieved so market failure is corrected
and there will be a decrease in negative externalities arising e.g.
sound pollution.
Inward shift of S curve but price inelastic

Conversely, an indirect tax is ineffective in correcting market failure

arising from negative externalities because it is a market based
form of government intervention so it is largely influenced by the
PED for the good/service. E.g. Many demerit goods such as drugs,
alcohol and cigarettes are price inelastic because they are addictive.
As a result, consumption for price inelastic goods may not decrease
as
much.
An
indirect
tax
is
supposed
to
reduce
overconsumption/production from Q1 to Q2(SOLO) but due to
certain goods being price inelastic, consumption/production is only
reduced to Q3. This leads to too many resources still being allocated
towards production of the good and allocative efficiency is not
achieved, so market failure arising from demerit goods producing
negative externalities will not be corrected.
Furthermore, indirect taxes should be equivalent to the external cost
associated with the negative externality. However, external costs
are based off estimates as they are difficult to determine the size to
set. If it is set too low, overconsumption/production will not be
reduced and firms will continue to produce negative externalities so
market failure will not be corrected. And if taxes are set too high,
firms may move abroad and continue to produce negative
externalities, so overconsumption/production will not decrease if
viewed from a global perspective. It will also lead to a decrease in
economic growth. Therefore the correct level of tax should be set.
However, arguably a more effective form of government
intervention in correcting market failure which arises from negative
externalities is regulation. Regulation is a non-market based form of
intervention which comprises of laws, rules and standards in order
to dictate how consumers and producers should behave. Its nonmarket characteristic implies that it is not affected by PED of the
good producing negative externalities. E.g. A regulation which

OCR Economics- Markets in Action

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requires firms whose factories which produce more greenhouse
gases such as CO2 beyond a given limit, must pay a heavy fee to
the government. It may increase cost of production for the firm and
shift S inwards so Price of good increases and quantity
demanded/produced decreases. Overconsumption/production will be
reduced to the SOLO and allocative efficiency will be achieved so
negative externalities arising from market failure will be corrected.
The weight of the evidence suggests that indirect taxation is not as
effective as regulation. This is because regulations are not affected
by PED of a product.
However, on its own regulations are also not effective. Therefore
both forms of government intervention should be used alongside
one another to correct market failure arising from negative
externalities of a product.

Discuss whether tradable pollution permits is the most effective

policy measure to correct market failure arising from the N.E of
pollution. (18)
Tradable pollution permits is a permit which allows the owner to
produce a certain amount of pollution, and that if unused/partially
used can be sold to other polluters. Market failure occurs when the
free market fails to achieve economic efficiency (allocative eff.
+productive eff). Negative externalities occur when the social cost
of an action is greater than the private cost. E.g. Air pollution, noise
pollution, visual pollution.
A negative externality which associates with factories producing
goods and services is the air pollution, carbon emissions and
greenhouse gases released into the atmosphere. The external cost
is the cost of the respiratory treatment that is imposed on the third
party that is the NHS who is outside of the decision making process.
Tradable pollution permits are a market-based form of government
intervention that attempts to correct market failure arising from
negative externalities. Permits are created to turn CO2 from public
good into a private good so that there is a market for the externality.
A permit gives a polluter the right to emit a given amount of
pollution. The total number of permits is strictly controlled as a
means of reducing pollution until it reaches an acceptable limit.

OCR Economics- Markets in Action

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Pollution permits impose a cap on pollution, which places a ceiling
on the amount of pollution that can be emitted by polluters and as a
result overproduction and consumption will be reduced to the SOLO
and allocative efficiency will be achieved. Negative externalities
such carbon emissions will be reduced and market failure will be
corrected.
Furthermore, if pollution permits were issued at the correct quantity
and the appropriate price, then only will the external cost arising
from the CO2 be covered. This suggests that the external cost is
internalised and is brought inside the market so that those who have
created the pollution must pay for it. Economic efficiency is
achieved as external cost is taken into account. This increases the
price and overconsumption/overproduction is reduced to the SOLO
so that fewer resources are being allocated towards this production.
Allocative efficiency is then achieved and negative externalities
arising from market failure is eliminated.
Most importantly, tradable pollution permits are effective as they
create an economic incentive for polluters. They aim to reduce
pollution through economic incentives whilst allowing output to
increase. The incentive is for permit holders to achieve a lower level
of pollution so that their unused or partially used permits can be
sold to polluters who fail to reduce pollution the required amount.
Polluters who do not have sufficient permits will be forced to pay a
fine.
If more polluters wish to emit more pollution, then the demand
curve will shift outwards (DD1). This will increase the price of
permits so they will be worth more and those who hold permits will
want to sell their permits in order to gain profit. In order to do this,
pollution must be reduced and firms will only produce CO2 when
they have no other alternative. They will ultimately decide if it is
cheaper investing in cleaner and greener technology than to buy
additional permits. Less negative externalities will be created and
over consumption/production will be brought to the SOLO.
Graph of D shifting outwards (DD1) with vertical supply curve

Conversely, tradable pollution permits are only distributed to

countries that were involved in the Kyoto Protocol of 1992. Therefore
although the pollution in certain countries are capped, global CO2
emissions are not capped so negative externalities such as pollution
will continue to be produced. Smaller polluters from vehicles such as
cars and motorcycles are not included so pollution will continue to
be produced. Both of this may create an offset to the reduction in
pollution in the countries involved in the Kyoto Protocol. Therefore
the negative externality (pollution) arising from market failure will
not be reduced and overconsumption and production will continue.

OCR Economics- Markets in Action

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Pollution permits are not the most effective as there is only an
incentive to invest in order to reduce carbon emissions if the price of
permits is high enough. If however too many permits are issued into
the market, it will result in too low of a price of permits. Polluters will
no longer have the incentive to hold on to their permits and reduce
pollution because little profit will be gained from a low price of
selling permits. E.g. At one point, the price of one permit was $0.45.
Therefore, the government must make an accurate judgement to
determine the true external cost in order for the economic incentive
from permits to exist.
Pollution permits may be ineffective at solving market failure arising
from pollution as richer countries may buy pollution permits off
poorer countries who may not produce as much pollution. This
means that air pollution arising from market failure will not be
reduced and the market will be allocatively inefficient as too many
resources are still being allocated towards production so
overconsumption and production continues.
An alternative to pollution permits would be regulation. Regulation
comprises of rules, standards and laws which dictate how
consumers and producers should behave. Unlike pollution permits
they are a non market based form of government intervention. This
may be in the form of a legislation relating to the maximum levels of
carbon emissions from transport, power generation or industry.
Regulations are cheap and easy to impose as opposed to a pollution
permit which requires creation of the permits. Regulations do not
rely on a market mechanism so they are straightforward and have
an immediate effect.
The weight of the evidence suggests that tradable pollution permits
is an effective policy measure to correct market failure arising from
the N.E of pollution but is however not the most effective if were to
be implemented on its own.
If however, it was accompanied with a tax on petrol to reduce air
pollution arising from smaller vehicles, market failure arising from
pollution may be corrected and allocative efficiency may be
achieved.
JAN 2011- Discuss whether regulation is the most effective way of
correcting market failure such as those arising from carbon
emissions. (18)
(L1)Regulation is a non-market based form of government
intervention that comprises of laws, rules, and standards that
dictate how consumers and producers should behave. It aims to
correct market failure by overruling the market mechanism. Market
failure occurs when economic efficiency is not achieved.

OCR Economics- Markets in Action

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(L2) Regulation can be used to correct market failure such as
sunbedding, consuming alcohol, cigarettes, drugs etc. e.g.
Implementing legislation whereby U18s are not allowed to sunbed.
Making health warnings on cigarette and alcohol packaging
compulsory and banning drugs completely enforced by severe
punishments.
Firstly, setting a clear standard to firms will place a cap on
production and immediately restricting quantity supplied. E.g. A
negative externality arising from overdosing paracetamol is liver
damage. A limit to production backed up by a fine is likely to reduce
the number of people who overdose. Quantity demanded will
decrease from QQ1(SOLO).
Graph showing effects of demand curve shifting inwards

(L3B2) This reduction in overconsumption/production to the SOLO

will ensure that allocative efficiency is achieved and market failure
arising from negative externalities is solved.
(L4+judgement) Conversely, regulations are ineffective as they are
costly and difficult to enforce. E.g. ensuring that all consumers who
sunbed are U18. Government has to hire workers to prevent people
who disobey the law. The opportunity cost of the government
spending on enforcement is the provision of merit goods such as
education, healthcare and improved infrastructure. This is unlike a
tax, which is able to generate additional tax revenue to spend on
merit
goods.
Regulation
may
fail
to
reduce
overconsumption/production to the SOLO. So allocative efficiency is
not achieved and market failure is not solved. The welfare of
consumers may not be maximised.
Also, a black market/shadow economy for regulated products may
arise. E.g. Drugs are banned and therefore there is a massive illegal
market for drugs. This causes difficulty for the government to
control the distribution of the banned product, which results in the
government spending even more on enforcement and crime
prevention. It will not solve overconsumption/production and reduce
output to the SOLO. Allocative efficiency will not be achieved and
market failure arising from negative externalities will not be solved.

OCR Economics- Markets in Action

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However, black market would be less likely to occur if people were
also educated through information provision.
(L4) Finally, if consumers and producers do not respond to the laws
implemented, then regulation would fail to solve market failure
arising from negative externalities. E.g. Government forces cigarette
companies to print pictures of consequences of smoking such as
lung cancer and rotten teeth onto cigarette boxes yet consumers
still choose to smoke cigarettes. Overconsumption/production will
not be reduced to the SOLO and allocative efficiency will not be
achieved. Market failure arising from negative externalities will not
be solved.
Another alternative would be information provision, which aims to
provide information to consumers and producers so that decisions
maximising their welfare will be made. e.g. The government can
educate the public so they are fully aware of the harmful effects that
arise from smoking. This may be more effective than regulation as
people will gain a full understanding of the consequences they will
face from consumption of a demerit good such as drugs and
cigarettes. A black market/ avoidance will be less likely as opposed
to regulation and this will eliminate overconsumption and
production, so that quantity demanded and supplied will be at the
SOLO. Allocative efficiency will be achieved and market failure will
be corrected.

JUNE 2011- Discuss the extent to which a subsidy given to producers

might encourage an increase in the consumption of a product such
as puer tea which generates positive externalities.

OCR Economics- Markets in Action

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Discuss whether subsidising the building of affordable new houses is
the most effective solution to a housing shortage. [18]- Jan 2013
A subsidy is a payment, usually provided by the government for the
provision of goods and services. It is a market based form of gov
intervention. Market failure occurs when economic efficiency is not
achieved. Examples of a producer and consumer subsidy is farming
and apprenticeships schemes respectively. Subsidies will increase
supply and decrease the price for houses to encourage greater
demand. Houses are a merit good as consumers are not fully aware
of its benefits.

Subsidy diagram
Cost of production for building houses will decrease and will lead to
an inward shift in the supply curve (SS1). Price of houses will
decrease (PP1) and quantity for houses will increase
(QQ1(SOLO)). Lower house prices will lead to an increase in
consumer surplus. (Shaded area= Area of increase in consumer
surplus) Under consumption for houses will be corrected and the
market failure arising from the housing shortage will be eliminated.
Allocative efficiency will be achieved and consumer satisfaction will
be maximised.
A subsidy is the most effective solution to a housing shortage as the
decrease in cost of production increases the supply of houses. This
increase in quantity of houses leads to the housing shortage being
corrected. Also, a reduction in house prices will make houses more
accessible especially to those in low income groups. Houses are
price elastic (Qd responsive to a decrease in price) as it makes up a
large proportion of income. Hence, there will also be an increase in
quantity demand for houses.
However, a subsidy is not the most effective solution to a housing
shortage.
Firstly, subsidies impose an opportunity cost on governments/local
authorities. The opportunity cost of subsidising the production of

OCR Economics- Markets in Action

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houses would be the benefits gained from spending on other public
services. Eg healthcare such as immunisation schemes and
education such as training more teachers. This is unlike regulation
which does not impose an opportunity cost on governments.
Instead, flexible regulations on building houses will remove the need
for suppliers to undergo a long winded process due to previous red
tape. This also decreases their cost of production and hence
increases supply for houses. Therefore, house shortage will be
corrected without imposing an opportunity cost.
Finally, it depends upon the size of the subsidy granted to housing
firms. It will be ineffective if the subsidy given is too low. It will not
lead to a significant decrease in cost of production and a large
increase in supply of houses. Hence, quantity of houses will not
increase. Ultimately, the market failure arising from housing
shortage will not be corrected. Conversely, an alternative to
subsidies may be information provision to producers about the
cheaper alternative to building new housing. This would be to
renovate old houses which results in a lower cost of production and
increase supply of houses will eventually reduce the housing
shortage as well.
The weight of evidence suggests that on balance, subsidising the
building of affordable new houses is an effective solution to a
housing shortage. However, the most effective solution would be to
provide a subsidy in tandem with decreasing red tape (regulation)
for the production of houses. This way, cost of production will
decrease more than if subsidies were used alone, which will lead to
a greater increase in supply for houses which will greater reduce or
even possibly eliminate the housing shortage.