Economics 9708/43 — October/November 2018
Cambridge A-Level · A Level Data Response and Essays · worked solutions for every part, with the mark scheme
Topics Government Policies to Correct Market Failure · Effectiveness of Macroeconomic Policies · Growth and Survival of Firms · Efficiency and Market Failure · Externalities, Social Costs and Benefits · Utility Theory · +10 more
The government and market failures
Countries are seeking innovation-led growth that is more inclusive and more sustainable than in the past. Modern capitalism is facing challenges of climate change, youth unemployment and rising inequality.
These challenges require rethinking the role of government and public policy. It requires a new justification of government intervention that goes beyond that of fixing market failures, to one of stimulating and facilitating change by creating markets which more fairly distribute both risk and rewards.
This is not just about spending public money on different activities; it requires new indicators through which to evaluate public investments.
Markets are ‘blind’ and the direction of change they provide often represents inefficient resource allocation from a society’s point of view. Market failure theory (MFT) justifies government intervention in an economy in order to correct a situation of inefficient resource allocation. This involves taking measures such as devising market mechanisms to internalise external costs or the direct provision of public goods.
MFT has developed methods to evaluate government actions, usually through cost-benefit analysis (CBA) – which has limitations in its effectiveness. The CBA then informs an assessment of the ‘principal-agent’ structure that will force private agents to do what the government wants.
Critics of MFT say that it assumes that the government only fixes existing problems and this is not as useful as a policy that creates dynamic new markets or products. However, this can lead to accusations of ‘crowding out’ private sector businesses.
The argument against those criticisms rests on showing how government investments cause both a larger national output that can be shared between private and public sectors, and creates cost savings. However, this argument does not include the idea that the goal of public investment is about more than just increasing output. It should also be, as Keynes wrote, to ‘do those things which at present are not done at all’.
In fact, new events that have transformed economies have also been influenced on both demand and supply sides by policymaking. The iPhone, Global Positioning Systems (GPS), touch-screen displays, solar power and wind farms, for example, were all publicly funded.
Source: RSA Journal, Issue 2, 2015
Explain what is meant by the ‘principal-agent’ problem and describe how it can be applied to governments and private sector businesses.
Answer
The principal-agent problem arises when one party (the principal) delegates decision-making to another party (the agent) whose objectives may not align with those of the principal. In the context of firms, it typically refers to the conflict between shareholders (principals) and managers (agents) who may pursue their own interests (e.g., higher salaries, job security) rather than profit maximisation.
Applied to governments and private sector businesses, the government acts as the principal, setting regulations and policies to achieve social welfare objectives (e.g., reducing carbon emissions). Businesses, as agents, may not fully comply or may seek to minimise costs in ways that undermine the government's goals, such as by externalising costs onto society. This conflict can lead to inefficiency, as businesses may not internalise the social costs of their actions, requiring government monitoring and enforcement.
The principal-agent problem is a conflict of interest between a principal and an agent; when applied to government and businesses, the government (principal) aims for social welfare but businesses (agents) may pursue profit, leading to non-compliance and inefficiency.
Background Concept
The principal-agent problem is a fundamental issue in economics and organisational theory. It occurs when one party (the principal) hires another party (the agent) to act on their behalf, but the agent has different incentives and may not act in the principal's best interest. This is often due to information asymmetry: the agent knows more about their actions than the principal, leading to moral hazard (the agent taking excessive risks because the principal bears the cost) or adverse selection (the agent misrepresenting their abilities).
Understanding the Question
This question asks you to first explain the general concept of the principal-agent problem, and then specifically apply it to the relationship between governments (as principals) and private sector businesses (as agents). The article discusses government intervention and market failures, so the application should focus on how businesses might not follow government regulations or objectives, leading to inefficiency.
Approach
Start with a clear definition of the principal-agent problem, using the classic example of shareholders and managers. Then, map this to the government-business context: the government sets rules to achieve social goals (e.g., environmental protection), but businesses may prioritise profit and avoid compliance. Explain the conflict and its consequences (e.g., need for monitoring, enforcement costs).
Step-by-Step Reasoning
- Define the principal-agent problem: a conflict of interest when a principal delegates authority to an agent whose goals differ.
- Give the standard example: shareholders (principal) want profit maximisation; managers (agent) may want perks or job security.
- Apply to government and businesses: government (principal) wants to correct market failures and improve social welfare; businesses (agent) want to maximise profit and may resist or circumvent regulations.
- Explain the conflict: businesses may externalise costs (e.g., pollution) to avoid compliance, leading to inefficiency. Government must monitor and enforce, which is costly.
- Conclude that this misalignment can undermine the effectiveness of government policy.
Key Takeaways
- The principal-agent problem is about misaligned incentives and information asymmetry.
- It is not limited to firms; it applies to any delegation relationship, including government and businesses.
- Understanding this helps explain why government regulations may not achieve their intended outcomes without proper enforcement.
Common Mistakes
- Only defining the problem without applying it to the specific context of government and businesses.
- Confusing the principal-agent problem with other market failures like externalities (though they can be related).
- Not explaining the consequences of the conflict (e.g., inefficiency, need for monitoring).
Things to Be Careful About
- Clearly distinguish between the two roles: government as principal, businesses as agent.
- Use precise economic terminology: moral hazard, information asymmetry, incentives.
- Keep the answer focused on the question; do not stray into unrelated aspects of government intervention.
Outline what the article means when it mentions ‘inefficient resource allocation’.
Answer
Inefficient resource allocation occurs when resources are not used in a way that maximises society's welfare. This can happen in two main ways:
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Productive inefficiency: output is not produced at the minimum possible cost, meaning that more of one good could be produced without reducing the output of another good. This occurs when firms operate above their lowest average cost.
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Allocative inefficiency: the marginal social cost (MSC) of producing a good does not equal the marginal social benefit (MSB). If MSC > MSB, too much is produced; if MSB > MSC, too little is produced. This leads to a deadweight welfare loss.
Market failures such as externalities, public goods, and imperfect competition cause inefficient resource allocation, as the price mechanism fails to signal the true social costs and benefits.
Inefficient resource allocation means resources are not used to maximise social welfare, either because production is not at minimum cost (productive inefficiency) or because marginal social cost does not equal marginal social benefit (allocative inefficiency).
Background Concept
Efficiency in economics is about getting the most out of scarce resources. Productive efficiency means producing goods at the lowest possible cost (on the production possibility frontier). Allocative efficiency means producing the mix of goods that society values most (where price equals marginal cost, or more broadly, MSB = MSC). When either condition is not met, resources are wasted or misallocated, reducing total welfare.
Understanding the Question
The article mentions 'inefficient resource allocation from a society’s point of view'. This question asks you to outline what that means. You need to explain the two main types of inefficiency and how they relate to market failure. The answer should be concise but cover both productive and allocative inefficiency.
Approach
Start by stating that inefficient resource allocation means not maximising social welfare. Then define productive inefficiency and allocative inefficiency separately. Finally, link to market failure as the cause.
Step-by-Step Reasoning
- Define inefficient resource allocation: resources not used to maximise welfare.
- Productive inefficiency: not producing at minimum average cost; could produce more of one good without sacrificing another (inside the PPC).
- Allocative inefficiency: MSC ≠ MSB; either overproduction or underproduction relative to the socially optimal level.
- Explain that market failures (externalities, public goods, monopoly) cause these inefficiencies because prices do not reflect true social costs/benefits.
- Conclude that the article is referring to these types of inefficiency when it says markets are 'blind'.
Key Takeaways
- Inefficient resource allocation can be productive or allocative.
- Both lead to a loss of potential welfare.
- Market failure is the key reason why free markets may not achieve efficiency.
Common Mistakes
- Only defining one type of efficiency (e.g., only allocative).
- Confusing productive efficiency with technical efficiency (though related).
- Not linking to market failure or the article's context.
Things to Be Careful About
- Use correct terminology: marginal social cost, marginal social benefit.
- Mention the deadweight welfare loss for allocative inefficiency.
- Keep the answer focused on 'outline' – no need for evaluation.
The article refers to ‘internalising external costs’. Explain what economists mean by this and consider whether cost-benefit analysis can be used to achieve it.
Answer
Internalising external costs means ensuring that the party responsible for generating a negative externality bears the full social cost of their actions, rather than imposing costs on others. For example, a factory emitting pollution should pay for the environmental damage it causes, so that its private costs reflect the true social costs.
Cost-benefit analysis (CBA) is a technique that attempts to assign monetary values to all costs and benefits of a project or policy, including externalities. By quantifying the external costs, CBA can inform the level of a Pigouvian tax or the price of pollution permits, thereby internalising the externality. For instance, if CBA estimates the social cost of carbon at $50 per tonne, a tax of that amount can be imposed on emissions.
However, CBA has significant limitations in achieving full internalisation. Many external costs, such as loss of biodiversity or human health impacts, are difficult to value accurately due to lack of market prices. There are also ethical concerns about putting a price on life or nature. Furthermore, CBA often relies on assumptions and discount rates that can be contested, and it may not capture long-term or irreversible effects. Therefore, while CBA can be a useful tool, it is not a perfect method for internalising external costs and must be used alongside other regulatory approaches.
Internalising external costs means making the polluter pay the full social cost; cost-benefit analysis can help by assigning monetary values to externalities, but it faces difficulties in accurately valuing non-market impacts, so it is a useful but imperfect tool.
Background Concept
Externalities are costs or benefits that affect third parties not directly involved in a transaction. Negative externalities (e.g., pollution) lead to overproduction because the private cost is less than the social cost. Internalising the externality means making the producer pay the full social cost, often through a Pigouvian tax or regulation. Cost-benefit analysis (CBA) is a systematic process for evaluating projects by comparing all social costs and benefits, often used by governments to decide on public investments.
Understanding the Question
This question has two parts: first, explain what 'internalising external costs' means; second, consider whether cost-benefit analysis can be used to achieve it. The 'consider' implies evaluation – you need to discuss both how CBA can help and its limitations. The mark scheme allocates up to 2 marks for the explanation and up to 4 marks for the discussion of CBA.
Approach
Start with a clear definition of internalising external costs, using an example. Then explain how CBA works and how it can assign monetary values to externalities, enabling internalisation. Then evaluate: discuss the strengths (e.g., provides a quantitative basis) and weaknesses (difficulty valuing non-market goods, ethical issues, uncertainty). Conclude with a balanced judgement.
Step-by-Step Reasoning
- Define internalising external costs: making the polluter pay the full social cost (MSC = MPC + MEC).
- Example: a factory emitting pollution; internalising means imposing a tax equal to the marginal external cost.
- Explain CBA: it attempts to measure all costs and benefits in monetary terms, including externalities.
- How CBA can help: by estimating the monetary value of external costs, it can set the correct tax or permit price.
- Limitations: valuing non-market goods (e.g., clean air, biodiversity) is difficult; use of discount rates can undervalue future costs; ethical objections to pricing life; uncertainty and assumptions.
- Conclusion: CBA is a useful tool but not perfect; it should be complemented by other methods (e.g., regulation, public participation).
Key Takeaways
- Internalising externalities aligns private and social costs.
- CBA provides a framework for quantifying externalities, but has significant limitations.
- A balanced view is required for evaluation questions.
Common Mistakes
- Only explaining internalising without discussing CBA.
- Describing CBA without linking it to internalisation.
- Giving a one-sided evaluation (only strengths or only weaknesses).
- Not providing a conclusion or judgement.
Things to Be Careful About
- Use correct terms: marginal external cost, Pigouvian tax.
- Mention specific examples of valuation difficulties (e.g., contingent valuation, hedonic pricing).
- Ensure the answer addresses both parts of the question explicitly.
Consider whether the article provides sufficient evidence to conclude that market failure theory (MFT) is inadequate as a government policy tool.
Answer
The article presents several arguments against market failure theory (MFT) as a policy tool, but the evidence provided is limited and one-sided.
On the one hand, the article points out that cost-benefit analysis (CBA), a key tool of MFT, has limitations, though it does not specify what they are. It also suggests that government intervention can lead to an inefficient public sector and crowding out of private investment, but again without detailed evidence. The article argues that MFT focuses on fixing existing problems rather than creating dynamic new markets, and that it fails to address modern challenges like climate change, youth unemployment, and inequality.
On the other hand, the article acknowledges that government investment can increase national output and create cost savings, and it provides examples of publicly funded innovations (iPhone, GPS, solar power) that have transformed economies. This suggests that government intervention, guided by MFT, can be effective in stimulating innovation and growth.
However, the article does not provide sufficient evidence to conclude that MFT is inadequate. The criticisms are largely assertions without empirical support, and the positive examples are not directly linked to MFT. Moreover, the article does not consider alternative justifications for government intervention beyond MFT, such as strategic trade policy or industrial policy. Therefore, while the article raises valid concerns, it does not offer enough evidence to dismiss MFT entirely. A more balanced analysis would require examining specific cases where MFT has succeeded or failed, and considering complementary policy frameworks.
The article provides some criticisms of MFT but lacks sufficient evidence to conclude it is inadequate; it offers assertions without empirical support and ignores successful applications of MFT, so the evidence is insufficient.
Background Concept
Market failure theory (MFT) justifies government intervention when free markets fail to allocate resources efficiently. Tools include taxes, subsidies, regulation, and public provision. Critics argue that government intervention can also fail (government failure) due to bureaucracy, lack of information, and political incentives. The article discusses these issues and questions whether MFT is adequate for modern challenges.
Understanding the Question
This question asks you to 'consider whether the article provides sufficient evidence to conclude that MFT is inadequate as a government policy tool.' You need to evaluate the strength of the evidence presented in the article. The mark scheme indicates that you should discuss both sides: evidence that MFT is inadequate (limitations of CBA, crowding out, lack of dynamism) and evidence that MFT is still useful (government investment creates output, funds innovation). Then reach a conclusion on the sufficiency of the evidence.
Approach
First, identify the arguments in the article against MFT. Then, identify the arguments in favour (or counterpoints). Evaluate the quality of the evidence: are the criticisms backed by data or examples? Are the positive examples directly relevant? Finally, conclude whether the evidence is sufficient to dismiss MFT.
Step-by-Step Reasoning
- Summarise the article's criticisms of MFT: CBA has limitations (unspecified), inefficient public sector, crowding out, lack of dynamism, failure to address modern challenges.
- Note that these are assertions without empirical support; the article does not provide specific examples or data.
- Identify the article's positive points: government investment can increase output and create cost savings; examples of publicly funded innovations (iPhone, GPS, solar).
- Evaluate: the positive examples show that government intervention can be successful, but they are not necessarily linked to MFT (they could be industrial policy). The criticisms are vague.
- Consider what is missing: the article does not discuss successful applications of MFT (e.g., carbon taxes reducing emissions, regulation improving public health). It also ignores the possibility of combining MFT with other approaches.
- Conclusion: the article raises valid concerns but does not provide sufficient evidence to conclude MFT is inadequate. More empirical analysis is needed.
Key Takeaways
- Evaluating evidence requires distinguishing between assertions and supported claims.
- A balanced answer considers both sides and reaches a justified conclusion.
- The sufficiency of evidence depends on its quality, not just quantity.
Common Mistakes
- Simply listing arguments for and against without evaluating the evidence.
- Concluding that MFT is inadequate because the article says so, without questioning the evidence.
- Ignoring the positive examples in the article.
- Not providing a clear conclusion on the sufficiency of evidence.
Things to Be Careful About
- Focus on the evidence in the article, not on your own knowledge of MFT (though you can use it to evaluate).
- Use phrases like 'the article asserts... but does not provide evidence'.
- Ensure the conclusion directly answers the question: is the evidence sufficient?
The rest of this paper
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