What can the government do to eliminate a market failure?
Policy 4: The government can provide information where this is lacking.
For those goods which are merit or demerit goods, and for which there is inadequate
information, the government can provide this information to bridge the gap. As an
alternative, the government could make a regulation which requires the firm to set
out certain information.
Give some examples of products and services which you can buy, and about which by
law the seller has to publish information about:
Financial products such as loans
Why does the government provide this information? What do you expect to happen to
demand for these goods or services following an effective information campaign by
Here are some goods for which information is usually asymmetric. The wrong price
may be paid for these goods. Why does the government not publish information
about how good or bad these things are?
Following information provision, draw ACE diagrams of what happens to demand for a
Merit Good De-merit Good
What are these goods or services? Tick all that apply, and suggest one or
more policies which might alleviate this market failure. Use the instructions
on the next page to evaluate the effectiveness of the policy tools you know.
by factor immobility
Causes or is caused
Good w. negative
Good w. positive
A good which is
Firm has price-
A private pension
you pay into for
Driving a car
cod in the north
emissions into the
Here are the policy options:
Tax the product
Subsidise the product
State provision of the product for free or at marginal cost
Introduce regulations regarding provision or use of the product
Provide information about the product which the consumer may not have
Create property rights (tradeable pollution permits, see below)
For the last two types of market failure, the government can also create property
rights. This is where the owners of a resource that is being polluted, such as air or
water, (usually the state) charge firms a fee for the right to pollute in the form of a
“tradeable pollution right” or “permit”. For example, for each tonne of carbon
dioxide released into the atmosphere one permit is needed. Firms must buy these
permit in an open, competitive market. The number of pollution permits in the
market is fixed by the government. To decrease pollution, the government could
decrease the number of permits in circulation over time by buying them up and not
issuing any new ones. This raises the price of permits, making it worthwhile for the
firms to invest in more expensive, but environmentally friendly equipment.
Instructions for the policy options – practice your exam technique
Use these instructions to help you identify the levels at which exam questions are
How much and what to write for a question can be seen by the directive word at the
beginning of the question.
State – a single word, or a simple phrase. (though sometimes questions ask for
several things to be stated.)
Q: State three possible causes of market failure.
A: the existence of externalities, information asymmetry and factor immobility.
Q: State one advantage and one disadvantage of taxing the polluter.
A: An advantage is the fact that the government raises revenue, a disadvantage is
that it is difficult to calculate the size of the tax.
Define – a short definition, Usually of one of the key words (these are printed on the
reverse of your dividers)
Q: Define the term “externality”.
A: An externality occurs where others are affected by the economic decisions of
individuals. With negative externalities, MSC>MPC, with positive externalities,
Explain – you need define the key word and say how or why something works or is
done. Use economics language, not lay language. Give an example (there is usually
one in the case study for the exam).
Q: Explain what is meant by “negative externality”.
A: A negative externality arises where MSC>MPC. (You could draw a diagram to
illustrate this). This is the case when others are affected by the economic decisions of
individuals. As a result, the total cost to society is higher than the cost of producing
the good. Examples of external cost include pollution, noise or blight. An example of
a good with negative externalities is car use, which creates pollution, congestion and
delays. These costs are borne by others not involved in the individual’s decision to
Analyse – You need to define the key word in the question and show to get from A to
B. This calls for an explanation of a process. Very often combined with the use of
diagrams. Even if no diagram is asked for, try to use one. Economic diagrams can
show the process very efficiently, and you then just need to describe what is going on
in the diagram to get full marks!
Q: Analyse, with the aid of a diagram, how state provision of information leads to the
“correct” amount of a merit good being consumed.
A: A merit good is underconsumed as consumers are not
D2 fully aware of its benefits. One policy option is to close this
information gap, leading to the correct quantity being
P2 B The diagram shows how, following provision of information
P1 A by the government, demand for a merit good shifts right.
At the original equilibrium point A, the good is
underconsumed (Q1) and undervalued (P1). Provision of
information makes consumers more aware of the benefits
Q1 Q2 of the product. This is shown by the shift in the demand
cuve from D1 to D2. At the new equilibrium point B, both
the quantity (Q2) consumed and the price (P2) of the good
have increased, reflecting its value to consumers more
At level 4, you need to go through all the stages in turn:
Define, explain, analyse and evaluate or discuss. Make a bulleted list of the
advantages and disadvantages of the policy you are being asked to discuss.
Discuss – you need to find the key economic concept in the question and define it.
Then explain giving the arguments for and against. You don’t need to come to a
conclusion to reach full marks.
Discuss the extent to which – weight the arguments for and against, and come to
Evaluate the extent to which – Same as discuss the extent to which. Weight the
arguments and mention the reasons why some have a large, and some a smaller
Q: Discuss the extent to which information provision is an effective policy tool when
tackling under-consumption of merit goods.
L1 (definition of the main terms): A negative externality arises where the consumer is
unaware of the true benefit of a good. Information provision is a government policy
used where information is lacking, one-sided or in the case of merit or de-merit
L2 (explanation and example): As a result, the private benefit exceeds the benefit
perceived by the consumer, and the good is under-demanded and therefore under-
produced. An example of such a good are vegetables, the benefits of which people
may not have been fully aware of until the government launched its “5-a-day”
L3 (analysis): As a result of the information provided by the government, the
consumer becomes fully aware of the benefits of the good. The demand curve shifts
to the right, establishing a new equilibrium at a higher price and quantity.
L4 (discussion): To be effective, the government must establish that the information it
provides is easily understood by the population. It is also important to ensure that
the target population is reached, hence the means of providing the information needs
to be considered. The extent to which the demand curve shifts closer to the true
value of the good depends on the effectiveness and timeliness of the government’s
information campaign. If other factors prevent the population from consuming the
good, the government will need to combine information provision with other forms of
intervention. This could be the case if the good is a mixed good, that is, it also has
features of other forms of market failure such as a public good or a good with positive
externalities. For example, the government could subsidise firms to reduce the price
of the good in the market. This would ensure that the good is affordable. Another
possibility is state-provision of the good. The good could be provided free or at a
below-market price cost. Another possibility would be regulation. The government
could require the public to consume certain goods. This is the case for state
education for children under 16.
(Conclusion): For a pure merit good, high quality information provision is an effective
policy tool. However, for a mixed good there are other policy options which could
improve the effectiveness of government intervention, including subsidy, state
provision and regulation.