FIN701 PUBLIC FINANCE

CASE STUDY QUESTION

th
DUE 28 June: Weighting - Alternative for Final Exam Part 2 (25%)

1. Explain the term market failure. (1 mark)

A market failure occurs whenever the individuals in a group end up worse off than if they
had not acted in perfectly rational self-interest.

Explanation

The term Market Failure:-The market failure is the economic situation defined by an
inefficient distribution of goods and services in the free market. In market failure, the
individual incentives for rational behaviour do not lead to rational outcomes for the
group. In other words, each individual makes the correct decision for him or herself, but
those prove to be the wrong decisions for the group. In traditional microeconomics, this
sometimes is shown as steady-state disequilibrium in which the quantity supplied does
not equal the quantity demanded.
 Market failure occurs when individuals acting in rational self-interest produce a
less than optimal or economically inefficient outcome.
 Market failure can occur in explicit markets where goods and services are bought
and sold outright, which we think of as typical markets.
 Market failure can also occur in implicit markets as favors and special treatment
are exchanged, such as elections or the legislative process.
 Market failure can be solved using private market solutions, government-imposed
solutions, or voluntary collective actions.

2. Discuss the key reason for the market failure in Sierra Leone in year 1980. (1 mark)
The Sierra Leone economy declined sharply in the 1980s.
Following instability: - declining per capital incomes, high inflation, low domestic
revenue, weak fiscal.
Creation of growth in the midst of monopolistic environment artificially established
through corrupt governance structure.

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 Explanation
Sierra Leone, market failures have resulted in the country's lagged state of development,
with bleak scope for the creation of growth in the midst of monopolistic environment
artificially established through corrupt governance structure. An examination of market
failure, focusing on the health service system in Sierra Leone. Market failure in the
country's health service system is a real concern, and has gone unchecked for decades by
successive governments. In view of the prevailing conditions, is noted that government
failure is to be blamed for poor conditions experienced in the health sector. The issue of
squeezed funding for management of the health service system must be revisited in order
to address critical health concerns in the country. Most important is the continued rent
seeking that health professionals have thrived on as a free-riding venture, increasing their
profit share, while depriving the poor and needy of affordable services in state-funded
hospitals and healthcare centers. Moreover, imperfect competition distorts market
condition and leads in the inefficient allocation of resources, in Sierra Leone imperfect
competition was the one reason for market failure. Externalities, natural monopoly were
also one of the big reasons of market failure in Sierra. Asymmetric information can be
considering one of the reasons of market failure because one agent in a market
transaction is better informed than other.

3. According to McMillan (2002), discuss how the economy can maintain good market.
(1 mark)
As per McMillan, for an economy to maintain a good market, the information should
flow smoothly. The economy should protect property rights and people must fulfill their
promises. The citizens should be trustworthy. The externalities should be in a limit and
the government should promote competition. Finally, to maintain good market, the
government must be strong as well.

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 4. As per the article discuss the consequences on corruption on Sierra Leone during
2017-18. (2 marks)
Sierra Leone had to face the following consequences of corruption:
a) Market became highly uncompetitive: Due to poor governance, the new entrants
were not able to enter the essential markets. This led to creation of an artificial
monopolistic market system. It led to high level of inflation and low salaries. The
market players who were politically connected prevented competition in the
market by stepping up their influences.
b) Generation of low-level equilibrium: A highly uncompetitive market leads to low
productivity as the new entrants are unable to enter the market. This type of
situation makes it possible for the market players to continue dictating the market
prices. This was evident in rural areas where producers were kept away from the
market. This made it impossible for them to increase for them to increase their
income. This level of corruption led to the collapse of iron and Ore market which
had a knock-on effect on other investors as well. These investors were those who
were not able to find ways from the no trade situation in the market.
c) Creation of sub-optimal delivery of critical investment: The country had low
research potential and the scope of expanding competitiveness through research
innovations also got limited. The potential investors were also scared of hedging
their risks due to high level of corruption in the economy.
d) Market failure reduced the scope for establishment of welfare opportunities:
Market failure created a lagged state of development in the country and also
reduced the scope for creation of growth opportunities. This led to high level of
poverty in the country. Market failure was also witnessed in Sierra Leone by
various watch-dog institutions. The market failure occurred due to the high level
of corruption in every sector of the economy.

5. According to Cunningham (2011: 28-29), there are serious consequences for market
failure by a nation, and particularly in a small and endowed country like Sierra
Leone. Discuss 5 of those consequences that can arise due to market failure. (5
marks)

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 The market failures refer to the inefficiencies that are caused by some of the factors that
move the market from optimal level of outcome. In the given case of small country, such
as Sierra Leone, consequences that can arise due to the presence of market failures are:

a) Poor competition in markets: higher market failure implies more power with some
entities, and less power with other. This leads to establishment of monopolies in
the markets. This reduces the possibility of perfectly competitive market.
b) Unsustainable levels of inflation: A monopolistic system can lead to increase in
prices of basic commodities leading to inflated cost of living for low income
earners
c) Low level of equilibrium: The output that is produced in such markets in the
presence of market failure is less than the optimal level. The price charged by the
firms is high, this makes the equilibrium establish at lower level. Moreover, this
makes it very highly possible for productivity to remain relatively low as
connected players reinforces their influences in the market, thus keeping others
away from entry, while also making it possible for them to continue dictating
market prices.
d) Less Investment: As there are imperfections in the market, the individuals,
households, and business firm are less motivated to make investments are risky,
and the returns are not certain, so the investments in such case are less.
e) Market failure create reduced scope for the establishment of welfare
opportunities: in a country like Sierra Leone, market failures have resulted in the
country's lagged state of development due to dwindling government revenue and
low growth environment for private players. Hence the welfare opportunities in
such nations are very low. There is more poverty, more discrimination and higher
corruption levels. The welfare opportunities in such case are very minimal.

6. Discuss 5 recommendations as how the government of Sierra can overcome with

market failure. (5 marks)
The recommendations about how the government can overcome these failures are:

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 a) Legislative measures: The government should establish strict actions against
discrimination done on the behalf of producers. The rights of consumers should
be protected at all cost, through various policy measures.
b) Setting up of proper taxation system: the taxation system in the nation should be
properly evaluated, and implemented by the government. The taxes should be
progressive in nature, so that more burden in on the higher income people.
c) Well established property rights: The property rights should be established by the
government, so that there is no problem associated with public goods. This will
also reduce the free rider problems.
d) Cooperation with the international entities: the government should establish
favorable terms with the international entities, such as banks, or government of
other nations. This helps in opening up of trade, and economic growth of the
nations.
e) Subsidies: The government should provide subsidies to the producers so that not
all the burden of costs is borne by the consumers. This will increase demand by
households.

7. Why is it often suggested that imperfect information will result in a misallocation of

resources? How can such a misallocation be avoided? (4 marks)
Imperfect information refers to situation where buyers or sellers do not have all the
necessary information to make an informed decision about the price or quality of a
product.

Explanation

Imperfect information is one of the reasons for failure of the current market system in any
economy. It occurs when some agents concerned with a trade of good have more relevant
information than others. There are two forms of these problems: adverse information and
moral hazard. The imperfect information may lead to a misallocation of economic
resources as a result of inefficient decisions taken by the economic agents and firms,
owing to fall down of the whole market structure. Market failure from imperfect

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 information can occur even when there is no intended moral hazard. Information failure
is another, significant, market failure and can occur in two basic situations. Firstly,
information failure exists when some, or all, of the participants in an economic exchange
do not have perfect knowledge. Secondly, information failure exists when one participant
in an economic exchange to as the problem of asymmetric, or unbalanced information.
Hence we can say that in both cases there is likely to be misallocation of resources, with
consumers paying too much or too little, and firms producing too much or too little.
Information failure is common and appears to exist in numerous market exchanges.

Some of the solutions for overcoming these problems are:

a) The misallocation is avoided by government intervention when government
provided information in the market or imposes regulation so that everyone reveals
the full information.
b) The use of strategies like warranties, insurance and advertising by the sellers to
provide information to the consumers about the product quality. It can be
illustrated with the help of the following example: in case of the used car market,
buyers do not have full information about the quality of cars relative to its sellers.
As a result, consumers would be willing to pay a small price, which would be
accepted only the sellers of lemon cars (or defective cars). Thus, only lemon cars
would be traded in this market driving out better quality used cars. This problem
can be solved when sellers of good quality cars provide assurance to the buyers
about the quality in the form of guaranties and insurance.

8. What is the term of imperfect information as used in the Case of Sierra Leone? (1
mark)
Sierra Leone, a country in West Africa, has a special significance in the history of the
transatlantic slave trade as the departure point for thousands of West African captives.
The capital, free town, was founded as a home for repatriated former slaves in 1787.
It suffers from many environmental problems including deforestation, degradation and
fragmentation, the loss of soil fertility, a dramatic decline and loss of biodiversity, air
pollution, and water pollution.

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 Mismanagement and corruption were rife and vast pool of young people lacked
opportunities for education or employment. Against this backdrop a small group of armed
Sierra Leoneans crossed over from Liberia and began to attack border village.
In mid-1994, the Sierra Leone Association of University proposed that women's groups
meet regularly for networking, information sharing and collective action on issues of
common concern. Women's participation is increasingly seen as vital to sustainable
peace. But women are still excluded from political processes and peace agreements do
not address their specific concerns. This first Accord insight documents the roles women
have played in peace processes, what they achieved and how their participation can be
better supported.
Moreover, in case of Sierra Leone economy, the imperfect information is also referred as
government failure. It is due to the presence of failed government system during 1980s
that led to an inefficient use of economic resources thereby dampening economic
development.

9. Suppose in Sierra Leone, raising taxes or borrowing are your only two choices of
financing current expenditures, which would you choose, and why, if you were in
charge of setting policy? (3 marks)
In the case of a temporary increase in government spending, it has been argued that debt
finance is optimal because the small increments in all future tax rates to finance interest
payments involves a smaller excess burden than the single large tax rate increase that
would be required to avoid an initial increase in the national debt. This argument ignores
the excess burden of debt finance that results if the initial capital stock is smaller than
optimal (e.g., because of taxes or capital income). Debt-finance advantage of a small
increase in tax rates can be explicitly balanced against the disadvantage of the excess
burden that arises from additional debt. The analysis shows that, with plausible parameter
values, the excess burden of debt finance is likely to outweigh the advantage of avoiding
a large single tax change and therefore that financing a temporary increase in government
spending by an immediate tax increase is likely to be preferable to debt financing.

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 10. We have learned from this course that the real value of the debt is eroded by
inflation and may be overestimated because of it and other factors. Discuss whether
you feel that the debt will be a major concern during your working lifetime and
retirement why or why not? (2 marks)
Over a life time of the individual, inflation generally increases due to increase in income
levels of the individuals. Inflation leads to higher costs of debts as required interest rates
increase on the debt which reduces the prices of the debt and hence make them less
valuable.

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