1.3

Question 1

The main role of the price mechanism in a free-market economy

Answer 1

to allocate scarce resources efficiently.

Question 2

Complete market failure happens when

Answer 2

market does not supply products at all

Question 3

Partial market failure happens when

Answer 3

market functions, but it supplies either the wrong quantity of a product or at the wrong price

Question 4

For markets to operate efficiently

Answer 4

property rights must be protected – perhaps through state regulation

Question 5

Failure to protect property rights may lead to what is known as the Tragedy of the Commons

Answer 5

individuals with access to a public reserve (a common) act in their own self interest and thus ultimately deplete the resource

Question 6

Externalities are defined as

Answer 6

spill-over effects from production and/or consumption to third parties

• can be negative or positive

Question 7

Externalities cause market failure if

Answer 7

The price mechanism does not take account of the social costs and benefits of production and consumption

Question 8

Private costs are the costs faced by

Answer 8

producer or consumer directly involved in a transaction.

Question 9

When negative externalities exist when social costs exceed

Answer 9

Private cost

Question 10

External costs occur when the activity of one agent has a

Answer 10

Negative effect on the well-being of a third party

Question 11

key aspect of all externalities is the difficulty of assigning values:

Answer 11

1. Shadow pricing: monetary value assigned to an abstract or intangible commodity which is not traded in the marketplace e.g. the external cost of road congestion can be calculated by multiplying the number of hours lost by the average wage e.g. 1m lost working hours x £12 average hourly wage = £12m
2. Compensation estimate the cost of correcting an externality e.g. includes the cost of installing double-glazing in houses affected by increased road noise from a new motorway. If 200 houses are affected each with £5,000 double glazing cost, increased road noise is estimated at £1m
3. Revealed preference- how much people are willing to pay to avoid an externality

Question 12

Marginal private cost (MPC)

Answer 12

o Cost to the producing firm of producing an additional unit of output or costs to an individual of any economic action. Private costs are internal costs.

demand curve represents private benefits, supply curve represents private costs

Question 13

Marginal external cost (MEC)

Answer 13

Cost to third parties from the production/consumption of an additional unit of output

Question 14

Marginal social cost (MSC)

Answer 14

• total cost to society of producing an extra unit of output

- MSC = MPC + MEC

Question 15

Marginal external benefit (MEB)

Answer 15

o The benefit to a third party from the production/consumption of an additional unit of something

Question 16

Marginal social benefit (MSB)

Answer 16

o Total benefit to society from consuming an extra unit.

o MSB = MPB + Marginal External Benefit (MEB)

Question 17

Examples of negative externalities from production

Answer 17

• air pollution from factories
• pollution from fertilisers
• industrial waste
• noise pollution
• collapsing fish stocks
• methane emissions

Question 18

If MSC pivots away from MPC, then

Answer 18

Marginal external cost of extra output is increasing

Question 19

When equilibrium is at MSC

Answer 19

price goes up as market has recognised and accommodated for negative externalities such as pollution

Question 20

social welfare loss is when market output (q1)

Answer 20

is higher than the optimum social position (q2)

Question 21

Negative externalities from consumption

Answer 21

• noise pollution from neighbours
• air pollution from smokers
• vehicle pollution
• litter from tourists
• spillover costs from rising levels of obesity

Question 22

Positive externalities exist when third parties

Answer 22

benefit from the spill-over effects of production/consumption e.g. the social returns from investment in training or the positive benefits from health care/medical research.

Question 23

Social benefit =

Answer 23

private benefits plus external benefits

Question 24

If there are negative externalities, then we must add the external costs to the firm’s

Answer 24

supply curve to find the marginal social cost curve (MSC).

Question 25

If there are positive externalities, then we must add the external benefits to the demand curve

Answer 25

demand curve (i.e. the marginal private benefit (MPB) curve) to find the marginal social benefit curve (MSB).

Question 26

if market ignores positive externalities,

Answer 26

then there'll be underconsumption, leading to a misallocation of resources

Question 27

Marginal private benefit (MPB):

Answer 27

benefit to the consumer of consuming an additional unit of output

Question 28

Marginal external benefit (MEB)

Answer 28

benefit to third parties from the consumption of an additional unit of output

Question 29

Marginal social benefit (MSB)

Answer 29

total benefit to society of consuming an extra unit of output. MSB = MPB + MEB

Question 30

With positive (consumption) externalities, marginal social benefit is

Answer 30

higher than marginal private benefit

Question 31

Examples of positive consumption externalities

Answer 31

- health programmes - bike schemes - free school meals

Question 32

social optimum is where msb =

Answer 32

msc

Question 33

negative externalities means MSC has

Answer 33

a higher gradient than MPC

Question 34

A private good or service has three main characteristics:

Answer 34

Excludable Rival in consumption Rejectable

Question 35

excludable?

Answer 35

excludability gives seller the chance to make a profit, buyers can be excluded if they are not willing and able to pay for it

Question 36

Non rivalrous?

Answer 36

One person’s use of a good does not prevent others from being unable to benefit and consume the good

Question 37

rejectable?

Answer 37

The consumer can reject private goods and services if their needs and preferences or their budget changes.

Question 38

What are the key features of pure public goods?

Answer 38

- non excludability - (could cause a free rider problem) - non-rivalrous - non rejectable (eg, nuclear defence system)

Question 39

It is up to the government to decide what, and how?

Answer 39

output of public goods is appropriate for society. | Estimate the net social benefits from making public goods available.

Question 40

do governments have to provide public goods?

Answer 40

NO, They might finance them but leave delivery to the private sector.

Question 41

Pure public goods are not normally provided by the private sector because

Answer 41

free rider problem, so no revenue for firms

Question 42

A quasi-public good is a

Answer 42

near-public good

Question 43

features of quasi public goods

Answer 43

- Semi-non-rival, ie it is public up to a point | - Semi-non-excludable, ie it is possible but difficult or costly to exclude non-paying consumers

Question 44

The Free-Rider Problem

Answer 44

The free rider problem leads to non-provision of a pure public good and thus causes pure market failure.

Question 45

For markets to work, there needs to be symmetric information

Answer 45

i.e. consumers & producers have the same knowledge about products, they know everything there is to know about the effects of consuming them

Question 46

Asymmetric information is when information does exist but

Answer 46

there is an imbalance in information between buyer and seller which can distort their choices

Question 47

chain of reasoning if car sellers know more than buyers

Answer 47

- sellers know more about quality - buyers can't tell quality - buyers will offer average price for all cars - typically lower than sellers perceived value - sellers may remove good vehicles from sale - average quality of cars drop - buyers no longer buy at previous prices = higher risk of market disappearing

Question 48

Moral hazard occurs when

Answer 48

insured consumers are likely to take greater risks, knowing that a claim will be paid for by their cover.

Question 49

if consumers had better/fuller information on the benefits to themselves of consuming a good

Answer 49

marginalprivate benefit curve would shift lower leading to a smaller equilibrium quantity. = possible market failure

Question 50

screening

Answer 50

finding out as much as possible about another agent in a transaction

Question 51

three main types of market failure:

Answer 51

- externalities - under-provision of public goods - information gaps

Question 52

externalities

Answer 52

an externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism. (define) spill over leads to over/under production of goods, meaning resources aren't allocated efficiently

Question 53

under provision of public goods

Answer 53

public goods are non-rivalry and non-excludable, meaning they are underprovided by the private sector due to the free rider problem. market is unable to ensure enough of these goods are provided, eg streetlights

Question 54

information gaps

Answer 54

homo economicus assumed to have perfect info, just like firms, so are assumed to make completely rational decisions. BUT, agents do not always make rational decisions and so resources are not allocated to maximise welfare. eg, 2nd hand goods

Question 55

when there are asymmetric markets

Answer 55

government provides information to allow people to make informed decisons, like smoking and drinking

Question 56

a merit good is

Answer 56

a good with external benefits, where the benefit to society is greater than the benefit to the individual, tend to be underprovided by the free market

Question 57

a demerit good is

Answer 57

good with external costs, where the cost to society is greater than the cost to the individual, tend to be overprovided by free market

Question 58

negative externalities of production occur when

Answer 58

social costs are greater than private costs

Question 59

economy should produce at

Answer 59

MSB=MSC, the social optimum position at Q2P2, difference between MSC and MPC increases at output grows, because external costs grow the more that people do something (think driving)

Question 60

positive externalities of consumption occur when

Answer 60

when social benefits are greater than social costs

Question 61

if market considers all benefits

Answer 61

will produce at MSB=MSC at Q2P2, failure of market to consider external benefits has led to the misallocation of resources so there is an underproduction of Q1-Q2, leads to a welfare loss in the shaded area. gap grows as output grows, eg vaccination

Question 62

difficult to work out size of

Answer 62

externality as it tends to be placed on value judgements, since it is difficult to monetise external costs, lots of externalities involved with information gaps, as people are unaware of full implications of their decisions

Question 63

government intervention

Answer 63

``` indirect taxes and subsidies tradable pollution permits provision of the good provision of information regulation ```

Question 64

indirect taxes and subsidies

Answer 64

- taxes can be put on goods with negative externalities and subsidies on goods with positive externalities

Question 65

tradable pollution permits

Answer 65

these allow firms to produce up to a certain amount of pollution, and can be traded amongst firms to give them a choice whilst reducing level of pollution

Question 66

provision of the good

Answer 66

when social benefit is very high, gov may decide to provide the good through taxation, eg, healthcare/education

Question 67

provision of information

Answer 67

since some externalities are associated with information gaps, gov can provide info to help people make informed decisions and acknowledge external costs

Question 68

regulation

Answer 68

this could limit consumption of goods with negative externalities, eg banning smoking ads

Question 69

public goods are non-rivalry + non-excludable

Answer 69

NR - which means that one persons use of the good doesn't stop someone else from using NE - meaning you can't stop someone from accessing the good and someone can not choose to not access the good eg, streetlights, roads are quasi

Question 70

free rider problem

Answer 70

- can't charge an individual a price for the provision of a non-excludable good because someone else will gain the benefit from it without paying anything - private sector producers will not provide public good to people because the cannot be sure of making profit, due to non-excludability of public goods, therefore if proven was left to market mechanism, market would fail

Question 71

what is a free rider

Answer 71

someone that receives the benefits without paying forr them

Question 72

symmetric information

Answer 72

when buyers and sellers have potential access to same info, but many decisions are based on imperfect info and so economic agents are unable to make informed decisions (suffer from information gaps)

Question 73

asymmetric information

Answer 73

when one party has superior knowledge compared to another. usually, the seller has more info than the buyer and this means they can take advantage of the other parts lack of knowledge, by charging them a higher price

Question 74

problems with advertising

Answer 74

leads to info gaps because it is designed to change attitudes of the consumers to encourage them to buy the good, could cause them to think benefits are greater than they are - improvements in technology mean info gap are on the decline

Question 75

info gaps lead to

Answer 75

market failure as there is a misallocation of resources, because people do not buy things that maximise their welfare - means consumer demand/ prod supply too high/low so price and quantity not at social optimum position

Question 76

examples of information gaps

Answer 76

drugs, pension, financial services