1.3

Question 1

When does market failure occur?

Answer 1

When the free market fails to allocate resources to the best interests of society. (inefficient allocation of scarce resources)
Economic and social welfare is not maximised.

Question 2

What are the 3 types of market failure?

Answer 2

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

Question 3

What is an externality?

Answer 3

The cost or benefit a third party receives from an economic transaction outside of the market mechanism.
Can be positive (external benefits)
or negative (external costs)

Question 4

Why is it hard to determine the extent to which the market fails with externalities?

Answer 4

• hard to determine what the monetary value of the externality is.
• for example, hard to decide what the cost of pollution to society is.

Question 5

What is a private cost?

Answer 5

costs to the economic agents involved directly in an economic transaction.
For example, the rent, cost of machinery and labour, paying for raw materials.

Question 6

What is a social cost?

Answer 6

private cost plus external cost
Cost to society as a whole

Question 7

What is a private benefit?

Answer 7

• consumers are concerned with the private benefit derived from consuming a good. The price the consumer is prepared to pay determines this.
• could also be a firms revenue from selling a good.

Question 8

What is a social benefit?

Answer 8

private benefits plus external benefits.

Question 9

What is the social optimum position?

Answer 9

MSC=MSB
Point of maximium welfare

Question 10

Draw external costs of production diagram:

Answer 10

• The market equilibrium where supply = demand ignored these negative externalities and leads to over- provision and under-pricing.
• External costs shown by distance between MSC and MPC.

Question 11

What is the area of deadweight welfare loss?

Answer 11

social costs> private benefits (triangle)

Question 12

Draw external benefits of consumption diagram:

Answer 12

Example: decline of diseases due to vaccination programmes.
- Since consumers do not account for them, they are under consumed in the free market MSB>MPB. This leads to market failure.

Question 13

What is the area of welfare gain?

Answer 13

social benefits> private costs

Question 14

How can the government help negative externalities?

Answer 14

Indirect taxes
subsidies- encourage consumption of merit goods.
regulation
provide good directly
provide information
carbon allowances

Question 15

How do indirect taxes help externalities?

Answer 15

• reduce the quantity of demerit goods consumed.
• increases the price of the good.
• if the tax is equal to the external cost of each unit, then supply becomes MSC rather than MPC.
• free market equilibrium becomes the socially optimum equilibrium.

Question 16

How does regulation help externalities?

Answer 16

• enforce less consumption of a good.
• bans could be enforced for harmful goods.
  HOWEVER:
• bans are only useful where MSC> MPB

Question 17

How does personal carbon allowances help externalities?

Answer 17

• They could be tradeable, so firms and consumers can pollute up to a certain amount, and trade what they do not use.

Question 18

What is an example of a public good?

Answer 18

street lights and flood control systems

Question 19

What are public goods?

Answer 19

non- excludable (by consuming the good, someone else is not prevented from consuming the good as well)

non rival (the benefit other people get from the good does not diminish if more people consume the good.

Question 20

What is the free- rider problem?

Answer 20

People who do not pay for the good still receives benefits from it, the same way people who pay for the good do.

This is why public goods are underprovided by the private sector: they do not make a profit from providing the good.

Question 21

Why else are public goods underprovided?

Answer 21

difficult to measure the value consumers get from public goods, so it is hard to put a price on the good.

Question 22

What are private goods?

Answer 22

rival and excludable.
For example: a chocolate bar can only be consumed by one consumer.

Question 23

What are quai public goods?

Answer 23

They are partially provided by the free market.
- semi- excludable and semi-non-rival.

Question 24

What is symmetric info?

Answer 24

consumers and producers have perfect market information to make their decision.

Question 25

What is asymmetric information?

Answer 25

• leads to market failure
• unequal knowledge between consumers and producers.
• Example: a car dealer might know about a fault with the car that the consumer is unaware of.

Question 26

What is imperfect information?

Answer 26

information is missing, so an informed decision cannot be made.
This leads to a misallocation of resources.
Consumers might pay too much or too little.

Question 27

How is asymmetric information linked with principal agent problem?

Answer 27

Managers might choose to make a personal gain, rather than maximise the dividends of the shareholders.

Question 28

How does asymmetric info lead to moral hazard?

Answer 28

• when a party with superior knowledge alters their behaviour which benefits themselves whilst disadvantaging the party with inferior knowledge.