1.3

Question 1

what is meant by market failure

Answer 1

when the free market leads to an inefficient allocation of resources

Question 2

what is meant by an externality and give an example

Answer 2

the effect on the third party who is not involved with the transaction. e.g. smoking has a negative effect on those around the smokers, the externality is the others inhaling the smoke.

Question 3

define negative externalities

Answer 3

a negative effect/cost on the third party not involved with the transaction

Question 4

define positive externalities

Answer 4

a positive effect/benefit on the third party not involved with the transaction

Question 5

define private costs

Answer 5

the cost to the consumer or producer only

Question 6

give three examples of private costs in the production of a pencil

Answer 6

the cost of wood
the cost of graphite
the cost of the eraser at the end of the pencil
these are private costs to the producer of the pencil.

Question 7

define external costs

Answer 7

costs to a third party

Question 8

give two examples of external costs in the production of a pencil

Answer 8

• the cost to the environment as trees are cut down for wood

- the emission of CO2 from factories, has external costs on environment

Question 9

define external benefits

Answer 9

benefits to a third party not involved with the transaction

Question 10

define social costs

Answer 10

the private + external cost

Question 11

define social benefits

Answer 11

private + external benefit

Question 12

draw a diagram showing positive externalities in CONSUMPTION

Answer 12

• costs/benefits y axis
• quantity x axis
• two skewed lines going downwards (AD) - top one MSB (marginal social benefit) and bottom one MPB (marginal private benefit)
• one line going up (AS) - MSC (marginal social cost)
• equilibrium (A) at Q1 P1 (MPB) + line going up to MSB (C)
• Q2 P2 at MSB (B) - outward shift from Q1
• welfare loss triangle (>) (CBA)

Question 13

draw a diagram showing negative externalities in CONSUMPTION

Answer 13

• 2 skewed AS lines, bottom one MSB and top one MPB
• AD line, MSC = MPC
• Equilbrium (C) Q1 P1 with line going up to MPB from MSC (B)
• inward shift to Q2 P2 (A)
• welfare loss (

Question 14

draw a diagram showing positive externalities in PRODUCTION

Answer 14

• two skewed AD lines, top one MPC and bottom one MSC
• one AS curve MPB = MSB
• (free market) equilibrium Q1P1 at MPC (A)
• outward shift Q2P2 (socially optimum eq) to MSC (B) with line continued to MPC (B)
• welfare loss triangle (

Question 15

draw a diagram showing negative externalities in PRODUCTION

Answer 15

• two skewed AS lines, top one MSC bottom one MPC
• one AD line MSB
• (free market) equilbrium Q1P1 MPC (A), line continued up to MSC (C)
• inward shift Q1P2 (socially optimium equilibrium) to MSC (B)
• welfare loss triangle (BCA)

Question 16

on all diagrams make sure you label free market and socially optimum equilbrium

Answer 16

free market equilbrium - Q1P1

socially optimum equilbrium - p2q2

Question 17

define and give examples of a merit good

Answer 17

a good which has positive externalities in consumption, such as education, vaccination

Question 18

define and give examples of a demerit good

Answer 18

a good which has negative externalities in consumption, such as cigarrettes

Question 19

define private goods

Answer 19

goods that are provided by the free market

Question 20

in what way are externalities a case of market failure?

Answer 20

externalities means that the socially optimum market equilbrium is different to the free market equilbrium. this means that some goods are over/under produced and consumed leading to an market failure

Question 21

what are missing markets

Answer 21

markets for goods which are not provided by the free market because they are not profitable to provide because of the free rider problem

Question 22

define and give examples of public goods

Answer 22

goods that are non-excludable and non-diminishable such as street lamps

Question 23

what is the difference between a merit and a public good

Answer 23

a merit good has positive externalities in consumption, but a public good is non-excludable and non-diminishable. merit goods are underconsumed and underprovided by the market mechanism, whereas public goods are not provided at all

Question 24

what is meant by asymmetric information

Answer 24

where a party in a transaction has more or superior infomration compared to another

Question 25

give three examples of markets with asymmetric information

Answer 25

• second hand car sales
• housing market
• life insurance

Question 26

in what way does information gaps give rise to market failure?

Answer 26

they restrict the ability of consumers and producers to make rational choices, which may lead to an inefficient allocation of resources

Question 27

how does asymmetric information give rise to adverse selection?

Answer 27

adverse selection is a situation in which sellers have more information than buyers have, or vice versa, about some aspect of product quality. Adverse selection occurs when asymmetric information is exploited.

adverse selection is also a situation in which a person at risk is more likely to take out insurance

Question 28

how does asymmetric information give rise to moral hazard?

Answer 28

moral hazard is a situation in which a person who has taken out insurance is prone to taking more risk. this is a second type of information gap.