1.3 Market Failure

Question 1

Define market failure

Answer 1

A situation in which the free-market does not lead to an optimum allocation of resources

Question 2

Define an externality

Answer 2

A cost or a benefit that is external to a market transaction, and is thus not reflected in market prices

Question 3

How can externalities lead to market failure?

Answer 3

If the externalities are not reflected in the price, decisions regarding consumption and production will not be aligned with the best interest for society

Question 4

How can information gaps lead to market failure?

Answer 4

Without sufficient information, buyers and sellers may not make a decision rationally.

e.g.- buyers may not know the harmfulness of smoking, so resources will keep being allocated to cigarettes.

Question 5

How can public goods lead to a market failure?

Answer 5

There is no obvious way that a firm could charge the user of a public good, such that street lighting, because we cannot measure the benefit everyone gets from these goods.

Question 6

What is a merit good?

Answer 6

Goods with positive externalities

Question 7

What is a demerit good?

Answer 7

Goods with negative externalities

Question 8

How can the idea of merit goods and demerit goods be used in market failure?

Answer 8

Merit goods are often under-consumed and demerit goods are often over-consumed, leading to a sub-optimal allocation of resources

Question 9

Define positive externality of consumption

Answer 9

When the consumption of a good causes a benefit to a third party

Question 10

Define negative externality of production

Answer 10

When production causes external costs on a third party outside of the market, for which no appropriate compensation is made

Question 11

What are private costs?

Answer 11

A cost that is incurred by the individual/firm that has produced the product or service

Question 12

What are external costs?

Answer 12

A cost created by an individual’s economic activities that is experienced by a third party and is not reflected in the market price.

Producers tend to ignore these.

Question 13

What are social costs?

Answer 13

Social cost = Private cost + External costs

Question 14

When do negative externalities of production occur?

Answer 14

When social costs exceed private costs, which shows an external cost must be present

Question 15

Define marginal social costs

Answer 15

The cost to society of producing an extra unit of a good

Question 16

What does a negative externality of production look like on a diagram?

Answer 16

• MSC exceeds MPC
• MSB=MPB (assuming there is no externality of
  consumption)
• Equilibrium delivered by a free-market is when
  MPC=MPB (allocative inefficiency)
• Social optimal equilibrium is when MSC=MSB
• Social welfare loss is the triangle created between
  MSC and MPC up from the free-market equilibrium

Question 17

When does a positive externality of consumption occur?

Answer 17

When the social benefit exceeds the private benefit, showing an external benefit is present

Question 18

How do you calculate social benefit?

Answer 18

Social benefit = Private benefit + External benefit

Question 19

What type of goods are displayed on a positive externality of consumption diagram?

Answer 19

Merit goods (under-produced and under-consumed)

Question 20

What does a positive externality of consumption look like on a diagram?

Answer 20

• MSB exceeds MPB
• MSC=MPC (assuming there are no externalities of
  production)
• Equilibrium delivered by the free-market is when
  MPC=MPB
• Social optimal equilibrium is when MSC=MSB
• Social welfare loss is the triangle created between
  MPB and MSB up from the free-market equilibrium

Question 21

Why is the positive externality of consumption diagram a normative judgement?

Answer 21

Not everyone will agree on the extent that a merit good has a MSB, hence, you must make a judgement

Question 22

How is global warming an externality?

How must this be solved?

Answer 22

Richer countries on average produce the most carbon emissions, however, the worst off countries suffer the consequences.

It can only be solved with international cooperation, because all countries contribute to global warming.

Question 23

How is acid rain an externality, using a real life example?

Answer 23

Due to pollution in many European countries, Scandinavian countries have suffered acid rain.

Forest fires left to burn in Indonesia had led to acid rain in Singapore and Malaysia.

Question 24

How can river water create externalities?

Answer 24

If one area increases its use of water, further downstream, other areas will suffer more.

If a river is polluted, this may affect those who rely on it downstream.

Question 25

How can congestion in London create externalities?

How are London authorities trying to combat this and why?

Answer 25

When another motorist decides to undertake a journey, there is the MPC of doing so, but also and extra MSC for all the other drivers who must now wait longer.

They have introduced a congestion charge because it ensures that each driver will face at least some of the social costs they are causing to the other drivers.

Question 26

How can education create positive consumption externalities?

Answer 26

Individuals undertake education because of the private benefits, however, they do not realise the added benefits, because when you are in work, when you are surrounded by productive people, this makes everyone more productive.

Question 27

How can waste disposal and recycling create positive and negative externalities?

Answer 27

Although the MPB of recycling is negligible, the MSB environmentally is much larger.

Equally, though the MPC of sending things to landfill is small, the MSC is much larger.

Question 28

Give some evaluation points of externalities. (3)

Answer 28

• Some aspects we can’t measure accurately
• May not have a market price
• If the equilibrium is not known precisely, then we
  don’t know how large the externality is. Furthermore,
  the government don’t know how much is needed to
  intervene

Question 29

What are the two characteristics of a private good and explain what these mean?

Answer 29

-Excludable= owners can exercise private property
rights, preventing others from using the good
- Rivalry- when one person consumes the good, fewer
of the benefits are available for others

Question 30

Define a public good

Answer 30

A good that is non-excludable and non-rivalry when it is being consumed

Question 31

What is the free-rider problem?

Answer 31

When an individual cannot be excluded from consuming a good, so has no incentive to pay for its provision. This can lead to market failure.

Question 32

How is the problem of public good provision often solved?

Answer 32

Some government intervention may be used to ensure a sufficient quantity of the goods are provided.
This may mean increasing taxes, so the government can sub-contract private firms.

Question 33

What is a semi-public (Quasi) good?

Give some examples.

Answer 33

• Semi-non-rival
• Semi-non-excludable

Park, beach, road.

Question 34

What is the problem of the missing market?

Answer 34

For pure-public goods, firms are not willing to produce a good because of the free rider problem.
Therefore a market for this good may not exist.

Question 35

What is the difference between asymmetric and symmetric information?

Answer 35

Asymmetric info is when one party has access to information that one party doesn’t.

Symmetric info is when all parties in a market have the same info

Question 36

What is the difference in information between two parties known as?

Answer 36

An information gap

Question 37

Give some reasons for information asymmetry. (5)

Answer 37

• Failure to disclose info
• Difficulty in estimating costs and benefits
• Lack of education
• Moral hazard
• Information bias

Question 38

Give ways in which information gaps can be prevented. (5)

Answer 38

• Increasing the supply of info
• Nudging towards more effective decisions
• Increasing demand for info- make it free
• New laws to protect consumers
• More advertisement

Question 39

How can asymmetric info arise in the healthcare sector?

Answer 39

When a patient is told they do not need treatment, they do not know whether it is actually needed, and what price it should cost, whereas medical professionals have much better info.

Question 40

How has there historically been an information gap in the tobacco industry, and how is this being combatted?

Answer 40

Due to sellers not previously conveying all the health dangers of cigarettes, consumers were unaware of these dangers.

Thus, the government required cigarette companies to add health warnings on the packaging.

Question 41

How can an information gap arise in the education sector?

Answer 41

Teachers tend to know a lot more about the curriculum than students, so students may not know why learning something is useful.

Question 42

How can information failure arise in the second-hand car market?

Answer 42

Often the sellers know more about the quality and durability than the potential buyers.

This can create problems for car dealers who don’t know whether to offer high or low prices for a car.

Question 43

How is there information failure in regards to pension schemes?

Answer 43

In younger years, individuals don’t know how much they will need for their pension, so may not prioritise it until its too late.

Question 44

Define adverse selection

Answer 44

A situation in which a person at risk is more likely to take out insurance

Question 45

Define the term moral hazard

Answer 45

A situation in which a person who has taken out insurance is prone to taking more risks.