1.3 Market Failure

Question 1

Market Failure

Answer 1

Occurs when the market fails to allocate scarce resources efficiently, causing a loss in social welfare

Question 2

Types of Market Failure

Answer 2

Externalities
Under Provision of Public Goods
Information Gaps

Question 3

Externalities

Answer 3

An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism
Spillover effect of the production/consumption of a good/service
Leads to the over/under production of goods meaning resources are not allocated efficiently

Question 4

Types of Externalities

Answer 4

Private Cost/Benefits
Social Costs/Benefits
External Costs/Benefits

Question 5

Private Costs/Benefits

Answer 5

Costs/Benefits to the individual participating in the economic activity
Demand curve represents private benefits and the supply curve represents private costs

Question 6

Social Costs/Benefits

Answer 6

Costs/Benefits of the activity to society as a whole

Question 7

External Costs/Benefits

Answer 7

Costs/Benefits to a third party not involved in the economic activity

Question 8

Merit Good

Answer 8

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 9

Demerit Good

Answer 9

Good with external costs, where the cost to society is greater than the cost to the individual
Tend to be over-provided by the free market

Question 10

Externalities Diagram

Answer 10

Look at marginal costs and benefits

Question 11

Marginal Costs/Benefits

MPX (Marginal Private X)
MSX (Marginal Social X)

Answer 11

Extra cost/benefit of producing/consuming one extra unit of the good

MPB is the extra satisfaction gained by the individual from consiming one more of a good
MSB is the extra gain to society from the consumption of one more good
MPC is the extra cost to the individual from producing one more of the good
MSC is the extra cost to society from the production of one more good

Question 12

Negative Production Externalities

Answer 12

Question 13

Positive Consumption Externalities Diagram

Answer 13

Question 14

Government Intervention

Answer 14

Indirect Taxes and Subsidies
Tradable Pollution Permits
Provision of the Good
Provision of Information
Regulation

Question 15

Government Intervention

Indirect Taxes and Subsidies

Answer 15

Taxes can be put on goods with negative externalities and subsidies on goods with positive externalities
These help to internalise the externalities, moving production closer to the social optimum position

Question 16

Government Intervention

Tradable Pollution Permits

Answer 16

Allow firms to produce up to a certain amount of pollution, and can be traded amonsts firms to give them the choice whilst reducing total level of pollution

Question 17

Government Intervention

Provision of the Good

Answer 17

When social benefits are high, the government may decide to provide the good through taxation
They do this with healthcare and education

Question 18

Government Intervention

Provision of Information

Answer 18

Since some externalities are associated with information gaps, the government can provide information to help people make informed decisions and acknowledge external costs

Question 19

Government Intervention

Regulation

Answer 19

This could limit consumption of goods with negative externalities
E.g. banning advertising of smoking etc.

Question 20

Public Goods

Answer 20

Public goods are missing from the free market, but offer many benefits to society

They are non-rivalrous and non-excludable

Non-rivalrous - one person’s use of the good does not stop someone else from using it
Non-excludable - you cannot stop someone from accessing the good and someone cannot choose not to access the good

Question 21

Free Rider Problem

Answer 21

You cannot charge an individual a price for the provision of a non-excludable good because someone else will gain benefit from it without paying anything
A free rider is someone who receives benefits without paying for it

Question 22

Public Goods

Private Sector

Answer 22

Private sector producers will not provide public goods to people because they cannot be sure of making a profit, due to the non-excludability of public goods. Therefore, if the provision of public goods was left to the market mechanism, the market would fail and so they are provided by the government and financed through taxation

Question 23

Information Gaps

Answer 23

Symmetric Information
Asymmetric Information
Advertising
Misallocation of resources

Question 24

Symmetric Information

Answer 24

Where buyers and sellers have potential access to the same information
Perfect information
Many decisions are based on imperfect information and so economic agents are unable to make an informed decision; they suffer from information gaps

Question 25

Asymmetric Information

Answer 25

When one party has superior knowledge compared to another
Usually, the seller has more information than the buyer and this means they can take advantage of the other party’s lack of knowledge, by charging them a higher price

Question 26

Advertising

Answer 26

Leads to information gaps as it is designed to change attitudes of the consumers to encourage them to buy the good
Could cause them to think the benefits are greater than they actually are
Increases in technology means information gaps are on the decline as people can get more information

Question 27

Misallocation of resources

Answer 27

Information gaps lead to market failue as there is a misallocation of resources because people do not buy things that maximise their welfare
It means that consumer demand for a good or producer supply of a good may be too high or too low thus price and quantity are not at the social optimum position
Economic agents are unable to make rational decisions due to the information gaps

Question 28

Principal Agent Problem

Answer 28

When the goals of the principle (the person who gains/loses from the decision) are different from the agents (those making decisions on behalf of the principle)

E.g. education where the child is the principle and the agents are parents/governments. The child has imperfect information as they do not see the benefits of education and so therefore will devote too few resources to education, if allowed.