1.3 Market Failure

Question 1

market failure

Answer 1

• when the free market fails to allocate scarce resources efficiently, causing a loss in social welfare
• there’s either under or over-provision of the good/service, so resources aren’t allocated efficiently
• can be positive (e.g. education) or negative (e.g. cigarettes) and on production or consumption

Question 2

types of market failure - externalities

Answer 2

• a cost/benefit to a third party not involved in the economic transaction (spillover effect)
• it leads to over/under production of goods, so resources aren’t allocated efficiently

Question 3

types of market failure - under-provision of public goods

Answer 3

• public goods are non-excludable and non-rival, so they’re under-provided by the free market due to the free-rider problem
• i.e. less opportunity for sellers to make economic profits from providing public goods
• e.g. streetlights

Question 4

types of market failure - information gaps

Answer 4

• information gaps distort market outcomes, resulting in market failure
• can occur due to imperfect knowledge (lack of knowledge) or asymmetric info (when one party has more info than the other)

Question 5

externalities

Answer 5

• an external impact (cost or benefit) on a third party not involved in the economic transaction;
• positive externality of consumption; consumption of electric vehicles reduce C02 emissions
• positive externality of production; the construction / operation of an airport will benefit local businesses because of the increased accessibility
• negative externality of consumption; consumption of alcohol increases antisocial behaviour
• negative externality of production; production of electricity increases air pollution

Question 6

private, external, and social costs

Answer 6

• private cost; cost to the individual, i.e. what the producer pays to sell and what the consumer pays to buy a good/service
• external cost (negative externality); the costs to a third party not involved in the economic activity
• social cost; full costs to society, i.e. private + external costs

Question 7

private, external, and social benefits

Answer 7

• private benefit; benefit to the individual, i.e. revenue gained for the producer and the satisfaction of consumption for the consumer
• external benefit (positive externality); the benefits to a third party not involved in the economic transaction
• social cost; full benefits to society, i.e. private + external benefits

Question 8

externalities diagrams

Answer 8

• shows MPB and MSB (benefit to individual and society of an extra unit consumed) on the demand curve
• shows MPC and MSC (cost to individual and society of an extra unit consumed) on the supply curve
• production externality; 2 supply curves
• consumption externality; 2 demand curves
• positive externality; shift outwards (right)
• negative externality; shift inwards (left)
• welfare gain; above supply curve
• welfare loss; above demand curve
• free market equilibrium; MPB = MPC
• social optimum level; MSB = MSC

Question 9

negative production externality

Answer 9

• diagram 1
• supply shifts inwards to reduce welfare loss
• market is failing due to over-provision of the (demerit) good/service as the producers only consider private costs
• if external costs were considered, output would decrease to the social optimum level and price would rise
• e.g. noise pollution from airplanes, external costs of fertilisers and pesticides used in farming (e.g. soil contamination), etc.

Question 10

positive consumption externality

Answer 10

• diagram 2
• demand shifts outwards to increase welfare gain
• market is failing due to under-provision of the (merit) good/service as the consumers only consider private benefits
• if external benefits were considered, output would increase to the social optimum level and price would rise
• e.g. healthcare, education, etc.

Question 11

govt. intervention with externalities

Answer 11

• indirect taxes and subsidies; taxes can be put on goods with negative externalities and subsidies on goods with positive externalities, to help internalise the externalities, moving production closer to the social optimum level
• tradeable pollution permits; imposed on firms with negative externalities to limit their production of pollution
• provision of the good; when social benefits are very high, the govt. may provide the good through taxation, e.g. with education and healthcare
• provision of information; the govt. can help provide info to reduce information gaps, which are associated with some externalities, as it can help people acknowledge external costs
• regulation; this can limit consumption of goods with negative externalities, e.g. banning advertising of smoking
• however, it’s hard to quantify the externality and identify the social optimal level, so the govt. regulation may be ineffective if they under-estimate it

Question 12

impact of negative externalities on economic agents

Answer 12

• obesity; increased costs for NHS - £6billion a year
• alcohol; increased costs for NHS, as well as the police and council (due to the behaviour of drunkards - higher crime)
• smoking; increased costs for NHS, and increased air pollution

Question 13

impact of positive externalities on economic agents

Answer 13

• education; higher skills means people have better jobs so they bring greater economic value to their community; e.g. higher skills means more doctors, which help many
• healthcare; private treatment, e.g. vaccinations, help many others as it prevents spread of the disease
• public transport; e.g. taking a train reduces congestion for other travellers (more space on roads)

Question 14

public goods

Answer 14

• goods that are beneficial to society but won’t be provided by the free market, as they’re;
• non-excludable; consumers can’t be excluded from using the product
• non-rivalry; one person’s use of the good doesn’t stop someone else from using it
• so, the govt. will often provide these beneficial goods themselves
• e.g. street lights

Question 15

quasi public goods

Answer 15

• goods which are semi non-excludable (it’s hard but possible to exclude customers) and semi non-rival (up to a certain point, consumption of the good doesn’t limit availability for another person)
• e.g. roads - semi-excludable due to tolls, and semi-rivalry as congestion causes issues

Question 16

private goods

Answer 16

• goods sold through the private sector, which are;
• excludable; anyone who can’t purchase goods is excluded from consumption
• rivalry; consumption by an individual prevents other individuals consuming the same good)
• most goods are private goods
• e.g. mobile phones

Question 17

free rider problem

Answer 17

• since public goods are non-excludable, you can’t charge an individual for the provision of the good, as someone else will gain the benefit from it without paying anything
• a free rider is someone who receives the benefits without paying for it
• this causes under-provision in a free market as private sector firms won’t provide public goods since they won’t make a profit, and this causes market failure so public goods are provided by the govt. and financed through taxation

Question 18

information gaps - symmetric and asymmetric information

Answer 18

• info gaps occur when people have inaccurate / incomplete data needed to make an informed decision
• advertising leads to info gaps as it can change attitudes of consumers to encourage them to buy the good
• increases in technology can decrease info gaps as people can get more info
• e.g;
• drugs, where users don’t see the long-term issues
• nutritional content in food
• pensions, where young people don’t see the long-term benefits of paying into pension schemes

Question 19

symmetric and asymmetric information

Answer 19

• symmetric info occurs when buyers and sellers have access to the same info
• asymmetric info is when one party has superior knowledge compared to the other
• usually the seller has more info than the buyer, so they can exploit their lack of knowledge by charging a higher price, e.g. in the used car market, sellers know more about the vehicle than buyers

Question 20

imperfect information and market failure

Answer 20

• perfect information; when every market participant has complete knowledge
• imperfect information; when either the buyer or seller has incomplete information
• imperfect info leads to market failure due to a misallocation of resources, as people don’t buy things that maximise their welfare
• this can lead to under-provision or over-provision of a good, so price and quantity aren’t at the social optimum position
• the govt. can intervene to correct this market failure through indirect taxes (over-consumption), subsidies (under-consumption), provision of info, and regulation

Question 21

asymmetric info - insurance markets

Answer 21

• 2 aspects of asymmetric info in these markets;
• moral hazards; when consumers will take greater risks as they know a claim will be paid for by their insurance cover (consumer knows more about their intended actions than the producer)
• adverse selection; those most likely to purchase it are those who will most likely use it, e.g. smokers, drinkers, etc. for health insurance - the insurance company knows this, so raises average price of insurance cover, which prices healthy consumers out of the market (market failure)