1.3 Market Failure

Question 1

Market failure

Answer 1

= occurs when the free market fails to allocate scarce resources at socially optimum level (efficiently) = net welfare loss to society

Question 2

Types of market failure

Answer 2

Externalities: cost/benefit a third party receives from an economic transaction they are not directly involved in = leads to over or under production of goods = resources aren’t allocated efficiently (car pollution, healthcare)

Under-provision of public goods: public goods are non-rivalry & non-excludable = under provided by private sector (free-rider problem = not profitable) & therefore under-provided (streetlights)

Information gaps: economic agents don’t always make rational decisions (producers on cost & revenue, gov on costs & benefits of each decision) = resources not allocated to maximise welfare (complex pension schemes)

Question 3

Private costs/benefits vs external costs/benefits vs social costs/benefits

Answer 3

Private costs/benefits = costs/benefits to the producer/consumer directly involved in the economic transaction

External costs/benefits = costs/benefits to third parties not directly involved in the economic transaction

Social costs/benefits = costs/benefits to society

Social costs/benefits = private costs/benefits + external costs/benefits

Question 4

Merit good vs demerit good

Answer 4

merit good = good with external benefits, where benefit to society greater than benefit to individual (tend to be underprovided by free market)

demerit good = good with external costs, where cost to society greater than cost to individual (tend to be over-provided by free market)

Question 5

Use diagram to illustrate external costs of production using marginal analysis (negative externalities)

Answer 5

= social costs greater than private costs, market ignores external costs involved in producing good & produces at MPB=MPC (market equilibrium at Q1P1)

costs to society higher than benefits to society = loss of welfare (shaded area)
external cost at Q1 = AB.

economy should produce where MSB=MSC (social optimum position at Q2P2)

difference between marginal social cost & marginal private cost increases as output grows (external costs grow the more people do something)

Question 6

Use diagram to illustrate external benefits of consumption using marginal analysis (positive externalities)

Answer 6

= social benefits greater than social costs.
Market produces at MPB=MPC, doesn’t consider benefits to society (produces at social optimum position at Q1P1)
If market considers all benefits, it would produce where MSB=MSC (at Q2P2. The failure of the market to consider the external benefits has led to the misallocation of resources and so there is an underproduction of Q1-Q2. This leads to a welfare loss of the shaded area. The line AB represents the external benefit. Again, the difference between marginal private benefit and marginal social benefit grows since external benefits grow the more people that undertake the activity, for example the external benefits of vaccinations are larger the more people that have the vaccination. ​Healthcare and education are two examples of positive consumption externalities

Question 7

Impact of externalities on economics agents (successful gov intervention)

Answer 7

• pollution on consumers due to negative externalities from overconsumption of cars (over 4000 ppl die every yr due to poor air quality in London)
• so gov introduced congestion charge £11.50 to encourage consumers to take alternative methods eg. Cycling, public transport) , reduced traffic in congestion zone by 27% = car market in London moved closer to socially optimum point

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Question 8

Government intervention for externalities in various markets

Answer 8

• indirect taxes (on goods with negative externalities) & subsidies (on goods with positive externalities) to move production closer to social optimum position
• tradable pollution permits (firms can trade to make money, incentive & reduced total level of pollution)
• provision of (public) goods (if social benefits are very high, through taxation eg. healthcare, education)
• provision of information (fill information gaps to help economic agents make informed decisions & acknowledge all externalities)
• regulation (limit consumption of goods with negative externalities eg. ban smoking advertising)

Question 9

Non-rival

Answer 9

= consumption of a good / service by one person doesn’t stop someone else using it or reduce the benefit derived from the good / service to other people

(Supply not affected by consumption)

Eg. Clean air, public safety, streetlights

Question 10

Non-excludable

Answer 10

= benefit derived from a good / service can’t be excluded from certain individuals

= can’t stop someone using a good / service

Question 11

Public vs private goods

Answer 11

Private goods are rival and excludable

Public goods are non-rival & non-excludable (many benefits to society, positive externalities, but under provided eg. streetlights)

Question 12

The free rider problem (why public goods may not be provided by the private sector)

Answer 12

Free rider problem = those who don’t pay for a good/service can still enjoy the benefits derived from it as it is non-excludable

Private sector producers won’t provide public goods as not as profitable (non-excludability) = if provision of public goods was left to market(price) mechanism, they would be under-provided, so they are ​provided by the government​ & financed through taxation.

Question 13

Symmetric vs asymmetric information

Answer 13

Symmetric information = consumers & producers have potential access to the same information (markets with high levels of transparency)

Asymmetric information = consumers & producers have access to different levels of information (one has more knowledge than the other, usually the producer so take advantage & charge higher prices), information gap

Question 14

How imperfect market information (information gaps) may lead to misallocation of resources

Answer 14

• information gap (advertising) = consumers don’t buy goods / services to maximise welfare, underconsumption of merit goods (consumer demand may be too high or low = price & quantity not at social optimum position) & economic agents cant make rational decisions
  Eg. Education
  Government intervention required

BUT increase in tech reduce information gaps as economic agents have access to more info

Question 15

Examples of information gaps

Answer 15

• drugs (consumers dont understand/see long term health problems)
• pensions (young ppl dont see long term benefits of paying into pension schemes)
• financial services (suppliers have more information than consumers so abuse customers for own benefit)