1.3 Market Failure

Question 1

What is market failure ?

Answer 1

• an inefficient allocation of resources in a market that occurs when individuals acting in rational self-interest produce a less-than-optimal outcome
• ie. resources are not allocated as efficiently as they could be
• main role of prices in a market economy is to allocate scarce resources efficiently

Question 2

What is complete market failure ?

Answer 2

• occurs when the market does not supply products at all ➡️ there is a missing market (main reason is under-provision of public goods)

Question 3

What is partial market failure ?

Answer 3

• occurs when the market exists, but supplies either the wrong quantity of a product or the wrong price
• incl. negative externalities from production, positive externalities from consumption & info gaps

Question 4

What are externalities ?

Answer 4

• spill over effects from production/consumption for which no appropriate compensation is paid to the third parties affected

Question 5

Why are externalities not reflected in market price ?

Answer 5

• as they lie outside the initial market transactions

Question 6

Why do externalities cause market failure ?

Answer 6

• if the price mechanism does not take into account the full social costs and benefits of production and consumption
• product/service’s price equilibrium does not accurately reflect the true costs and benefits of that product/service

Question 7

What are private costs ?

Answer 7

• the costs faced by the producer or consumer directly involved in a transaction

Question 8

What are external costs ?

Answer 8

🔔 the costs imposed on third parties as a result of a transaction that they are not directly involved in

• occurs when the activity of one group has a negative effect on the wellbeing of a third party ➡️ BUT the consumer and producer don’t have to pay, meaning that output will be too high and therefore the market price is too low (over provision)
• also knows as negative externalities ➡️ social costs exceed private costs

Question 9

What are social costs ?

Answer 9

• private costs + external costs
• 🔔 when negative externalities exist, social costs > private costs

Question 10

What meant when its said economists work ‘at the margin’ ?

Answer 10

• when drawing diagrams, economists consider the impact of one more unit of consumption/production

Question 11

What is meant by marginal private cost (MPC) ?

Answer 11

• cost to the firm of producing an additional unit of output

Question 12

What is meant by marginal external cost (MEC) ?

Answer 12

• cost to third parties from the production of an additional unit of output

Question 13

What is meant by marginal social cost (MSC) ?

Answer 13

• total cost to society of producing an extra unit of output
• MSC = MPC + MEC

Question 14

Examples of negative externalities from production ?

Answer 14

• noise & atmospheric pollution from factories
• air pollution from factories
• pollution from fertilisers
• industrial waste
• noise pollution
• collapsing fish stocks
• methane emissions from farming cows

Question 15

What are positive externalities ?

Answer 15

• exist when third parties benefit from the spill over effects of production/ consumption
• eg. the social returns from investment in training or the positive benefits from health care/medical research

Question 16

What are private benefits ?

Answer 16

• the benefits faced by the producer or consumer directly involved in a transaction

Question 17

What are external benefits ?

Answer 17

🔔 the benefits enjoyed by third parties as a result of a transaction that they are not directly involved in

• occurs when the activity of one group has a positive effect on the wellbeing of a third party ➡️ they are good for third parties but the consumer and producer don’t take this into account meaning that output is TOO LOW and therefore market price will be TOO HIGH (under provision)
• also known as positive externalities

Question 18

What are social benefits ?

Answer 18

• private benefits + external benefits
• 🔔 therefore when positive externalities exist, social benefits > private benefits

Question 19

What is meant by marginal private benefit (MPB) ?

Answer 19

• the benefit to the consumer of consuming an additional unit of output

Question 20

What is meant by marginal external benefit (MEB) ?

Answer 20

• the benefit to third parties from the consumption of an additional unit of output

Question 21

What is meant by marginal social benefit (MSB) ?

Answer 21

• the total benefit to society of consuming an extra unit of output
• MSB = MPB + MEB

Question 22

Examples of positive consumption externalities ?

Answer 22

• health programmes eg. NHS
• early years education eg. nursery provision
• subsidised bikes schemes in urban areas
• public libraries/community spaces
• museums and gallaries
• free school meals/nutritional advise

Question 23

What are public goods and why do they cause market failure ?

Answer 23

• goods that are both non-rival & non-excludable
• they cause market failure due to the problem of missing markets ➡️ private firms will not provide the good as unable to profit from it

🔔 public goods is not one provided by the public sector but instead public sector provision is usually the solution to market failure

Question 24

What are the characteristics of a public good ?

Answer 24

1. Non-excludable: the benefits derived from pure public goods cannot be confined solely to those who have paid for it ➡️ non-payers can enjoy the benefits of consumption at no financial costs 🔔 known as the ‘free-rider’ problem
2. Non-rival: consumption by one consumer does not restrict consumption by other consumer (if it is supplied to one person, it is available to all)
3. Non-rejectable: the collective supply of a public good for all means that people cannot reject it eg. nuclear defence system or major flood defence projects affecting the entire community

Question 25

What are private goods ?

Answer 25

• cover most types of goods
• consumption by one individual means that is it not available for another to use

Question 26

What are the characteristics of private goods ?

Answer 26

1. Excludable: buyers can be excluded from enjoying the product if they are not willing or able to pay for it ➡️ this gives the seller a chance to make a profit (when goods are excludable the owners can exercise property rights)
2. Rival in consumption: one persons consumption of a product reduces the amount left for others to consume and benefit from ➡️ because scarce resources are used up in supplying the product
3. Rejectable: consumers can reject private goods and services if their needs or preferences or their budget changes ❗️eg. you do not like the soup on the menu so you use your money to buy something else

Question 27

What are quasi-public goods ?

Answer 27

• a near public goods (has some characteristics of a public good)➡️ either non-rival or non-excludable but not both

1. Semi-non rival: up to a point, more consumers using a park or road does not reduce the space available for others, BUT beaches can become crowded as do parks/leisure facilities + open-access WIFI networks
2. Semi-non-excludable: it is possible but difficult or costly to exclude non-paying consumers eg. fencing a park or beach and charging an entrance fee or toll booths

Question 28

How do public goods create market failure ?

Answer 28

• if the provision of public goods was left to the market mechanism/private sector then there would be market failure due to the free rider problems (someone who receives the benefit but allows other to pay for it)
• once a public good is provide it is impossible to stop all the people from receiving the benefit of it (non-excludable) therefore very little reason for people to pay for the consumption of the good
• firms will not pay for the good (no profit) and so govts are forced to provide them instead due to the failure of the market
  🔔 public goods are market failure since they are creating missing markets ie. total market failure

Question 29

What is the free-rider problem ?

Answer 29

• as public goods are non-excludable it is difficult to charge people for benefitting once a product is made available
• people who use the good/service once it is provided and do not pay are known as free riders ➡️ they have no incentive to reveal how much they are willing and able to pay for a public good
• the free rider problem leads to under-provision of a good and therefore causes market failure ➡️ the good is not provided at all by the private sector because they would be unable to supply it for a profit
• eg. access to open spaces, fare dodging, tax evasion, download sharing

Question 30

Arguments for why the govt should always provide public goods ?

Answer 30

1. if the govt doesn’t provide them then no one will
2. only the state can force people to pay (through tax) and therefore avoid the free rider problem
3. providing essential public goods helps affordability and access to important services for lower income households ➡️ helps to address inequalities of income
4. state provision may help to prevent under-provision and under-consumption of merit public goods so that social welfare is improved
5. in some cases the state will fund and the private sector provides public goods eg. public private partnerships
6. if the govt provides public goods they may be able to do some more efficiently because of economies of scale eg. bulk buying discounts
7. helps the economy become more efficient as its an injection into the circular flow + creates employment
8. govt has the responsibility to keep people safe, not only economic responsibility eg. street lights

Question 31

Arguments for why the govt should not provide public goods ?

Answer 31

1. providing public goods carries large opportunity cost ➡️ if the govt spends money on this what will they have to stop spending money on ? (there are many other demands on govt finance)
2. taxation might need to be increased for everyone so that some people benefit from the public good
3. if the govt becomes a monopoly provider, there is danger of a lack of efficiency arising from lack of competition
4. the country is in debt ➡️ can they really afford to provide public goods?
5. people do not get to choose what ‘their’ money is spent on (tax)
6. where do you draw the line ➡️ the state can’t do everything
7. raising income tax means people will have less money to spend
8. the state is not good at everything (might lack info)

Question 32

What is information failure ?

Answer 32

• occurs when people have inaccurate/uncertain or misunderstood data and so potentially make the ‘wrong’ or sub-optimal choices ➡️ govt may have to intervene in a market in some way if info failures become serious and persistent

🔔 the key issue is whether information failure is trivial or instead has a big effect on individuals, their family and society as a whole

Question 33

What are the causes of information failure ?

Answer 33

• misunderstanding true costs/benefits: eg. side effects of tanning salons
• complex information when buying specialist products
• inaccurate or misleading info: persuasive advertising may ‘oversell’ the benefits of a product leading to more consumption than is optimal
• addiction: eg. drug addicts may be unable to stop consumption of harmful substances
• lack of awareness: eg. tuition fees in Britain ➡️ many parents and students find the system of university finance difficult to understand
• habitual purchase: buying goods simply out of habit eg. reordering the same items in an online food shop because consumers are presented with their ‘favourites’ list when they log in

Question 34

Examples of information gaps ?

Answer 34

• risks from using tanning beds
• addiction to painkillers and other drugs
• uncertain quality of second hand products
• knowledge of the nutritional content of food
• cowboy builders or other “rip-off merchants’
• tourist bazaars or buying and selling antiques

Question 35

What is symmetric information ?

Answer 35

• consumers and producers have the same level of knowledge about the products and they know everything there is to know about them
• needed for markets to work best

Question 36

What is asymmetric information ?

Answer 36

• occurs when somebody knows more than somebody else in the market ➡️ this imbalance can distort choices
• most markets will be asymmetric as sellers often know more than the buyers so they can gain a better profit ➡️ use it to their advantage

❗️eg. landlord who know more about their property than tenants (allows for higher rent payments)
eg. mortgages: a borrower knows more about their ability to repay a loan than the lender (insufficient checks might be made)
eg. a used car seller knows more about vehicle quality than a buyer (may pay too much for their car)
eg. car insurance companies cannot tell the risks associated when selling premiums to each single driver (they have to pool risks)

Question 37

What are merit goods ?

Answer 37

• these goods are better for people than they realise ➡️ the MPB is higher than realised which leads to under-consumption

🔔 merit/demerit goods refer to information failure leading to difference between actual and perceived private benefits whereas positive/negative externalities refer to impacts on third parties

Question 38

What are demerit goods ?

Answer 38

• these goods are worse for people than they realise ➡️ the MPB is less than realised which leads to over-consumption

Question 39

Explain why … is a public good ?

Answer 39

• explain what a public good is: a good is non excludable and non rival
• explain how it is non excludable
• explain how it is non rival