1.3 Market Failure

Question 1

What is a free market?

Answer 1

an economic system in which prices are determined by unrestricted competition between privately owned businesses.

Question 2

What is market failure?

Answer 2

inefficient allocation of goods and services in the free market

Question 3

Why does market failure occur?

Answer 3

• externalities
• under provision of public goods
• information gaps

Question 4

What are externalities?

Answer 4

external impact (cost or benefit) on a third party not involved in the economic transaction

Question 5

What are the types of externalities and give examples?

Answer 5

• positive externality of consumption
• positive externality of production
• negative externality of consumption
• negative externality of production

Question 6

Give an example of a positive externality of consumption.

Answer 6

electric vehicles are consumed, CO2 emissions fall

Question 7

Give an example of positive externality of production.

Answer 7

managed pine forests produce timber but also increase CO2 absorption

Question 8

Give an example of a negative externality of consumption.

Answer 8

consumption of alcoholincreases anti social behaviour

Question 9

Give an example of a negative externality of production.

Answer 9

production of electricity increases air pollution

Question 10

What is a public good?

Answer 10

a good or service that is provided without profit to all members of a society

Question 11

Why would public goods be under-provided by the free market?

Answer 11

less opportunity for sellers to make economic profits from providing these goods/services

government provide instead for the public benefit

Question 12

What are examples of public goods?

Answer 12

national defence, parks, libraries, lighthouses

Question 13

If there is asymmetric information what could happen to market prices and quanitites?

Answer 13

it will distort market prices and quantities

good/service with dangerous side effects would be sold in lower quantities if buyers were aware of these effects vice versa.

Question 14

How might government intervention address market failure?

Answer 14

imposing regulations, taxes, or subsidies to address externalities, providing public goods directly, or ensuring better information dissemination to reduce information gaps

Question 15

What is external costs and when do they occur?

Answer 15

when social costs of an economic transaction are greater than the private costs

it is the damage not factored in to the economic activity

Question 16

What is external benefits and when do they occur?

Answer 16

when social benefits of an economic transaction are greater than the private benefits

it is the benefit not factored in to the economic activity

Question 17

How do you work out social costs?

Answer 17

private cost + external cost = social costs

Question 18

How do you work out social benefits?

Answer 18

private benefits + external benefits = social benefits

Question 19

Savemyexams: externalities - external costs of production

Question 20

How do negative externalities of production lead to market failure?

Answer 20

producers only consider their private costs and benefits and not the external costs. results to over provision of goods and services and inefficient allocation of resources

Question 21

What would happen if producers considered external costs in their decision-making?

Answer 21

quantity would decrease, which would increase price. it would reduce the negative impact on third parties and improve allocative efficiency

Question 22

What is marginal analysis in economics, and why is it important?

Answer 22

evaluating the cost or benefit of producing or consuming an additional unit of a good or service

it helps determine the optimal level of production or consumption where marginal benefits equal marginal costs, leading to efficient resource allocation.

Question 24

What is market failure?

Answer 24

Market failure occurs when the free market fails to allocate resources efficiently, leading to a loss of economic and social welfare. This happens when marginal social benefits (MSB) do not equal marginal social costs (MSC), often due to externalities, under-provision of public goods, or information gaps.

Question 25

What are externalities? Provide an example for both positive and negative externalities.

Answer 25

Externalities are costs or benefits to third parties not involved in a transaction.

Positive externality: Vaccinations reduce disease transmission, benefiting society beyond the vaccinated individuals. Negative externality: Pollution from factories imposes health costs on nearby residents.

Question 26

Why are public goods under-provided in a free market?

Answer 26

Public goods are under-provided because of their characteristics of non-rivalry and non-excludability. This leads to the free rider problem, where individuals benefit without paying, discouraging private firms from supplying these goods.

Question 27

How do information gaps cause market failure?

Answer 27

Information gaps occur when one party in a transaction has more or better information than the other (asymmetric information). This leads to misallocation of resources, such as overconsumption of unhealthy products or under-consumption of beneficial products.

Question 28

Differentiate between private costs, external costs, and social costs.

Answer 28

Private costs: Costs borne by producers or consumers directly involved in a transaction. External costs: Costs imposed on third parties. Social costs: The sum of private and external costs.

Question 29

Differentiate between private benefits, external benefits, and social benefits.

Answer 29

Private benefits: Benefits received by individuals directly involved in a transaction. External benefits: Benefits to third parties. Social benefits: The sum of private and external benefits.

Question 30

Draw and explain a diagram to show the external costs of production.

Answer 30

The supply curve represents marginal private costs (MPC). The external costs shift the curve upward to marginal social costs (MSC). Market equilibrium occurs where demand (marginal private benefit, MPB) intersects MPC. Socially optimal equilibrium occurs where MPB = MSC. The triangle between MSC and MPC represents welfare loss due to overproduction.

Question 31

Draw and explain a diagram to show the external benefits of consumption.

Answer 31

The demand curve represents marginal private benefits (MPB). The external benefits shift the curve upward to marginal social benefits (MSB). Market equilibrium occurs where MPB intersects supply (marginal private cost, MPC). Socially optimal equilibrium occurs where MSB = MPC. The triangle between MSB and MPB represents welfare gain due to under-consumption.

Question 32

How do externalities impact economic agents?

Answer 32

Consumers: May pay more for products or benefit from improved goods/services after intervention. Producers: Face higher costs with taxes or regulations but benefit from subsidies. Third parties: Experience reduced harm or greater benefits.

Question 33

How can government intervention correct externalities?

Answer 33

Taxes: Discourage production/consumption of goods with negative externalities. Subsidies: Encourage goods/services with positive externalities. Regulation: Set limits on harmful activities. Provision of public goods: Directly provide goods/services to address under-provision.

Question 34

Define public and private goods and explain the difference using examples.

Answer 34

Public goods: Non-rivalrous and non-excludable. Private goods: Rivalrous and excludable.

Examples: Public goods (e.g., street lighting, national defense) vs. Private goods (e.g., food, clothing).

Question 35

What is the free rider problem, and how does it lead to market failure?

Answer 35

The free rider problem occurs when individuals benefit from a public good without paying for it, as it is non-excludable. This disincentivizes private firms from providing the good, leading to under-provision and market failure.

Question 36

What is the difference between symmetric and asymmetric information?

Answer 36

Symmetric information: Both parties in a transaction have equal and accurate information. Asymmetric information: One party has more or better information than the other, often leading to inefficient outcomes.

Question 37

How does imperfect market information lead to resource misallocation?

Answer 37

Consumers may overconsume harmful goods due to lack of knowledge about risks. Producers may underproduce socially beneficial goods if unaware of long-term benefits. Misallocation arises when decisions are based on incomplete or inaccurate information.