1.3 Market Failure

Question 1

How is market failure caused?

Answer 1

• caused by the misallocation of resources
• resulting in an inefficient allocation of resources or unequal/inequitable (unfair) allocation of resources

Question 2

What is allocative efficiency?

Answer 2

• when producers provide what consumers want
• this happens when price is equal to marginal cost (cost of making an additional unit)

Question 3

What is product efficiency?

Answer 3

• when average costs are minimised

Question 4

What are negative externalities?

Answer 4

• costs from production to a third party, not involved in the production or consumption
• can also be written as external costs
• e.g. pollution, litter

Question 5

What are private costs?

Answer 5

• costs to firms e.g. rent, wages, salaries, costs of raw materials, taxation, business rates
• private costs are costs firms have to pay
• affects the supply curve
• markets assume that firms/individuals consider only the private costs resulting from their actions

Question 6

What are social costs

Answer 6

Costs to society as a whole

Question 7

How to calculate social costs

Answer 7

Private costs + external costs

Question 8

What is marginal social cost

Answer 8

cost to society of producing an additional unit of output

Question 9

Calculation for marginal social cost

Answer 9

Marginal private cost + marginal external cost

Question 10

What are private benefits?

Answer 10

• a benefits that is gained by the person or group that is directly involved in the transaction
• private benefits from consuming a good = utility
• private benefit to firm = profit

Question 11

What are social benefits?

Answer 11

benefits to society as whole

Question 12

What are external benefits?

Answer 12

• benefits to a third party not involved in the transaction
• e.g. education, inoculation, health

Question 13

What are marginal social benefits?

Answer 13

• benefits to society of consuming an additional unit of output
• MSB = MPB + MEB

Question 14

What is marginal analysis?

Answer 14

• use of marginal cost + marginal benefits
• looks at effects on society of producing or consuming an additional unit

Question 15

Why is it difficult to identify the socially optimum output?

Answer 15

• while it is true that there are external costs + benefits from production and consumption, it is difficult to put a monetary value on them
• e.g. global warming
• there is also an information issue -> hard to quantify all costs and benefits due to practical limitations -> however still a good starting point

Question 16

What does a Positive externalities diagram show?

Answer 16

• the diagram shows that merit goods or goods with positive externalities will be under consumed if left to the free market - e.g. health/education is only provided by the market + not the government
• this is because individuals do not take into account the external benefits of the good + just consider private benefits

Question 17

Where is the free market equilibrium on a positive externalities diagram?

Answer 17

At the point where MPB = MPC/MSC

Question 18

How can market failure be solved?

Answer 18

• government intervention or free market economists would argue leaving it to solve itself
• this is why there is the NHS, state schools etc.
• however there are examples of government intervention failures e.g. excess demand -> NHS waitlist

Question 19

Government intervention examples

Answer 19

• state provisions -> NHS, prisons
• subsidies -> renewable energy, prescriptions, public transport
• government subsidies what they want people to do or use more - e.g. subsidies goods with external benefits
• they will also tax to discourage - e.g. cigarettes, alcohol, petrol

Question 20

What are pure public goods?

Answer 20

Non-excludability -> once provided individuals (non-payers) can’t be excluded from the benefits e.g. lighthouse
Non rivalry -> (also called non diminish ability) if one person uses the good/service, it doesn’t diminish the enjoyment of others e.g. road, beach, park

Question 21

What are Quasi (semi) public goods?

Answer 21

• in some cases there may be times when public goods become busy/overcrowded when the presence of others affects an individuals consumer enjoyment of a good
• when over crowded, the characteristic of non-rivalry no longer holds as the use of a good affects the enjoyment of individuals
• e.g. firework display, beach, park

Question 22

When is it possible to exclude non payers from public goods?

Answer 22

• roads -> tolls, M6 relief road
• in some cases roads do not have the characteristic of non-excludability
• however, tolls on all roads would lead to congestion, therefore it is more efficient for roads to be pay for from taxation

Question 23

What is the free rider problem?

Answer 23

• once provided individuals can’t be excluded from using/benefitting from a public good -> individuals have the incentive to ‘free ride’
• this is when an individual waits for a good to be provided + uses it free of charge
• the existence of free riders (and inability to exclude non payers) means there is no incentive for private producers to supply the good or service as they will not make much profit
• therefore, providing a strong incentive for the government to provide goods rather than private providers

Question 24

Types/ causes of market failure?

Answer 24

• public goods
• information gap
• externalities

Question 25

What is asymmetric information?

Answer 25

• when the seller knows more then the customer -> could be used to exploit customers, leading to a misallocation of resources
• economies use models that are underpinned by the assumption that people behave rationally + have perfect information -> however there can be asymmetricinformation due to sellers having superior knowledge
• e.g. private healthcare, driving lessons, builders, second hand car seller

Question 26

When could the buyer have more information?

Answer 26

Health insurance - the person has to fill out the form, and therefore could lie ( a smoker that claims to be a non smoker)

Question 27

What is imperfect information?

Answer 27

• individuals underestimate the benefits of merit goods, e.g. healthy food, education
• leads to people not saving enough for their retirement
• individuals underestimate the danger from certain goods e.g. demerit goods, sun beds

Question 28

How do information gaps cause market failure?

Answer 28

• lack of information -> customer can’t make informed choices -> misallocation of resources -> market failure