1.3 market failure Flashcards
what is the definition of market failure?
- occurs when the market fails to allocate scarce resources efficiently
- where the market mechanism doesn’t result in socially optimum quantity or price
name the types of market failure
information failure/gaps
externalities
underprovision of public goods
moral hazard
speculation/market bubbles
explain what externalites are
the third party (spillover) effects arising from the consumption and production of goods/services
explain what the underprovision of public goods is
the market may fail to provide certain goods/services or underprovide them due to the fact that it is relatively easy to gain the benefits from the goods without having to pay for it - free rider principle
explain what information failure/gaps are
imperfect information - the buyers and/or sellers do not have all the information necessary to make an informed decision
asymmetric information - where one party, either the buyer or the seller, has more information about the product’s quality or price than the other party
explain what moral hazard is
a term to describe a situation in which an individual or organisation is protected from the consequences of their actions
explain what speculation and market bubbles are
speculation - an economics agent buys or sells something in the expectation of a future price change in the hope of generating a profit
market bubble - a spike in asset values within a particular industry, commodity, or asset class to unsubstantiated levels, fueled by irrational speculative activity that is not supported by the fundamentals
what is an external benefit?
a benefit to a third party outside the transaction
what is an external cost?
a cost to a third part outside the transaction
what is a social benefit?
the total benefit to private individuals and third parties:
private benefit + external benefit
what is a social cost?
the total cost to private individuals and third parties:
private cost + external cost
what is a private cost?
costs to the producing firm of producing an additional unit of output
what is a private benefit
benefits to the consumer of consuming an additional unit of output
externalities are
the effects that producing or consuming goods have on other third parties or society as a whole
externalities may lead to market failure as
buyers or producers do not consider externalities when making decisions therefore goods or services can be under or over consumed
positive consumption externalities are
‘good’ externalities created in the consumption of a good
on a negative production externality diagram, how do you find socially optimum equilibrium?
where MB (MSB) meets MSC
on a negative production externality diagram, how do you find private equilibrium?
where MB (MSB) meets MPC
on a negative production externality diagram, how do you find under/over consumption in a private market?
overconsumption - the difference between the quantity at social equilibrium and at private equilibrium
on a positive consumption externality diagram, how do you find social equilibrium?
where MC (MSC) meets MSB
on a positive consumption externality diagram, how do you find private equilibrium?
where MC (MSC) meets MPB
on a positive consumption externality diagram, how do you find under/over consumption in a private market?
underconsumption, the difference between the quantity at social equilibrium and at private equilibrium
give ways the government can correct externalites
indirect taxes and subsidies
tradable pollution permits
provision of the good
provision of information
regulation
explain how indirect taxes and subsidies affect externalities
- taxes can be put on goods with negative externalities and subsidies on goods with positive externalities
- these help to internalise the externalities, moving production closer to the social optimum position
explain how tradable pollution schemes affect externalities
these allow firms to produce up to a certain amount of pollution, and can be traded amongst firms so give them choice whilst reducing the total level of pollution
explain how the provision of the good affects externalities
- when social benefits are very high, the government may decide to provide the good through taxation
- they do this with healthcare and education
explain how provision of information affects externalities
since some externalities are associated with information gaps, the government can provide information to help people make informed decisions and acknowledge external costs
explain how regulation affects externalites
this could limit consumption of goods with negative externalities, for example banning advertising of smoking etc
what are the two features of public goods?
non-excludability and non-rivalry
what is the name for a good which displays only one feature?
quasi-public goods
what is non-excludability?
consumption by one person does not reduce the benefits for others
what is non-rivalry?
one person’s consumption does not affect another’s
what is the free rider problem?
where consumers can consume good without paying for it because it is non-excludable
are public goods under or over-consumed in the free market and why?
underconsumed because no-one wants to pay for them; they all want to free-ride on someone else’s purchase
give a reason why governments may choose not to provide public goods
expense
adverse consequences
crowding out
government inefficiency
explain why producers may choose not to provide public goods
- private sector producers will not provide public goods to people because they cannot be sure of making a profit , due to the non-excludability of public goods
- therefore, if the provision of public goods was left to the market mechanism, the market would fail and so they are provided by the government and financed through taxation
give an alternative to full state provision
subsidisation
public-private partnerships
what is information asymmetry?
where one party in a transaction knows more than another
why is information asymmetry a form of market failure?
it can create an imbalance of power between the parties and can lead to outcomes that are not efficient or fair
what is adverse selection?
where information asymmetry leads to a narrower market
what is moral hazard?
an incentive to increase its exposure to risk because it does not bear the full costs of that risk
how can independent reviews help moral hazard?
people are less likely to change their behaviour if they know it may affect their future transactions
what are the disadvantages of independent reviews?
they can be faked or sabotaged
what are merit goods?
- goods or services that are considered to be beneficial to individuals and society as a whole, but are often under-consumed
- goods which would be demanded more if consumers had full information
what are demerit goods?
- a good or service whose consumption is considered harmful to the consumer themselves
- goods which would be demanded less if consumers had full information
