1.3 market failure

Question 1

what is the definition of market failure?

Answer 1

• occurs when the market fails to allocate scarce resources efficiently
• where the market mechanism doesn’t result in socially optimum quantity or price

Question 2

name the types of market failure

Answer 2

information failure/gaps
externalities
underprovision of public goods
moral hazard
speculation/market bubbles

Question 3

explain what externalites are

Answer 3

the third party (spillover) effects arising from the consumption and production of goods/services

Question 4

explain what the underprovision of public goods is

Answer 4

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

Question 5

explain what information failure/gaps are

Answer 5

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

Question 6

explain what moral hazard is

Answer 6

a term to describe a situation in which an individual or organisation is protected from the consequences of their actions

Question 7

explain what speculation and market bubbles are

Answer 7

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

Question 8

what is an external benefit?

Answer 8

a benefit to a third party outside the transaction

Question 9

what is an external cost?

Answer 9

a cost to a third part outside the transaction

Question 10

what is a social benefit?

Answer 10

the total benefit to private individuals and third parties:
private benefit + external benefit

Question 11

what is a social cost?

Answer 11

the total cost to private individuals and third parties:
private cost + external cost

Question 12

what is a private cost?

Answer 12

costs to the producing firm of producing an additional unit of output

Question 13

what is a private benefit

Answer 13

benefits to the consumer of consuming an additional unit of output

Question 14

externalities are

Answer 14

the effects that producing or consuming goods have on other third parties or society as a whole

Question 15

externalities may lead to market failure as

Answer 15

buyers or producers do not consider externalities when making decisions therefore goods or services can be under or over consumed

Question 16

positive consumption externalities are

Answer 16

‘good’ externalities created in the consumption of a good

Question 17

on a negative production externality diagram, how do you find socially optimum equilibrium?

Answer 17

where MB (MSB) meets MSC

Question 18

on a negative production externality diagram, how do you find private equilibrium?

Answer 18

where MB (MSB) meets MPC

Question 19

on a negative production externality diagram, how do you find under/over consumption in a private market?

Answer 19

overconsumption - the difference between the quantity at social equilibrium and at private equilibrium

Question 20

on a positive consumption externality diagram, how do you find social equilibrium?

Answer 20

where MC (MSC) meets MSB

Question 21

on a positive consumption externality diagram, how do you find private equilibrium?

Answer 21

where MC (MSC) meets MPB

Question 22

on a positive consumption externality diagram, how do you find under/over consumption in a private market?

Answer 22

underconsumption, the difference between the quantity at social equilibrium and at private equilibrium

Question 23

give ways the government can correct externalites

Answer 23

indirect taxes and subsidies
tradable pollution permits
provision of the good
provision of information
regulation

Question 24

explain how indirect taxes and subsidies affect externalities

Answer 24

• 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

Question 25

explain how tradable pollution schemes affect externalities

Answer 25

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

Question 26

explain how the provision of the good affects externalities

Answer 26

• when social benefits are very high, the government may decide to provide the good through taxation
• they do this with healthcare and education

Question 27

explain how provision of information affects externalities

Answer 27

since some externalities are associated with information gaps, the government can provide information to help people make informed decisions and acknowledge external costs

Question 28

explain how regulation affects externalites

Answer 28

this could limit consumption of goods with negative externalities, for example banning advertising of smoking etc

Question 29

what are the two features of public goods?

Answer 29

non-excludability and non-rivalry

Question 30

what is the name for a good which displays only one feature?

Answer 30

quasi-public goods

Question 31

what is non-excludability?

Answer 31

consumption by one person does not reduce the benefits for others

Question 32

what is non-rivalry?

Answer 32

one person’s consumption does not affect another’s

Question 33

what is the free rider problem?

Answer 33

where consumers can consume good without paying for it because it is non-excludable

Question 34

are public goods under or over-consumed in the free market and why?

Answer 34

underconsumed because no-one wants to pay for them; they all want to free-ride on someone else’s purchase

Question 35

give a reason why governments may choose not to provide public goods

Answer 35

expense
adverse consequences
crowding out
government inefficiency

Question 36

explain why producers may choose not to provide public goods

Answer 36

• 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

Question 37

give an alternative to full state provision

Answer 37

subsidisation
public-private partnerships

Question 38

what is information asymmetry?

Answer 38

where one party in a transaction knows more than another

Question 39

why is information asymmetry a form of market failure?

Answer 39

it can create an imbalance of power between the parties and can lead to outcomes that are not efficient or fair

Question 40

what is adverse selection?

Answer 40

where information asymmetry leads to a narrower market

Question 41

what is moral hazard?

Answer 41

an incentive to increase its exposure to risk because it does not bear the full costs of that risk

Question 42

how can independent reviews help moral hazard?

Answer 42

people are less likely to change their behaviour if they know it may affect their future transactions

Question 43

what are the disadvantages of independent reviews?

Answer 43

they can be faked or sabotaged

Question 44

what are merit goods?

Answer 44

• 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

Question 45

what are demerit goods?

Answer 45

• a good or service whose consumption is considered harmful to the consumer themselves
• goods which would be demanded less if consumers had full information