1.3 Market failure

Question 1

What is market failure?

Answer 1

Market Failure is when the free market (market forces of supply and demand) fails to allocate scarce resources at the socially optimal level of output/price.

Question 2

What is an externality?

Answer 2

An externality is a cost or benefit that a third party outside the initial transaction receives. E.g cars/ cigarettes have negative externalities; education and healthcare have positive externalities.

Question 3

What are information gaps?

Answer 3

Information gaps are a lack of knowledge which may cause firms to make irrational decisions.

Question 4

What are private costs/benefits?

Answer 4

Costs/benefits to the individuals in the initial transaction.

Question 5

What are social costs/benefits?

Answer 5

The costs/benefits of society of the activity to society as a whole. Represented by a shift in demand/supply curve.

Question 6

What are external costs/benefits?

Answer 6

Costs/ benefits to a third party outside the initial transaction. Difference between private and social costs/benefits.

Question 7

How do markets respond to external costs/benefits?

Answer 7

Government interventions can intervene to ensure the market considers external costs/benefits.

Question 8

What government interventions can help markets with externalities?

Answer 8

Indirect taxes/subsidies
- Increase cost of goods with negative externalities; reduce production
Tradeable pollution permit
- Allow firms to produce a certain amount of pollution
Provision of the good
- If social benefits are high, government decide to provide through taxation; public good
Provision of information
- Provide information to prevent externalities
Regulation
- Limit consumption of goods e.g advertising ban on cigs

Question 9

What is a public good?

Answer 9

A public good is a product that is beneficial to society but not provided by private firms due to:
- non-rivalry; consumption doesn’t diminish utility to other consumers
- non-excludable; firms can’t stop/choose not to access this good

Question 10

What is the free-rider problem?

Answer 10

The free-rider problem is when consumers realise they can benefit from a product without paying. Private firms won’t provide these goods as no profit. If provision is left to market mechanism, no one would provide the goods. Government have to provide them

When customers realise they can still access goods without paying for them.
At some point firms cease to provide these goods; become under-provided; government have to provide