1.3 Market Failure

Question 1

When does market failure occur?

Answer 1

When the free market fails to allocate resources to the best interest of society thus an inefficient allocation of resources

Question 2

What are the 3 types of market failure?

Answer 2

• externalities
• under provision of public goods
• information gaps

Question 3

What is an externality?

Answer 3

The cost of benefit a third party receives from an economic transaction outside of the market mechanism.

Question 4

What are the 2 types of externalities?

Answer 4

Positive - external benefits
Negative - external costs

Question 5

What are private costs?

Answer 5

The costs to economics agents involved directly in an economic transaction
- determining how much the producer will supply
- may refer to market price of good

Question 6

What is a social cost?

Answer 6

Cost to the society as a whole

Question 7

How are social costs calculated?

Answer 7

private costs + external costs

Question 8

How are private costs shown diagrammatically?

Answer 8

• By the vertical distance between the two curves
• difference between private costs and social costs
• the MSC and MPC diverge from each other

Question 9

What are private benefits?(3)

Answer 9

• Consumers are concerned with private benefits derived from the consumption of a good.
• the price the consumer is prepared to pay determines this
• private benefits could also be a firms revenue from selling a good

Question 10

How do you calculate social benefits?

Answer 10

Private benefits + external benefits

Question 11

How are external benefits shown diagrammatically?

Answer 11

External benefits are the difference between private and social benefits
- external benefits increase disproportionately as output increases

Question 12

What is the social optimum position?

Answer 12

Where MSC=MSB, the point of maximum welfare
- social costs are made from producing the last unit of output is equal to the social benefit derived from consuming the unit of output

Question 13

What are the government policies for negative externalities?(7)

Answer 13

• indirect taxes
• subsidies
• regulation
• provide the good directly
• provide information
• property right
• personal carbon allowances

Question 14

How is the government policy, indirect taxes, used for negative externalities?(1+3)

Answer 14

To reduce the quantity of demerit goods consumed.
- by increasing price of the good
- the tax is = tot he external cost of each unit thus supply curve becomes MSC instead of MPC, so the free market equilibrium becomes the socially optimum equilibrium.
- this internalises the externality so the polluter pays for the damage

Question 15

How is the government policy,subsidies, used for negative externalities?

Answer 15

To encourage the consumption of merit goods.
- including the full social benefit in the market price of the good

Question 16

How is the government policy, regulation, used for negative externalities?

Answer 16

To enforce less consumption of s good.
- bans are only useful where MSC > MPB

Question 17

How is the government policy of providing the good directly used for negative externalities?

Answer 17

The government could provide public goods which are under provided in the free market.

Question 18

How is the government policy of proving information be used for negative externalities?

Answer 18

So there is no information failure, and consumers and firms can make informed economic decisions

Question 19

How is the government policy of property rights, used for negative externalities?

Answer 19

To encourage innovation as entrepreneurs can create new ideas which are protected and earn profit.

Question 20

How is the government policy, personal carbon allowances, used for negative externalities?

Answer 20

• they could be tradable so firms and consumers can pollute up to a certain amount, and trade what they don’t use.

Question 21

What are public goods?

Answer 21

Items missing from the free market but offer benefits to the society.
- e.g. street lights, flood control systems are public goods

Question 22

What is a non-excludable good?

Answer 22

When consuming the good, someone else is not prevented from consuming the good as well and they are non rival, so the benefit other people get from the good does not diminish if more people consume the good.

Question 23

What effect does public goods have due to its non excludable nature?

Answer 23

Free-rider problem.

Question 24

What is the free rider problem?

Answer 24

When people who do not pay for the good still received benefits from it in the same way people who pay for the good do.

Question 25

Why are public goods under provided in the private sector?(2)

Answer 25

• They don’t make a profit from providing the good since consumers don’t see a reason for paying for it if they still receive the benefit without paying for it
• difficult to measure the value consumers get from public. Producers will over value the product while consumers under value it

Question 26

What are private goods?

Answer 26

Goods that are rival and excludable

Question 27

What is a Quasi Public good?

Answer 27

A non pure public good
- has characterised of both public and private goods
- partially provided by the free market

Question 28

What is symmetric information?

Answer 28

Consumers and producers have perfect market information to make their decision.
Leading to an efficient allocation of resources

Question 29

What is asymmetric information?

Question 30

What is imperfect information

Answer 30

Where information is missing so an informed decision cannot be made

Question 31

What does a misallocation of resources lead to?

Answer 31

Consumers paying too much or too little, firms producing the incorrect amount.

Question 32

What is a principal agent problem?

Answer 32

When the agent makes decisions for the principal, but the agent is inclined to act in their own interest rather than those of the principal.

-e.g. shareholders and managers have different objectives which might conflict. Managers might choose to make a personal gain, rather than maximise the dividend of the shareholders