1.3- Market failure

Question 1

What is market failure?

Answer 1

Occurs when the market fails to allocate scarce resources efficiently, causing a social welfare loss

Question 2

What are the different types of market failure?

Answer 2

• externalities
• under-provision of public goods
• asymmetric information - information gaps
• overproduction of demerit goods
• under-consumption of merit goods
• price volatility and unstable markets

Question 3

What is an externality?

Answer 3

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

Question 4

What is marginal private benefit? (MPB)

Answer 4

The benefit to the individual of consuming or producing a good or service
e.g. getting a medical degree = good salary

Question 5

What is marginal external benefit?

Answer 5

The benefit to the third party not involved in the transaction, of the production or consumption of a good or service
e.g. get a medical degree = others get treated by a well-trained doctor

Question 6

What is marginal social benefit? (MSB)

Answer 6

MPB + MEB

The benefit of the activity to society as a whole

Question 7

What is marginal private cost? (MPC)

Answer 7

The cost to the individual of consuming or producing a good or service
e.g. get a medical degree = student debt

Question 8

What is marginal external cost? (MEC)

Answer 8

The cost to the third party not involved in the transaction, of the production or consumption of a good or service

Question 9

What is marginal social cost? (MSC)

Answer 9

MPC + MEC

The cost of the activity to society as a whole

Question 10

What are merit goods?

Answer 10

A good with external benefits, where the benefit to society is greater than the benefit to the individual - underprovided by free market

Question 11

What are demerit goods?

Answer 11

A good where the cost to society is greater than the cost to the individual - overprovided by free market

Question 12

What are negative externalities and how do they cause market failure?

Answer 12

Occurs when production and/or consumption impose external costs on third parties outside of the market for which no appropriate compensation is paid

• Over-production + over-consumption
• Social cost > private cost

Question 13

What are positive externalities and how do they cause market failure?

Answer 13

• Exists when third parties benefit from the spill-over effects of production/consumption
• When social benefits > social costs
• Underconsumption

Question 14

What is the social optimum?

Answer 14

The point which maximises welfare - the optimal allocation of resources from society’s point of view

Question 15

What ways can the government intervene to prevent market failure?

Answer 15

• Indirect tax & subsidies: taxes on goods with negative externalities and subsidies for goods with positive externalities -> internalise the externalities moving production closer to social optimum
• Minimum/maximum price
• Tradable pollution permits: regulated allowances that allow producers to generate pollution
• State provision of public goods
• Provision of information: helps people make informed decisions and acknowledge external costs
• Regulation: limit consumption of goods with negative externalities e.g. banning advertising

Question 16

What are public goods and what are they characterised by?

Answer 16

• Goods that are beneficial to society
• Non-excludable: someone not paying for a good doesn’t affect their ability to use it
• Non-rivalrous: if one person consumes a good, this doesn’t stop another person from using it

Question 17

What is the distinction between public and private goods?

Answer 17

• Private goods are goods that firms are able to provide to generate a profit - they are excludable (via the price mechanism) and rivalrous (limited supply)
• Public goods are non-excludable and non-rivalrous

Question 18

What is the free-rider problem?

Answer 18

• You can’t charge an individual for the provision of a non-excludable good because someone else will gain the benefit from it without paying anything
• A free-rider is someone who receives the benefits without paying for it

Question 19

What is symmetric information?

Answer 19

Where buyers and sellers have exactly the same level of information about the good or service

Question 20

What is asymmetric information?

Answer 20

• When one individual or party has more information than another individual or party, and uses that advantage to exploit the other party
• Distorts socially optimal prices & quantities in markets - leads to over-provision or under-provision of goods/services

Question 21

What are information gaps?

Answer 21

Exists when either the buyer or seller does not have access to the information needed for them to make a fully-informed decision

• Exist in nearly all free markets & distort market outcomes -> market failure
• One of the underlying assumptions of a free market is that there is perfect information in the market

Question 22

How can the government try to fix the problem of information asymmetry?

Answer 22

• Legislation
• Increased protection of whistleblowers
• Provision of information