1.3- Market failure Flashcards
What is market failure?
Occurs when the market fails to allocate scarce resources efficiently, causing a social welfare loss
What are the different types of market failure?
- externalities
- under-provision of public goods
- asymmetric information - information gaps
- overproduction of demerit goods
- under-consumption of merit goods
- price volatility and unstable markets
What is an externality?
The cost or benefit a third party receives from an economic transaction outside of the market mechanism
What is marginal private benefit? (MPB)
The benefit to the individual of consuming or producing a good or service
e.g. getting a medical degree = good salary
What is marginal external benefit?
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
What is marginal social benefit? (MSB)
MPB + MEB
The benefit of the activity to society as a whole
What is marginal private cost? (MPC)
The cost to the individual of consuming or producing a good or service
e.g. get a medical degree = student debt
What is marginal external cost? (MEC)
The cost to the third party not involved in the transaction, of the production or consumption of a good or service
What is marginal social cost? (MSC)
MPC + MEC
The cost of the activity to society as a whole
What are merit goods?
A good with external benefits, where the benefit to society is greater than the benefit to the individual - underprovided by free market
What are demerit goods?
A good where the cost to society is greater than the cost to the individual - overprovided by free market
What are negative externalities and how do they cause market failure?
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
What are positive externalities and how do they cause market failure?
- Exists when third parties benefit from the spill-over effects of production/consumption
- When social benefits > social costs
- Underconsumption
What is the social optimum?
The point which maximises welfare - the optimal allocation of resources from society’s point of view
What ways can the government intervene to prevent market failure?
- 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
What are public goods and what are they characterised by?
- 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
What is the distinction between public and private goods?
- 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
What is the free-rider problem?
- 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
What is symmetric information?
Where buyers and sellers have exactly the same level of information about the good or service
What is asymmetric information?
- 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
What are information gaps?
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
How can the government try to fix the problem of information asymmetry?
- Legislation
- Increased protection of whistleblowers
- Provision of information
