1.3 - Market Failure

Question 1

Definition of market failure

Answer 1

The misallocation of resources in the free market results in socially undesirable outcome

Question 2

What are the types of market failure

Answer 2

1. Externalities
2. Under provision of public goods
3. Information gaps (Asymmetric information) in the form of moral hazard and adverse selection

Question 3

Definition of private costs

Answer 3

The costs incurred by producers or consumers directly involved in a transaction / economic activity
E.g. the private costs of producing a car will be the cost of labour, raw materials and manufacturing equipment

Question 4

Definition of external costs

Answer 4

Costs imposed on the third party who are not part of the transaction / economic activity
E.g. air pollution by a factory will lead to external costs on the residence nearby causing health and environmental damage

Question 5

Definition of private benefit

Answer 5

Benefits received by the producer or consumer directly involved in a transaction / economic activity
E.g. private benefit of education means improved job prospects and higher earned potential for individual who has a education

Question 6

Definition of social costs

Answer 6

Represents the total costs of an economic activity, including both the private and external costs

Question 7

Definition of external benefit

Answer 7

Benefits received on the third party who are not part of the transaction
E.g. vaccination not only benefits individual but also those around them from preventing the spread of disease

Question 8

Definition of social benefit

Answer 8

Represents the total benefit of an economic activity, including both private and external benefits

Question 9

Diagram for negative externality (in production and consumption)

Answer 9

• results in market inefficiencies and reduced social welfare

Question 10

Diagram for positive externality (in production and consumption)

Answer 10

• results in underallocation of resources that is beneficial for society

Question 11

What policies can the government impose to reduce externality?

Answer 11

1. Indirect tax (negative externality)
2. Subsidy (positive externality)
3. Regulation - e.g. impose emission standards or safety standards
4. Tradeable pollution permits (negative externality)

Question 12

2 characteristics of public goods

Answer 12

1. Non rival - consumption by one person does not reduce the availability of good for others (non depletable)
2. Non excludable - the good does not prevent other individuals from benefitting the good

Question 13

Example of public goods

Answer 13

• street lights
• national defence (the protection provided by the military benefits all citizens, and it is challenging to exclude non-payers from this benefit)
• national parks

Question 14

What is the free rider problem?

Answer 14

The free rider problem occurs when individuals can benefit from a public good without having to pay for it

Since it is difficult to exclude non payers, individuals do not pay for the public good as they assume that others will pay for it and they can enjoy the benefits

Question 15

What does the free rider problem explain?

Answer 15

It explains why the free market (i.e. private businesses) does not provide public goods as they will not be making any profit

Question 16

How is the free rider problem overcome?

Answer 16

Through taxation - e.g. public schools
Government provides public goods instead

Question 17

What are quasi public goods and give me an example?

Answer 17

A good that possess both private and public good characteristics

E.g. toll roads - while they are excludable (you must pay to use them), they are non rival as one person’s use does not significantly affect another’s ability to use the road

Question 18

Symmetric information vs asymmetric information

Answer 18

Symmetric information - all parties involved in the transaction possess the equal / same access of information - this leads to transparency, well informed decision making

Asymmetric information - one party of the transaction possess superior or lacks access of the information - this leads to decision making based on incomplete, inaccurate data

Question 19

How does information gaps lead to misallocation of resources?

Answer 19

1. Adverse selection
2. Moral hazard
3. Market failure
4. Role of government and regulation