1.3 Market Failure

Question 1

What is market failure?

Answer 1

The inefficient allocation of resources in the free market which leads to a loss of social welfare

Question 2

What are the 3 types of market failure?

Answer 2

1. Information gaps
2. Under-provision of public goods
3. Externalities

Question 3

What is an externality?

Answer 3

A spillover effect from consumption or production on a third party (can be positive or negative)

Question 4

What is a marginal private cost (MPC)?

Answer 4

The cost incurred by an individual (producer/firm) as part of the production of a good

Question 5

What is a marginal private benefit (MPB)?

Answer 5

The extra satisfaction gained by an individual for consuming a good

Question 6

What is MSB = MSC?

Answer 6

The social optimum level of production

Question 7

What is a negative production externality?

Answer 7

When the production of a good/service has a harmful external impact on a third party (social costs are greater than private costs)

Question 8

What is deadweight welfare loss?

Answer 8

A cost to society due to a reduction in economic efficiency when market is not in equilibrium (loss of consumer or producer surplus)

Question 9

What are merit goods?

Answer 9

Goods/services which have positive consumption externalities but are often underproduced by the free market

Question 10

What are demerit goods?

Answer 10

Goods/services with negative externalities that are often overproduced by the free market and consumed to a greater extent than considered socially desirable

Question 11

What are indirect taxes?

Answer 11

A tax imposed by the government that increases the supply cost of producers, aims to decrease the supply of a good or service

Question 12

How does an indirect tax solve externalities?

Answer 12

The cost of the externality is internalised, moving production closer to the social optimum

Question 13

What are 3 drawbacks of indirect tax to solve externalities?

Answer 13

• Difficult to measure externality
• Regressive
• Opportunity/enforcement costs

Question 14

What is cap and trade?

Answer 14

A market based policy in which the government sets a ‘cap’ on carbon emissions and firms are given permits to pollute which can be traded or sold to other firms

Question 15

Why is the supply of carbon permits inelastic and what is the effect?

Answer 15

Government increases the scarcity of permits resulting in an increase in price. This makes it more expensive for firms to gain permits, discouraging them from polluting

Question 16

What are 2 advantages of cap and trade?

Answer 16

• Encourages investment in green technology
• Does not deter future investment: it is a gradual reduction

Question 17

What are 2 disadvantages of cap and trade?

Answer 17

• Political favouritism: governments likely to distribute more permits to companies with national significance
• Setting correct cap is complex: too high=limited effect on pollutants, too low=permits expensive for smaller businesses

Question 18

What is regulation?

Answer 18

A set of rules, normally imposed by government that firms must follow in order to modify their behaviour

Question 19

What are 2 advantages of regulation?

Answer 19

• Can be gradually toughened/implemented over time
• Theoretically ‘cheaper and simpler’ to implement

Question 20

What are 3 disadvantages of regulation?

Answer 20

• High enforcement and opportunity costs
• Unintended consequences e.g black markets, smuggling
• Deters future investment

Question 21

What is nationalisation?

Answer 21

The transfer of an industry from private to public ownership and the government begins to provide the good/service

Question 22

What are 2 benefits of nationalisation?

Answer 22

• Better coordination with the central plan or strategy
• State can monitor externalities easily: can reduce negative externalities and increase positive externalies

Question 23

What are the alternative interventions to increase the production/consumption of merit goods?

Answer 23

1. Legislation
2. Advertising/Information
3. Direct Provisioning

Question 24

What is good information?

Answer 24

When the buyer and seller both have full knowledge of the price, benefits and costs of a good

Question 25

What is symmetric information?

Answer 25

When both parties in a transaction have access to the same, complete and accurate information

Question 26

What are information gaps?

Answer 26

When the buyer or the seller does not have access to the information to make a fully-informed decision

Question 27

What is asymmetric information?

Answer 27

When one party has superior information compared to another

Question 28

What are 4 causes of information gaps?

Answer 28

- Addiction/Habits - Asymmetry - Poor knowledge of long-term impacts - Framing (decisions based on the way information presented rather than facts)

Question 29

How does poor information lead to the misallocation of resources?

Answer 29

Leads to poor decisions and therefore consumer demand or producer supply of the good/service being too high (thus price and quantity are not at social optimum)

Question 30

What is moral hazard?

Answer 30

When a party has an incentive to increase its exposure to risk because it does not bear the full costs associated with that risk e.g doctors/dentists, insurance

Question 31

What is information provisioning?

Answer 31

Directly supplying information to consumers or requiring producers to do so e.g nutrition labels, cigarette packaging

Question 32

What are 2 problems with information provisioning?

Answer 32

- **Issues when provided by government:** from what sources?, opportunity cost of collecting and publishing - **Issues when provided by firms:** may provide information that is difficult to understand e.g chemical instead of common names (lack of transparency)

Question 33

What are 2 ways to solve information failure?

Answer 33

**- Regulation:** laws requiring businesses to disclose information e.g labeling requirements **- Licensing:** schemes to ensure trained professionals act according to standard

Question 34

What are 2 problems with licensing?

Answer 34

- Limits the supply of workers - Controls competence not morality

Question 35

Draw: Positive consumption externality

Question 36

Describe the free rider problem

Answer 36

- Consumers realise they can access goods without paying (non-excludable) - Individuals who benefit from a public good/service without contributing to the cost of providing it - Private firms will will not produce good as there is no profit incentive (under-provision) - The good/service will be provided by government

Question 37

What are public goods?

Answer 37

Goods that are beneficial to society but are under provided in the free market

Question 38

What are 2 features of public goods?

Answer 38

- Non-rivalry: goods that can be consumed by multiple people without reducing the amount available for others - Non-excludable: goods that cannot exclude a certain person or group of persons from using them

Question 39

What are private goods?

Answer 39

Goods that firms are able to provide to generate profits (excludable and rivalrous)

Question 40

What makes a good excludable?

Answer 40

- The price mechanism, as some customers cannot afford to buy the good/service

Question 41

What makes a good rivalrous?

Answer 41

Consumers compete for goods which are limited in supply (this rivalry helps to generate profits for firms)

Question 42

How does imperfect market information may lead to a misallocation of resources

Answer 42

- Consumers do not buy things that maximise their welfare - Demand for a good/supply of a good may be too high or too low - Price and quantity are not at the social optimum position

Question 43

EVAL for correcting externality (e.g subsidies, max/min price, regulation, state provision)

Answer 43

- Depends on government correctly identifying socially optimum level - Intervention may lead to under/overestimations of optimum level = welfare loss will still remain