1.3 Market Failure

Question 1

When does market failure occur

Answer 1

Market failure occurs when the market fails to allocate scarce resources sufficiently. Causing a loss in social welfare loss

Question 2

What are the three types of market failure

Answer 2

Externalities
Under-provision of public goods
Information gaps

Question 3

What is an externality

Answer 3

An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism. In other words, the spillover effect of the production or consumption of a good or service.

Question 4

What is under-provision of public goods

Answer 4

Public goods are non-rivalry and non-excludable, meaning they are underprovided by the private sector due to the free rider problem. The market is unable to ensure enough of these goods are produced

E.g. streetlights

Question 5

What is information gaps

Answer 5

Homo economics is assumed to have perfect information, allowing them to make rational decisions. Similarly, firms are assumed to have perfect info in their cost and revenue curves and governments are assumed to know the cost and benefits of each decision. In reality, this is not the case. Therefore, consumers do not always make rational decisions and so resources are not allocated to maximise welfare.

Question 6

What are private costs/benefits

Answer 6

The costs/benefits to the individual participating in the economic activity.

Question 7

What does the supply and demand curve represent in terms of private costs and benefits

Answer 7

The demand curve represents private benefits and the supply curve represents private costs

Question 8

What are social costs / benefits

Answer 8

The costs/benefits of the activity to society as a whole

Question 9

What are external costs / benefits

Answer 9

The costs / benefits to a third party not involved in the economic activity. They are the difference between private costs / benefits and social costs / benefits

Question 10

What is a merit good

Answer 10

A merit food is a food with external benefits,where the benefit to society is greater than the benefit to the individual

Question 11

What is a demerit good

Answer 11

A demerit good is a good with external costs, where the cost to society is greater than the cost to the individual, ususally overprovided by the free market

Question 12

What are marginal costs / benefits

Answer 12

A marginal cost / benefit is the extra cost/benefit of producing / consuming one extra unit of the good.

Question 13

What is marginal private cost

Answer 13

The extra cost to the individual from producing one more of the good

Question 14

What is marginal social costs

Answer 14

Marginal social cost is the extra cost to society from the production of one more good

Question 15

When do negative externalities of production occur

Answer 15

Occur when social costs are greater than private costs

Question 16

Where on the externalities graph should the economy produce

Answer 16

Where MSB=MSC

Question 17

When do positive externalities of consumption occur

Answer 17

Occur when social benefits are created than social costs.

Question 18

What ways can the government intervene to ensure the market considers the external costs and benefits

Answer 18

• Indirect taxes and subsidies- taxes on goods with negative externalities and subsided on goods with positive externalities

• tradable pollution permits - allow firms to produce up to a certain amount of pollution. Can be traded among firms

• provision of the good - when social benefits are very high, the government may decide to provide the good through tax. Healthcare and education

• regulation - limit the C of goods with negative externalities.

Question 19

Key characteristics of public goods

Answer 19

• Non rivalry - one persons use of the good doesn’t stop someone else from using it

• non-excludable - cannot stop someone from accessing the good and someone cannot chose not to access to good

Streetlights are an example

Question 20

What are quasi-public goods (non-public goods)

Answer 20

Good which aren’t perfectly non-rivaly and non-excludable but aren’t perfectly rival or excludable. One example is roads.

Question 21

What is the free rider problem

Answer 21

You cannot charge an individual a price for the provision of a non-excludable food because someone else will benefit from it without paying

A free rider is a person who received the benefits of something without paying

Question 22

What is the problem with public goods

Answer 22

Private sector producers will not make a profit due to the non-excludability of the good. Therefore if it was left to the market, the market would fail so they are provided by the government

Question 23

What is symmetric information

Answer 23

Symmetric information occurs where buyers and sellers have potential access to the same information; this is perfect info. However, many decisions are based on imperfect information and so economic agents are unable to make an informed decision; they suffer from an info gap

Question 24

What is asymmetric information

Answer 24

When only one party has superior knowledge compared to another. Usually, the seller has more info than the buyer and this means they can take advantage over the lack of knowledge of the other buyer, usually by charging higher prices

Question 25

What has lead to info gaps

Answer 25

Advertising has led to info gaps as it is designed to change attitudes of the consumers to encourage them to buy the good. It could cause them to think the benefits are greater than they actually are.

Question 26

What has led to a decrease in information gaps

Answer 26

Increased technology has led to a decrease in info gaps as people can get more info

Question 27

Why do information gaps lead to market failure

Answer 27

As there is a misallocation of resources because people do not buy things that maximise their welfare.

Question 28

Examples of info gaps

Answer 28

Drugs, where users do not see the long term problems
Pensions, where young people don’t see the benefits of paying into their pension schemes
Financial services, where the suppliers have more info than the consumers so abuse their customers for their own benefit

Question 29

What is the principle agent problem

Answer 29

When the goals of the principle (the person who gains or loses from the situation) are different from the agents (those making decisions on behalf of the principle.