1.3 Market failure Flashcards
What is market failure
When the price mechanism leads to a misallocation of resources
What are the three types of market failure
- Externalities
- Under provision of public goods
- Information gaps
What is an externality
unintended side effects that affect third parties who are not part of the transaction.
What is a negative consumption externality
when the consumption of a good or service negatively impacts third parties who aren’t involved in the transaction.
What is a negative production externality
When the production of a good affects people or the environment who are not involved
3 examples of consumption externalities
- Second hand smoking
- Alcohol consumption: excessive drinking leads to public health issues/ accidents
- Noise pollution
3 examples of production externalities
- Air pollution: affects the health of residents
- Water pollution: harm to marine life
- Deforestation: loss of diversity
What are private costs
The costs that a person or business has to pay directly when making or buying something
What are external costs
Costs imposed on third parties who are not part of the transaction or activity.
What are social costs
Represent the overall impact of an activity on society: external costs + private costs
What are private benefits
Benefits received by producers or consumers directly involved in a transaction
What are external benefits
Benefits received by third parties who are not part of the transaction or activity.
What are social benefits
Represent the total benefits of an economic activity: private benefits + external benefits
Impact of negative externalities in consumption
- Consumers focus upon personal satisfaction to maximise utility rather than a wider impact
- Overconsumption: negative effects aren’t factored into prices creating excessive demand for them
- Misallocation of resources: resources are directed towards producing harmful good to meet demand
Impact of negative externalities in production
- Firms may ignore social cost and focus upon private cost in order to maximise profits
- Misallocation of resources: the true cost of production (private + external) is not considered.
- Loss of welfare for external individuals
Impact of positive externalities in consumption
- Under consumption: People may consume less of the good than is socially optimal because they don’t fully consider the benefits to others
- Welfare gain: the overall well-being of society increases as more people consume these beneficial goods.
Impact of positive externalities in production
- Underproduction: Producers don’t take into account the positive external effects they generate, producing less and leading to a loss in potential social welfare
How can the government correct externalitiees
- Taxes
- Subsidies
- Regulation
- Tradeable pollution permits
- Minimum/ maximum price
How does taxes correct externalities
Indirect tax = increases costs -> production becomes more expensive and private costs increase -> reduces incentives for producers to supply more of the good or service -> ensures market is working at the socially efficient equilibrium -> internalises negative externality
Specific tax = shifts supply curve up as producers require higher prices to makeup for tax - reduces equilibrium quantity & over production/consumption
How does subsidies correct externalities
Subsidies = reduces the cost of production or consumption -> increases the incentive to supply more of the good or service -> subsidy reduces the price of the good for consumers increasing demand -> : The subsidy helps the market reach the social optimum, where the quantity produced and consumed is higher -> reduces welfare loss
What is a public good
Public goods = non-excludable and non-rivalrous, meaning that no one can be excluded from their benefits, and consumption by one does not reduce availability to others.
What is a private good
Private goods = rivalry and excludability, consumption by one individual reduces the availability of the good for others and Producers or sellers can prevent individuals from consuming the good if they do not pay for
What is the free rider problem
When individuals can benefit from a public good without having to pay for it
Why should the government provide public goods
- State provision helps to prevent under production and under consumption increasing social welfare
- Providing public goods helps affordability as private firms rely on profit-making,
Why shouldn’t the government provide public goods
If the government becomes a monopoly provider the good and service may lack high quality due to lack of competition
* Market failure through free rider problem
What is a quasi-public good
Containd qualities of both public and private goods: i.e could be non-rivalrous, meaning one person’s use does not reduce the amount available for others, but they can be excludable, meaning it is possible to limit access.
What is symmetric infomation
All parties in a transaction have equal access to information about the product, service, or market.
What is asymmetric information
When one party in a transaction has more or better information than the other party.
What is adverse selection
When information asymmetry leads to the selection of unfavorable or risky choices.
What are the consequences of Information Failure
- Adverse selection
- Moral hazard
- Market failure
What is moral hazard
Where one party is able to take risks because they do not have to bear the full consequences of those risks.
What causes information failure
- Complexitity
- Price infomatinon
- Imperfect Information
- Misinformation
What is imperfect information
Even when both parties have access to some information, it may be incomplete, outdated, or inaccurate
