1.3 Market Failure Flashcards
What is market failure?
When the market fails to allocate scarce resources efficiently, causing a loss in social welfare.
What are the three main types of market failure?
- Externalities – Costs or benefits to third parties outside the market mechanism.
- Under-provision of public goods – Public goods are underprovided due to the free-rider problem.
- Information gaps – Economic agents lack full information to make rational decisions.
What are private costs and benefits?
Costs or benefits to the individual participating in an economic activity.
What are external costs and benefits?
Costs or benefits to the third parties outside of the market mechanism.
What are social costs and benefits?
The total costs or benefits to society, including both private and external effects.
What is the difference between a merit good and a demerit good?
- Merit good: A good with external benefits that is underprovided in the free market (e.g. education, healthcare).
- Demerit good: A good with external costs that is overprovided in the free market (e.g. cigarettes, pollution).
What is a negative production externality?
When the production of a good imposes external costs on third parties (e.g. industrial pollution).
Graph: Negative externalities of production
In a free market (P1&Q1), the product is under priced and over produced as the negative externalities are ignored. The socially optimal level is at P2&Q2. For the amount of over production, MSC>MSB: there is a net social cost and this is the social welfare loss area (orange triangle).
What are the impacts of external costs on economic agents?
- Inefficient pricing, since the free-market price is not at the socially optimal level of pricing.
- Over production, since the free-market output is above the socially optimal level of production. This results in an inefficient allocation of resources to the production of the good/service.
- An area of welfare loss, as marginal social costs are greater than marginal social benefits for the amount over produced.
This leads to an over provision of goods/services with external costs, creating concerns for future generations and concerns over pollution levels.
What are three possible methods of government intervention to correct for negative production externalities?
- Taxation
- Quotas on production
- Information provision on effects in order to reduce demand
What is a positive consumption externality?
When the consumption of a good provides external benefits to society (e.g. vaccinations).
Graph: Positive externalities of consumption
In a free market (P1&Q1), the product is under priced, under valued, and under produced as the positive externalities are ignored. The socially optimal level is at P2&Q2. For the amount of under production, MSB>MSC: there is a net social benefit and this is the social welfare gain area if output were at the socially optimal level (orange triangle).
What are the impacts of external benefits on economic agents?
- Inefficient pricing, since the free-market price is not at the socially optimal level of pricing.
- Under production, since the free-market output is bellow the socially optimal level of production. This results in an inefficient allocation of resources to the production of the good/service.
- An area of welfare gain is not realised, as marginal social benefits are greater than marginal social costs for the amount under produced.
This leads to an under provision of goods/services with external benefits such as healthcare and education. This could lead to lower economic growth, lower international competitiveness, and living standards my progress at a slow pace.
What are three possible methods of government intervention to correct for the under provision of goods/services with positive consumption externalities?
- Subsidies
- Information provision on effects to increase demand
- Government provision of the product (e.g. NHS)
What are the three key characteristics of private goods?
- Rivalry – One person’s use reduces availability for others.
- Excludability – Consumers be prevented from using it if they are not willing or able to pay for it.
- Rejectability - Private goods and services can be rejected as consumers may not want to buy them.
What are the two key characteristics of public goods?
- Non-rivalry – One person’s use does not reduce availability for others.
- Non-excludability – No one can be prevented from using it.
What are some examples of private and public goods?
Private:
- Cars
- Sky membership
- Food and drink
Public:
- Street lights
- National defence
- Lighthouse protection
Why does the government provide public goods?
The private sector does not supply them due to the free-rider problem and lack of profit incentives.
What is the free-rider problem?
People benefit from public goods without paying, leading to under-provision in the free market.
What is symmetric information?
When buyers and sellers have equal access to information.
What is asymmetric information?
When one party has more information than the other (e.g. sellers knowing more about car defects than buyers).
How do information gaps cause market failure?
Consumers and producers make poor decisions, leading to a misallocation of resources.
Give examples of information gaps.
- Drugs – Users underestimate long-term harm.
- Pensions – Young people undervalue future benefits.
- Financial services – Providers exploit consumer ignorance (moral hazard).
How can the government correct negative externalities?
- Indirect taxes – Increase the cost of harmful goods.
- Regulation – Legal restrictions (e.g. smoking bans).
- Tradable pollution permits – Limit pollution while allowing firms flexibility.
