1.3 Market Failure

Question 1

When does market failure occur?

Answer 1

When the market fails to allocate scarce resources efficiently, causing a loss in social welfare loss

Question 2

What are the three main 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. It is the spillover effect of the production or consumption of a good or service

Question 4

How do externalities lead to market failure?

Answer 4

This leads to the over or under-production of goods, meaning resources aren’t allocated efficiently.

For example, ​cars and cigarettes have negative externalities whilst education and healthcare have positive externalities​

Question 5

What is a public good?

Answer 5

A commodity, product or service that is both non-excludable and non-rivalrous

Question 6

What does it mean when a good is non-rivalrous?

Answer 6

Consumption of a good by one person does not reduce the amount available for others

Question 7

What does it mean when a good is non-excludable?

Answer 7

Goods that cannot exclude a certain individual or group of individuals from using them

Question 8

How does the underprovision of public goods lead to market failure?

Answer 8

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 provided

One of the best examples of a public good is ​streetlights​

Question 9

How do information gaps lead to market failure?

Answer 9

Economic agents are assumed to have perfect information, in reality, this is not the case. Therefore, economic agents do not always make rational decisions and so resources are not allocated to maximise welfare.

For example, ​consumers do not know the quality of second hand products, such as cars, and pension schemes are complex so it is difficult to know which one is best.

Question 10

What are private costs?

Answer 10

Private costs ​are the costs to the individual participating in the economic activity. The supply curve represents private costs.

Question 11

What are private benefits?

Answer 11

Private benefits ​are the benefits to the individual participating in the economic activity. The demand curve represents private benefits

Question 12

What are social costs/benefits?

Answer 12

Social costs/benefits​ are the costs/benefits of the activity to society as a whole.

Question 13

What are external costs/benefits?

Answer 13

External costs/benefits are 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 14

What is a merit good?

Answer 14

A good with external benefits, where the benefit to society is greater than the benefit to the individual. These goods tend to be underprovided by the free market.

Question 15

What is a demerit good?

Answer 15

A good with external costs, where the cost to society is greater than the cost to the individual. They tend to be over-provided by the free market.

Question 16

What is a marginal cost?

Answer 16

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

Question 17

What is a marginal benefit?

Answer 17

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

Question 18

When do negative externalities of production occur?

Answer 18

When social costs are greater than private costs.

Question 19

What does this diagram show?

Answer 19

Negative production externalities. The loss of welfare/deadweight loss is the shaded orange region

Question 20

What is the socially optimum point on this diagram?

Answer 20

Where MSB=MSC

Question 21

When do positive externalities of consumption occur?

Answer 21

When social benefits are greater than social costs

Question 22

What does this diagram represent?
What does the shaded orange region show?

Answer 22

This diagram represents positive consumption externalities
The shaded region represents the welfare loss/deadweight loss

Question 23

How can the government intervene to ensure the market considers externalities?

Answer 23

● Indirect taxes and subsidies
● Tradable pollution permits
● Provision of information
● Provision of the good (e.g healthcare, education)
● Regulation (banning adverts for smoking etc)

Question 24

What are Quasi-public goods/non-pure public goods?

Answer 24

Goods which aren’t perfectly non-rivalrous or non-excludable but aren’t perfectly rival or excludable

One example could be roads which are semi-excludable as there could be tolls, and semi-rivalry as people don’t ‘use up’ the roads but congestion causes problems during rush hour

Question 25

What is a free rider?

Answer 25

A ​free rider is someone who receives the benefits without paying for it.

Question 26

Why does the private sector not provide public goods?

Answer 26

You ​cannot charge an individual a price for the provision of a non-excludable good because someone else will gain the benefit from it without paying anything (free rider problem). Therefore they cannot be sure of making a profit ## Footnote If the provision of public goods was left to the market mechanism, the market would fail and so they are provided by the government and financed through taxation.

Question 27

What is symmetric information?

Answer 27

Where buyers and sellers have potential access to the same information

Question 28

What is imperfect information?

Answer 28

The buyers and/or sellers do not have all the information necessary to make an informed decision

Question 29

What is asymmetric information?

Answer 29

When one party has superior knowledge compared to another ## Footnote Usually, the seller has more information than the buyer and this means they can take advantage of the other party’s lack of knowledge, by charging them a higher price

Question 30

How can advertising lead to information gaps?

Answer 30

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 31

How have increases in technology affected information gaps?

Answer 31

Increases in ​technology mean information gaps are on the decline as people can get more information easier and faster

Question 32

How do information gaps lead to market failure?

Answer 32

As there is a ​misallocation of resources because people do not buy things that maximise their welfare ## Footnote Economic agents are unable to make rational decisions due to the information gap.

Question 33

What is the principal-agent problem?

Answer 33

When the goals of the principle (the person who gains/loses from the situation) are different from the agents (those making decisions on behalf of the principle) ## Footnote E.g. education where the child is the principle and the agents are the parents/governors: the child has imperfect information as they do not see the benefits of education and so therefore will devote too few resources to education, if allowed