1.3 - Market Failure Flashcards
What is market failure?
When the price mechanism causes an inefficient allocation of resources, leading to a net welfare loss.
- externalities
- under provision of public goods
- information gaps
What are externalities?
Costs or benefits which are external to an exchange. Third party effects ignored by the price mechanism. Negative externalities are external costs. Positive externalities are external benefits.
Types of costs
- external costs: negative third party effects
- private costs: internal costs in a market transaction, which are therefore taken into account by the price mechanism.
- social costs: sum of private and external costs
Types of benefits
- external benefits: positive third party effects
- private benefits: internal to a market transaction
- social benefits: sum of external and private benefits
External costs of production and consumption
Production: air pollution, noise pollution, deforestation
Consumption: passive smoking and overeating
External benefits of production and consumption
Production: farmer keeping bees (pollination), recycling plant reduces landfill
Consumption: vaccinations and herd immunity, well-kept gardens increase house prices
Where is the social optimum?
The social optimum equilibrium level of output out price for a good or service occurs were marginal social costs equals marginal social benefits.
What are the impacts of external costs?
- overproduction
- underpricing
- welfare loss
- concerns over future resources, e.g. over-fishing
- concerns over pollution levels, e.g. burning fossil fuels
- calls for government intervention
What are the impact of external benefits?
- underproduction
- underpricing
- welfare gain
- concerns over long-term implications: e.g. under provision of education could lead to lower economic growth in the long run
- calls for govt intervention
What are public and private goods?
Public: goods that have non-rivalry and non-excludability in their consumption
Private: goods that have rivalry and excludability in their consumption
The free-rider problem
Once a public good has been provided for one individual, it’s automatically provided for all. Consumers who refuse to pay cannot be excluded. Rational consumers would wait for the good to be provided then reap the benefits by consuming it for free. Firms are reluctant to supply them as its difficult to profit. The solution is for govt to provide public goods and fun’s them through tax.
What is an information gap?
Where consumers, producers or the govt have insufficient market knowledge to make rational economic decision.
What is the difference between symmetric and asymmetric information?
Symmetric: where consumers and producers have access to the same information about a good or service in the market.
Asymmetric: where consumers and producers have unequal access to information about a good to service in the market.
Producer knowledge exceeding consumer knowledge
A second hand car salesman, for example, has more knowledge than consumers. This may lead to a consumer paying too much. The fear of buying a lemon reduces the market price for all second hand cars even good ones. The solution is to have inspection schemes offered by monitoring organisations such as the automobile association - overcoming information failure. Private doctors or dentists may over-treat patients in order to increase profits.
Consumer knowledge exceeds producer knowledge
Consumer may purchase an insurance policy and conceal information about themselves. The insurance company then provides insurance at too low a price and make a loss. Could lead to insurers leaving market or refusing to make the payouts due. The solution is a watchdog body to investigate fraudulent insurance claims.
This is the principal-agent problem: the agent makes decisions for the principal, but the agent is inclined to act in their own interests rather those of the principal. Moral hazards.
