1.3 - Market Failure

Question 1

What is market failure?

Answer 1

Market failure is where the price mechanism fails to efficiently allocate goods and services, instead failing to meet the needs of society and causing a net welfare loss.

Question 2

How does the government help correct market failure?

Answer 2

As elimination of market failure is the one of the main aims of government, the government will attempt to remedy any allocatively inefficient markets and ensure allocation is efficient and fair (equitable) and intervene in markets.

Question 3

Give the two primary types of market failure.

Answer 3

• Complete market failure

- Partial market failure

Question 4

Describe one of the types of market failure.

Answer 4

Complete market failure is where there is no market present at all (missing market), so this implies that no goods and services will be supplied to the market as the firms will receive no revenue.

Question 5

Describe the other type of market failure.

Answer 5

Partial market failure is where there is a market present but there is a significant misallocation of resources where the demerit goods are overproduced and merit goods are dangerously underproduced.

Question 6

Give examples of market failure.

Answer 6

• Externalities
• Public goods
• Imperfect market information

Question 7

What is an externality?

Answer 7

An externality is a positive or negative impact on a party who is not involved in the economic transaction.

Question 8

When does an externality arise?

Answer 8

An externality typically arises when the private costs and benefits are different from the social costs and benefits.

Question 9

Give an example of an externality.

Answer 9

A person purchases a cigarette from the store and smokes the cigarette outside; for the person, the private benefit is that they feel more ‘relaxed’ but in public, there is a big social cost where unrelated passers-by, might inhale the smoke (passive smoking). In this case, there is a negative externality.

Question 10

What is a private cost?

Answer 10

The private cost is the cost of consuming and producing goods and services which the producers and consumers pay for.

Question 11

What is a private benefit?

Answer 11

The private benefit is the benefit a person gains from consuming a good.

Question 12

What is a social cost?

Answer 12

The social cost is the cost of producing goods and services which the producers do not pay for.

Question 13

What is a social benefit?

Answer 13

The social benefit is the benefits gained by society as a whole, including the individual from consuming a good.

Question 14

Give the types of externalities.

Answer 14

• Positive externalities (external benefits)

- Negative externalities (external costs)

Question 15

Define one of the types of externalities.

Answer 15

Positive externalities (external benefits) are the benefits to a third party, which are not included in the price of the economic activity.

Question 16

Define the other type of externalities.

Answer 16

Negative externalities (external costs) are the costs to a third party, which are not included in the price of the economic activity.

Question 17

What is the negative production externality?

Answer 17

The negative production externality is where the social costs exceed private costs so producers may not properly take into account the external costs, leading to over production and market failure.

Question 18

What is the positive consumption externality?

Answer 18

The positive consumption externality is where the social benefits exceed the private benefits, so

Question 19

Give the formula for social cost.

Answer 19

Social cost = external cost + private cost

Question 20

Give the formula for social benefit.

Answer 20

Social benefit = external benefit + private benefit

Question 21

What is marginal analysis?

Answer 21

Marginal analysis is the change in benefit or cost as a result of production of an additional unit.

Question 22

What is the marginal social cost (MSC)?

Answer 22

The marginal social cost is the cost to society for producing one extra unit.
MSC = MPC + MEC (maginal external cost)

Question 23

What is the marginal private cost (MPC)?

Answer 23

The marginal private cost is the cost to the firm for producing one extra unit of a good.

Question 24

Describe free market equilibrium.

Answer 24

Free market equilibrium is where the marginal private benefit; the benefit perceived by consumers from consuming the good, are equal to the private cost firms pay when supplying the good.

Question 25

Describe socially optimum equilibrium.

Answer 25

Socially optimum equilibrium is where the marginal social cost and marginal social benefit intersect and are the same; the social cost of producing and consuming the good is equal to the social benefit of consuming the good.

Question 26

Give the two characteristics of private goods.

Answer 26

• Excludable

- Rival

Question 27

Describe one of the characteristics of a private good.

Answer 27

The excludable characteristic of a private good is focused on how the consumer can consume the good and reap the benefits as long as they pay the price charged. The price is charged for these private goods so the private sector can gain more profit.

Question 28

Describe the other characteristic of a private good.

Answer 28

The rival characteristic of a private good is focused on how consumption of a good by a consumer can reduce the amount for other consumers.

Question 29

Give the two characteristics of pure public goods.

Answer 29

• Non-excludable

- Non-rival

Question 30

Describe one of the characteristics of a pure public good.

Answer 30

The non-excludable characteristic of a pure public good is focused on how the consumer can consume and enjoy the public good at no financial cost. This means that when the good is provided, it is impossible to stop individuals from using the good.

Question 31

Describe the other characteristic of a pure public good.

Answer 31

The non-rival characteristic of a pure public good is focused on how consumption of a good by a consumer does not reduce the amount of consumption for others.

Question 32

Give examples of pure public goods.

Answer 32

Police service, fireworks display, street lights.

Question 33

Define a quasi public good.

Answer 33

A quasi public good is a good which exhibits characteristics of both public and private goods; they can be non-rival during crowding or congestion or financed using general taxation as a result of government intervention.

Question 34

What is a free-rider?

Answer 34

A free-rider is someone who benefits from a public good or service without paying for it; knowing that consumption is not limited to an individual who has paid, they free-ride over others to consume the good.

Question 35

Describe the free-rider problem and how it contributes to market failure.

Answer 35

The free-rider problem is where consumers do not pay for the public good they are consuming; although there is high demand, as no profit is incurred by the private company, this will result in the price mechanism or private company halting provision of the good. The low supply from this will cause complete market failure and a missing market.

Question 36

What is the solution for the free-rider problem?

Answer 36

The solution for this free-rider problem is for the government to supply public goods as private companies are no longer willing to supply goods due to no money being made.

Question 37

How are public goods financed today?

Answer 37

Typically, general taxation or other forms of charge such as TV licence fees are used to finance public goods.

Question 38

Define information gap.

Answer 38

Information gap is a type of market failure where consumers and producers have imperfect/asymmetric information.

Question 39

What market failures can arise as a result of information gap?

Answer 39

• Adverse selection
• Principal-agent problem
• Moral hazard

Question 40

Give examples of information gap.

Answer 40

Examples include:

• Applying to elite degree university courses
• Addiction to painkillers/drugs
• Tourist bazaars and buying/selling antiques

Question 41

What is asymmetric information?

Answer 41

Asymmetric information is where there is an imbalance in information between the buyer and seller, causing a distortion of choices; a doctor will generally know more than the patient on drugs and treatments, a used car seller will have more knowledge on the quality or age of the car than the buyer.

Question 42

Define moral hazard.

Answer 42

Moral hazard is a type of information gap where an economic agent makes a decision which could result in any adverse effects or a great cost carried by the economic agent.

Question 43

Give an example of moral hazard.

Answer 43

A good example is insurance; insured consumers are insured for a reason (health insurance is given to those who have a long-term health condition), so they will have a greater risk which can lead to a claim being paid for when they are covered. So here, it is the consumer who is more aware of their actions than the insurer (producer).

Question 44

Describe the principal-agent problem.

Answer 44

The principal-agent problem is where the goals of the principal differ from that of the agent; the principal stands to gain or lose from a decision whereas the agent makes decisions for the principal; if the principal was the parent or teacher, they may view education as the most important priority while the student may think otherwise.

Question 45

Give examples of government action to help improve information access for consumers.

Answer 45

• Campaigns for anti-speeding advertising to reduce road accidents
• Anti-gambling adverts
• Performance leagues for schools

Question 46

Describe adverse selection in the market for cars.

Answer 46

Lemons are cars that have a problem and generally these cars are cheaply priced while good quality cars are priced much higher. But because of the lack of information of the buyer, the buyer may not notice the quality difference between the lemon and good quality car so they may pay the same average price for both. This may cause an overproduction of lemons and underproduction of the latter, causing good quality cars to leave the market.

Question 47

Describe adverse selection in terms of health insurance.

Answer 47

Health insurance is typically given to those who smoke, drink or have a long term health condition rather than those who are healthy. Knowing this, the companies increase average price of health insurance, making it harder for healthy consumers to purchase. This can drive out healthy consumers from the market.