Chapter 16: Market Failures

Question 1

Monopoly of violence

Answer 1

The government’s control over all physical violence that is employed to enforce its laws and policies

Question 2

3 defences of free markets according to Adam Smith

Answer 2

• Free markets co-ordinate the actions of decentralised decision makers
• The pursuit of profits in free markets provides a stimulus to innovation and rising material living standards
• Free markets permit a decentralisation of economic power

Question 3

Market failure

Answer 3

Failure of the unregulated market system to achieve unregulated allocative efficiency

Question 4

Externality

Answer 4

An effect on parties not directly involved in the production or use of a commodity

Question 5

Private cost

Answer 5

The value of the best alternative use of resources used in production as valued by the producer

Question 6

Social cost

Answer 6

The value of the best alternative use of resources used in production as valued by society

Question 7

Externalities cause _____

Answer 7

Discrepancies between private cost and social cost

Question 8

With a positive externality, a competitive free market will produce too ____ of a good

Answer 8

Little

Question 9

With a negative externality, a competitive free market will produce too ____ of a good

Answer 9

Much

Question 10

Rivalrous good or service, 1 example

Answer 10

A good or service is rivalrous if one person’s consumption of it reduces the amount available for others
-Any food

Question 11

Excludable good or service, 1 example

Answer 11

A good or service is excludable if its owner can prevent others from consuming it
-Chocolate bar (any good that must be purchased before use)

Question 12

Private good or service, 1 example

Answer 12

Both excludable and private

-Aeroplane seat (any good that must be purchased before use, and cannot be used by anyone else)

Question 13

Common-property resource, 1 example

Answer 13

Rivalrous but not excludable

-Clean air (any good that cannot be used by anyone else, but use cannot be regulated)

Question 14

Club good or service, 1 example

Answer 14

Excludable but not rivalrous

-Roads (any good that can be used my anyone at any time, but use can be regulated)

Question 15

Public good or service, 1 example

Answer 15

Non-excludable and non-rivalrous

-National defence

Question 16

The optimal quantity of a public good is such that the marginal cost of the good equals ___________

Answer 16

The sum of all users’ marginal benefits of the good

Question 17

Asymmetric information

Answer 17

A situation in which one party to a transaction has more or better relevant information about the transaction than the other party

Question 18

Two sources of market failure arising from asymmetric information

Answer 18

• Moral hazard

- Adverse selection

Question 19

Moral hazard

Answer 19

A situation in which an individual or a firm takes advantage of special knowledge while engaging in socially inefficient behaviour

Question 20

Adverse selection

Answer 20

Self-selection, within a single risk category, of persons of above-average risk e.g. an individual with a heart condition taking out additional health insurance coverage without a medical examination

Question 21

Even in the absence of market failures, the government may choose to intervene in markets to achieve ________

Answer 21

Broader social goals

Question 22

Paternalism

Answer 22

Intervention in the free choices of individuals by others to protect them against (what is presumed to be) their own ignorance or folly

Question 23

Cost-benefit analysis

Answer 23

An approach for evaluating the desirability of a given policy, based on comparing total (opportunity) costs with total benefits

Question 24

Rent seeking

Answer 24

Private firms and individuals trying to use the powers of the government to enhance their own economic well-being in ways that are not in the social interest

Question 25

Rational ignorance

Answer 25

When agents have no incentive to become informed about a government policy because the cost of doing so would exceed the benefits of any well-informed action the agent might take