Chapter 5 - Market Failure and Public Policy

Question 1

free riding problem

Answer 1

when an agent’s decision does not take into account the costs imposed on other agents

Question 2

externality

Answer 2

when a agent’s actions have an effect on other agents that goes beyond the market transaction per se
positive or negative

Question 3

tragedy of the commons

Answer 3

the situation where a common resource is overused with respect to the socially optimal level (negative)

Question 4

congestion

Answer 4

when many agents are in the same situation, not only harming themselves but others as well (negative)
example: traffic

Question 5

public goods

Answer 5

actions of an agent that benefit themselves but also the rest (positive)

Question 6

externality-correcting taxes

Answer 6

to correct these externalities, economists propose applying this

Question 7

in markets with externalities, the fundamental theorem fails to hold

Answer 7

market price is no longer the right guide for consumers and producers, something else is required to establish social efficiency
-> Pigou tax

Question 8

pigou tax

Answer 8

an output tax should be imposed if there is a negative externality and an output subsidy if it is positive
is intended to correct a specific market outcome
social costs should be included, shifting the supply curve upwards/downwards by the tax

Question 9

alternative solutions to the externality problem

Answer 9

direct regulation on externality-creating activity

social norms may already regulate externalities

Question 10

coase theorem

Answer 10

in the face of market inefficiencies resulting from externalities, entities are able to negotiate a mutually beneficial, socially desirable solution as long as there are no costs associated with the negotiation process.

Question 11

market externalities imply market failure. Pigou taxes and other mechanisms may reestablish equilibrium efficiency

Question 12

imperfect information

Answer 12

asymmetric information -> Adverse selection advantageous selection, moral hazard

Question 13

reasons for the creation of a monopoly

Answer 13

• government granted monopoly such as patent or copyrights
• network effects where firms beat in market cap
• frequently mixture of things: product quality and efficient production, high entry and set-up costs,…

Question 14

Differences between competitive markets and monopolies

Answer 14

Question 15

residual demand curve

Answer 15

An individual firm faces a residual demand curve. This is the market demand not met by other sellers. It is equal to the market demand minus the supply of all other firms.

Question 16

the monopoly model provides a good approximation to the behaviour of dominant firms

Question 17

monopoly power

Answer 17

the ability to sell at a price substantially above cost

Question 18

the degree of monopoly power is … related to the demand elasticity faced by the seller

Answer 18

inversely

Question 19

regulation

Answer 19

government intervention in an economic activity using commands, controls and incentives

Question 20

different types of regulation

Answer 20

market regulation (price mechanism)
entry regulation
firm regulation
social regulation (apply to everyone)

Question 21

normative theory of regulation

Answer 21

consumers faced with negative effects of market failure demand regulation from the government

Question 22

capture theory

Answer 22

defends that market regulation is a tool employed by firms to better serve their own interest

Question 23

price fixing

Answer 23

firms collude to set a price acting as a monopoly together, they have market power, these collusions are called horizontal agreements

Question 24

merger policy

Answer 24

focuses on preventing firms to merge or acquire others resulting in an excessive concentration of market shares

Question 25

abuse of dominant position

Answer 25

monopolies are not per se illegal, but an abuse of such monopoly or a dominant position is

Question 26

natural monopoly

Answer 26

if fixed costs are very large or scale economies are very significant the competition might not exist
cost structures are such that costs are minimized with one supplier only
-> direct firm regulation
social welfare will be maximized but firms may leave as they cannot take on that price

Question 27

regulatory capture

Answer 27

situation whereby firms invest resources into influencing the regulator’s decisions, to the point that regulation reflects the objective of profit maximisation rather than that of welfare maximisation

Question 28

average cost pricing

Answer 28

firm is forced to set the lowest price consistent with making a non-negative profit; that is price equal to marginal cost
this solution is intermediate between those of marginal cost pricing and unregulated monopoly

Question 29

rate-of-return regulation

Answer 29

is a mechanism whereby prices are set so as to allow the firm a fair rate of return on the capital it invests (similar to average cost pricing)
gives the firm little incentive for cost reduction

Question 30

regulatory lag

Answer 30

the gap between the time when the firm reduces its cost and the time when the new regulated prices take effect

Question 31

low-power incentive mechanism

Answer 31

price varies in the same measure as cost, which minimises the incentives for cost reduction

Question 32

high-power incentive mechanism

Answer 32

price is set beforehand and does not change at all even if cost changes

Question 33

a high-power regulation mechanism provides strong incentives for the cost reduction but little incentives for quality provision. In addition it implies a high degree of risk for the regulated firm and requires strong commitment on the part of the regulator

Question 34

efficient component pricing rule (ECPR)

Answer 34

allows the independent downstream firms to survive if and only if they are competitive with respect to the vertically integrated firm
if ECPR is applied, production efficiency is maximised