E: Market Failure

Question 1

What price function does this describe: as prices rise, excess demand is removed and only consumers with the ability to pay are able to purchase the good

Answer 1

The rationing function

Question 2

What price function does this describe: Prices provide important signals to market participants

Answer 2

The signalling function

Question 3

What price function does this describe: increased prices strengthen incentives to firms to produce more in order to make a profit

Answer 3

The incentive function

Question 4

What does the allocative function do?

Answer 4

Acts to divert resources to where they can maximise their returns and away from uses where they do not

Question 5

What is the role of the government in a free market economy?

Answer 5

The government limits itself to protecting property rights of people and businesses using LEGAL system and protecting the value of money or the value of a currency

Question 6

What is the idea of consumer sovereignty?

Answer 6

Consumer sovereignty is the idea that it is consumers who influence production decisions. The spending power of consumers means effectively they ‘vote’ for goods. Firms will respond to consumer preferences and produce the goods demanded by consumers. It is a manifestation of the ‘invisible hand’

Question 7

How can we link allocative efficiency and consumer sovereignty?

Answer 7

As advantages of the free market. It enables an efficient allocation of scarce resources so factor inputs go where expected profit is highest which in turn represents the goods/services most desired by consumers (allocative efficiency + consumer sovereignty)

Question 8

How does the free market benefit the consumer?

Answer 8

Competition and Profit motive:
* Drives innovation, higher profits so better products
* Trade competition reduces domestic monopoly power
* Competitive prices as firms want to up market share
* Stimulates investment - economies of scale - lower prices

Question 9

Failures of a free market economy

Answer 9

• Public goods not provided
• Demerit goods over produced
• Merit goods underproduced, even education + healthcare
• Those unable to work will live in poverty - inequality
• Monopolies
• Exploited labour and environmental damage

Question 10

Define market failure

Answer 10

Misallocation of resources

Question 11

What makes partial market failure different from complete market failure?

Answer 11

The market exists (so it is not a missing market) , but it is consumed or produced in quantities that do not maximise economic welfare.

Question 12

Why is a lighthouse a public good and not a private good?

Answer 12

It is non-excludable and **non-rival **

Question 13

What problem can be associated with non-excludability

Answer 13

free-rider problem

Question 14

What is the marginal cost of supplying a public good to an extra person?

Answer 14

ZERO

Question 15

Explain how a beach is a quasi-public good

Answer 15

It is semi non-rival because consumption by one consumer does not restrict consumption for another until the beach becomes crowded. It is semi non-excludable because it is difficult or costly to exclude non-paying people. E.g fencin a beach and charging an entrance fee

Question 16

Why should the government provide public goods?

Answer 16

• Solve the market failure
• Under provision or consumption is prevented so social welfare improves
• Helps affordabilty and access to important services for lower income households

Question 17

Why should the government NOT provide public goods?

Answer 17

If it becomes a monopoly power, inefficiencies arise from lack of competition. There could be a signigicant opportunity cost

Question 18

What is the underlying issue behind Tragedy of the commons?

Answer 18

The lack of property rights (confer legal control or ownership). For markets to operate efficiently, property rights must be protected (perhaps by regulation). An un-owned asset carries no incentive for protection. E.g. long-term decline of fish stocks. Individual users aim to maximise their own utility and in doing so, reduce the benefits for everyone and ultimately themselves because it’s overused.

Question 19

What are externalities?

Answer 19

Externalities are impacts on third parties as a result of a market transaction

Question 20

essay repeatable, think exchange

Why aren’t externalities reflected in the market price?

Answer 20

Because they lie outside the initial market transaction

Question 21

multiple choice questions like this one

Social cost = ?

Answer 21

Social costs = private + external costs

Question 22

specification wording

Externalities occur when…

Answer 22

There is a divergence between private and social costs and benefits

Question 23

evaluation

How can we use externalities to argue that government interventions may be ineffective?

Answer 23

It is virtually impossible to value an external cost. If the government used a tax to reduce production to the S.O.L this required an indirect tax EQUAL to the value of the external cost

Question 24

What should we remember when drawing the deadweight welfare loss trianlge

Answer 24

1. The traingle forms an arrow that points to the socially optimal outcome

Question 25

What analysis do we say when explaining negative production externalities

Answer 25

1. In the free market, the individual firm will only consider their private costs and benefits and not those of wider society so they will produce at the free market equilibrium Q1P1
2. MSC > MPC
3. The socially optimal level occurs where MSB=MSC at Q2P2 so there is over production by Q1-Q2 leading to …
4. An overall welfare loss equal to the triangle enclosed by the letters AEF

Question 26

What analysis do we say when explaining negative consumption externalities?

Answer 26

1. In the free market, Consumers only consider the private benefits to themselves and not those of wider society
2. MPB>MSB
3. The socially optimal level occurs where MSB=MSC at Q2P2 so there is overconsumption by Q2-Q1
4. This leaves an overall welfare loss equal to the triangle enclosed by the letters FEA

Question 27

What analysis do we say when explaining positive consumption externalities

Answer 27

1. MSB>MPB
2. The socially optimal level is where MSB=MSC and at Q2P2 so there is underconsumption by Q1-Q2
3. This leaves an overall welfare loss equal to the triangle enlosed by AEF

Question 28

What analysis do we say when explaining positive production externalities?

Answer 28

1. MPC>MSC
2. The socially optimal level is where MSB=MSC at Q2P2 so there is underproduction by Q1-Q2
3. This leaves an overall welfare loss equal to the triangle enclosed by FEA

Question 29

just a tip for externalities essays

Answer 29

Carefully consider the 3rd party being affected. If a production process is creating atmospheric pollution; don’t just write “pollution is a negative externality” but write “people living close to the factory may be inhaling air containing particles that are likely to make them ill which may result in them taking time off work and losing income as a result”

Question 30

The classification of a merit or demerit good depends on ___

Answer 30

A value judgement

Normative

Question 31

Merit good definition

Answer 31

A good underconsumed in the free market because consumers are unaware of the potential (long term) benefits of consumption and do not take the external benefits into account

Question 32

Demerit good definition

Answer 32

A good overconsumed in the free market because consumers are unaware of the long term damage from consumption and do not take the external costs in to account

Question 33

What behavioural economics concepts apply to merit and demerit goods?

Answer 33

1. Information failure
2. Present value bias

Question 34

How does Asymmmetric information lead to market failure?

Answer 34

Where there is an imbalance of information between buyer and seller choices can be distorted

Question 35

Insurance markets are plagued by two important aspects of asymmetric information. What are they?

Answer 35

1. Moral hazard - insured consumers are likely to take greater risks knowing that a claim will be paid for by their cover. The consumer knows more about their intended actions than the insurer
2. Adverse selection - those most likely to need e.g. health insurance are those most likely to purchase it. Since the insurance company knows this, they raise the avg. price of the cover, potentially pricing out some healthy low risk consumers out of the market

Question 36

monopoly - only one firm supplying (or largest market share)

Low price elasticity of demand means profits can be increased by restricting output and elevating price when there is a monopoly. What are the issues with this?

Answer 36

1. A monopoly producer has no incentive to be economically efficient so consumers will not benefit form the lowest prices or have a choice of products
2. The market failure leads to productive inefficiency
3. Allocative inefficiency
4. Reduced choice for consumers - an equity issue

Question 37

A mismatch between skills on offer and those required

Give an example of occupational immobility

Answer 37

A former steel worker may not find it easy to switch to working as an IT consultant as they may lack the specific skills required.

Link to structural unemployment

Question 38

Define geographical immobility

Answer 38

a source of factor immobility that means workers have difficulty moving to locations where jobs are available for reasons such as a lack of affordable housing or family commitments

Question 39

What is equity

Answer 39

the notion of fairness in the allocation of economic resources

Question 40

What are the opposite sides of the coin when it comes to views on inequality?

Answer 40

• free market capitalists would argue inequality creates useful incentives among economic agents that positively influence overall national income and can ‘trickle down’ to poorer members of society, raising overall living standards
• critics say inequality creates social tensiosn between the relatively rich and poor, leading to reduced living standards