Intro to Market Failure

Question 1

Key Idea for Market Failure

Answer 1

There are a number of situations in which the market, through the price mechanism, is not able to deliver the socially optimal allocation of resources. There are a range of reasons why markets do not always work efficiently and effectively, so there are many types of market failure. Market failure may be complete or partial.

Question 2

What is market failure?

Answer 2

Market failures arise when free markets fail to develop, or when they fail to allocate resources efficiently. Market failure is the economic situation defined by an inefficient distribution of goods and services in the free market.

Individual incentives for rational behaviour do not lead to rational outcomes for the group. Put another way, each individual makes the correct decision for him/herself, but not for the group. In traditional microeconomics, this is evidenced by a steady state of disequilibrium where quantity supplied does not equal quantity demanded.

Question 3

What is a deadweight loss?

Answer 3

A deadweight loss is a cost to society created by market inefficiency, which occurs when supply and demand are out of equilibrium. It can be applied to any deficiency caused by an inefficient allocation of resources. The price of the product becomes not accurately reflected, meaning goods are either overvalued or undervalued.

Question 4

Asymmetric Information

Answer 4

A situation where one party to an economic transaction has more or better knowledge than the other party; consumers are less informed than suppliers in almost all economic transactions.

Question 5

Common property goods

Answer 5

Goods or resources for which there are no clearly defined property rights, so no price can be attached to their use (eg. the ocean, atmosphere, wilderness and space).

Question 6

Demerit Good

Answer 6

A private good with negative externalities.

Question 7

Externalities

Answer 7

Indirect costs and benefits associated with the production and consumption of certain goods and services that the market fails to take into account; these benefits or costs are imposed on a third party, who normally cannot pay or be compensated for them through the market mechanism.

Question 8

Factor immobility

Answer 8

Refers to the ability of factors of production to move, usually to an industry or location where they can operate at a higher level of economic efficiency.

Question 9

Market Failure

Answer 9

The inability of a market to determine the use and allocation of resources in a way society most desires, because certain conditions are lacking (eg. limited market power, externalities and public goods).

Question 10

Merit Good

Answer 10

A good or service that is not produced in sufficient quantities by markets because individuals do not value them highly enough; a private good with positive externalities.

Question 11

Public Good

Answer 11

Goods such as national defence, a beach or road that are non-rival (consumption does not reduce quantity) and can be consumed by people that are not paying for the good.

Question 12

The tragedy of commons

Answer 12

The overuse or destruction of a common property good because it has no price and so markets do not ration its consumption.

Question 13

Positive and negative externalities

Answer 13

Goods/services which give benefit to a third party eg. less congestion from cycling.

Question 14

Merit goods

Answer 14

People underestimate the benefit of the good eg. education

Question 15

Demerit goods

Answer 15

People underestimate the costs of good eg. smoking

Question 16

Public Goods

Answer 16

Goods which are non-rival and non-excludable - eg. police, national defence.

Question 17

Factor Immobility

Answer 17

Geographical/occupational immobility

Question 18

Information failure

Answer 18

Where there is a lack of information to make an informed choice.

Question 19

Principal-agent problem

Answer 19

A conflict in priorities between the owner of the asset and the person to whom control of the asset has been delegated. The risk that the agent will act in a way that is contrary to the principal’s best interests can be defined as agency costs.

Question 20

Monopoly Power

Answer 20

When a firm controls the market and can set higher prices.

Question 21

Key Terms with Social Factors

Answer 21

SOCIAL BENEFIT: the total benefit to society
Private Marginal Benefit (PMB) + External Marginal Benefit (XMB)

SOCIAL COST: the total cost to society
Private Marginal Cost (PMC) + External Marginal Cost (XMC)

SOCIAL EFFICIENCY: when resources are utilised in most efficiency way.
Social Marginal Cost (SMC) = Social Marginal Benefit.

Question 22

Complete Failure

Answer 22

A complete market failure exists when free markets are unable to allocate scarce resources to the satisfaction of a need or want. This occurs because there are insufficient incentives to encourage profit-seeking firms to enter a market.

This is commonly the case with pure public goods, such as street lighting, for which there is a need, but private individuals would not be prepared to pay. If no-one is prepared to pay, no revenue can be derived, and no profit earned: hence no firm would enter the market.

Question 23

Partial Failure

Answer 23

A partial failure can occur in four ways:

1. When some but not all necessary conditions for market formation exist. Markets will form, but will fail to develop and supply sufficient quantities of a good or service. eg. Merit good markets are inefficient because they under-supply the goods, and fail to meet society’s demand.
2. When free markets over-supply a good or service, either because producers fail to take into account the full costs of production, or because consumers fail to take into account the full costs of consumption to themselves, or society.
3. When there is a break-down in self-regulation, as in the case of a financial crisis.
4. Where a market becomes highly unstable and fails to return quickly to a stable equilibrum, as in the case of some commodity markets.