L3 - Market Failures & the Role of Governments

Question 1

Explain the concept of opportunity cost.

Answer 1

• Opportunity cost – best alternative that is forgone o Any allocation of resources has an opportunity cost – you make the optimal allocation BUT optimal for WHO? o A private company will produce at the level to maximize profits o A social welfare theory wants production at a level that maximizes social good, uses govt to make lump-sum payments that redistribute wealth

Question 2

Explain game theoretic dilemmas and their applications in aerospace

Answer 2

• A company must decide what to do in relation to other companies in the market • Dominant strategy – a players best strategy is independent of others actions • Nash equilibrium – when each player is doing the best he can, given the strategies of the other players • Govt subsidies are an external factor that impacts the payoff matrix – i.e. ESA subsides an Airbus venture, making it unprofitable for Boeing to enter the market

Question 3

Explain fundamentals of cost-benefit analysis and decision-making

Answer 3

• For Govt, cost-benefit analysis includes social welfare and cost effectiveness • Tangible/intangible, direct/indirect, social/private (define agent/stakeholder) → bring all in NPV format and compare using relevant tools

Question 4

Explain the concept of utility.

Answer 4

• Utility – representation of preferences – correlates w/satisfaction
o Utility curves – any point on curve gives the same level of satisfaction
o Shape depicts preference – i.e. an L shaped curve indicates perfect complements
o Curve where U2 is preferred over U1 – curves are indifferent, any point on U2 is better than any point on U1

Question 5

Explain the three main types of market failure (externalities, public goods and natural monopoly/imperfect competition)

Answer 5

• In competitive markets you have efficiency – MC=MB
• Externalities – an agents actions do not take into account the impact on others
o +/- and production/consumption
o difference between marginal social benefit and marginal private benefit
o I.e. negative production externalities:

• Public goods – non-rivalry in consumption and non-excludability → costly provision of public good and free-riding b/c no incentive to pay for good (national security)
o Levels of consumption are the same for all individuals
o Marginal social benefit = sum of marginal private benefits
• Natural monopoly/imperfect competition – minimum efficient scale of operations is substantial → monopolies or oligopolies that engage in strategic interactions, tacit collusion