Market Failure

Question 1

Define market failure.

Answer 1

Market Failure is defined as the failure of the free market to achieve an efficient allocation of resources that maximizes the society’s welfare and to achieve social goals such as equity.

Question 2

Name the six sources of market failure.

Answer 2

Externalities 
Demerit goods and merit goods 
Public goods 
Market imperfections 
Information failure 
Immobility of factors of production

Question 3

Name the measures used to correct market failure.

Answer 3

Taxes and Subsidies (market-based policies)
Legislation and Government regulations
Direct provision
Education and Campaigns

Question 4

Define externalities.

Answer 4

In short, externalities are the third party effects ignored due to the pursuit of self-interest by consumers and producers.

An externality occurs when some of the costs or benefits associated with the production or consumption of a good spill over onto third parties (other than the immediate buyer/seller of the good). They can be in the form of external costs or benefits. They create a divergence between private and social costs and benefits as producers and consumers of a good, in their pursuit of self-interest, will only consider their own private costs and benefits. Hence, these private-decision makers will not take into account any external costs or benefits on third parties. There can be positive or negative externalities that arise from either the production or consumption of a good or service.

Question 5

Define private cost, external cost, social costs.

Answer 5

Private costs are the opportunity costs incurred by those who actually produce or consume a good. It measures the value of the next best alternative use of resources available to the private producers or consumers borne solely by the individuals who incur them.

External costs are the costs imposed on third parties who are not directly involved in the production or consumption of the good or service.

Social costs are the opportunity costs to society and consists of both private and external costs the production or consumption of the good or service..

Question 6

Define private benefit, external benefit, social benefit.

Answer 6

Private benefits is the satisfaction or reward that private individuals or firms obtain from the production or consumption of the good or service.

External benefits are the benefits enjoyed by third parties who are not directly involved in the production or consumption of the good or service.

Social benefits are the total gains in welfare by the whole society and consists of the private and external benefits from the production or consumption of the good or service.

Question 7

Define demerit goods.

Answer 7

(imperfect information and externalities)

Demerit goods are goods or services deemed socially undesirable by the government and are over-consumed when left to the free market price mechanism (leading to mkt failure). This is because of consumers’ failure to recognise the full costs arising from the consumption of the good, including the expected private costs to themselves and the external costs that can be incurred by third parties. Thus, over-consumption will result in too much resources allocated to the production and consumption of these goods and hence, allocative inefficiency.

Question 8

Define merit goods.

Answer 8

Merit goods are goods or services deemed socially desirable by the government and are under-consumed when left to the free market price mechanism (leading to mkt failure). This is because of consumers’ failure to recognise the full benefits that could be derived from the consumption of the good, including the expected private benefits to themselves and the external benefits that can be enjoyed by third parties. Thus, under-consumption will result in too little resources allocated to the production and consumption of these goods and hence, allocative inefficiency.

Question 9

Explain why consumers would overconsume demerit goods, leading to market failure. Draw diagrams to explain.

Answer 9

(a) Imperfect information/information failure: Government believes that consumers overvalue demerit goods as they have imperfect information about the MPB arising from the consumption of the good, causing their perceived MPB to be height than their actual MPB. (Diagrams on page 14) For example, individuals may not be fully aware of all the ill effects of consuming cigarettes such as lung cancer and other diseases. The underestimation of ill effects results in an overestimation of their private benefits from smoking. Hence, if left to the free market, consumers’ demand for cigarettes under imperfect information (perceived MPB) would be higher than the demand under perfect information (actual demand). As shown in the diagram, assuming that there are no externliaties in the production of the good, consumers will overconsume by QeQs and the market is allocatively inefficient, leading to a DWL of area XXX as the social benefits gained from consuming QeQs units is less than the opportunity costs incurred from the production of QeQs units and society would be better off if fewer units of the good were consumed*.
(b) Negative externalities from consumption (explain by yourself)

Question 10

Explain why consumers would under consume merit goods, leading to market failure. Draw diagrams to explain.

Answer 10

(a) Imperfect information:
The government believes that consumers undervalue their own private benefits arising from consuming merit goods as they have imperfect information about the private benefits they can enjoy when consuming merit goods. This results in a divergence between DD0 (with imperfect information) and DD1 (perfect information) where DD0 is lower than DD1. Assuming that there are no externalities in the production of the good, free-market eqm occurs at Qe and a socially optimal level of output occurs at Qs. (Diagrams on page 15) Hence, if left to the free market, with imperfect information, consumers will under consume by QeQs and too little resources are diverted to the consumption and production of the good and the market is allocatively inefficient, leading to a DWL of area XXX as the social benefits lost from not producing QeQs units is more than the resources saved in not producing QeQs units of the good and society would be better off if more units of the good were consumed*.

(b) Inability to pay due to excessive income inequality
In a free-market economy, an individual’s ability to consume goods and services and the allocation of resources depends on dollar votes, which is dependent on the individual’s income or savings. When individual consumers pay to consume a good or service, they are showing support for the good with their dollar votes and hence allocating resources in the market. Excessively unequal distribution of income and wealth may result in a misallocation of resources as the free market prioritises effective demand for goods and services and will not always respond to the needs and wants of people with insufficient dollar votes. Hence, there will be groups of people who do not have the ability to pay and hence the ability to consumer merit goods such as education and healthcare. (Diagram on page 16 - if income distribution is less unequal, demand will rise and arrive at the socially optimal level of output)

(c) Positive externalities from consumption

Question 11

Define public goods and explain why they are typically not supplied by the free market (source of market failure).

Answer 11

Public goods are goods that possess two defining features:
(a) non-rivalry in consumption: A good is non-rivalrous in consumption when the consumption of the good by one person does not reduce the amount or benefits available to others/the consumption of the good by one more user does not reduce the benefit enjoyed by another user/the rest in terms of the quality and quantity of the good available. . The supply of a public good, once provided, is not depleted by an additional user. Thus, the marginal cost of providing for and allowing an additional user to share in the usage of the good or service (e.g. defence services) is zero. To achieve the AE provision of a public good, consumers should pay a price = MC of serving an additional user. Since MC = 0, public goods should be made available free of charge to all individuals to achieve AE and optimal consumption level.

(b) non-excludability. A good is non-excludable when it is impossible or very costly to exclude non-payers from consuming and benefiting from the good once it has been provided. Since those who do not pay cannot be excluded from benefiting, no one has much incentive to pay for the good and this is called the ‘free rider problem’. Suppliers will find it difficult and impossible to collect revenue for the goods they provide, When a large number of consumers become free riders, the lack of profitability leads to the non-provision of the good by profit-maximising private firms in the free market, resulting in missing market for public goods like national defence.

Note: Many students erroneously wrote, “Due to the non-rivalrous nature, the marginal cost of producing an additional unit of public goods is zero …”. This is inaccurate as the production of an additional unit of the good will require the use of resources and hence incur marginal costs. The marginal cost of an additional unit of the good is NOT zero. The correct expression should be “due to the non-rivalrous nature, once the public good is produced, the marginal cost of serving an additional user is zero ..” There is a difference between the marginal cost of an additional good versus the marginal cost of serving an additional user. Students must learn to read their lecture notes carefully with understanding.

✗) National defence is a public good as it is impossible to exclude a non-payer from the benefits of
defence.
(✓) National defence is a public good as it is non-excludable. Once defence is provided, all within the
country will benefit from security against external threats, and it is impossible to exclude immigrants,
tourists or other non-taxpayers. As long as these non-payers are within the borders of a country, it is
very difficult for a provider to identify these non-payers and choose not to defend them.

(✗) National defence is non-rivalrous as more consumption of defence by another person does not
cause another to enjoy less defence.
(✓) National defence is a public good as it is non-rivalrous. An army defends the borders of a country
against external threats. Even with an increase in the population size or the number of immigrants, the
quality of defence does not diminish for those already within the borders. Hence, the cost of providing
the service to an additional user (an immigrant or a tourist) is zero.

Question 12

Explain why market imperfections are sources of market failure using a diagram.

Answer 12

Market imperfections arise when the market structure departs from perfect competition. If BTE becomes stronger, market dominance would allow the firm to possess the greater price-setting ability and result in adverse impacts with regards to allocative and productive inefficiency. Hence, market dominance is a source of market failure.

In an imperfect market, a price-setting firm’s profit- maximising output level is allocatively inefficient. As firm will produce at an output where MR = MC to maximise their profits while the socially optimal level of output is where P = MC, the price where P = MC will be lower than the price where MR = MC, the value of the benefit that consumers get from the last unit of output produced is higher than the cost of housing society’s resources to produce that unit. Hence, there is under production and consumption of the good and society will be better off if more units of the good are produced.

With the ability to make supernormal profits in the long run due to high BTE, firms can afford to be X-inefficient due to complacency and may operate at a point above the LRAC curve. Hence, they are not maximising their profits and are not incurring the lowest possible LRAC for any given level of output level produced, resulting in wastage of scarce resources. Hence, there is productive inefficiency.

Question 13

Explain how information failure comes about.

Answer 13

In perfect competition, it is assumed that consumers, firms and factor suppliers have perfect knowledge of costs and benefits. However, in the real world, imperfect information may prevent economic agents from consuming or producing at the levels they would otherwise choose if given perfect information.

(a) Imperfect information in the consumption of merit and demerit goods
(b) Imperfect information (created by persuasive advertising)
(c) Asymmetric information

Question 14

Explain how the immobility of factors of production is a source of market failure.

Answer 14

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Question 15

Explain the government’s rationale for intervening in a free-market.

Answer 15

When there are distortions in the free market which result in inefficient allocation of resources and unequal income distribution, the government intervenes to correct market failure by implementing different policies that seek to modify the behaviour of consumers and producers by creating incentives to produce the desired behaviour.

Question 16

Using diagrams, explain how indirect taxes address production externalities.

Answer 16

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Question 17

Using diagrams, explain how indirect taxes address consumption externalities from demerit goods.

Answer 17

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Question 18

Define taxes and explain the advantages and disadvantages of taxes.

Answer 18

The government uses financial disincentives in the form of taxes which are compulsory payments to the government to influence the behaviour of producers and consumers as people respond to incentives.

Question 19

Define subsidies and explain the advantages and disadvantages of subsidies.

Answer 19

A subsidy is a negative tax, payment made either to a firm or to a consumer when the firm produces or when the consumer buys a good or service. They are used to incentivised private producers to increase their supply of the good that generates positive externalities.

Merits / Advantages of Subsidies
• A subsidy is popular and can be easily implemented to bring about an increase in production and consumption and is flexible enough to be adjusted according to the magnitude of the problem.
• Consumer sovereignty is still present since subsidies allow the market to operate (although distorted
by the subsidy). Financial incentives are given to economic agents to internalise the positive
externalities, resulting in a change in their behaviour.

Limitations of Subsidies
• To achieve allocative efficiency, accurate information on the size of the external benefits is required.
The valuation of the external benefit is difficult to quantify, leading to government’s failure in
achieving social optimal level.

EV: However, in the situation of under-valuation of external benefit, society will still be better off
given that the free market equilibrium is closer to social optimal level and deadweight loss is
smaller.

• Subsidies can impose a huge burden on the government and taxpayers because huge financial resources are required to finance subsidies. The government may not have the ability to fund all merit goods and goods that generate positive externalities. They may have to set high direct tax rates like personal income tax rates and corporate tax rates. However, raising direct tax rates above the optimal rates can discourage work effort (if the substitution effect outweighs the income effect), savings and investment in the country, as well as give rise to the problem of brain drain in the country. Raising
taxes is also politically unpopular which may reduce the chances of the government being re-elected
into parliament. Alternatively, the government can borrow from the private sector or other countries but this may result in unsustainable levels of government debt.
• Huge subsidies in one project, like in the health care sector, can result in large opportunity costs
because there will be fewer government financial resources available for other developmental projects,
e.g. education sector. In the presence of a budget constraint, all spending decisions, at the margin,
imply trade-offs.

Question 20

Using diagrams, explain how indirect subsidies address production externalities.

Answer 20

Governments can correct positive consumption externalities using an indirect subsidy. For example, in the case of merit goods that generate positive consumption externalities, too little resources are allocated to the consumption and production of these goods if left to the free market. This is because in the
pursuit of their self-interests, consumers disregard the positive consumption externalities generated for
instance a more productive workforce and higher economic growth with consumption of education. providing subsidies to the producers such as grants given to schools has the effect of reducing the marginal private cost of providing education services, which will thus result in lower education fees. Figure 1 shows that with an indirect subsidy of an amount equal to the MEB at OQs (EB), the MPC curve shifts downwards from MPC to MPC – indirect subsidy. This causes the price that consumers pay to fall from PO to P1 and the post-subsidy price received by profit-maximising producers to increase from PO to P2. Underconsumption of education is corrected as the quantity of education rises from OQe to OQs, which eliminates the deadweight loss to society (AES). Allocative efficiency achieved.

Question 21

Using diagrams, explain how indirect subsidies address consumption externalities from merit goods.

Answer 21

.

Question 22

Using diagrams, explain how direct subsidies to consumers can address consumption externalities from merit goods.

Answer 22

In Figure 2, the free market equilibrium level of consumption is at OQe where MPC = MPB. With government intervention, a direct subsidy to consumers equal to the MEB at OQs of amount CD will shift the MPB curve from MPB to MSB because the direct subsidy increases consumers’ ability to increase consumption, which leads to a higher effective demand, resulting in the socially optimal level, OQs where MSC = MSB. The under-allocation of resources would be corrected as the positive externality is said to have been ‘internalised’. The deadweight loss to society (ABC) is thus eliminated, achieving allocative efficiency.

Question 23

Using diagrams, explain how government legislation and regulation can correct negative consumption externalities. Explain how government legislation and regulation can correct positive consumption externalities.

Answer 23

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Question 24

Using diagrams, explain how government legislation and regulation can correct negative production externalities.

Answer 24

Production quota

Tradable permits system

Question 25

Explain the advantages and disadvantages of government legislation and regulation.

Answer 25

Controlling production or consumption activities.

Question 26

Explain the advantages and disadvantages of a tradable permit system.

Answer 26

.

Question 27

Using diagrams, explain how the direct provision of merit goods can correct positive consumption externalities and why it is important to do so.

Answer 27

Merit goods such as healthcare and education with external benefits so huge and important that it is widely believed that they must not be left to the private sector provision alone (there is also private sector provision although to varying degrees).

Supplementing private sector

Acts as only supplier and provides it free of charge

Question 28

Explain the advantages and disadvantages of direct provision of merit goods.

Answer 28

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Question 29

Explain how education and campaigns can correct market failure. Explain the advantages and disadvantages of education and campaigns.

Answer 29

Governments can influence the behaviour of consumers through education and campaigns. With imperfect information about the importance of early detection and treatment, consumers underestimate/ are ignorant about the private benefits of health screening and consume health screening at Qe. This is under consumption in contrast to the social optimal level at Qs with perfect information, leading to the deadweight loss of ABC. The government can correct imperfect information through the use of campaigns. For example, campaigns can be helpful to correct the underconsumption of healthcare screenings. The Health Promotion Board may choose to advertise on TV, the radio or social media on the importance of health screenings in preventing the onset of chronic diseases like cancer. Posters can be placed in clinics and hospitals and doctors can also spread the information during clinic visits. Talks and roadshows can be held in community centres to help spread the message amongst the elderly. Through education and campaigns, private demand for merit goods would move to the socially desirable levels, causing consumers to consume at the socially optimal level.

Referring to Figure 3, when the government educates consumers via campaigns or supplying information
directly to them about the full private benefits from consuming healthcare screening services, consumers,
who are more accurately informed, will seek to maximise their self-interests by increasing their demand for these services from DD0 to DD1, resulting in the socially desired output level OQs to be achieved and elimination of deadweight loss of ABC. Thus under perfect information, consumers will not only maximise
their own well-being, but also society’s well- being.

Advantages
• If information failure is the source of market failure, education and campaigns will effectively target the
root cause of market failure.

Limitations
• Public education and campaigns are costly and may drain government resources. They are
normally done through roadshows, mass community events, advertisements in media and these
typically need to be large scale, pervasive and sustained over a long period of time to in order to be
effective in achieving the desired outcome
because it tends to be difficult to change consumers’ habits, values, attitudes and mindsets.

(✗) One limitation of campaigns is opportunity cost. The funds used for campaigns could be used
for other projects by the government.
(✓) However, the extensive use of campaigns would entail opportunity cost. Government resources
have competing needs, and the use of funds toward campaigns might use up funds for other
projects, such as subsidies for housing and education, or long-term infrastructure developments.
Given campaigns need to be carried out over a long period of time to be effective, the extensive
use of campaigns can be an unjustified use of tax revenue. Taxes might even need to be raised if
the government suffers a deficit.

• Collecting and disseminating information to consumers is difficult and costly.

Question 30

Explain how the direct provision of public goods can correct market failure and the decisions that go into providing them. Explain the advantages and disadvantages of direct provision of public goods.

Answer 30

In correcting the market failure due to zero-provision of public goods (for example, national defence and street lighting), the government’s only feasible option is to provide these goods and services directly and fund them through taxes because public goods are non-excludable and non-rivalrous. In the Singapore context, the Singapore government provides national defense and street-lighting directly and funds their production through taxes. The Ministry of Defense manages the army while the Singapore Land Transport
Authority manages the streetlights along public roads since the free market often cannot provide such public goods.

Merits/Advantages of direct provision
• Without government intervention, public goods would not be provided. A missing market in this case may indicate a significant loss to society’s welfare. For instance, street lighting can be used to promote
security in urban areas and to increase the quality of life by artificially extending the hours in which it is light so that activities can continue to be carried out by the community. Street lighting also improves safety for drivers, riders, and pedestrians.

Limitations of direct provision
• The benefits from and costs of providing public goods are often highly uncertain. For instance, it is in
practice difficult to measure the size of the marginal private benefits generated from the provision of
public goods because there is no effective demand or price signals for public goods due to the free
rider problem. Putting a monetary value on benefits like safety and security is also difficult. Herein lies
the major difficulty in calculating expected benefits, i.e. ascertaining the market price of the good as
such good has no price (which is a gauge of its value to consumers).
• Direct provision of public goods is financed through the taxes that the government collects. This means
that there will be distortions and opportunity costs associated with acquiring these taxes, and society’s welfare could be reduced

Question 31

Explain government failure and the reasons why it may arise.

Answer 31

Government failure refers to situations where the government intervention in the free market increases market distortions and reduces economic efficiency and welfare, and leads to worsening of the allocation of resources. It can be due to unintended consequences (achieves oppositive effect etc), imperfect information (on prices, weak valuation of goods/services, miscalculated long term benefits), bureaucracy and inefficiency of government intervention (administrative costs reduce economic efficiency when too many scarce resources are used), time lags and shifts in government policy (unstable and unpredictable climate deters investment and potential firms from setting up in the country).

Question 32

Explain how externalities are a source of market failure - explain how negative externalities from the production of petrochemicals are a source of market failure.

Answer 32

1) Define market failure: Market Failure is defined as the failure of the free market to achieve an efficient allocation of resources that maximizes the society’s welfare and to achieve social goals such as equity.
2. 1) Identify activity: Production of petrochemicals
2. 2) Define the type of externality: Negative production externality occurs when external costs are imposed on third parties from the production of a good or service by firms.
2. 3) Explain the private costs and benefits (MPC and MPB) with examples: Private costs are the costs of production incurred by the petrochemical factory such as the cost of electricity and manpower costs. Private benefits are the free market price they receive for the sale of their product.
3) Explain the presence of external costs or benefits and the MEC or MEB from the production or consumption of a good by identifying the 3rd parties and impact on third parties: However, the presence of external costs that are incurred by third parties include fishermen and companies downstream. Fishermen may experience a loss in income due to the lower quality and quantity of catch. The companies downstream may incur higher costs when they install expensive purification plants to purify the polluted water. The presence of external costs creates a divergence between marginal private costs (MPC) and marginal social costs (MSC).
4) Illustrate the divergence between MPC and MSC or MPB and MSB with a diagram, due to the presence of externalities and show that the vertical distance between MSC and MPC or MSB and MPB is equal to MEC or MEB (where MEC or MEB > or < 0)
5) Identify the free market eqm where MPB = MPC by explaining why consume/produce up to MPB = MPC using rational decision making: In the pursuit of their self-interests, petrochemical factories would only consider their own private costs and benefits, they will ignore the external costs imposed on the third parties and produce at the free market equilibrium output of the industry where MPC = MPB.
6) Assuming no consumption externalities (or production externalities) where MSB = MPB (or MSC = MPC),
7) Identify society’s optimal level of output where MSB = MSC, Qs: society’s optimal level of output is where MSC = MSB.
8) Compare Qe with Qs (write in full): Thus, the free market eqm output level is higher than the socially optimal level of output.

9) At Qe, MSC/MSB >/< MPC/MPB, identify over/under consumption/production and DWL of area XXX:
At Qe, the MSC for producing the chemicals exceeds the MSB for consuming them, meaning that the opportunity costs of producing the 0Qeth unit are higher than the benefits that society gains from consuming this unit. Society’s welfare would increase if fewer units are produced. Thus, output 0Qe is allocatively inefficient as it results in an overproduction of the chemicals by QeQs units and a deadweight loss of area XXX (sum of MSC over MSB for the overproduction of units QeQs).

10) Link to market failure: As a result of the negative production externalities, scarce resources are not allocated efficiently by the free market. Market failure arises due to the overproduction of petrochemicals. Governments may adopt measures such as subsidies or taxation or legislation or government regulation and education campaigns to tackle market failure.

Draw diagram

Question 33

Distinguish positive externality from imperfect information.

Answer 33

These are two totally different concepts.
This is incorrect: Positive externality is a result of consumers not being aware of the external benefits, hence leading to under-consumption.

A positive externality is due to the pursuit of self-interest by individuals and NOT ignorance. Hence positive externality is a situation of “I don’t care”! In contrast, imperfect information is usually related to ignorance about the full private benefits NOT ignorance about external benefits. Imperfect information is about “I don’t know it is good for me”!

Question 34

Define negative production externalities. Describe MEC/MEB and the relationship between MSC and MPC or MSB and MPB.

Answer 34

Negative production externalities occur when external costs are imposed on third parties from the production of a good or service by private firms.

MEC >0
MSC > MPC
Over-production of good

Question 35

Define negative consumption externalities. Describe MEC/MEB and the relationship between MSC and MPC or MSB and MPB.

Answer 35

Negative consumption externalities occur when external costs are imposed on third parties from the consumption of a good by private individuals.

MEB <0
MSB < MPB
Over-consumption

Question 36

Define positive production externalities. Describe MEC/MEB and the relationship between MSC and MPC or MSB and MPB.

Answer 36

Positive production externalities occur when external benefits are enjoyed by third parties from the production of a good or service by private individuals.

MEC <0
MSC < MPC
Under-production

Question 37

Define positive consumption externalities. Describe MEC/MEB and the relationship between MSC and MPC or MSB and MPB.

Answer 37

Positive consumption externalities occur when external benefits are enjoyed by third parties from the consumption of a good or service by private firms.

MEB >0
MSB > MPB
Under-consumption

Question 38

Explain how information failure is a source of market failure - explain how imperfect information leads to information failure and thus market failure.

Answer 38

(a) Imperfect information (consumption of merit and demerit goods): In the case of merit and demerit goods, the government believes that individuals may not act in their own best interests because of imperfect information which causes them to either under-estimate or over-estimate their own private benefit from consuming the good. As a result, there will be under-consumption of merit goods and over-consumption of demerit goods, leading to allocative inefficiency and thus, market failure.
(b) Imperfect information (created by persuasive advertising): Persuasive advertising may contribute to people’s ignorance by giving people misleading information about a product and ‘over-selling- the benefits of the good. As a result, consumers would overestimate the benefits of the product and have a higher demand than what they would otherwise choose if they receive perfect information about the product. This can lead to a higher than socially optimal level of consumption of the good, and hence, market failure.

Question 39

Explain how information failure is a source of market failure - explain how asymmetric information leads to information failure and thus market failure.

Answer 39

Asymmetric information occurs when one party involved in a trade has more or better information compared to another when making decisions and transactions. Asymmetric information would lead to market failure if the more well-informed party in the trade utilises their superior information to benefit themselves at the expense of others.

Due to the presence of asymmetric information,

(a) Adverse selection
(b) Moral hazard are two common problems that arise and lead to market failure

Question 40

Explain how information failure is a source of market failure - explain how asymmetric information (adverse selection) leads to information failure and thus market failure in the market for used cars and health insurance.

Answer 40

(i) Profit-seeking seller knows more about the attributes of the good sold than the buyer. As a result, the buyer runs the risk of being sold a good of low quality.

For instance, in the market for used cars, sellers have more information about the vehicles’ quality than the buyers and have the incentive to conceal information about any defect their vehicles might have, in the pursuit of profits. Buyers, knowing the sellers’ tendency to conceal information, would likely offer a lower price for all the vehicles in the market because they cannot tell the good quality cards apart from the bad ones. This low price in turn discourages sellers of higher quality cars to offer their cars for sale in the market. This gives rise to a market for ‘lemons’, in which only the low-quality products are offered for sale in the market while good quality products (‘gems’) drop out from the market. The market ends up adversely selecting against the higher quality products in favour of the lower quality ones, resulting in an under-representation of good products and over-representation of bad products. In the long run, this could lead to a ‘missing market’ where the goods will not be provided in the free market, exacerbating the extent of market failure.

(ii) Buyers have more superior information about themselves than the sellers.

For instance, in the market for health insurance where the buyers know more about their own health conditions than insurance companies. Self-interested, utility-maximising insurance buyers might not divulge accurate and sufficient information about their full-health conditions to insurance companies because any pre-existing health problems may result in higher insurance premiums that they need to pay. They are incentivised to conceal information about their health. Knowing this, insurance companies that are unable to adequately know and monitor the health conditions of those who seek insurance coverage will thus raise the average price of insurance premiums. This, in turn, would discourage healthy individuals to buy insurance because the premium is too high to justify the coverage. As a result, the insurance company would be left with an even-riskier (adverse) pool of insurance buyers because only people with more underlying health conditions would find the high premiums worth paying for. This leads to an under-representation of ‘good consumers’ and an over-representation of ‘bad consumers’. In the long run, this could even lead to a missing market where the goods will not be provided in the free market, exacerbating the extent of market failure.

Question 41

Explain how information failure is a source of market failure - explain how asymmetric information (moral hazard) leads to information failure and thus market failure in the market for health insurance.

Answer 41

In the market for health insurance, adverse selection occurs before the transaction. After the transaction, a moral hazard occurs. This is because the insurance company lacks adequate information about how and whether the insured would change their behaviour when they are protected by the insurance. Individuals who are insured against loss would be more incentivised and able to be lax in their behaviour (take less care to prevent the loss) than they would in the absence of insurance as…

Question 42

Explain why adverse selection arises.

Answer 42

Adverse selection arises because of the incentive of sellers or buyers to conceal information from the other party involved in the trade, resulting in either the buyer not being able to distinguish between products of different qualities, or the seller not being able to distinguish between consumers of different qualities. Low-quality products/High-risk buyers crowd out high-quality products/Low-risk buyers.

Question 43

Explain what moral hazard is and when it occurs.

Answer 43

A moral hazard is a situation in which economic agents take greater risks than they normally would after a transaction has taken place. This is because the costs that result from their riskier behaviours would not be solely borne by themselves.

This occurs when the party with more superior information in a transaction has both the incentive and the ability to shift costs onto the other party.