Market failure

Question 1

When is social efficiency acheived?

Answer 1

MSB (demand) = MSC (supply), acheived in equilibrium in a perfectly competitive market, total surplus is maximised.

Question 2

What is pareto optimality?

Answer 2

A situation where if there is no feasible allocation where no one can be made better off without making someone worse off (social efficiency)

Question 3

What is market failure and how can it be solved?

Answer 3

Inability of market to allocate resources effectively. Public ploicy may be used to acheive increased efficiency.

Question 4

What are the reasons for market failure?

Answer 4

Market power (trade union, monopsony)
Externalities
Public goods
Common resources
Imperfect information

Question 5

What is an externality?

Answer 5

Impact on a third party not involved in economic transaction. Efficiency isnt maximised here.

Question 6

Give an example of a) negative externality b)positive externality

Answer 6

a) in consumption = smoking, in production = pollution
b) in consumption = education, in production = tree farm

Question 7

What is a) production externality
b) consumption externality

Answer 7

a) production of a good creates costs or benefits on third partys that arent invloved in production process
b) consumption of a good creates costs and benefits on third party that dont consumr the good.

Question 8

What is marginal social cost?

Answer 8

Cost incurred by the whole of society. MSC = MPC + MEC

Question 9

Why is the market inefficient where a negative production externality exists?

Answer 9

The efficient point is where MSB+MSC.
In this case MSB<MSC so there is overproduction of this good and a deadweight loss is created.

Question 10

Whats a Pigouvian tax and how does it correct market failure?

Answer 10

A correcting tax that closes the gap between private and social cost by setting tax = to MEC to restore welfare optimum. Gov can set tax equal to the MEC so that externality is internalised and makes MPC=MSC

Question 11

Explain how positive production externalities generate inefficient outcomes? How might this be solved and explain effect on diagram?

Answer 11

MSB>MSC so there is underproduction and creation of DWL.
Could be solved by government subsidy - MC shifts right to MC+ sub at optimal point.

Question 12

What is marginal social benefit?

Answer 12

Benefit enjoyed by the whole of society of producing or consuming a good. MSB = MEB+MPB

Question 13

What is the coase theorem?

Answer 13

Proposition that if private parties can bargain without cost over the allocation of resources, they can solve problem of externalities on their own. Interested parties can always reach an outcome where everyone is better off and the outcome is efficient. The private market will reach the efficient outcome on its own.

Question 14

What is the socially efficient income if NPower has a wind farm but it disturbs neighbouring households?

Answer 14

The outcome that maximises NPower and the households wellbeing. If the cost is greater to households than the benefit to NPower then the wind farm should go therfore the private outcome is = to the efficient outcome.

Question 15

What is the private and socially efficient outcome if NPower benefit = £500,000 and cost to households is £800,000?

Answer 15

Households pay NPower £600,000 and wind farm goes. Now both are better off.

Question 16

What is the private and socially efficient outcome if Npower benefit is £1m and cost to households is £800,000?

Answer 16

Wind farm stays as NPower not willing to accept less than £1m and households not willing to pay more than £800,000.

Question 17

What two types of public policies do the gov use to correct externalities?

Answer 17

a) command and control policies; regs that forbid or require certain behaviour e.g pollution limits, requirment for business to adopt tech to reduce emissions
b)market based policies; taxes, subsidies, tradeable permits to align private incentives with social efficiency.

Question 18

What are the benefits of the pigouvian tax?

Answer 18

• reduces neg ex by placing a price on it
  -moves allocation of resources closer to the socially efficient outcome.

Question 19

What are the drawbacks of a pigouvian tax?

Answer 19

hard to determine where the socially efficient outcome is and how much MEC is needed to acheive this.

Question 20

What is a subsidy and how does it correct market inefficiencies?

Answer 20

It induces private decision makers to account for the social benefit that arises from positive externalities.
Set subsidy = to MEB

Question 21

What is a tradeable pollution permit and why is it better than regulation?

Answer 21

Pay for right to pollute, allows for transfer of right to pollute to other firms, those that pollute less can sell their surplus to those that pollute more. This incentivises firms to decrease pollution.

Question 22

Explain how a pigovian tax and pollution permit have the same effect?

Answer 22

Demand to pollute is downward sloping, less attractive at higher prices.
A tax raises this price and so reduces desire to pollute (horrizontal tax curve)
A permit limits supply also raising the price (vertical tax curve)

Question 23

What is a public choice and give an example?

Answer 23

A decision that has consequences for many people, perhaps the whole society e.g deciscions by political leaders about regulation and taxes.

Question 24

Define two characterisitcs of goods?

Answer 24

a) Excludability - can a person be prevented from using it e.g a concert is excludable whereas London Met Police are non excludable or national defence
b) rival - does one persons use of the good diminish the use for someone else e.g a sandwich is rival but a radio station isnt

Question 25

Define the following goods:
a)private good
b)public good
c)common resource
d)natural monopolies

Answer 25

a) goods are excludable and rival in consumption e.g a can of coke
b)GOODS are non excludable and non rival in consumption e.g a street light
c) goods that are rival in consumption but not excludable e.g the environment. There is little incentive for firms to supply this as can freeride. Gov should see that they are provided but not overused.
d) goods that are excludable but not rival in consumption e.g goods that can be produced at a marginal cost of 0 such as the internet.

Question 26

What is free riding?

Answer 26

A reason to why public goods are sometimes not provided in the free market as people can use the good without paying for it. So even if the individual values the good more than the cost they still wont pay for it.

Question 27

How is the free riding problem dealt with. - whats the problem?

Answer 27

Provided with tax revenue but dont know how much to provide.

Question 28

What is cost-benefit analysis?
What are the limitations?

Answer 28

Refers to study that compares cost and benefit of providing and maintaining a public good
- hard to measure the beneift due to the abscence of price so estimate the social beneifts and cost of resources. Without prices it is hard to estimate the value of life, consumers time and aesthetic of goods.

Question 29

What is the tragedy of commons?

Answer 29

Illustrates why common resources get used more than desireable from the standpoint of society as a whole.
One persons use of the resource diminishes the amount available for another person

Question 30

How can the issue of the tragedy of the commons be solved?

Answer 30

Through regulation and taxes to decrease use of the good.
Turn it into a private good by imposing property rights
Auction off permits to allow use of the resource.

Question 31

How to deal with the limitations of cost-benefit analysis?

Answer 31

Contingent Valuation- survey respondents based on their willingness to pay (inc if they dont use the good) and their willingness to accept (shows how much theyd pay to put up with the good) instead of revealed preference (whereby the value they place on a good is established when they purchase the good at its given price).

Question 32

Define asymetric information? What are the two types?

Answer 32

One party in an economic transaction has more information than the other party.
1) Hidden actions - one person knows more than another about an action they are taking leading to moral hazard.
2) Hidden Characteristics - one person knows more about the attributes of the product than the other leading to adverse selection.

Question 33

What is moral hazard? Give an example.

Answer 33

Where the party with more information has an incentive to do something undesirable from the perspective of the party with less info. E.g someones whos property is insured might not try as hard to protect it from theft etc.

Question 34

Define the following:
- agent
-principal
-principal agent problem

Answer 34

• someone who performs the task for the principal
• the person for whom the agent is performing the task
• when the principal cant perfectly monitor the work of the agent the agent may do something undesirable e.g playing video games at work.

Question 35

WHat is agency theory?

Answer 35

Focuses on the relationship between the agent and the principal and how their principals diverge and can be realigned.

Question 36

How can firms respond to moral hazard?

Answer 36

• monitoring (costly, may be a combination of efforts or influenced by random factors outside employee control)
  -incentives (link wage to perfromance, output or profitability)

Question 37

What is adverse selection and give an example?

Answer 37

Occurs where the party with more knowledge on the attributes of a product benefits from transacting with the non informed party. E.g products with differing quality are sold at the same price as the consumer isnt informed enough to determine the difference at the time of purchase.

Question 38

What are the assumptions about the used car market for the lemons problem?

Answer 38

There are two types of used cars - good cars and lemons
The seller knows more about the quality than the buyer
Sellers of lemons are more likely to put their car up for sale and buyers want to avoid these
The price of good cars is higher than price of lemons as the max price consumers are willing to pay is greater and the min price producers are willing to supply at is higher due to higher cost of producing.
Sellers of good cars are therefore less likely to get a fair price as an avg of the two is taken and so many of them exit the market, decreasing the number of good cars.
Supply increases for lemons as the avg price is greater than their actual price. When they realise they have paid too much for the lemons they will revive their perceptions and offer a lower price. The more the price falls, the more good cars leave the market which continues until the demand intersects supply and the market is left with only lemons.

Question 39

Whats a self confirming belief and the two types?

Answer 39

• if people hold these beleifs and act on them, the consequences will be consistent
  optimistic and pesimistic self confirming (look at notes for this section of revision)

Question 40

Explain adverse selection in terms of the insurance market?

Answer 40

buyers of health insurance know more about their health than the
people with health problems are more likely to buy insurance causing the price of policies to reflect the sicker and leading to the healthy not purchasing.
so insurers so charge a single premium as cant distinguish between high risk and low risk individuals and because more high risk are likely to insure it would make it unprofitable to sell insurance (market failure)

Question 41

What are mechanisms to provide info to buyer about quality (market response to asymetric information)

Answer 41

• sellers gain a reputation for selling high/low quality
• standardised products can inform customer of the quality before they purchase
• branded products inform customer of quality before purchase

Question 42

What is market singalling and the requirments for its effectiveness?

Answer 42

informed party reveals private info to uninformed party
required to be costly but less costly to the person with the higher quality product.

Question 43

WHy is there a problem of adverse selection in the labour market?

Answer 43

Potential workers know more about their skills/quality than buyers of labour (the firm)

Question 44

How does labour use market signalling?

Answer 44

Uses education as a market signal but it must be eaiser to obtain for a higher productivity person than a low productivity person.

Question 45

How is a guarantee/warantee an effective market signal?

Answer 45

signal products quality and is more costly for a producer of a low quality producer than a high quality producer.

Question 46

What is screening and an example?

Answer 46

an action taken by an uninformed party to induce an informed party to reveal information e.g a graduate employer may demand an aptitude test from applicants or car selling car insurance can offer diff policies that induce seperation amongst high and low risk drivers by offering lower premiums to those willing to accept a higher deductible - most likely safer drivers)

Question 47

How does public policy deal with assymetric information?

Answer 47

Quality assurance
Building regulations ensure houses meet certain quality standards
MOT ensures cars meet minimum safety standards