Market failure

Question 1

Define market failure

Answer 1

When the price mechanism causes an inefficient allocation of resources leading to a net welfare loss

Question 2

Consequence of market failure

Answer 2

Resources are not allocated to their best or optimum use

Question 3

What are the main types of market failure

Answer 3

• Externalities
• Under-provision of public goods

-Information gaps

Question 4

One reason for market failure

Answer 4

Allocative efficiency: marginal social costs = marginal social benefits

Question 5

Define externalities

Answer 5

Costs or benefits which are external on a third party

Question 6

Define negative externalities (external costs)

Answer 6

• the costs imposed on third parties from the production and consumption decision of others.
• social costs exceeds private costs
• E.g pollution from coal extraction

Question 7

Example of external costs in production

Answer 7

E.g a chemical firm polluting a river with waste.

• This causes an external cost to the fishing and water supply industries
• Fish catches may be reduced
• Purification of water may be very expensive to meet the European Commission’s safety standards

Question 8

Example of external costs in consumption

Answer 8

• Smoking tobacco would pollute the air for others

Question 9

Define positive externalities (external benefits)

Answer 9

• the benefits which third parties gain from the production and consumption decision of others.
• social benefits exceeds private benefits

Question 10

Consumption external benefit examples

Answer 10

Consumption of vaccinations help reduce spread of disease which increase life expectancy for millions

Question 11

Production external benefit examples

Answer 11

The use of renewable forms of energy to create electricity to emit less carbon emissions than fossil fuels (e.g wind turbines)

Question 12

Define private costs

Answer 12

direct costs to producers and consumers for producing and consuming a product.

Question 13

Examples of private costs for firms

Answer 13

• Wages for workers
• Payment for raw materials
• Rent of buildings
• Machinery costs
• Electricity/gas costs
• Insurance
• Transport costs

Question 14

Private costs for consumers

Answer 14

The market price that a consumer pays for a good service

Question 15

Define social costs

Answer 15

• The sum of external costs and private costs from a market transaction.
• Private costs + external costs = social costs

Question 16

Define private benefits

Answer 16

direct benefits to producers and consumers for producing and consuming a product.

Question 17

Consumers and private benefits

Answer 17

In a free market, consumers are only concerned with the private benefits/utility from consuming a good/service

Question 18

Producers and private benefits

Answer 18

The revenue a firm obtains from selling a good or service

Question 19

Define social benefits

Answer 19

sum of private benefits and external benefits

Question 20

Define public goods

Answer 20

unique as the benefit that they provide affects many people rather than just one individual.

Question 21

What do public goods demonstrate characteristics of

Answer 21

• Non-rivalrous
• Non-excludability

Question 22

Define non-excludability

Answer 22

if a good is available for one person, it is available for everyone.

Question 23

Define non-rivalry

Answer 23

consumption by one person does no limit consumption by others.

Question 24

Define private goods

Answer 24

goods which firms are able to provide to generate profits

• excludable and rivalrous

Question 25

Examples of public goods

Answer 25

• street lighting
• national parks
• nuclear defence systems

Question 26

What does it mean if private goods can be rejected

Answer 26

If customers cannot afford to buy them, then they are excluded.

Question 27

What is the free rider problem

Answer 27

when it is provided by someone other people will be able to benefit from it without paying

Question 28

Why does the market fail due to the free-rider problem

Answer 28

an insufficient number of people will be willing to pay for the product and it will not be profitable for a business to provide it.

Question 29

Examples of public goods that contribute to the free-rider problem

Answer 29

• People who use public parks or recreational facilities without paying for them
• People who download music or movies illegally instead of paying for them

Question 30

Government solutions to the free-rider problem

Answer 30

• Compulsory taxation to fund collective provision of services
• Community solutions for example establishing social norms to manage common pool resources such as fishing grounds and grazing land

Question 31

Define information gaps

Answer 31

exist when either the buyer or seller does not have access to the information needed for them to make a fully-informed decision.

Question 32

How do information gaps lead to market failure (1)

Answer 32

1.Unequal balance of information

producers may have more information than consumers about a product or service.

Question 33

How do information gaps lead to market failure (2)

Answer 33

2.Non-rational decisions

consumers may not have enough information to make a rational decision.

Question 34

Define symmetric information

Answer 34

both parties in a transaction have the same information

Question 35

Define asymmetric information

Answer 35

where one party in a transaction has more or superior information compared to another.

Question 36

How does asymmetric information lead to an inefficient allocation of resources

Answer 36

distorted socially optimal prices and quantities in markets resulting in over-provision or under-provision of goods/services.