Market Failure

Question 1

Market Failure

Answer 1

Market failure occurs when the free market allocation fails to be Pareto optimal. This
can happen when there are externalities or public goods in the economy.

Question 2

Externalities

Answer 2

An externality is present when consumption or production of a commodity by one
agent directly affects other agents (positively or negatively)

Question 3

Corrective (Pigovian) Taxation

Answer 3

Place a tax (or subsidy) on the price consumer A pays for x1 to ‘correct’ the externality.
Consumer A should face prices of (1+t)p1 and p2, where t is the tax on commodity 1. Consumer B should remain exempt from taxation

Set t such that:
MRSA = (1+t)p1/p2
MRSB = p1/p2

Question 4

Public Goods

Answer 4

A commodity is a public good if one agent’s consumption of the commodity does not
preclude consumption of the commodity by other agents

Question 5

Free rider problem

Answer 5

Once a public good is purchased, everyone can enjoy it, so everyone would prefer it if
someone else purchased the public good.

This typically leads to less than the socially
optimal level of the public good being provided.

Question 6

Crowding Out

Answer 6

Rising public sector spending drives down or even eliminates private sector spending

to what extent does tax-financed public goods provision “crowd-out”
private-sector provision