Market Failure

Question 1

When does market failure occur

Answer 1

Market failure occurs when the price mechanism causes an inefficient allocation of resources and so leads to a net welfare loss. Consequently, resources are not allocated to their best or optimum use.

Question 2

What are the theme 1 market failures we focus on

Answer 2

Externalities

Under provision of public goods

Information gaps

Question 3

Define market failure

Answer 3

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

Question 4

What are externalities

Answer 4

Externalities are those costs or benefits which are external to an exchange. They are third party effects ignored by the price mechanism.

Externalities are also known as indirect costs and benefits, or as spillovers from production or consumption of a good or service. In effect, external costs are negative externalities and external benefits are positive externalities.

Question 5

External costs are…

Answer 5

Negative externalities

Question 6

External benefits are..

Answer 6

Positive externalities

Question 7

Define external costs

Answer 7

Negative third party effects outside of a market transaction

Question 8

What are external costs, when do they occur

Answer 8

External costs may occur in the production and the consumption of a good or service.

An example of an external cost in production is a chemical firm polluting a river with its waste. This causes an external cost to the fishing and water supply industries. Fish catches may be reduced and it may become very expensive to purify water to meet safety standards.

Be prepared to give an example in exam questions
Eg. External cost in consumption is a person smoking tobacco, polluting the air for others. The effect is to cause passive smoking, where non smokers may suffer the same illnesses as smokers.

Question 9

In a free market, what costs are producers concerned with

Answer 9

Producers are only concerned with the private costs of production.

Question 10

What are private costs of production

Answer 10

These are costs internal to the firm, which it pays for directly. These costs include wages for workers, rent of buildings, payment for raw materials, machinery costs, electricity, insurance, packaging and transport costs.

Private costs may also refer to the market price that a consumer pays for a good or service

Question 11

Define private costs

Answer 11

Costs internal to a market transaction, which are therefore taken into account by the price mechanism.

Question 12

How do we get social costs

Answer 12

By adding private costs to external costs, we obtain social costs.

This means that external costs are the difference between private costs and social costs.

Question 13

The marginal private cost and marginal social cost curves often diverge, what does this indicate

Answer 13

indicating that external costs increase disproportionately with output. However, it is possible that external costs per unit of output remain constant, in which case the marginal private cost and marginal social cost curves are drawn parallel to each other.

Question 14

Define social costs

Answer 14

The sum of external costs and private costs from a market transaction.

Question 15

What does the edexcel spec focus on to do with external costs

Answer 15

It focuses on diagrammatic analysis of external costs in production.

Question 16

What does the relationship between private cost, external cost and social cost in the production of a good look like on a diagram

Answer 16

2 straight lines in same direction as supply curve, on graph of costs (y axis) and quantity (x axis) are drawn from a single point.

One line has a lower gradient and so falls below the other line. The lower line is the MPC (marginal private costs), the higher line are MSC (marginal social costs) and the difference between the two lines is external cost.

Question 17

What are external benefits and give me an example of one in production

Answer 17

External benefits may occur in the production and consumption of a good or service. An example of an external benefit in production is the recycling of waste materials such as newspapers,glass and tins. It has the benefit of reducing the amount of waste disposal for landfill sites as well as re using materials for production. It helps to promote sustainable economic growth.

Question 18

Give me an example of an external benefit in consumption

Answer 18

An external benefit in consumption is the vaccination of an individual against various diseases. It reduces the possibility of other people catching a disease who come into contact with the vaccinated individual.

Question 19

Define external benefits

Answer 19

Positive third party effects outside of a market transaction.

Be prepared to give an example in exam

Question 20

When are we only concerned with private benefits

Answer 20

In a free market

Question 21

What are private benefits

Answer 21

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

Question 22

How can we measure private benefits

Answer 22

Economists assume this can be measured by the price that consumers are prepared to pay for a good or service.

Question 23

What may private benefits also refer to

Answer 23

Aside from the utility from consuming a good or service, private benefits may also refer to the revenue that a firm obtains from selling a good or service.

Question 24

Define private benefits

Answer 24

Benefits internal to a market transaction, which are therefore taken into account by the price mechanism.

Question 25

How do we obtain social benefits

Answer 25

By adding private benefits to external benefits, we obtain social benefits.

Question 26

What are external benefits in terms of private and social benefits

Answer 26

External benefits are the difference between private benefits and social benefits.

Question 27

The marginal private benefit and marginal social benefits curves often…

Answer 27

Diverge, MPB below MSB

Indicating, that external benefits increase disproportionately with output consumed.

On diagram, y axis is benefits

However, it is possible that external benefit per unit consumed will remain constant, in which case the marginal private benefit and marginal social benefit curves are drawn parallel to each other.

Note that the spec focuses on diagrammatic analysis of external benefits in consumption of goods and services.

Question 28

Define social benefits

Answer 28

The sum of external benefits and private benefits from a market transaction

Question 29

Give me some examples of external costs in production

Answer 29

A waste disposal firm dumping toxic waste at sea, which destroys fish life

Burning coal in power stations to create electricity, adding to global warming

Increased production of biofuels, which destroy rain forests and increase food prices

Question 30

Give me some examples of external costs in consumption

Answer 30

Excess alcohol intake, which leads to vandalism

Increased road congestion around the expansion of Heathrow airport

Tobacco smoking, which affects passive smokers

Question 31

Tell me some examples of external benefits in production

Answer 31

A paper and glass recycling plant, which reduces the waste for landfill sites

Construction of the London cross rail project, increasing inward investment and raising local property prices.

The use of wind turbines and tidal power to create electricity. These are renewable forms of energy, which emit less carbon emissions than fossil fuels.

Question 32

Tell me some examples of external benefits in consumption

Answer 32

Education and training programmes, which increase human capital levels. Higher labour productivity increase profits for firms.

Improving the quality of ones garden, which increases the value of neighbouring houses

The consumption of vaccinations, which help reduce the spread of disease and so increase life expectancy for millions.

Question 33

What is the supply curve for a firm equal to

Answer 33

The supply curve for a firm is the marginal private cost curve (MPC)

Question 34

What is the market supply curve

Answer 34

The addition of all the MPC curves of firms in a market for a particular good or service will form the market supply curve.

Question 35

What’s the demand curve for consumers equal to

Answer 35

The demand curve for consumers is the marginal private benefit curve (MPB)

Economists assume that it is possible to measure the benefit obtained from consuming a good by the price people are prepared to pay for it. As an individual consumes more units of a good, the marginal benefit (marginal utility) will fall.

This is why the demand curve slopes downwards from left to right.

Question 36

What’s the market demand curve a sum of

Answer 36

The addition of all the consumers MPB curves for a particular good or service will form the market demand curve.

Question 37

Define market equilibrium

Answer 37

Where marginal private benefit equals marginal private cost

Question 38

What’s market equilibrium

Answer 38

Occurs at the price and output position where marginal private benefit equals marginal private cost.

Question 39

What’s the social optimum equilibrium

Answer 39

The social optimum equilibrium level of output or price for a good or service occurs where marginal social cost, MSC, equals marginal social benefit, MSB. The social cost of producing the last unit of output equals the social benefit from consuming it.

When the social optimum is reached in a market, welfare is maximised

Question 40

When social optimum is reached in a market, what is maximised

Answer 40

Welfare

Question 41

Define social optimum

Answer 41

Where marginal social benefit equals marginal social cost

Question 42

The free market ignores ….

Answer 42

Externalities

Question 43

Tell me about external costs and the triangle of welfare loss

Answer 43

Adding external costs on to the production of a good or service, causes the supply curve of the firm to shift to the left and become the marginal social cost.

For simplicity we assumed there are no external benefits so MPB=MSB

We go to the social optimum and then to market equilibrium and draw up to the MSC curve. This triangle pointing towards the y axis is the triangle of welfare loss.

There is an excess of social costs over social benefits for the marginal output in this area.

This area of welfare loss to society shows the market has failed, since negative externalities are ignored

Question 44

Tell me about external benefits and the triangle of welfare gain

Answer 44

The free market ignores positive externalities.

Adding external benefits on to the consumption of a good or service, causes the demand curve to shift to the right and become the marginal social benefit curve.

Assuming there are no external costs in the consumption of the good, (MPC = MSC), we find the triangle by…

Finding the market equilibrium and drawing up to toe MSB and then go to the social optimum and the triangle area facing away from the y axis is the welfare gain.

There is a welfare gain to society, the market has failed, since positive externalities are ignored

Question 45

What’s an exam tip to do with finding welfare gain and loss areas on an externality diagram

Answer 45

Always start from the free market equilibrium position and draw a line vertically up to the MSC or MSB curve. Then find the social optimum and this makes the triangle

Question 46

For a welfare loss which way will area lost point

Answer 46

Triangle point towards y axis

Question 47

For a welfare gain, which way will triangle point

Answer 47

Area point away from y axis

Question 48

External costs can be taken into account or ignored?

Answer 48

External costs can be ignored by consumers and producers when they make their economic decisions, so causing market failure.

Question 49

List the consequences of ignoring external costs

Answer 49

Overproduction

Underpricing

Welfare loss

Concerns over the availability of resources

Concerns over pollution levels

Calls for government intervention to internalise the external costs and so correct market failure

Question 50

How does ignoring external costs lead to overproduction

Answer 50

Since the free market level of output exceeds the social optimum level of output, overproduction occurs

Question 51

How does ignoring external costs lead to underpricing

Answer 51

Since the free market price is below the social optimum price.

Question 52

How does ignoring external costs lead to welfare loss

Answer 52

Since marginal social costs exceed marginal social benefits

Question 53

How does ignoring external costs lead to concerns over the availability of resources for future generations

Answer 53

Eg. Overfishing will lead to a collapse in fish stocks, which may become unsustainable

Question 54

How does ignoring external costs lead to concerns over pollution levels

Answer 54

Eg. Burning fossil fuels to produce energy could lead to global warming and consequent problems of climate change. Air pollution could also increase respiratory diseases and reduce life expectancy

Question 55

How does ignoring external costs lead to calls for government intervention to internalise external costs and so correct market failure

Answer 55

This may take the form of indirect taxes and trade pollution permits

Question 56

External benefits can be….

Answer 56

Ignored by consumers and producers making their economic decisions and so cause market failure.

Question 57

What can ignoring external benefits lead to

Answer 57

Underproduction

Underpricing

Potential welfare gain

Concerns over the long term implications of underproduction

Calls for government intervention.

Question 58

How does ignoring external benefits lead to underproduction

Answer 58

Underproduction since the free market level of output is less than the social optimum level of output

Question 59

How does ignoring external benefits lead to underpricing

Answer 59

Underpricing since the free market price is below the social optimum place. (Note that society should be prepared to pay more for the goods or services to take account for external benefits)

Question 60

How does ignoring external benefits lead to potential welfare gain

Answer 60

Since marginal social benefits exceed marginal social costs

Question 61

How does ignoring external benefits lead to concerns over the long term implications of underproduction

Answer 61

For example, under provision of education and healthcare could lead to lower economic growth and a less competitive economy. Living standards may rise more slowly

Question 62

How does ignoring external benefits lead to calls for government intervention to internalise the external benefits and so correct market failure

Answer 62

This may take the form of regulation, government provision and subsidies.

Question 63

What are public goods

Answer 63

Some goods may not be produced at all through the markets, despite offering significant benefits to society. Where this occurs it is known as a MISSING MARKET and the goods are called public goods. These goods involve a large element of collective consumption: eg. National defence, flood defence systems, the criminal justice system and refuse collection

Question 64

Define public goods

Answer 64

Those goods that have non-rivalry and non-excludability in their consumption

Question 65

Public goods demonstrate characteristics of….

Answer 65

Non-excludability and non-rivalry

Question 66

What is non excludability

Answer 66

Means that once a good has been produced for the benefit of one person, it is impossible to stop others from benefitting.

Question 67

What is non rivalry

Answer 67

Means that as more people consume a good and enjoy its benefits, it does not reduce the amount available for others, in effect, it is non diminishable.

Question 68

Once a public good has been provided, the cost of supplying it to an extra consumer is…

Answer 68

Zero.

Further examples include public firework displays, lighthouses, public beaches, public parks, drains and street lighting.

Question 69

What are private goods

Answer 69

Private goods are the opposite of public goods. They display characteristics of rivalry and excludability in consumption. The owners of private goods are able to use private property rights which prevent other people from consuming them. Private goods can also be rejected, which means one has a choice over whether to consume them or not.

Question 70

Define private goods

Answer 70

Those goods that have rivalry and excludability in their consumption.

Question 71

What shouldn’t we mistake public goods for

Answer 71

The NHS and state educations are not public goods. Theirs is rivalry in consumption.

It is more appropriate to describe them as goods which yield external benefits, or merit goods.

Question 72

What is meant by the free-rider problem

Answer 72

In a free market economy, public goods are under provided due to the free rider problem. Once a public good has been provided for one individual, it is automatically provided for all. The market fails because it is not possible for firms to withhold the good from those consumers who refuse to pay for it. Examples are national defence and street pavements.

The rational consumer would wait for someone else to provide the good and then reap the rewards by consuming it for free. However, if everyone waits for others to supply a public good then it may never be provided. The non excludability characteristic means that the price mechanism cannot develop as free riders will not pay. Firms are reluctant to supply such a good in a free market as it is difficult to gain profits from it. The solution is for government to provide public goods and fund them from general taxation.

Question 73

What are information gaps

Answer 73

Information gaps can lead to market failure due to either consumers or producers having more market knowledge than the other about a particular good or service. It means there is an unequal balance upon which to conduct economic transactions between them. A good example is the second hand car market.

Question 74

Define information gaps

Answer 74

Where consumers, producers or the government have insufficient knowledge to make rational decisions.

Question 75

How can information gaps lead to market failure

Answer 75

Information gaps can also lead to market failure when consumers or producers simply lack perfect knowledge about a particular good or service and so end up making non rational economic decisions. A good example is the pension market, where people tend to make too few contributions for their retirement.

Question 76

When is it assumed there is symmetric information

Answer 76

In competitive markets, it is often assumed that consumers and producers have symmetric information when making their economic decisions - that they have access to the same information about a good or service in a market.

Question 77

What will symmetric information lead to

Answer 77

Assuming that consumers and producers act in a rational way, symmetric information will lead to an efficient allocation of resources. This means consumers will buy a good or service from a producer offering the best deal, taking into account things like price, quality, reliability and after sales service.

Question 78

Define symmetric information

Answer 78

Where consumers and producers have access to the same information about a good or service in the market.

Question 79

What is asymmetric information

Answer 79

In reality, consumers and producers have asymmetric information - that is, unequal market knowledge upon which to make their economic decisions, and this could lead to a misallocation of resources.

Question 80

Asymmetric information

Answer 80

Where consumers and producers have unequal access to information about a good or service in the market.

Question 81

What is a lemon market

Answer 81

Producer knowledge may exceed consumer knowledge. A second hand car salesman for example, may have greater knowledge of the history of vehicles for sale as well as more technical knowledge than consumers. This could lead to a consumer paying too much for a poor quality car. The fear of buying a defective car tends to reduce the market price for all second hand cars, even the good quality ones. Consequently, the losers could be both buyers and sellers, depending on the car sold. This is known as a lemon market.

Question 82

What’s the solution to a lemon market / imperfect knowledge

Answer 82

The solution is to have inspection schemes offered by motoring organisations such as the Automobile Association for 2nd hand car dealers. Eg inspecting cars on behalf of consumers.

Question 83

What happens when consumer knowledge may exceed producer knowledge

Answer 83

A consumer may purchase an insurance policy, concealing information about himself or simply knowing more than the insurance company about his intended future actions. This might include having a risky lifestyle. The insurance company may then provide insurance at too low a price or insure someone who might be too risky to insure, and therefore may make a loss. This could lead to insurers exiting the market or refusing to make the payouts due. The solution is to have a watchdog body with powers to investigate and prosecute fraudulent insurance claims.

Question 84

What’s an example of the government solving imperfect knowledge

Answer 84

Government intervention with pensions which makes it compulsory for workers to contribute to a National Insurance scheme that pays for state pensions

Question 85

What are the types of market failure

Answer 85

There are various types, for example

Externalities

Under provision of a public good

Information gaps

Question 86

Why do external costs and benefits arise

Answer 86

Due to third party effects in market transactions that the price mechanism ignores

Question 87

External costs in production lead to…

Answer 87

A welfare loss triangle as the free market output equilibrium exceeds the social optimum position

Question 88

External benefits in consumption lead to…

Answer 88

A potential welfare gain as the free market output equilibrium is less than the social optimum

Question 89

What characteristics do public goods display

Answer 89

Non rivalry

Non excludability

Question 90

In a free market public goods are…

Answer 90

Under-provided or not provided at all in a free market economy due to the free rider problem

Question 91

Information gaps mean…

Answer 91

Consumers and producers may make economic decision on buying and selling goods which reduce their welfare. This can be seen in the underconsumption of healthcare, education, pensions, or the overconsumption of Tabasco, alcohol or gambling

Question 92

What is symmetric information

Answer 92

Is where consumers and producers have equal access to market knowledge.

Asymmetric information is where consumers and producers have unequal access to market knowledge

Question 93

What are social costs

Answer 93

Social costs are the total of private costs and external costs

Question 94

What are social benefits

Answer 94

Social benefits are the total of private benefits and external benefits

Question 95

Distinguish between the market equilibrium and social optimum positions in a market

Answer 95

Market equilibrium is the output position where MPB equal MPC. externalities are ignored. However, the social optimum is where MSB equal MSC.

Question 96

What is the triangle of welfare loss

Answer 96

The welfare loss triangle is the area on an externality diagram that depicts the excess of social costs over social benefits for a given level of output.

Question 97

What is the triangle of welfare gain

Answer 97

The welfare gain triangle is the area on an externality diagram that depicts the excess of social benefits over social costs for a given output level.

Question 98

Why do external costs cause market failure

Answer 98

External costs cause market failure since they are ignored by the price mechanism and lead to a welfare loss. For example, a person smoking leads to passive smoking for others, who suffer but are not compensated.

Question 99

Why do external benefits cause market failure

Answer 99

External benefits cause market failure since they are ignored by the price mechanism and lead to a loss of potential welfare. For example, a person paying for a vaccination will reduce the risk of disease for others but this benefit is not accounted for by the price mechanism and so under provision occurs.

Question 100

When might a public beach cease to be a public good

Answer 100

On a hot day a public beach might become so overcrowded that people compete for space on the beach - there may be rivalry in consumption. A public beach might also be sold off to a property developer who restricts access to members of the public.

Question 101

What is meant by the free rider problem

Answer 101

The free rider problem is where an individual is able to consume a good without paying for it. Consequently, there is no incentive for firms to supply the good in a free market.

Question 102

Why do public goods represent a type of market failure

Answer 102

Public goods are a type of market failure since there would be no provision or very little provision of them in a free market. This is due to the free rider problem - where it is possible to consume the goods without paying for them. Consequently, there is no profit incentive for firms to provide them.

Question 103

Why does imperfect market information lead to market failure

Answer 103

Imperfect market information leads to market failure because consumers and producers may make decisions on buying or selling a good which reduce their overall welfare.