Market Failure

Question 1

What is Market Failure?

Answer 1

Market Failure occurs when a market allocates resources inefficiently.

Question 2

How can a market fail?

Answer 2

A market fails when the price mechanism (the forces of supply and demand) fails to allocate scarce resources efficiently and society suffers as a result.

Question 3

What is complete market failure?

Give an example.

Answer 3

When there’s complete market failure, no market exists - this is a ‘missing market’.

National defense is an example of a missing market as there’s no market which allocates national defense. This means that governments need to intervene and provide it.

Question 4

What is partial market failure?

Give an example.

Answer 4

When the market functions, but either the price or quantity supplied of the good/service is wrong, as the allocation of resources are inefficient, then there’s partial failure.

The provision of health care, if left completely to market forces, is an example of partial failure.

Question 5

Describe why the provision of health care, if left completely to market forces in a free market, becomes a market failure.

Answer 5

• In the UK, we have the NHS, also known as the National Health Service, which exists in order to provide completely subsidized, free healthcare to make sure everyone can afford it.
• If the provision of health care was left to market forces, the price mechanism determines price and quantity supplied.
• This means that there is a price associated with each product offered in health care, meaning that not everyone can afford it. This means that MSB drops and MPB increases. In the presence of profit-maximizing firms, which, rationally, have no other incentive at this point, they would cut output to increase prices, and would be able to increase it dramatically as healthcare is often associated with extreme price inelasticity - individuals are still likely to pay for it, regardless of if it’s much more expensive than what they’re even prepared to pay for it.
• As a result, market failure of consumption can occur, where the MPB is over MSB; there is an incorrect allocation of resources and society is affected heavily for the benefit of the firm.

Question 6

What is an externality?

Answer 6

An externality are the effects producing or consuming a good/service has on people who aren’t involved in the making, buying/selling or consumption of the service. These people are called ‘third parties’.

Question 7

Give the 2 types of externalities.

Answer 7

Positive Externality

Negative Externality

Question 8

What is a positive externality?

Answer 8

A positive externality is the external benefit to a third party caused by the consumption, production or selling of a good/service.

Question 9

What is a negative externality?

Answer 9

A negative externality is the external disadvantage to a third party, such as the increase in their costs, caused by the consumption, production or selling of a good/service.

Question 10

GIve one example of a negative externality that could occur in steel production.

Answer 10

A negative externality of producing steel could be pollution that harms the local environment.

Question 11

Give one example of a negative externality that may be associated with opening and eating a chocolate bar.

Answer 11

A negative externality of opening and eating a chocolate bar could be litter that’s dropped on the street..

A negative externality of eating a chocolate bar could be in the form of costs to the NHS as it may contribute to the development of a disease, such as diabetes, in the individual.

Question 12

Give one example of positive externality that is generally associated with the service providing or nurses.

Answer 12

A positive externality in the service providing of nurses could be the benefit to society in the form of offering better and more available healthcare to deal with the demand.

Question 13

What is private cost?

Answer 13

Private cost is the cost of doing something to either a consumer or a firm.

Question 14

Give an example of private cost generally held by a firm, and private cost generally held by a consumer.

Answer 14

The cost a firm pays to make a good or service is it’s private cost

The price a consumer pays to buy the good or service is it’s private cost.

Question 15

What are external costs caused by?

Answer 15

Externalities

Question 16

An individual dropped an empty crisp packet onto the floor.

In what way does this cause an externality?

Answer 16

That creates an external cost to the council, a third party, who would have to employ someone to sweep it up - that and the product of many others littering.

Question 17

Private cost + External Cost = ?

Answer 17

Social Cost

Question 18

What is social cost?

Answer 18

Social cost is the full cost borne by society of a good or service that is not directly related to them.

Question 19

What are External Costs?

Answer 19

External costs are those costs faced by a third party for which no appropriate compensation is forthcoming - they are paying for someone else’s consumption or production.

Question 20

What is Private Benefit?

Answer 20

Private benefits are the benefit gained by a consumer or firm by doing something.

For example, the private benefit a consumer might get from purchasing a skiing holiday is their enjoyment of the experience.

Question 21

Using your knowledge of competitive markets, describe why Private Benefit decreases for each time it is consumed.

Answer 21

The law of marginal diminishing utility refers to, each time a product is consumed, the marginal utility gained from each product of the good decreases each time it is consumed in a short time period.

This means that private benefit would also decrease.

Question 22

What are External Benefits?

Answer 22

An external benefit is the benefit gained by an individual or firm as a result of an economic transaction but where they are not directly involved in the transaction.

A country that invests in new equipment may create the external benefit of needing less electricity, which reduces it’s impact on the climate, increasing it’s social benefit which benefits third parties such as the government and individuals that may be affected by climate change.

Question 23

Private Benefit + External Benefit = ?

Answer 23

Social Benefit

Question 24

What is Social Benefit?

Answer 24

Social Benefit is the full benefit received by society from a third party good or service.

Question 25

In a rational firm, describe why they may operate where there is market failure.

Answer 25

Market Failure may occur in a rational firm as they may operate to account the private costs and benefits, but not the external costs and benefits.

Question 26

Externalities can be shown by using diagrams.

Draw the diagram of a negative externality of production.

Show the external cost.
Show the social cost.
Show the deadweight welfare loss.

Answer 26

https://media.discordapp.net/attachments/352951793187029005/842866983208353832/unknown.png?width=799&height=564

Question 27

Describe and explain the diagram of a negative externality of production.

Describe the impact of taxation on the good, as well as the associated advantages.

Answer 27

https://media.discordapp.net/attachments/352951793187029005/842866983208353832/unknown.png?width=799&height=564

Firstly, a good with a negative externality of production means that an imperfect allocation of resources has occurred due to the fact that the firm has chosen to produce at an equilibrium concerning their private benefit and cost only, not considering the impact the production of their good or service has on third party providers.

For example, factories may use a lot of fossil fuels for the generation of energy at high rates. This causes carbon emissions that are bad for the atmosphere - third parties, such as the government that may attempt to combat climate change, pay to do so without compensation for what they did not cause, thus the difference between MSC and MPC shows the external cost, the cost associated with the production of a good towards a third party, with the deadweight loss being the loss to society gained by ignoring externalities.

MSC is lower than MPC as a result of this - the cost the production of the good has on society is higher than the cost of the firm.

As a result of this, the firm is overproducing at Q2 than what is socially beneficial for society, which is wanting to be at Q1, as it is currently producing where MPB and MPC meet - what is best for the firm, being able to price lower at P2. The government, as a result, may impose a taxation:

https://media.discordapp.net/attachments/773632730650378290/842891356464087090/unknown.png?width=785&height=564

This taxation causes price to increase to Pt, and this is due to the fact that this is the equilibrium wherein Q2 can be reached but also be socially desirable at MSB = MSC - this means that quantity produced stays at Q2, however, the firm pays extra due to an additional cost that the government has implemented so that the firm operates to compensate for the social benefit and cost associated with the production of the good. As you can see, MPC goes up to MPCt, where MSC is, meaning that the private cost is equal to the social cost, and so no external costs exist anymore. The amount of taxation added can be seen with EC.

This has a number of advantages:

• The extra cost associated with the taxation generates extra revenue for the producer - this extra revenue may be given to the government as this is so they can compensate for the external costs they have produced to them, thus eliminating the market failure, and also helping the government as they just generally have more justified funding.

Question 28

(MSB=MPB) = MSC Is a level of output associated with being?

Answer 28

Socially Beneficial

Question 29

(MSB=MPB) = MPC is a level of output associated with being?

Answer 29

Not socially beneficial.

The firm is rational to it’s private costs and equilibrium at it’s private benefit, without considering the entirety of it’s social costs, due to it not considering external costs which society gets no compensation for.

Question 30

What is welfare loss?

Answer 30

Welfare loss is often shown on a diagram that shows the loss to society caused by ignoring externalities.

Question 31

Externalities can be shown by using diagrams.

Draw the diagram of a positive externality of production.

Show the external benefit.
Show the deadweight welfare gain.

Answer 31

https://media.discordapp.net/attachments/842867015052296192/842880188634890250/unknown.png?width=704&height=564

Question 32

What is welfare gain?

Answer 32

Welfare gain is often shown in diagrams, and it demonstrates the gain to society lost by ignoring positive externalities.

Question 33

Externalities can be shown by using diagrams.

Draw the diagram of a negative externality of consumption.

Show the external cost.
Show the deadweight welfare loss.

Answer 33

https://media.discordapp.net/attachments/842867015052296192/842881428034682900/unknown.png?width=662&height=563

Question 34

Externalities can be shown by using diagrams.

Draw the diagram of a positive externality of consumption.

Show the external benefit.
Show the deadweight welfare gain.

Answer 34

https://media.discordapp.net/attachments/842867015052296192/842882962848481280/unknown.png?width=672&height=564

Question 35

Describe and explain the diagram of a positive externality of production.

Describe the impact of use of a subsidy.

Answer 35

https://media.discordapp.net/attachments/842867015052296192/842882962848481280/unknown.png?width=672&height=564

In the diagram, MPB is lower than MSB, meaning that, per unit of the good or service produced, the benefit to society is greater than the benefit to the individual. For example, eating a healthy meal, which may improve your health, will impose less potential costs to third parties such as the NHS, being socially desirable.

Because firms only consider their private benefits and private costs, this price mechanism causes the firm to have an inefficient allocation of resources in the eyes of society, as the equilibrium wherein MPB = MPC is not socially desirable, as the good is underproduced, measured as the difference between Q1 and Q2 - more should be made for society to maximize societal benefit, which is done by increasing price from P2 to P1 and increasing output from Q2 to Q1in order for more individuals to consume said good.

Keep in mind that it is unlikely that the firm will be able to support going from P2 to P1 due to the increase in price while also supporting an increase in demand, as for the law of diminishing marginal utility, demand would fall, meaning less should be produced - instead, a subsidy should be placed on the good which will mean that the government accounts for part of the marginal cost of producing each good or service - this decreases the cost of production, meaning products are cheaper so that Q1 can go to Q2 without P2 going to P1. Instead, it may go to Ps:

https://media.discordapp.net/attachments/842867015052296192/842886884727717909/unknown.png?width=746&height=563

The usage of a government subsidy can raise output from Q2 to Q1 while having the demand to facilitate it due to the decrease in price; causing them to pay for part of the cost of each unit of the good. This has many advantages to society:

• The lower prices in this product may cause individuals to move to it from other products that cause negative externalities of consumption, making them less of a market failure (more socially beneficial).
• The lower prices in the product benefit the consumer as prices are lower - this improves their consumer welfare due to the increase in consumer surplus.
• The lower prices in the product cause more people to consume it to meet the production demands of what’s socially beneficial to get rid of the market failure.

The welfare gain, an area shaded in yellow, is the gain to society lost by ignoring externalities.

Question 36

Describe the effect of a subsidy on a good with a positive externality, including two advantages and disadvantages associated with it.

Answer 36

The usage of a government subsidy can raise output from while having the demand to facilitate it due to the decrease in price; causing them to pay for part of the cost of each unit of the good.

The use of a subsidy allows for production to face equilibrium way from MPB = MPC to MSB = MSC, where it is most socially beneficial.

This has many advantages to society:

• The lower prices in this product may cause individuals to move to it from other products that cause negative externalities of consumption, making them less of a market failure (more socially beneficial).
• The lower prices in the product benefit the consumer as prices are lower - this improves their consumer welfare due to the increase in consumer surplus.
• The lower prices in the product cause more people to consume it to meet the production demands of what’s socially beneficial to get rid of the market failure.

There are also disadvantages:

• All subsidies have an opportunity cost - the subsidy may be better used somewhere else.
• Subsidies lower costs, and so the producer has less incentive to innovate for lower costs themselves.
• The effectiveness of subsidies are reliant heavily on the elasticity of demand; subsidies wouldn’t significantly increase demand for inelastic goods.

Question 37

Market failure of a good with a negative externality causes it to be what?

Answer 37

Overconsumed (than what is beneficial for society).

Question 38

Market failure of a good with a positive externality causes it to be what?

Answer 38

Under-consumed (than what is beneficial for society).

Question 39

Describe the effect of a tax on a good with a negative externality, including two advantages and disadvantages associated with it.

Answer 39

The effect of tax on a good with negative externality causes the good, service or the production involved to be at an equilibrium of MSB = MSC by raising MPC to MSB, where the firm operates where it is socially beneficial and where external costs = 0 - the extra revenue generated per good can also be given to the third party effected, meaning that they are compensated.

There are advantages associated with this:

• The extra cost associated with the taxation generates extra revenue for the producer - this extra revenue may be given to the government as this is so they can compensate for the external costs they have produced to them, thus eliminating the market failure, and also helping the government as they just generally have more justified funding.
• Taxation means that the firm must pay more in order to keep their production at the same as without a tax. While they are still able to do this, it may mean that less producers buy the good if part of the price of the good increases due to the tax, decreasing the amount of negative externality produced overall.

There are also disadvantages associated with this:

• The use of taxation depends on the elasticity of demand, and if demand is price inelastic, many consumers will keep consuming the good, regardless of a change in price, regardless of how bad their consumer surplus is affected - this may mean that taxes can be ineffective.
• Taxes carry an opportunity cost - there may be a better scenario to be using them for different firms.
• It’s difficult to determine the external costs of a negative externality good, meaning that taxes are hard to determine.
• Firms may choose to relocate and sell their goods abroad to avoid the indirect taxation, causing their contributions to the economy to be removed, such as the payment of tax and the provision of employment.

Question 40

Give a real world example of a positive externality of production.

Answer 40

A positive production externality, for example, is the pollination of surrounding crops by the bees. The value generated by the pollination may be more important than the actual value of the harvested honey.

Question 41

Give a real world example of a positive externality of consumption.

Answer 41

A positive consumption externality, for example, is education:

• Better educated workforce means a higher average annual income due to the fact that there is a higher abundance of employees in advanced professions and employers.

Question 42

Why is education a positive externality of consumption?

Answer 42

In a free market, the positive externalities of education will be ignored by suppliers of education; their choices are based on profit maximization, where MPC = MPB - what benefits them the most.

Question 43

Give a real world example of a negative externality of production.

Answer 43

A chemical factory ignores the externalities it produces, such as carbon into the atmosphere, and so an external cost is generated where MSC is larger than MPB, causing a market failure since the firm will focus on profit maximization (MPB = MPC).

Question 44

Describe and explain Alcohol as a negative externality of consumption.

Answer 44

Alcohol is an ubiquitous example of a negative externality of consumption:

Individuals that consume alcohol ignore, do not consider, or do not know (by asymmetric information) that their consumption of the good is more beneficial to them than society, meaning that MPB is higher than MSB - firms will price where MPB = MPC as this is profit maximization, and they do not consider, at this point, the implications of their product on third parties that create an external cost associated with them.

The reason why the good is overconsumed in the first place is because Alcohol causes more health than it does harm - it is considered addictive to many individuals due to the effects the good may have on them, causing them to consume it without being wary of the effects on their health. This may increase the chance of them getting damage to their liver, which may cause costs to the NHS if they are ever admitted for alcohol-related incidents; this is an external cost, the cost associated with a third party as a result of the consumption of a good.

A welfare loss is also present, which shows the loss to society gained from ignoring externalities.

Due to the production of where MPC = MPB, and since MPB is higher than MSB, the good is being overconsumed, compared to what is socially beneficial, and production of the good must be cut.

Therefore, the good may be taxed, for example, to produce where (MPC=MSC) = MSB - this causes price to increase dramatically for the same level of output as compared to without a tax, and the extra marginal revenue caused by the consumption of each unit of the good will most likely be given to the government in order to compensate for the external costs the good provides to the NHS.

Question 45

What is a (Pure) Public good?

Answer 45

A commodity or service that is provided without profit incentive to all members of a society, either by the government or by a private individual or organization.

Question 46

(Pure) Public goods are non-excludable.

What does this mean?

Answer 46

People cannot be stopped from consuming the good even if they haven’t paid for it, e.g. you can’t stop an individual benefiting from the services of the armed forces.

Question 47

(Pure) Public goods are non-rivalrous.

What does this mean?

Answer 47

One person benefiting from the good doesn’t stop others from benefiting, meaning that, when one person consumes the good, another person is still able to consume as much, if not more, of it.

For example, the consumption of a light house from one person does not interfere with the consumption of the same light house from a different person.

Question 48

(Pure) Public goods have no marginal cost.

Why is this?

Answer 48

Pure Public goods have no marginal cost because there’s no cost associated with it being consumed to other people because they’re non-rivalrous.

Question 49

(Quasi) Public goods may be rivalrous.

What does this mean?

Answer 49

The consumption of the good affects other individuals that consume the same good - as they may not be able to have as much as they could out of it if you didn’t consume it - such as a chocolate bar.

Question 50

(Quasi) Public goods may be excludable.

What does this mean?

Answer 50

You can rationally stop people from having an excludable good, such as a chocolate bar.

Question 51

Public goods may have some characteristics of Private goods.

What is this known as?

Answer 51

A Quasi-Public good.

Question 52

Some goods can appear to be (pure) public goods, but can become quasi-public goods due to certain additions.

Give one example of this.

Answer 52

Roads appear to have the same characteristics as a public good:

• Often they’re free for everyone to use (non-excludable)
• One person using a road doesn’t prevent another person from using it (non-rivalrous)

However, tolls can be used to make a road excludable by excluding individuals from driving on the road by making them pay.

Congestion can also make a road rivalrous as there’s a limit to the number of people who can benefit from the road at a given time.

Question 53

What is a Merit good?

Answer 53

Merit goods are goods whose consumption is regarded as beneficial to society.

They provide benefits to both individuals, and society as a whole (due to positive externalities that result from the consumption of the associated good or service).

Question 54

Why are Merit goods underconsumed?

Answer 54

People are usually unaware of the full benefits that merit goods provide, meaning that they tend to be under-consumed:

In the free market the positive externalities that merit goods provide are ignored, and production and consumption will be below the socially optimal level.

Due to imperfect information, consumers don’t always realize the full benefits that merit goods provide. For example, people might not have enough information on how serious their health problems might be, so demand for health care may not be as high as it should be and health care is underprovided.

Question 55

What are Demerit goods?

Answer 55

Demerit goods are goods whose consumption or production is regarded as being harmful to the third parties or people that consume them.

Question 56

Why are Demerit goods overconsumed?

Answer 56

Demerit goods tend to be overconsumed for two main reasons:

In the free market, the negative externalities that demerit goods cause are ignored, and production and consumption will be above the socially optimal level. For example, producers and consumers won’t consider the wider disadvantages to society of cigarettes, such as smoking-related health issues putting a strain on health care services.

Imperfect information means that consumers don’t always realize the harm that demerit goods cause, for example, people might not have enough information on how a harmful drug might affect their health, so their demand for the drug is higher than it should be and so the drug is overprovided.

Question 57

Sometimes it’s hard to say which goods should be classified as merit or demerit goods.

Are goods classified as merit or demerit depending on economic theory and facts or individual’s opinions and value judgement?

Answer 57

Whether a good is merit or demerit is based on value judgement - people’s opinions.

Question 58

Sometimes it’s hard to say which goods should be classified as merit or demerit goods;

Some individuals can consider a certain good merit, while others may consider it demerit.

Give a real world example of a good that may cause this.

Answer 58

Contraception

Question 59

What is the diagram of a merit good the same as?

Answer 59

Positive externality of consumption

Question 60

What is the diagram of a demerit good the same as?

Answer 60

Negative externality of consumption

Question 61

Which of the following reasons explain why it is unlikely that where will be a market provided flood defense system for an area prone to flooding?

A) There is insufficient knowledge to build an adequate flood defense system.

B) Flooding is important for farming.

C) Individuals may be charged for their usage of the flood defense system

D) The existence of the free rider problem.

Answer 61

D

Question 62

The non-excludability of public goods leads to what phenomenon?

Answer 62

The free rider problem

Question 63

What is the free rider problem?

Answer 63

In the social sciences, the free-rider problem is a type of market failure that occurs when those who benefit from public goods do not pay for them or under-pay.

Free riders are a problem because while not paying for the good, they may continue to access or use it.

Question 64

Can the price mechanism work if there are free riders?

Answer 64

No, because consumers won’t pay to use a good or service if they can get it for free.

Question 65

Describe why private firms that act rationally do not provide public goods.

Answer 65

Public goods are goods that are non-excludable, meaning that you cannot stop individuals from benefitting from the production of the good or service, regardless of if they pay for it or not.

This causes an effect called the free rider problem, and the price mechanism cannot work if there are free riders. Individuals will not pay for the use of a good if they can use it for free, meaning that private firms that act rationally will not be able to generate a revenue high enough to justify the cost of creating public services or goods, causing them to be disincentivized to even produce any - they will most likely operate at a loss.

As a result of this, governments or altruistic firms such as charities are most likely to produce pure public goods and services.

Question 66

The pollution of clean air relates to the free rider effect, causing the tragedy of the commons

Describe how it relates to the free rider effect, why it does and identify what the tragedy of the commons is.

Answer 66

Parts of the environment are often considered to have characteristics of public goods, such as air - a public good which isn’t bought or sold on the market - it is both non-excludable and non-rivalrous.

The non-excludability of clean air leads to the free rider problem. The benefits of not polluting the air, or cleaning the air afterwards, aren’t restricted to those who have paid for the clean air by choosing not to pollute, or choosing to clean the air. Therefore, in the free market, it’s unlikely that anyone will either choose not to pollute, or to clean up the pollution they make (as others will be able to consume it for free).

This is an example of the economic theory known as the tragedy of the commons - the idea that people acting in their own best interests will overuse a common resource leading to the depletion or degradation of that resource.

Question 67

What is the tragedy of the commons?

Answer 67

It is the idea that people acting in their own best interests will overuse a common resource, leading to the depletion or degradation of that resource.

Question 68

What is symmetric information?

Answer 68

The idea that buyers and sellers are assumed to have full knowledge regarding prices, costs, benefits and availability of the product.

Question 69

What is asymmetric information?

Answer 69

Asymmetric information deals with the study of decisions in transactions where one party has more or better information than the other.

Question 70

Moral hazard is what type of information?

Answer 70

Imperfect (Asymmetric)

Question 71

What is moral hazard?

Answer 71

In economics, moral hazard occurs when an entity has an incentive to increase its exposure to risk because it does not bear the full costs of that risk.

For example, when a corporation is insured, it may take on higher risk knowing that its insurance will pay the associated costs.

Question 72

Why does imperfect information cause market failure, referring to both demerit and merit goods?

Answer 72

Imperfect information means that merit goods are under-produced or under-consumed, as individuals are not aware of the true benefit to society the goods or services bring, such as health care and education, causing them to consume or produce less of it as they do not consume it with the full advantages of consuming or producing the good or service in mind.

This means that the market equilibrium for merit goods in a free market are not socially desirable, as they are underproduced.

Imperfect information also means that demerit goods are over-consumed or over-produced, as individuals are not aware of the disadvantages to third parties or society that the goods or services are associated with, therefore, individuals generally consume or produce more of the good as they do not consider the full disadvantages of doing so.

This means that the market equilibrium for demerit goods in a free market are not socially desirable, as they are overproduced.

Question 73

Consumption by an individual depends on wealth and income.

Define wealth and income.

Answer 73

Wealth is the value in money of assets held. Assets can include property, land, money and shares.

Income is the amount of money received over a set period of time, i.e. annually or per month.

Question 74

If the wealth and income of an individual increases, will they be able to buy more, or less goods?

Answer 74

More

Question 75

Many people view differences in income and wealth as unfair.

Describe why they think this.

Answer 75

In economics with high levels of inequality, there can be those who are starving and those who have very high levels of income and wealth.

Inequality is caused by several things, such as wage differentials, discrimination and regressive taxes.

Generally speaking, those born in a poor family remain poor, as they won’t have the income or wealth needed to improve their situation - they may not be able to afford education, and this may mean they won’t have a good potential for income during their lifetime.

As a result of this, it may be seen as unfair for them to be in their position, as if income and wealth is distributed more equally, there can will be chances for them to recover and change their lives while removing what may be seen as a surplus from much richer individuals.

Using the main argument, that the benefit to a poor person from an additional £1 of income would be greater than the loss to a rich person who paid £1 extra in tax, you can see why the surplus in riches from a rich person may be best used for the poor.

Question 76

Describe the main argument to distributing income and wealth more equally.

Answer 76

The benefit to a poor person from an additional £1 of income would be greater than the loss to a rich person who paid £1 extra in tax.

Question 77

Describe a disadvantage of wanting to distribute wealth and income more equally.

Answer 77

Some people argue that redistributing income reduces the incentive for individuals and firms to work as hard/harder - these incentives are needed to encourage efficiency within the market, and not having them may cause greater market failure.