market failure and externalities

Question 1

market failure

Answer 1

occurs when the free market fails to allocate resources to the best interests of society, so there is an inefficient allocation of scarce resources.
economic and social welfare is not maximised where there is market failure

Question 2

externalities

Answer 2

the cost or benefit a third party receives from an economic transaction outside of the market mechanism.
in other words, it is the spill- over effect of the production or consumption of a good/service.

Question 3

externalities can be…

Answer 3

• positive (external benefits)

- negative (external costs)

Question 4

negative externalities

Answer 4

• caused by demerit goods
• associated with information failure, since consumers are not aware of the long run implications of consuming the good, and they are usually over-provided.
• for example, cigarettes and alcohol are demerit goods. the negative externalities to third parties of consuming cigarettes is second- hand smoke or passive smoking.

Question 5

positive externalities

Answer 5

-caused by merit goods
-associated with information failure too, as consumers do not realise the long run benefits to consuming the good.
-they are under-provided in a free market
-for example, education and healthcare are merit goods.
the positive externalities to third parties of education is a higher skilled workforce.

Question 6

private costs

Answer 6

• producers are concerned with private costs of production. for example, the rent, the cost of machinery and labour, insurance, transport and paying for raw material are private costs.
• this determines how much the producer will supply.
• it could refer to the market price which the consumer pays for the good.

Question 7

marginal private cost

Answer 7

the cost to an individual or a firm of (producing the last unit of a good) an economic transaction

Question 8

social cost

Answer 8

• on a diagram, external costs are shown by the vertical distance between the two curves (the difference between private costs and social costs)
• MSC & MPC diverge from each other. external costs increase disproportionately with increased output.

Question 9

marginal social cost=

Answer 9

marginal external cost+ marginal private cost

Question 10

private benefit

Answer 10

• consumers are concerned with the private benefit derived from the consumption of a good. the price the consumer is prepared to pay determines this.
• private benefits could also be a firms revenue from selling a good.

Question 11

social benefit

Answer 11

• on a diagram, external benefits are the difference between private and social benefits
• similarly to external costs, external benefits increase disproportionately as output increases

Question 12

marginal social cost

Answer 12

the full cost to society of an economic transaction, including both the private costs to the individual and the external costs to the wider society

Question 13

marginal social benefit

Answer 13

the full benefit to society of consuming additional nits of a good or service, including both the benefits to an individual, and to wider society

Question 14

marginal social benefit=

Answer 14

marginal external benefit + marginal private benefit

Question 15

social optimum position

Answer 15

• this is where MSC=MSB and it is the point of maximum welfare.
• the social costs made from producing the last unit of output is equal to the social benefit derived from consuming the unit of output.
• triangle of welfare loss

Question 16

external costs of production

Answer 16

-external costs occur when a good is being produced/consumed, such as pollution.
they are shown by the vertical distance between MSC and MPC.

• the market equilibrium, where supply=demand as a certain price, ignores these negative externalities. this leads to over-provision and under-pricing.
• with negative externalities, MSC>MPC of supply. at the free market equilibrium, therefore, there are an excess of social costs over benefits at the output between Q1 and Qe.
• the output where social costs> private benefits is known as the area of deadweight welfare loss, shown by the triangle in the diagram.
• the market fails to account for the negative externalities that occur from the consumption of this good, which would reduce welfare in society if it was left to the free market.

Question 17

external benefits of production

Answer 17

• an example of an external benefit from the production/consumption of a good or service could be the decline of diseases and the healthier lives of consumers through vaccination programmes.
• since consumers and producers do not account for them, they are under-provided and under-consumed in the free market, where MSB>MPB. this leads to market gain.
• the triangle in the diagram shows the excess of social benefits over costs. it is the area of welfare gain

Question 18

partial market failure

Answer 18

happens when the private sector may partially provide it but at the wrong price or quantity.
e.g. private healthcare vs NHS

Question 19

complete market failure

Answer 19

happens where, unless the good or service is provided outside the mechanism, there wouldn’t be a market for it.
e.g. a country’s military services

Question 20

causes of market failure

Answer 20

• externalities
• a lack of public goods
• information gaps

Question 21

positive consumption externallities

Answer 21

MSB=MPB+externality

• MSB>MPB
• consumers do not account for the benefit of the externality and this good will be under-consumed.
• merit good- such as eductation, vaccination

Question 22

negative consumption externalities

Answer 22

MSB=MPB+ consumption externality

if the consumption externality is negative, then the MSB

Question 23

positive production externalities

Answer 23

MSC=MPC-production externality.
if the production externality is positive, then the social cost is less than the private cost and the good will be under-produced
-renewable energy is an example as it can replace fossil fuels which damage the environment

Question 24

negative production externalities

Answer 24

if the production externality is negative, then the social cost is greater than the private cost and the good will be over-produced

Question 25

triangle of welfare loss

Answer 25

shows the welfare loss to society from the over-production of something that has a negative production externality.
government would want to reduce consumption to the socially optimum level

Question 26

asymmetric information

Answer 26

this happens when both parties in transaction have an unequal amount of information.
-e.g. a car dealer knowing more about ther condition of a car than a potential buyer
it can cause a decline in prices or quantity of products sold

Question 27

thin market

Answer 27

if buyers and sellers are discouraged from participating in the market, there will be fewer active in the market

Question 28

thick market

Answer 28

when there are many buyers and sellers

Question 29

price signalling

Answer 29

buyers with imperfect information often think that price signals product quality.

• e.g. a restaurant selling expensive food is often assumed to be of better quality than a cheaper alternative, like Mcdonalds
• when buyers use market prie to make assumptions about quality, markets can struggle to reach an equilibrium price and quantity

Question 30

imperfect information

Answer 30

when buyers and sellers have unequal information. it can lead to the over and under consumption of goods in a free market

Question 31

demerit goods

Answer 31

• consumers only realise the private gain
• if they had perfect information, they might realise the negative effects consumption of the good can bring.
• eg. consumers may not realise the effect smoking can have due to imperfect information

Question 32

merit goods

Answer 32

• consumers take into account only the private benefits
• if they had perfect information, they might realise the additional benefits a merit good can bring.
  e. g. they may realise how beneficial education is

Question 33

characteristic public goods

Answer 33

non-rivalry:
if one person consumes a good this doesnt stop another from consuming it
non-excludable:
someone not paying for a good doesnt affect their ability to consume it

Question 34

public goods

Answer 34

• not provided by free market

- government intervention is needed to change this missing market

Question 35

public vs private goods

Answer 35

• private goods exhibit both excludability and rivalry.
• e.g. a phone is a private good
• if i purchase a particular phone, that means someone else cannot have that phone (rivalry)
• if i do not pay for the phone, i cannot have the benefits of the phone (excludable)

Question 36

quasi-public goods

Answer 36

a public good can start to have private characteristics and become quasi-public
-e.g. putting a tollbooth on a road makes it excludable, and so a quasi- public good.

Question 37

public goods and market failure

Answer 37

• the private sector rarely provides true public goods.
• the government must intervene and decide the suitable quantity of public goods for society. to do so, the government has to guess the MSB (which may inaccurate)

Question 38

free rider problem

Answer 38

• this is the reason public goods are not provided by the free market.
• it is impossible to exclude the benefits of a public good from someone
• as a result, people that dont pay for the product will receive the same benefit as those that do.
• this disincentivises people from producing a good in the free market because of the free riders who receive the benefit without paying
• this is market failure

Question 39

pricing public goods

Answer 39

• hard to price them
• producers may over-value the product and consumers under-value.
• this further discourages the production of public goods in the free market

Question 40

asymmetric information and merit goods

Answer 40

imperfect information causes:

• under-consumption of merit goods
• over-consumption of demerit goods
• poor provision of merit goods
• excessive provision of demerit goods

imperfect information influences provision of goods because:

• complex info can confuse consumers. they may make decisions without properly understanding the info.
• sellers/service providers may be motivated to sell more expensive products or services than the consumer actually needs.

Question 41

asymmetric information in the labour market

Answer 41

• means people cant find jobs they are best suited to.
• employers cannot find the most suited employees
• this increases frictional unemployment, which is when worker are between jobs.
• worker not being in their most suited job is not allocatively efficient.
• this is a source of market failure

Question 42

symmetric information

Answer 42

• symmetric information is perfect and equally available to everyone on the market.
• competitive markets assume perfect information exists.
• traditional economists assume that resources would be allocated efficiently if their rational buyers & sellers had perfect information

Question 43

monopolies

Answer 43

price-setters that control a market. they produce an output that maximises their profits and this leads to a lower quantity and higher price than in a competitive market

Question 44

monopolies and market failure

Answer 44

-monopolies restrict output and raise prices, which is not allocatively efficient and creates a deadweight loss for society.
this is a source of market failure because there could be a welfare gain for society at a higher level of output.

Question 45

market failure- immobile factors of production

Answer 45

across industries:

• workers may have skills that are relevant for a particular occupation.
• a fireman may not have the skills to become a software developer
• lead to occupational mobility.

over time:

• factors, like capital are assumed to be fixed in the short run, but flexible in the long run
• investments in new software and capital equipment can take time to come to fruition.

geographically:

• workers may not be able to move from one city to another with one week’s notice
• on a global level, capital equipment and workers may not be able to move from india to the uk
• this may be because ‘people’ have preferences that arent captured in the term labour or because of labour market imperfections

Question 46

market failure- economic inactivity

Answer 46

-skill shortages
if skilled workers are in short supply, their supply of labour is more inelastic.
this is because they become harder to replace quickly. as a result, they can demand
a higher wage, increasing a firms costs of production.

-positives of economic inactivity
if people are inactive so they can focus on education, this is a positive long term result.
it is an investment into the future economy

-labour as a scarce resource
it is a factor of production and is in scarce supply
being inactive is bad in lointerms of economies