Market Failure & its Causes

Question 1

What are the 2 types of market failures?

State why each occurs.

Answer 1

Partial market failure

• Externalities
• Imperfect information
• Merit/Demerit goods

Complete market failure
- Public goods

Question 2

What are public goods?

Answer 2

Public goods are non-excludable and non-rivalrous.

Non-excludable: Near impossible and very hard to exclude non-payers from consuming good

Non-rivalrous: Consumption of good by any individual does not reduce the amount of good available for consumption by others

Question 3

Things to take note when drawing externality diagram.

Answer 3

(-ve)

• MPC,MSC (Supply) , MPB=MSB (Demand)
• DWL area –> MSC over MSB

(+ve)

• MPC=MSC (Supply), MPB,MSB (Demand)
• DWL area –> MSB over MSC

Question 4

5 Step process for negative externality

Answer 4

1) Explain MPB,MPC
- dd –> MPB of …
- ss –> MPC of …

2) Free mkt eqm
- (consumption) Consumers rational+self interested, maximise satisfaction, consider only their PB+PC when deciding how much to consume, consume till MPB =MPC at Qe

-(production) Producers rational+self interested, maximise utility, consider only their PB+PC when deciding how much to produce, produce till MPB = MPC at Qe

3) Explain -ve externality, MSC = MPC+MEC
- MEC to (state 3rd party + cost)
- Not compensated for cost
- Divergence of MSC and MPC, where MSC = MPC + MEC

4) Socially optimal level Qs (MSC=MSB)
- Qe > Qs, over consumption/production

5) Compare mkt and social eqm
- From Qe to Qs, MSC > MSB, additional cost to society more than benefit to scoiety to produce these units
- Summing excess MSC over MSB for QeQs, DWL area …
- Society welfare not maximised

Question 5

5 Step process for positive externality

Answer 5

1) Explain MPB,MPC
- dd –> MPB of …
- ss –> MPC of …

2) Free mkt eqm
- (consumption) Consumers rational+self interested, maximise satisfaction, consider only their PB+PC when deciding how much to consume, consume till MPB =MPC at Qe

-(production) Producers rational+self interested, maximise profit, consider only their PB+PC when deciding how much to produce, produce till MPB = MPC at Qe

3) Explain +ve externality, MSB = MPB + MEB
- MEB to (state 3rd party + benefit)
- Do not pay for benefit
- Divergence of MSB and MPB, where MSB = MPB + MEB

4) Socially optimal level Qs, MSC = MSB
Qs > Qe, under consumption/production

5) Compare mkt and social eqm
- From Qe to Qs, additional benefit to society > additional cost to society to produce these additional units
- Summing excess MSB over MSC for QeQs, DWL area …
- Society welfare not maximised

Question 6

Imperfect information (underconsumption)

Answer 6

Fail to recognise full benefits.
Undervalue future benefits (Money) in the long run + e.g.
Underconsume

Question 7

Imperfect information (overconsumption)

Answer 7

Fail to recognise full cost
Underestimate future cost (Money) in the long run + e.g.
overconsume

Question 8

What are Merit/Demerit goods?

Answer 8

Goods deemed socially desirable/undesirable by govt. and are under/over consumed due to imperfect info

Question 9

How do merit/demerit goods lead to mkt failure?

Explaining the problem

Answer 9

1. Externalities
2. Imperfect info

(2) Further over/under consumption, higher than/ lower than Qe, bigger DWL