Market Failures

Question 1

Externality

Answer 1

Occurs when a persons well being or a firms profits are directly affected by the actions of other consumers or firms rather than indirectly through price changes

Question 2

How are mergers used in response to externalities

Answer 2

Mergers can be used to internalise the externality.

Question 3

Coase theorem

Answer 3

If ownership rights to a recourse can be clearly assigned, the affected parties can bargain and externalities do not create efficiency problems. However this rarely happens, the cost of bargaining may be too high, affected parties may have asymmetric information

Question 4

Types of government intervention

Answer 4

Quantity restrictions (emission standard for cars)
Taxes (congestion charge)
Creation of markets (EU emissions trading system)

Question 5

What is required to set the right tax or standard?

Answer 5

Perfect information and a way of measuring the value of the damage done.

Question 6

What does the deadweight loss from a standard of tax depend on?

Answer 6

The steepness of the MB curve. If curve is steep, the DWL from taxes is bigger. If curve is shallow, DWL from standards is bigger.

Question 7

Private goods

Answer 7

Good which are rivalrous and exclusive

Question 8

Rivalrous

Answer 8

Only one person can consume the good

Question 9

Exclusive

Answer 9

Can prevent other people from consuming the good

Question 10

Open access common properties

Answer 10

Goods which lack exclusion (ocean fisheries)

Question 11

Club goods

Answer 11

Goods which lack rivalry (streaming service)

Question 12

Main types of asymmetric information

Answer 12

Hidden characteristics

Hidden actions

Question 13

Hidden characteristics

Answer 13

A fact about a person or thing that is known to one party but unknown to others (second hand cars)

Question 14

Hidden actions

Answer 14

One party in a transaction can’t observe important actions fandom by another party (a firms manager uses the consonants private jet for personal use)

Question 15

Adverse selection

Answer 15

Asymmetric information about a hidden characteristic causes low quality products to be over represented in transactions. This creates a market failure by reducing the size of a market or eliminating it

Question 16

Moral hazard

Answer 16

An informed person takes advantage of a less informed person through an unobserved action (a homeowner pays less attention to fire hazards because they have fire insurance)

Question 17

Ways to reduce adverse selection

Answer 17

• Government intervention- to prevent opportunism by better informed sellers by product liability laws and standards and certificates
• screening- consumers can avoid lemons if they can obtain reliable information about quality
• signalling- actions through which producers of high quality goods can distinguish themselves from low quality producers (brands and reputations, guarantees and warranties)

Question 18

Explain why a homeowner cares less about fire safety once they have insurance.

Answer 18

Once they have insurance, the marginal benefits of them looking after fire safety decrease so MC=MB Is now smaller. This means the homeowner dedicates less care since the cost of the fire is split between himself and the insurer so MSB>MPB

Question 19

Wats to reduce moral hazard

Answer 19

• insurance to co insurance

* employer-employee relationships

Question 20

How do adverse selections and moral hazard require different kinds of solutions?

Answer 20

Adverse selection: need to create mechanisms to transfer information to uninformed party
Moral hazard: need to create incentives for the informed party not to undertake harmful hidden actions