The market Mechanism and Market Failure

Question 1

Market Failure

Answer 1

When the market fails to allocate resources efficiently i.e. the market uses too many or not enough resources to produce a particular good

Question 2

Complete and Partial Market Failure

Answer 2

When a market completely fails to provide a good or service. This is largely restricted to pure public goods e.g. defence.
Partial market failure happens when the private sector may partially provide it but at the wrong price or quantity. E.g. private healthcare vs the NHS.

Question 3

Public goods

Answer 3

A good that is non-excludable (it is not possible to exclude non-consumers from the benefit of a good or service i.e free rider problem) and non-rival (the consumption of a good by one consumer does not diminish the supply available to other consumers) e.g. armed forces, police, street lighting, flood defences

Question 4

Positive externalities

Answer 4

Goods/services which give benefit to a third party e.g. less congestion from cycling.
Positive externalities exist when third parties benefit from the spill-over effects of production/consumption e.g. the social returns from investment in education & training or the positive benefits from health care and medical research.
MSB>MPB

Question 5

Negative externalities

Answer 5

Goods/services which impose a cost on a third party e.g. cancer from passive smoking.
An externality is also known as an external effect or a spillover effect. With a negative externality, the marginal social cost is higher than the marginal private cost. Market failure happens if the price does not take into account externalities so that there is over-use, over-production leading to a Pareto-inefficient allocation of resources.

Question 6

Merit goods

Answer 6

People underestimate the benefit of good, e.g. education. It may also have positive externalities.
A product that society values and judges that everyone should have regardless of whether an individual wants them. In this sense, the government (or state) is acting paternally in directly providing free at point of consumption or subsidising merit goods and services.
Can use positive consumption externality diagram to show a merit good.
A government may use a subsidy to encourage the consumption of merit goods.

Question 7

Demerit goods

Answer 7

People underestimate the costs of a good, e.g. smoking. It may also have negative externalities.
The consumption of de-merit goods can lead to negative externalities which causes a fall in social welfare. Consumers may be unaware of the negative externalities that these goods create - they have imperfect information.
Use negative consumption externality diagram. Gov could reduce consumption by using a tax.

Question 8

Private good

Answer 8

Consuming them only benefits you and your consumption prevents others from consuming the same good. Private goods exhibit both excludability and rivalry.

Question 9

Quasi-public good

Answer 9

Goods that have the feel of public goods but do not completely satisfy the definition of a public good. They are largely non-rival (apart from during peak/times and periods) and it is possible to exclude third parties from the benefits but the costs associated with this mean that this is rarely enforced. e.g. roads and NHS.

Question 10

The free-rider problem

Answer 10

This occurs when people can benefit from a good/service without paying anything towards it. If enough people can enjoy a good without paying for the cost – then there is a danger that, in a free market, the good will be under-provided or not provided at all.

Question 11

The tragedy of the commons

Answer 11

The depletion of a freely accessible resource because a rational individual will base usage decisions on their own self interests even if they know that the cumulative effect of everyone’s actions are depleting the resource. For instance, in the fishing industry each fisherman has an incentive to maximise their own profits by catching as many fishes as possible in the sea, as this is a public resource and does not have clearly defined property rights. However, if each fisherman does this then eventually the sea will become depleted of this type of fish and the industry will suffer.

Question 12

Monopoly power

Answer 12

The ability of a single firm to influence an entire market. In this type of market structure monopoly power allows the monopolist to restrict output and become price makers i.e. price above the marginal cost.

Question 13

Inequality

Answer 13

Unfair distribution of resources in a free market, e.g. some experiencing poverty and homelessness.

Question 14

Factor immobility

Answer 14

E.g. geographical/occupational immobility. For example, when there are pockets of high unemployment, but it is difficult for the unemployed to move and get a job.

Question 15

Information failure

Answer 15

Where there is a lack of information to make an informed choice.
Symmetric information is perfect and equally available to everyone in the market. Whereas, asymmetric information happens when both parties in a transaction have an unequal amount of information.
Means people cannot find jobs that they are best suited to. Employers cannot find the best employees. Increases frictional unemployment. This isn’t allocatively efficient and so, is a source of market failure.

Question 16

Price mechanism

Answer 16

The price of a good/service is the value its exchanged at. The price mechanism involves using the invisible hand to achieve an efficient allocation of resources.
Incentive function: rising prices encourages firms to expand their level of output because of higher profits.
Signalling function: if the price of a good changes, this signals to the consumer or producer that they should change their level of consumption or production.
Rationing function: resources are scarce. The price of a good rations that good. This limits supply to those who are willing and able to pay for it.

Question 17

Pricing public goods

Answer 17

It is hard to price a public good. Producers may overvalue the product and consumer undervalue. This further discourages the production of public goods in the free market.

Question 18

positive consumption externality

Answer 18

Positive externality created in the consumption of a good. The marginal social benefit is the total benefit of consuming a good or service to society. MSB = MPB+ Externality. If the consumption externality is positive, then the marginal social benefit is more than the marginal private benefit. E.g. School education is a positive consumption externality because students become more productive for employers.

Question 19

Negative consumption externality

Answer 19

Another type of negative externality is the negative consumption externality, in which the consumption of a good reduces the well-being of others who are not compensated for this harm. Cigarette smoking is a common example, in which one’s consumption affects others as a result of the health hazards of secondhand smoke.

Question 20

Positive production externalities

Answer 20

MSC=MPC-Production externality.
MSC is the total cost of producing a good or service to society.
If the production externality is positive, then the social cost is less than the private cost and the good will be underproduced.

Question 21

Negative production externality

Answer 21

The social cost is greater than the private cost (cost curves are equal to the supply curves, because producing is the same as supplying) and the good will be overproduced. E.g. a factory producing noise and air pollution is likely to have a social cost larger than the private cost.

Question 22

Property rights and externalities

Answer 22

Assigning property rights (ownership) of resources to a group is one way in which a good can be made excludable - helping to address the free-rider problem and tragedy of the commons.
As a result only those willing to pay the costs of the damage they do can use the resources.
externalities such as pollution degrade common resources. If the property rights for these resources are assigned, then firms would have to pay to damage them. The price would be decided by the market forces and would lead to the cost to society being included in the cost of production.