Theme 1 - Market failure Flashcards
When does market failure occur?
Market failure occurs when the price mechanism fails to allocate scarce resources effectively, or when the operation of market forces lead to a net welfare loss
What are the 3 causes of market failure?
Externalities
Under-provision of public goods
Information gaps
What are externalities?
Third party effects arising from production and consumption of goods and services
When does a negative externality exist?
When the social cost of an activity is greater than the private cost
What are private costs/benefits?
The costs/benefits to the individual participating in the economic activity. The demand curve represents private benefits and the supply curve represents private costs
The price mechanism only accounts for private costs
What are social costs/benefits?
The costs/benefits of the activity to society as a whole
private cost + external cost = social cost
What is a merit good?
A merit good is a good with external benefits, where the benefit to society is greater than the benefit to the individual. These goods tend to be underprovided by the free market.
What is a demerit good?
A demerit good is a good with external costs, where the cost to society is greater than the cost to the individual. They tend to be over-provided by the free market.
Why do externalities cause market failure?
The market mechanism only accounts for private costs, not social costs, meaning scarce resources aren’t allocated effectively, and there is overconsumption of goods with negative externalities and underconsumption of goods with positive externalities. The price mechanism fails to recognise externalities, only recognising private costs and benefits
What is a marginal cost/benefit?
A marginal cost/benefit is the extra cost/benefit of producing/consuming one extra unit of the good.
What are the ways the government can intervene to ensure the market considers the externalities?
Indirect taxes and subsidies
Tradable pollution permits
Provision of the good
Provision of information
Regulation
How will indirect taxes and subsidies ensure the market considers the externalities?
Taxes can be put on goods with negative externalities and subsidies on goods with positive externalities. These help to internalise the externalities, moving production closer to the social optimum position.
How will tradable pollution permits ensure the market considers the externalities?
These allow firms to produce up to a certain amount of pollution, and can be traded amongst firms so give them choice whilst reducing the total level of pollution.
How will provision of the good ensure the market considers the externalities?
When social benefits are very high, the government may decide to provide the good through taxation. They do this with healthcare and education.
How will provision of information ensure the market considers the externalities?
Since some externalities are associated with information gaps, the government can provide information to help people make informed decisions and acknowledge external costs.
How will regulation ensure the market considers the externalities?
This could limit consumption of goods with negative externalities, for example banning advertising of smoking etc.
What 2 characteristics do public goods possess?
Non-excludability - you cannot stop someone from accessing the good or service without paying for it
Non-rivalrous consumption - one person’s consumption of the good doesn’t reduce another person’s ability to consume the good
What is the free-rider problem?
You cannot charge an individual a price for the consumption of a non-excludable good because someone else will gain benefit from it without paying for it. A free rider is someone who receives the benefits without paying for it.
Why do private sector producers not provide public goods?
They cannot be sure of making a profit, as public goods are non-excludable
Therefore, if the provision of public goods was left to the price mechanism the market would fail, so they are provided by the government and financed through taxation.
What is asymmetric information?
When one party has superior knowledge compared to another. Usually the seller has more information than the buyer, and this means they can take advantage of the other party’s lack of knowledge by charging them a higher price.
What is symmetric information?
Symmetric information occurs where buyers and sellers have access to the same information; this is perfect information
However, many decisions are based on imperfect information so economic agents are unable to make an informed decision; they suffer from an information gap
Why do information gaps lead to market failure?
There is a misallocation of resources because people don’t buy things that maximise their welfare. It means that consumer demand for a good or producer supply of a good may be too high or too low, and thus price and quantity are not in the socially optimum position. Economic agents are unable to make rational decisions due to the information gap
Why does most advertising lead to information gaps?
It is designed to change the attitudes of the consumers to encourage them to buy the good. It could cause them to think the benefits are greater than they actually are. Increases in technology mean information gaps are on the decline as people can get more information
