Theme 1 - Market Failure

Question 1

When does market failure occur?

Answer 1

When the free market mechanism does not lead to an optimal allocation of resources.

Question 2

What is marginal social cost?

Answer 2

The cost to society of producing an extra unit of good.

Question 3

What is marginal social benefit?

Answer 3

The benefit that society gains from consuming an extra unit.

Question 4

What is a demerit good?

Answer 4

A good that brings less benefits to an individual than they realise, such that too much will be consumed under a free ticket.

Question 5

What is a merit good?

Answer 5

A good that brings unanticipated benefits to consumers such as society believes it will be under consumed in a free market.

Question 6

What is the information gap?

Answer 6

A situation where some participants have better information about market condition than others.

Question 7

What are public goods?

Answer 7

A good which is non-exclusive and non-rivalrous.

Question 8

What are externalities?

Answer 8

A cost or benefit that is external to a market transaction, and borne by a third party.

Question 9

What are the 3 forms of market failure?

Answer 9

Public goods
Information failure
Externalities

Question 10

What do externalities lead to and why?

Answer 10

Lead to market failure because the external costs and benefits are not reflected in the market prices under the free market mechanism.

Question 11

Name the negative externalities.

Answer 11

Pollution
Health
Congestion

Question 12

Name the positive externalities.

Answer 12

Employment
Recycling
Renewable resources

Question 13

Why do externalities come about?

Answer 13

Because of consumption or production and therefore affect demand or supply.

Question 14

Why does the free market fail with externalities?

Answer 14

Because they only consider private costs and benefits.

Question 15

How do you work out marginal social costs?

Answer 15

Marginal private costs + marginal external costs

Question 16

How do you work out marginal social benefit?

Answer 16

Marginal private benefit + marginal external benefit

Question 17

What is marginal external cost?

Answer 17

The cost of production to third parties.

Question 18

What are marginal external benefits?

Answer 18

The benefits of consumption to third parties.

Question 19

What are marginal private costs?

Answer 19

The cost to the firm or consumer involved in the private transaction.

Question 20

What are marginal private benefits?

Answer 20

The benefit to the firm or consumer involved in the private transaction.

Question 21

What is a asymmetric information?

Answer 21

Where some participants in a market have better information about market conditions than others.

Question 22

What impact does information failure have on merit goods and demerit goods?

Answer 22

Merit: under-consumed
Demerit: over-consumed

Question 23

What are the 2 main reasons why information failure occurs?

Answer 23

Lack of shared information: one party withholds important information either before or after an agreement.
Principle agent problem: the seller (the agent) and the buyer (the principle) have different incentives.

Question 24

What is meant by adverse selection?

Answer 24

It is often the case that those who take insurance are the ones who need it the most, this means the insurance industry faces a skewed market.
Insurance companies deal with it by putting higher premiums on the riskier population.

Question 25

What are public goods and name the 3 types.

Answer 25

These are non-excludable and non-rivalrous and are also non-rejectable

• non-excludable:not possible to exclude someone from benefitting
• non-rivalrous: once consumed they are still available
• non-rejectable: a person cannot exclude themselves from benefitting from it.

Question 26

What is a private good and name the 3 types.

Answer 26

Once consumed by someone they cannot be consumed by someone else; such goods are excludable and rivalrous.

• public goods: public transport, traffic lights, defence and the law
• private goods: housing development
• quasi goods (ones that have partial characteristics of a public good): a public bench, healthcare, roads, police.

Question 27

Explain free-rider problems.

Answer 27

These problems come about once once the goods are provided, public goods are free so there is no way you could ever try to make profit from them because a paying consumer would get the same benefit as a free consumer so there is no incentive to pay.