Theme 1.3

Question 1

What is market failure?

Answer 1

This is when the price mechanism leads to a inefficient allocation of resources leading to net wealth loss.

Question 2

What are the three types of market failure that we focus on?

Answer 2

• Externalities
• Under-provision of public goods
• Information gaps

Question 3

What are externalities?

Answer 3

These are the costs and benefits which are external to an exchange, they’re third party effects ignored by the price mechanism. Externalities are also known indirect cost and benefits, or spillovers. External costs are called negative externalities and external benefits and called positive externalities.

Question 4

What are external costs?

Answer 4

These are negative third-party effects outside of a market transaction. An example of this when a person smokes in public, there are external costs of those who end up passively smoking.

Question 5

What are private costs?

Answer 5

These are the costs internal to a market transaction, which are therefore taken into account by the price mechanism. For example: machinery costs, wage of workers, transport and insurance on a firm.

Question 6

What are social costs?

Answer 6

This is the sum of the external costs plus the private costs from a market transaction. This means the the external costs are the difference between the private and social costs. If the marginal private costs and marginal social costs diverge, this means external costs increase disproportionately than private costs. However they can be parallel lines, if the external costs per unit remains equal.

Question 7

What are external benefits?

Answer 7

These are positive third-party effects outside of the market transaction. An example of this would be recycling waste materials of bottles, which means it will then be used again and not put in a landfill site. The external benefits are then on the environment, but these aren’t included within the price of the transaction.

Question 8

What are private benefits?

Answer 8

These are internal to a market transaction, which are therefore taken into account by the price mechanism. This can be measured by the price consumers are willing to pay for a good or service.

Question 9

What are social benefits?

Answer 9

This is the sum of external and private benefits within a market transaction. The external benefits are the different between the social and private benefit. If the private marginal benefit and social marginal benefit curves divert, then this means the external benefits grow disproportionately to the output consumed. However, the lines can be parallel if the external benefit per unit consumed remains constant.

Question 10

What are some examples of external costs of production?

Answer 10

• A waste disposal firm dumping toxic waste at sea, which destroys fish life.
• Burning coal in power stations to create electricity, adding to global warming.
• Increased production of biofuels, which destroy rainforests and increase food prices.

Question 11

What are some examples of external costs of consumption?

Answer 11

-Excess alcohol intake, which leads to vandalism
-Increased road congestion around the expansion of Heathrow airport.
-Tobacco smoking, which affects passive smokers.

Question 12

What are some external benefits of production?

Answer 12

• A paper and glass recycling plant, reducing waste for landfill sites
• Construction of the London Crossrail project, increasing inward investment and raising local property prices.
• The use of wind turbines and tidal power to create electricity. These are renewable forms of electricity, meaning that in the end there is less carbon emissions from fossil fuels.

Question 13

What are some external benefits of consumption?

Answer 13

-Education and training programmes, which increase human capital levels. Higher labour productivity increases profits for firms.
-Improving the quality of a garden, which then causes the price of neighbouring homes to increase.
-The consumption of vaccinations, which then helps to cause herd immunity and reduce the spread of diseases, increasing life expectancy.

Question 14

What is market equilibrium?

Answer 14

This is the price where marginal private benefit matches marginal private cost. Economists assume it is possible to measure this by the price people are willing to pay for a product, however it isn’t necessarily true as it fails to include the benefits/costs of externalities.

Question 15

What is the social optimum equilibrium?

Answer 15

This is the level of output or price for a good or service where the marginal social benefit equals the marginal social cost. At the price, welfare would be maximised along with the allocation of recourses.

Question 16

What is the area of welfare loss/gain on an externalities diagram?

Answer 16

This is the amount by which the market has failed because the price is at the incorrect point, either not accounting for external negatives or not accounting for all external benefits.

Question 17

What are the impacts of external costs on consumers and producers?

Answer 17

-Overproduction, since the free market level of output exceeds the social optimum level of output.
-Underpricing, since the free market price is below the social optimum price.
-Welfare loss, since marginal social costs exceeds marginal social benefits.
-Concerns over availability of resources for future generations. For example, over fishing will lead to a crash in fish stocks.
-Concerns for pollution levels
-Calls for government intervention to internalise external costs and correct market failure. E.g indirect costs or permits.

Question 18

What are the impacts of external benefits on consumers and producers?

Answer 18

-Underproduction, since the free-market level of output is less than the social optimum level of output.
-Underpricing, since the free market price is less than the socially optimum price.
- Potential welfare gain, since marginal social benefits exceed marginal social costs.
- Concerns over the long term implications of underproduction. E.g the under provision of education and healthcare could lead to lower economic growth and therefore a less competitive economy.
- Calls for government intervention to internalise the external benefits and correct market failure. E.g through subsidies.

Question 19

What are public goods?

Answer 19

These are good which are both non-rivalry and non-excludable in their consumption. For example, national defence, flood defence systems, street lights.

Question 20

What does non-excludable mean?

Answer 20

-This means that once a good has been produced for the benefit of one person, it is impossible to stop others from benefitting.

Question 21

What does non-rivalry mean?

Answer 21

This means that as more people consume a good and enjoy its benefits, it does not reduce the amount available for others.

Question 22

What is a quasi-public good?

Answer 22

These are goods that act like a public good in their provision part of the time, however during peak times there may be rivalry and excludability. An example of this would be roads, which have high rivalry for space during rush hour.

Question 23

What are private goods?

Answer 23

These are goods which are rivalry and excludable in their consumption. The opposite of a public good. Owners of private goods can use private property rights to exclude people from their good. As well as this, private goods can be rejected, you don’t have to consume them like you would have to use a street light if driving down a road which has them.

Question 24

What is the free-rider problem?

Answer 24

In a free market economy, public goods are under provided due to the free-ride problem. Once a public good has been provided for one individual, it is automatically provided for all. The market fails because it is not possible for firms to withhold the good from those customers who refuse to pay for it. Examples are national defence and street pavements.

The rational customer would then just wait for someone else to pay for it, but if everyone does this, a public good will end up never being provided. The non-excludability characteristic means the the price mechanism cannot develop as free riders won’t pay for it. This means private firms are reluctant to supply these in a free market as it is difficult to gain profit. As a result they’re usually provided by the government from general taxation.

Question 25

What are information gaps?

Answer 25

This is where consumers, producers or the government have insufficient knowledge to make rational economic decisions about a particular good or service. An example of this is a second hand car, where the buyer has no way of telling the exact condition of the car.

Question 26

How can information gaps lead to market failure?

Answer 26

When consumers and producers simply lack perfect knowledge about a particular good or service and end up making non-rational economical decisions. For example with a pension, young people don’t see or understand the benefits of adding to their pension and end up making too few contributions for their retirement.

Question 27

What is symmetric information?

Answer 27

Where consumers and producers have access to the same information about a good or service in the market. Assuming consumers and producers act in a rational way, this would lead to an efficient allocation of resources.

Question 28

What is asymmetric information?

Answer 28

This is when consumers and producers have unequal access to information about a good or service in the market. This means consumers or producers cannot act rationally, due to a lack of market info, and as a result there will be a misallocation of resources.

Question 29

What are some examples of producer knowledge exceeding consumer knowledge?

Answer 29

A second-hand car salesman will have greater knowledge of his cars history than the buyer. This could result in the buyer paying too much for what is actually a poor quality car. The fear of this tends to reduce the market price for all second-hand cars, even the good quality ones. This means that both the buyers and sellers could lose, depending on the quality of the car. This is known as the lemon market and is associated with the work of economist George Akerlof.

The solution to this is to have inspection schemes offered by motor organisations, they can inspect a car on the behalf of a consumer to overcome information failure.

Question 30

What are some examples of where consumer knowledge may exceed producer knowledge?

Answer 30

Insurance policy, where the consumer knows more about their likelihood to have an accident than the insurance company does. They may have a risky lifestyle but not tell the insurance company this. As a result they will get a cheaper insurance than they should have done. This could end up costing the insurance company money if they get into an accident. This can lead to insurers exiting the market. The solution is to have watchdog parties with powers to investigate and prosecute fraudulent insurance claims.