Unit 3: Market Failure

Question 1

Define market failure

Answer 1

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

Question 2

Define efficient

Answer 2

When total welfare is maximised given current resources

Question 3

Define externality

Answer 3

When the consumption of a good/service has effects on something/someone not involved in the transaction

Question 4

Define consumption externality

Answer 4

An externality that affects the consumption side of a market, which may be positive or negative

Question 5

Define production externality

Answer 5

An externality that affects the production side of a market, which may be positive or negative

Question 6

Define private cost

Answer 6

A cost borne by a party in a transaction

Question 7

Define external cost

Answer 7

A cost that is borne by a third party and not reflected in market prices

Question 8

Define private benefit

Answer 8

A benefit received by a party when producing/consuming a good

Question 9

Define external benefit

Answer 9

A benefit which is received by a third party and is not reflected in market prices

Question 10

How is social cost calculated?

Answer 10

Private cost + external cost

Question 11

Define marginal social cost

Answer 11

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

Question 12

Define a demerit good

Answer 12

A good with a negative externality in consumption

Question 13

Define free market output

Answer 13

where marginal private benefits = marginal private costs with no government intervention

Question 14

Define socially optimum output

Answer 14

where marginal social benefits = marginal social costs and societies welfare is maximised

Question 15

Define a private good

Answer 15

A good that, once consumed by one person, cannot be consumed by someone else

Question 16

Define a public good

Answer 16

A good that is non-excludable and non-rivalrous in consumption (consumers cannot be excluded from consuming the good, and consumption by one person does not affect the amount of the good available for others to consume)

Question 17

Define a quasi-public good

Answer 17

A good that has some of the qualities of a public good but does not fully possess the two required characteristics of non-rivalry and non-excludability

Question 18

Define the free-rider problem

Answer 18

When an individual cannot be excluded from consuming a good, and thus has no incentive to pay for its provision

Question 19

Define asymmetric information

Answer 19

A situation in which some participants in a market have better information about market conditions than others

Question 20

Define adverse selection

Answer 20

A situation in which a person at risk is more likely to take out insurance

Question 21

Define moral hazard

Answer 21

A situation in which a person who has taken out insurance is prone to taking more risk

Question 22

Define merit good

Answer 22

Goods with a positive externality in consumption

Question 23

Give an example of external cost

Answer 23

e.g pollution when petrol is consumed when driving a car

Question 24

Are goods with negative externalities over or under produced and consumed?

Answer 24

Overproduced and over consumed

Question 25

Are goods with positive externalities over or under produced and consumed?

Answer 25

Underproduced and underconsumed

Question 26

What are the 3 types of market failure?

Answer 26

Externalities

public goods

Information gaps

Question 27

How do free markets work (4 ways)

Answer 27

Invisible hand

No government intervention

Price mechanism

Supply and demand mechanism

Question 28

How is social cost calculated?

Answer 28

Private cost + external cost

Question 29

Who is affected by an external cost?

Answer 29

A 3rd party

Question 30

What happens to social costs in a free market system?

Answer 30

They are ignored

Question 31

What are the 3 types of market failure?

Answer 31

Externalities

Public goods

Information gaps

Question 32

What happens to public goods in a free market, and what is this called?

Answer 32

They go missing as people refuse to pay due to non-excludability, missing markets

Question 33

Give an example of a quasi public good

Answer 33

National park

Question 34

Define the tragedy of the commons

Answer 34

Public goods have no incentive to be looked after so the natural resources diminish

Question 35

Name 2 reasons why govs should provide public goods

Answer 35

Loss of welfare due to ‘missing markets’ if unprovided

Only institution that can make payment compulsory

Question 36

Name 2 reasons why govs shouldn’t provide public goods

Answer 36

Gov intervention may make things worse (government failure)

Opportunity cost - money may be better spent on other things

Question 37

Define information gaps

Answer 37

When a party in a transaction doesn’t have full information

Question 38

Why are information gaps bad?

Answer 38

Lead to purchase/sales errors as irrational decisions are made that are inoptimal - this is market failure as there is a misallocation of resources