Week 5 - Market failure

Question 1

What is equity?

Answer 1

Is a normative judgement - different for different people

Question 2

Types of equity

Answer 2

• Horizontal equity
• Vertical equity

Question 3

Define horizontal equity

Answer 3

Identical treatment of identical people

Question 4

Define vertical equity (2)

Answer 4

• The different treatment of different people in order to reduce the consequences of these innate differences
• E,g Income tax

Question 5

Define Pareto efficiency

Answer 5

• For given tastes, inputs and technology an allocation is ‘efficient’ if no one can be better off without making someone else worse off
• Market equilibrium can be shown to be Pareto efficient

Question 6

Interpret a Competition and Pareto-efficiency graph in equilibrium (4)

Answer 6

• D is the demand curve, but also the marginal product benefit curve (MPB)
• S is the supply curve, but also represents the marginal private cost curve (MPC)
• At point A, the consumers’ willingness to pay is equal to the firms’ willingness to supply
• MPB = MPC (Pareto efficient)

Question 7

Interpret a Competition and Pareto-efficiency graph in disequilibrium

Answer 7

• At P, the willingness of consumers buy is greater than the willingness of producers to supply
• Thus there is potential Pareto improvement
• Point A is efficient and there is no government intervention

Question 8

Ways market failure arises (4)

Answer 8

• Imperfect competition (P > MC)
• Taxation - creates distortions such that P > MC
• Externalities
• Missing markets

Question 9

What is an externality? (2)

Answer 9

• An externality is a cost or benefit, not transmitted through prices, incurred by a third party who did not agree to the action causing the cost or benefit
• Externalities can also be as a result of consumption aswell as production

Question 10

Example of positive externality

Answer 10

Spill-over expects created by foreign direct investment in a host country

Question 11

Interpret a negative externality in production diagram (3)

Answer 11

• MPC = MPB
• MSC => externality
• Q > Q* = overproducing

Question 12

Impact of pigovian tax when there is a negative externality (3)

Answer 12

• MPC => MPC
• Now at A:
• Price = P2
• Quantity = Q*

• MPC = MSC = MPB = MSB

Question 13

Define public goods

Answer 13

Are goods not provided by the private market because of the free-rider problem

Question 14

Examples of public goods are free riders

Answer 14

Street lighting - Charging people for using them would be very difficult as a result the firm would make no revenue and goes bust

Question 15

Define public good

Answer 15

A good/service that is provided without profit to all members of a society either by the goverment or by a private firm

Question 16

Two characteristics of public goods

Answer 16

• Non-rivalrous
• Non-excludable

Question 17

Define non-rivalrous - characteristic of public good

Answer 17

One person consuming it doesn’t affect the ability of someone else to consume it (e,g national defence)

Question 18

Define non-excludable (characteristic of public goods)

Answer 18

You cannot stop an individual from consuming the good e.g street lightning

Question 19

Examples of public goods

Answer 19

• Flood defences
• Immunisation projects
• Policing etc

Question 20

What is asymmetric information? (2)

Answer 20

• Is where one party has more information than another therefore is unlikely that a socially optimal equilibrium will be reached
• Social equilibrium is unlikely to be reached as party with more info may exploit the other party e.g buying something that’s second hand

Question 21

What is adverse selection? (2)

Answer 21

• Refers to a market process in which “bad” results occur when buyers and sellers have asymmetric information
• Example would be life insurance where the most risky will charge a premium to make sure they are covered

Question 22

Define moral hazard

Answer 22

Occurs when a party insulated how risk behaves differently than it would be have if it were fully exposed to the risk

Question 23

Examples of moral hazard (2)

Answer 23

• Mobile phone insurance - Insure my phone therefore I’m less careful as it can be replaced
• Bond bail out - by bailing out the banks in the 07/08 financial crisis have we encouraged them to take more risks