Welfare Economics and Market Failure Flashcards
First theorem of welfare economics
when there is perfect competition, allocation of resources is pareto efficient (impossible to improve outcomes for someone without harming someone else.)
second theorem of welfare economics
If the market gets the
economy to the Pareto-efficient frontier, the government can make the value
judgement about which point on this frontier the economy should attain (i.e whether to have the pareto efficient outcome of the top 1% having all the wealth or to use taxes to re-distribute the income equally.
What is market failure
When the free market provides an allocation of resources that is not at the socially optimum level.
(marginal social cost doesn’t equal marginal social benefit
Name several causes of market failure
Externalities
Public goods (because of the free rider problem)
Imperfect competition
Asymmetric information
What are externalities and what are the consequences?
An externality is a cost or benefit that is bore by a third party outside of the market.
Since they’re outside of the market, you don’t consider the impact of your actions on them. Examples include, passive smoking, congestion, pollutant heavy factories
MPC don’t equal MSC or MPB doesn’t equal MSB (depending on whether its an externality of production or consumption)
Coase thereom?
When there are negative externalities, if there are no transaction costs, property rights can internalise the externality and lead to an efficient outcome (no matter who the property rights are given to (whether the victim or the perpetrator)
Merit Goods
Why do the government provide merit goods? (2 reasons)
Merit goods are goods that societies should consume regardless of whether an
individual wants them.
These goods have positive externalities. if we leave providing merit goods to the private market , those goods
will be underprovided.
Also society may believe that
individuals don’t act in their own best interests if there’s lack of information e.g. about the fact that graduates earn more than non-graduates.
Merit goods include education and health
Demerit goods
Why do the government intervene with demerit goods? (2 reasons)
Demerit goods are goods that society thinks everyone should not have regardless of whether an individual wants them e.g. tobacco, cocaine
If left to the free market, people will consume more than the socially optimum quantity (negative externalities) , so the government intervenes, taxing cigarettes and banning cocaine.
Also society may believe that
individuals don’t act in their own best interests and so it has to decide on their
behalf. e.g. Addiction to drugs
What is adverse selection and how can it lead to market failure?
A hidden information problem. In this case, the uninformed
individual isn’t able to observe a key characteristic of the
informed individual.
EG
suppose that buyers want to buy used cars. There are various sellers in the market,
some selling high-quality used cars, some selling low-quality used cars. If the
buyers cannot tell the difference between low and high quality, they will probably
be unwilling to pay much for a used car (they always face the possibility of getting
a low-quality used car). As a result, the sellers with high-quality used cars may end
up selling them at a price that is lower than their value, meaning it is unprofitable
for those sellers to stay in the market
2nd example health insurance (person buying knows more about their own health), insurance company may charge an average premium to all people requesting insurannce, preventing healthy people from getting health insurance even though they want it.
Job applications (person applying knows more about their skills and work ethic)
What is moral hazard
A hidden action problem. the uninformed agent cannot
observe a particular action of the informed individual.
Car insurance: peoples driving may become riskier once they have insurance, if they have full insurance, theres less incentive to take good care with the car, this is why insurance companies only give partial insurance, to limit the moral hazard, and increase people’s chances of taking precautions.
Another example, a worker
may put little effort into performing his job if it is difficult for the employer to
monitor him. The problem of moral hazard is also known as the principal–
agent problem, where the principal is the name we give to the uninformed
individual and the agent is the informed individual.
Public Good
A public good is a good for which individuals cannot be excluded from using it
and the use by an individual does not reduce availability to others.
E. GNational defence, clean air
What is the Free rider problem?
In a free market public goods would not be provided for as everyone is waiting for someone else to buy it and they know that they can’t be prevented from benefiting from it so they won’t pay for it
Why does Imperfect competition lead to market failure?
In imperfect competition price is set above MC.
P= MC (1+markup) consumers demand at the point P=MB (the demand curve) so putting these equations together MB=MC(1+markup) so MB>MC
This is distortion and the quantity in the market is below the social optimum as the price is too high
