1.3 market failure

Question 1

what is meant by the efficient allocation resources?

Answer 1

• the assignment of scarce resources to various areas of industry where they would be considered most efficient

Question 1

what are the three sources of market failure?

Answer 1

• externalities
• underprovision of public goods
• the information gap

Question 2

what are the roles of markets?

Answer 2

• to allocate scarce resource

Question 3

what is productive efficiency?

Answer 3

occurs when maximum output is produced from the available factors of production and when it is not possible yo produce more of one good without producing less of another

Question 4

what is allocative efficiency?

Answer 4

when an economy’s factors of production are used to produce the combination of goods and services that maximize society’s welfare

Question 5

what is market failure?

Answer 5

when the price mechanism leads to an inefficient allocation of resources and a deadweight loss of economic welfare

Question 6

what are the two ways in which markets can fail?

Answer 6

• partial market failure; markets may lead to the over or underproduction of goods
• markets may not exist (missing markets), leading to no production of a good or service

Question 7

how are externalities created?

Answer 7

• created when social benefits and costs differ from private benefits and costs.
• the free market mechanism doesn’t always consider social costs and benefits e.g. the cost of pollution by a firm is a negative externality. the cost to society is greater than the cost to the firm that is producing

Question 8

what does a misallocation of resources look like on a graph?

Answer 8

• will occur if the market prices do not accurately reflect the costs and benefits to society of economic activities
• the greater the externality, the larger the divergence between private costs and benefits and social costs and benefits
• the greater the externality, the greater the market failure, and the less market prices provide accurate signals for the optimal allocation of resources

Question 9

what are public goods? + examples?

Answer 9

• goods that are both non-rivalry and non-excludable e.g. defence, lighting, policing, roads
• different from private goods because the marginal cost (the extra cost) of providing another unit of the good is 0

Question 10

what does non-rivalry mean?

Answer 10

the consumption of the good by one person does not reduce the amount available for consumption by another person

Question 11

what is non-excludability?

Answer 11

once provided, no one can be excluded from benefitting

Question 12

what is a key reason for the underprovision of public goods

Answer 12

• it is relatively easy for people to gain the benefits for the goods without having to pay for them as there is a large incentive for people to not have to pay for the good
• suggesting that firms cannot profit maximise which deters them from wanting to produce the good
• as a result, public goods are underprovided if left to free market forces

Question 13

what is an information gap?

Answer 13

• in an efficient market, it is expected that buyers and sellers have good knowledge of a product - though sometimes, that information is imperfect
• an info gap occurs when a lack of information leads to a consumer making the wrong choice: doesn’t maximize their social welfare

Question 14

what are externalities?

Answer 14

the unintended side effects or consequences of an economic activity that affects third parties who are not directly involved in the transaction

Question 15

what is a private benefit?

Answer 15

the benefit that an individual agent, such as a consumer or business derives from consuming or producing something

Question 16

what are social benefits? what is the equation for social benefits?

Answer 16

they include private benefits but also add in external benefits that might occur from production and/or consumption
social benefits = privatet benefit + external benefit

Question 17

when does a positive externality occur?

Answer 17

can occur in both production and consumption when the social benefit is greater than the private benefit

Question 18

what are private costs?

Answer 18

the internal costs faced by the producer or consumer directly involved in a transaction e.g. the cost of owning and running a vehicle

Question 19

what is the social cost? what is the equation for this?

Answer 19

includes private costs but adds on the effect of the product on a third party as the external costs e.g. worsening health conditions of pedestrians due to air pollution from road vehicles
social cost = private cost + external cost

Question 20

when does a negative externality occur?

Answer 20

when the social cost is greater than the private cost

Question 21

what does it mean when something is measured at the margin?

Answer 21

they measure the cost/benefit of the production/consumption of an extra unit of output

Question 22

what are the equations for marginal social cost (MPC) and marginal social benefit (MSB)?

Answer 22

MSC = MPC + MEC
MSB = MPB + MEB

Question 23

what is the social optimum of consumption and production in the market?

Answer 23

the point where MSB = MSC

Question 24

what happens if the market ignores positive externalities?

Answer 24

there will be under-consumption of the product, leading to a welfare loss or more potential for welfare gain

Question 25

what are some examples of negative externalities?

Answer 25

pollution:
- industrial waste
- air pollution from factories
- noise pollution

Question 26

what is a social welfare loss?

Answer 26

when the market output is supplied higher than the social optimum when MSC > MPC

Question 26

how can negative externalities on production be reduced?

Answer 26

• imposing taxes
• introduction of quotas

Question 26

what are the advantages and disadvantages of imposing taxes on pollution and otherwise?

Answer 26

+ internalises the externality and makes the polluter pay
+ utilises the price mechanism to change incentives and choices e.g. to reduce pollution
+ raises tax revenue which may then be used to address other market failures

• low price elasticity of demand - tax may not change behaviour
• risk of tax evasion and tax avoidance
• may hit lower income families most and cause social unrest

Question 27

what are two features of a private good?

Answer 27

• rivalrous
• non-excludable

Question 27

what is a quasi-public good?

Answer 27

a good that does not perfectly possess the characteristics of non-excludable and non-rivalry and yet which isn’t a private good e.g. beaches or open access wifi networks

Question 28

what is a free rider?

Answer 28

a person or organisation which receives the benefits that others have paid for without making contributions

Question 29

why does the free rider problem eventually lead to market failure?

Answer 29

free rider problem leads to an underprovision of a good or a missing market because the private sector would be unable to gain a profit when supplying them - this leads to market failure

Question 30

what is a good solution to the free rider problem?

Answer 30

• government provision
  -introduction of government legislation to enforce excludability of certain goods such as copyright and patent laws to protect intellectual property

Question 31

why are public goods financed by the government?

Answer 31

• non-excludability: taxation ensures that everyone contributes to the funding of public goods, preventing free-riding and ensuring that the costs are distributed across the population
• economies of scale: producing public goods for a larger population can lead to lower per capita costs. + taxation allows governments to collect tax from a broad tax base, which can be cost effective in providing these goods compared to private firms
• public interest and equity: taxation allows govs. to allocate resources based on societal prioritues and ensure that public goods are provided in a way that promotes social welfare and equity

Question 32

how does the information gap affect market demand?

Answer 32

• as buyers possess imperfect information regarding a product, they overestimate the benefits of it
• this leads to them buying too much, resulting in a misallocation resources (outward shift)
• market demand would be lower if the consumers had better information

Question 33

what is assumed in a perfect market?

Answer 33

in a perfect market, it is assumed that consumers and producers have full knowledge about prices, benefits and costs of goods and services aka perfect information

Question 33

what is symmetric information?

Answer 33

assumption that buyers and sellers have potential access to the same information

Question 34

what is asymmetric information?

Answer 34

where either the buyer or seller has more information about the other. asymmetric info leads to an information failure

Question 34

what are some examples of asymmetric information in markets?

Answer 34

• landlords: know more about the property than their tenants
• doctors have superior knowledge about drugs and treatments
• used car seller knows more about vehicle quality than the buyer

Question 34

what are some examples of markets where there is an information gap?

Answer 34

• addiction to painkillers and drugs
• the uncertain quality of second-hand products like cars
• knowledge of the nutritional content of foods

Question 35

what are the causes of information failure?

Answer 35

1) complexity: information failure when a product is highly complex
2) unbalanced knowledge: when the buyer knows more than the seller or vice versa
3) price information: when consumers are unable to quickly/cheaply find sufficient info on the best prices

Question 36

what is the principal-agent problem?

Answer 36

occurs when the goals of principals, those standing to gain or lose from a decision, are different from agents, those making the decisions on behalf of the principal e.g. children (principals) and parents (agents)

Question 37

what is a moral hazard?

Answer 37

occurs when an economic agent makes a decision in their own best interest, knowing that there are potential risks that will be faced by others e.g. insured consumers are more likely to drive dangerously knowing that they are insured

Question 38

what can the government do to address information failures?

Answer 38

• compulsory labelling on products
• advertising/campaigns to raise awareness
• consumer protection laws
• ## industry standards and guarantees