1.3 Market Failure

Question 1

What is a third party?

Answer 1

A ‘third party’ is a group or individual that is not directly involved in a decision or action.

Question 2

What is an externality?

Answer 2

Externality – refers to the unintended side effects or consequences of an economic activity or transaction that affect third parties who are not directly involved in that activity or transaction.
Externality – are spill-over effects from production and/or consumption for which no appropriate compensation is paid to one or more third parties affected.

Question 3

What are main externalities?

Answer 3

Negative externalities in production
Negative externalities in consumption
Positive externalities in production
Positive externalities in consumption
Mixed externalities

Question 4

What are the types of externalities?

Answer 4

Private cost
Private benefit
External cost
External benefit

Question 5

What is a private cost?

Answer 5

These are the internal costs faced by the producer or consumer directly involved in a transaction.
For example, the private cost of owning and running a vehicle.

Question 6

What is an external cost?

Answer 6

Occur when the activity of one agent has a negative impact on the wellbeing of a third party.
They impose costs on other agents.
This causes social cost > private cost.
For example, a car would produce pollution

Question 7

What is a private benefit?

Answer 7

The benefit, satisfaction or utility that an individual agent such as a consumer or business derives from producing or consuming something.

Question 8

What is an external benefit?

Answer 8

Social benefits include private benefits and also external benefits that might occur from production and/or consumption.
An unintended benefit for someone outside the transaction.

Question 9

What is a marginal private cost?

Answer 9

Is the internal cost to a producer or consumer from supplying or consuming one extra unit of a good or service.

Question 10

What is a marginal private benefit?

Answer 10

Is the extra benefit, satisfaction or utility gained by a consumer or producer through consuming or producing one extra unit of a good or service.

Question 11

What is a marginal external cost?

Answer 11

Cost to third parties from the production/consumption of an extra unit of output.

Question 12

What is a marginal social cost?

Answer 12

Total cost to society arising from producing/consuming an extra unit of output.
MSC = MPC + MEC

Question 13

How do you calculate social cost?

Answer 13

Social cost = private cost + external cost

Question 14

What is market failure?

Answer 14

Market failure – occurs whenever markets fail to deliver an efficient allocation of resources, and the result is a loss of welfare.
Exists when the competitive outcome of markets is not satisfactory from the point of view of society.

Question 15

What are the causes of market failure?

Answer 15

Knowledge is not perfect – ignorance
Goods are differentiated
Resource immobility
Market power is abused
Services/goods would or could not be provided in sufficient quantity by the market – merit/demerit goods
Existence of external costs and benefits – externalities
Inequality exists

Question 16

How is imperfect knowledge a cause of market failure?

Answer 16

Consumers do not have adequate technical knowledge (what the product actually is)
Advertising can mislead or misinform
Producers are unaware of all opportunities
Producers cannot accurately measure productivity
Decisions are often based on past experience rather than future knowledge

Question 17

How are differentiated goods and services a cause of market failure?

Answer 17

Goods/services are differentiated through:
Branding
Designer labels
Technology – lack of understanding of the impact
Labelling and product information

Question 18

How is resource mobility a cause of market failure?

Answer 18

Where factors of production are not fully mobile

Labour immobility – geographical and occupational
Capital immobility
Land – cannot be moved to where is may be needed (e.g. London)

Question 19

How is market power a cause of market failure?

Answer 19

Existence of monopolies and oligopolies (where the market is controlled by a few firms)
Collusion (working with someone else)
Price fixing
Abnormal profits
Rigging of markets
Barriers to entry to markets

Question 20

What is a marginal benefit?

Answer 20

Marginal benefit – is the change in total private benefit from one extra unit.

Question 21

What is a marginal cost?

Answer 21

Marginal cost – is the change in total private cost from one extra unit.

Question 22

How do you calculate marginal social benefit?

Answer 22

Marginal social benefit = marginal private benefit + marginal external benefit

Question 23

What are mixed externalities?

Answer 23

Occur when production and/or consumption leads to both external costs and external benefits simultaneously.
The socially optimum level of output depends on the extent and value of the negative and positive externalities.

Question 24

What is a merit good?

Answer 24

Goods and services that could be provided by the market but consumers may not be able to afford or feel the need to purchase them.
Consumers are unaware of the full benefits of consumption.
Market would not provide them in the quantities society needs.

Question 25

What is a demerit good?

Answer 25

Goods which society over-produce. Consumers are unaware of the full costs of consumption. Goods and services that are provided by the market which are not in our best interests. E.g. Alcohol and drugs.

Question 26

What are public goods?

Answer 26

These are non-rival and non-excludable goods usually provided collectively by the state. Markets would not provide such goods and services as they do not make a profit.

Question 27

What are some examples of public goods?

Answer 27

Broken road signs Streetlights National parks Crime control for a community

Question 28

What do non-rival goods mean?

Answer 28

consumption by one person does not reduce the supply available for others

Question 29

What does non-excludability mean?

Answer 29

Meaning that the benefits derived from them cannot be confined solely to those who have paid for it. Non-payers can enjoy the benefits of consumption at no financial cost to themselves. This leads to the free rider problem which equals a market failure.

Question 30

What is the free rider problem?

Answer 30

Where individuals or organisations can enjoy the benefits from a resource, service or public good without bearing any cost.

Question 31

How does the free rider problem result in a market failure?

Answer 31

Lack of profit incentive – Private companies have little motivation to produce public goods. Underproduction or no production – since producers can’t exclude non-payers they may not produce the good at all, even if society values it highly. Discourages people from contributing voluntarily, which can cause essential goods or services to be underfunded or degraded. Inefficient allocation – The market fails to match supply with demand. Even if people want the good and would benefit from it, it won’t be provided unless the government or a third party intervenes.

Question 32

What are characteristics of public goods?

Answer 32

Non-excludability - Benefits derived from pure public goods cannot be confined solely to those who have paid for it. (free rider problem) Non-rival consumption - Consumption by one consumer does not restrict consumption by other consumers. Non-rejectable - The collective supply of a public good for all means that people cannot reject it.

Question 33

What are characteristics of private goods?

Answer 33

Excludable – Sellers can easily prevent individuals who have not paid for the good from consuming it. Allows for the enforcement of property rights and collection of payment. Rival in consumption – when one person consumes or uses a private good it reduces the quantity available for others to consume. Rejectable - a consumer can reject private goods and services if their needs and preferences or their budget changes.

Question 34

How are private goods priced and allocated?

Answer 34

Private goods are typically priced in markets based on supply and demand.

Question 35

What are advantages of public goods?

Answer 35

Reduces average cost – economies of scale. Producing public goods for a larger population can lower per capita costs. Non-excludability – Tax ensures everyone contributes to the funding of public good preventing free riding. Public interest and equity – taxation allows gov to allocate resources based on societal priorities and ensure public goods are provided in a way that promotes social welfare and equity.