[1.3] Market Failure

Question 1

What is a market failure?

Answer 1

A situation whereby the market fails to allocate scare resources efficiently.

Question 2

What are the three main types of market failure (needed for the Edexcel Economics course).

Answer 2

1. Externalities (negative and positive)
2. Under-provision of public goods (e.g. street lighting)
3. Asymmetric information (an information gap between firms and consumers)

Question 3

What is the difference between private cost, external cost, and social cost?

Answer 3

• Private costs are the costs experienced by the individual firm or consumer (e.g. the costs of production).
• External costs are the costs that are not reflected in the private costs, yet are still experienced by society as a whole.
• The social cost is the total cost to society. It is equal to the private cost + the external cost.

Question 4

What is the difference between private benefit, external benefit, and social benefit?

Answer 4

• Private benefits are the benefits experienced by the individual firm or consumer.
• External benefits are the costs that are not reflected in the private benefits, yet are still experienced by society as a whole.
• The social benefit is the total benefit to society. It is equal to the private benefit + the external benefit.

Question 5

What is the difference between the market equilibrium position and the socially optimum position?

Answer 5

The market equilibrium position is where supply equals demand, whereas the socially optimum position is where the marginal social benefit equals the marginal social costs.

Question 6

What type of good causes a negative externality?

Answer 6

Demerit good

Question 7

What type of good causes a positive externality?

Answer 7

Merit good

Question 8

How can a the size of a negative externality (external cost) be found on a diagram?

Answer 8

The vertical distance between the marginal private cost and the marginal social cost.

Question 9

How can the size of a positive externality (external benefit) be found a diagram?

Answer 9

The vertical distance between the marginal private benefit and the marginal social benefit.

Question 10

What two characteristics are held by public goods?

Answer 10

1. Non-rival

2. Non-excludable

Question 11

What is meant by the term ‘non-rival’?

Answer 11

The consumption of the good does not prevent other consumers from also consuming the good.

For example, ‘consuming’ street lightening by walking underneath a lamppost does not stop other consumers from also consuming the benefits of that street lighting.

Question 12

What is meant by the term ‘non-excludable’?

Answer 12

A good that firms are unable to prevent consumers who have not paid from consuming.

For example, firms cannot stop consumers from using street lighting - even if they haven’t paid.

Question 13

Why aren’t public goods provided by private firms?

Answer 13

The free rider problem means that that rational consumers will not purchase the good, as only the first consumer needs to make the purchase for the benefits to be accessible to everyone.

This means firms will make zero revenue, as consumers will have no reason to pay the firm.

Question 14

What is the difference between symmetric and asymmetric information?

Answer 14

• Symmetric information means both parties have all of the information needed to make a rational economic decision.
• Asymmetric information occurs when one party in a transaction has more information that the other (e.g. dentists have more information than their patients).

Question 15

How does asymmetric information lead to an inefficient allocation of resources?

Answer 15

• Consumers pay too little or too much for a good

- Firms produce too little or too much of a good