1.3.5 market failure

Question 1

market failure

Answer 1

when the price mechanism fails to allocate scare resources efficiently and the operation of market forces lead to a net social welfare loss

Question 2

partial market failure

Answer 2

occurs when markets may lead to production of too many/ too few goods

Question 3

missing markets/ complete market failure

Answer 3

markets do not exist for a good or service, there is no production

Question 4

private costs

Answer 4

the costs incurred by an individual or a firm from a production/ consumption decision

Question 5

external cost

Answer 5

spill-over costs imposed on third parties arising from the production/ consumption decision of someone else
- MSC > MPC
- market ignores these costs which leads to the overconsumption of the product
- market price will be below the socially optimum price/ too cheap

Question 6

social costs

Answer 6

private cost + external cost
cost of production/ consumption to the individual/ firm as well as the rest of society

Question 7

private benefits

Answer 7

benefits obtained by the private individuals or company from a production/ consumption decision

Question 8

external benefits

Answer 8

spill-over benefits enjoyed by third parties arising from a consumption/ production decision of someone else
- MSB > MPB
- market ignores these benefits which leads to underconsumption of the product
- price is higher than optimum/ too expensive

Question 9

negative production externalities

Answer 9

• MSC > MPC
• resources are over allocated to the production of the good
• firms are producing more than socially optimum amount
• there is a welfare loss:
  
  • for every unit of the good produced beyond Qopt, society is incurring a loss from production
  • misallocation of resources —> market failure

Question 10

positive production externalities

Answer 10

MSC < MPC

Question 11

positive consumption externalities/

Answer 11

• MSB > MPB
• consumers only consider their private costs & benefits, ignores impact on third parties and undervalues the benefit to society
• resources are underallocated to the production of the good
• underproduction of the good
• welfare loss/ potential welfare gain
  
  • loss of social benefits due to the underproduction of the good

Question 12

negative consumption externalities

Answer 12

MSB < MPB

Question 13

what are some common external costs?

Answer 13

• pollution/ environmental costs
• healthcare costs (healthcare system)
• less production/ output
• less education —> less productive workforce
• overcrowding
• unemployment

Question 14

what are some common external benefits?

Answer 14

• more workers, production possibilities frontier expands
• more productive/ output
• more and quality workers —> high quality products —> consumer surplus increases
• cover healthcare costs

Question 15

public goods

Answer 15

• non-rivalry & non-excludability in consumption
• beneficial to society
• unlikely to be produced if left to the free market (under allocation of resources)
  —> gov provides

Question 16

private goods

Answer 16

rivalrous and excludable in consumption

Question 17

rivalrous

Answer 17

consumption of it by one individual reduces the quantity available for others to consume

Question 18

excludable

Answer 18

once a good is produced, it is possible to prevent someone else from consuming it

Question 19

problem of non-excludability of public goods/ free-rider problem

Answer 19

people would ‘free ride’ the public good by not paying but benefiting from them
—> very little incentive for people to pay for consumption of good

Question 20

problem of non-rivalry of public goods

Answer 20

if one person pays for the good then everyone else can use it too
- difficult for firms to charge money for it bc no one would be willing to pay
—> no profit incentive for private firms to produce it
- underproduction/ unproduction —> market failure

Question 21

what are some examples of public goods?

Answer 21

• street lamps
• roads
• police
• fire services

Question 22

symmetric information

Answer 22

both the buyer and seller have the same level of information of knowledge about the product
thus, they can make rational and well-informed economic decision

Question 23

asymmetric information

Answer 23

one party (buyer or seller) has more information than the other party
they don’t have full information to maximise their utility
the party can exploit the information gap to their benefit

Question 24

information gap

Answer 24

causes market failure because without full information, buyers may under/ overestimate the true benefits to be gained from consuming a good
thus, they buy too much/ little and they might have paid a higher/ lower price too
sellers may also supply too much/ too little if they under/overestimate the value of the good
—> there is a misallocation of resources

Question 25

how can asymmetric information be corrected?

Answer 25

governments can impose regulations that forces sellers to be transparent/ reveal information

Question 26

how does imperfect market information cause a misallocation of resources in HEALTHCARE?

Answer 26

there could be an information gap between patients and doctors. since doctors know more about healthcare and treatments than patients, there is an incentive for doctors to prescribe more expensive treatments than necessary the patient (buyer) may also not fully disclose their problems, leading to an over/ underconsumption of resources which is a misallocation of resources. this leads to market failure

Question 27

how does imperfect market information cause a misallocation of resources in EDUCATION?

Answer 27

consumers of education (students) may not see the long-term benefits of education to themselves, such as higher earning potential, and higher productivity due to imperfect information. therefore, students may fail to submit work and miss school. as a result, education would be under consumed of left to the free market and children may choose not to go to school if given the choice

Question 28

how does imperfect market information cause a misallocation of resources in PENSIONS?

Answer 28

Many young adults may not be able to imagine life as a retiree due to imperfect information, so they may spend too much money on short-term pleasure and not save up for the future (overallocate to current expenditure and underallocate to future expenditure) government prevents market failure by forcing workers to save for retirement

Question 28

how does imperfect market information cause a misallocation of resources in INSURANCE?

Answer 28

buyers may not be fully aware of the certain risks they may take, like when they are driving or travelling. therefore they lack demand for insurance such as life insurance, property insurance, and car insurance. they underconsume insurance and this leads to market failure

Question 29

moral hazard

Answer 29

when a party takes on excessive risks or poor decisions because the posts of those risks are partly or fully borne by someone else. the party is protected from the consequences of their actions, so they would be less careful and inclined to take on undue risks as there is no incentive to take normal precautions and act sensibly

Question 30

what is the impact of moral hazard to INSURANCE markets?

Answer 30

people protected with insurance may take excessive risks as they feel protected. they know that insurance companies would offer them compensation if things go wrong. there is an overconsumption of insurance and this leads to market failure. sometimes the insurance company may not know the intention and action of the insured person due to asymmetric information. if they had known, the company would have charged higher prices to cover the extra risks or refused to provide any insurance at all

Question 31

what were the NINJA mortgage loans? and how did moral hazard play a part in this?

Answer 31

during the 2000s, mortgage companies were granting property loans to risky clients that were highly unlikely to repay the loans. they did so because they had financial incentives to arrange as many mortgages as possible. the banks then repackaged these loans into investments and sold them to government orgs, banks and pension funds without fully disclosing the risks of these investments, leading to asymmetric information. after selling the loans, the mortgage companies did not bear any risks if people failed to repay their mortgages so they had no incentive to be careful to whom they were offering loans to. this is an example of moral hazard - they lent excessively, which is a misallocation of resources that leads to market failure. banks at that time also gave risky loans to people who had no repaying power as they felt protected and that the government would save them with bailouts if things go wrong.

Question 32

what is the impact of moral hazard on housing market?

Answer 32

when the housing market failed in 2008, consumers paid excessive prices for houses and bank depositors lost some of their deposits investors lost money workers lost their jobs as their companies went bankrupt government taxpayers had to pay out billions to avoid a market collapse

Question 33

how can moral hazard be prevented?

Answer 33

heavily regulate the banking system and protect depositors

Question 34

speculations

Answer 34

buying or selling an asset in the expectation of a future price change, with the aim off gaining a profit

Question 35

market bubbles

Answer 35

when the speculative motive is all one way (eg only buying)

Question 36

what happens to market bubbles?

Answer 36

1. the rising demand may drive prices beyond sustainable levels because there is a limited supply of the asset and rising demand - prices get overinflated 2. when prices are unsustainable, something changes and people start to sell - interest rates rise, consumer confidence falls - prices may drop rapidly and people start panic-selling 3. bubble bursts and prices may eventually return to a value that reflects their true value

Question 37

how do market bubbles benefit stakeholders?

Answer 37

1. consumers have assets that are worth are worth a lot so they can resell them at a higher price 2. workers have more work since the prices and demand are rising so the companies' total revenue increases, thus increasing their salaries 3. the government has higher tax revenue eg. higher property tax

Question 38

what are the consequences of market bubbles?

Answer 38

1. consumers of assets lose a lot of wealth because they may have paid excessive prices 2. investors lose a lot of money from their investments in stocks that rapidly lose value 3. companies and workers may lose their jobs because their companies may be forced into bankruptcy and shut down 4. government (taxpayers) may have to pay out billions of dollars to financial institutions to avoid a market collapse

Question 39

why do market bubbles occur in housing?

Answer 39

limited supply of houses fuels high prices since housing is a necessity, there is a high demand for it, it is even resilient in bad times

Question 40

why do market bubbles occur in the stock market?

Answer 40

the supply is limited because there are limited shares, owners don't want to lose control and they want to maximise share of profits the demand is high because stocks are a way of getting quick profits, plus it is easy to buy and sell (high liquidity)