1.4 Market Failure

Question 1

What is market failure?

Answer 1

Exists when the price mechanism allocates scarce resources in an inefficient way ie. either an over or under allocation of goods and services.

Question 2

What are some examples of market failure?

Answer 2

Underprovision of merit goods such as education and healthcare as these services would only be provided to those who were willing and are able to pay.
Under provision of public goods such as street lighting and public roads because producers cannot exclude those who do not pay from benefitting front he provision of the service.
Over provision of demerit goods such as tobacco and alcohol as there is a lack go government intervention in such markets.
Abuse of monopoly power charging customer prices above market equilibrium and hence associated inefficiencies.

Question 3

When does market failure occur?

Answer 3

When the price machine cannot allocates resources efficiently but causes external costs or external benefits of production or consumption.

Question 4

What a private benefits?

Answer 4

Benefits of production and consumption enjoyed by a third party.

Question 5

What are private costs?

Answer 5

Costs of production and consumption that are the actual costs incurred by a third party.

Question 6

What are social benefits?

Answer 6

The full benefits of consumption or production ie. the sum of private and external benefits.

Question 7

What are social costs?

Answer 7

The full costs of consumption and production ie. the sum of private and externals costs.

Question 8

What are externalities?

Answer 8

The external costs or benefits of an economic transaction causing the market to fail to achieve the social optimum level of output where marginal social benefits equal marginal social costs MSB=MSC.

Question 9

What is the marginal private benefit?

Answer 9

The addition value enjoyed by third parties from the consumption or production of an extra unit of a particular good or service.

Question 10

What is the marginal private cost?

Answer 10

The additional costs of production for firms or the extra charge paid by customers for the output or consumption for an extra unit of good or service.

Question 11

What are external costs/negative externalities?

Answer 11

Costs incurred by a third party in an economic transaction for which no compensation is paid.

Question 12

What are some examples of negative externalities?

Answer 12

Passive smoking 
Air pollution from factories
Noise pollution from nightclubs
Litter 
Child obesity from junk food
Climate change from factories

Question 13

What are external benefits/positive benefits?

Answer 13

Benefits enjoyed by a third party from an economic transaction.

Question 14

What are some examples of positive externalities?

Answer 14

National defence
Law and order systems
Flood defence systems
Street lighting

Question 15

What is the marginal social benefit?

Answer 15

The added benefit to society from the production or consumption of an extra unit of output ie. the sum of the MPC and marginal external costs.

Question 16

What is the marginal social cost?

Answer 16

The extra costs of an economic transaction to society ie. the sum of the MPB and marginal external benefits.

Question 17

What exerts positive externalities?

Answer 17

Production and consumption of public and merit goods.

Question 18

What exerts negative externalities?

Answer 18

Production and consumption of demerit goods.

Question 19

What are demerit goods?

Answer 19

Products that create negative externalities to a their party. Hence their production and consumption result in social costs being firewater than private costs of production and consumption MSC > MPC.

Question 20

What are examples of demerit goods?

Answer 20

Cigarettes, alcohol and druygs.

Question 21

Why do government intervene in the market?

Answer 21

To discourage the production and consumption of demerit goods.

Question 22

What are the two ways governments try to result market failure?

Answer 22

Market based policies - intervention in the price mechanism to make the market forces of demand supply operate more effectively eg. taxation and tradable permits.
Government regulations - such as environmental standards.

Question 23

How is taxation used to reduce the negative externalities?

Answer 23

Used to internalise negative externalities ie. the buyer and the seller pay for the true costs of their actions without any burden being placed on the third party.

Question 24

What happens to the supply curve when the tax is implemented?

Answer 24

Shifts the supply curve to the left increasing the price and decreasing the quantity demanded.

Question 25

What are the advantages of imposing a tax?

Answer 25

It increases the price and should therefore decrease the quantity demanded. It creates tax revenue for the government which can be used on other goods and services.

Question 26

What are the disadvantages of imposing a tax?

Answer 26

The demand for many of these products is price inelastic so the tax may have little impact on the level of consumption. The tax on many of these products is regressive so has a greater impact on low income earners than on high income earners. It can encourage smuggling and unofficial market activity.

Question 27

What are tradable permits?

Answer 27

Pollution rights issued to firms thus capping the level of pollution from economic activity. The policy creates incentive not to pollute so that excess permits can be sold to other less efficient firms.

Question 28

What happens when there is an increase in the demand for pollution permits?

Answer 28

It will raise the price of pollution rights but without affecting the level of output and hence the level of pollution. Hence an increase in the price of tradable permits also increase the opportunity cost to firms that pollute.

Question 29

How else can government try to deal with negative externalities?

Answer 29

By imposing laws and regulations.

Question 30

What are some examples of regulations?

Answer 30

Laws to regulate where people can drive. Making it illegal for people to smoke, eat or use their phone while driving. Seatbelt laws. Motorcyclists being made to wear a he,emtn. Laws on the minimum age people must be before legally purchasing alcohol or cigarets. Laws restricting where people can smoke.

Question 31

What are some advantages of imposing regulations?

Answer 31

Consumption of the good or service may be reduced. Awareness of the negative impacts of demerit goods may change the behaviour of people in the long term. Awareness of the positive impact of consumption of merit goods is raised.

Question 32

What are some disadvantages of imposing regulations?

Answer 32

Restriction cause parallel markets to develop where the good or service can be purchased often at a very high price. The government has no control over the quality of the good produced in parallel markets which in some cases can be dangerous. People may still choose to break the rules. The fine or punishment for ignoring the ban must be enforced and be set high enough to discourage consumption of the good or service.

Question 33

What are merit goods?

Answer 33

Products that create positive externalities when they are produced or consumed. Hence the social benefits from the production and consumption of merit goods are greater than the private benefits.

Question 34

What are some examples of merit goods?

Answer 34

Education, healthcare, trining.

Question 35

Why are merit goods deemed of value to society?

Answer 35

Due to the positive externalities of production and consumption they improve the general standard of lining int he economy.

Question 36

Why do positive externalities exist?

Answer 36

Because MSB > MPB of consumption at all level of output this is due to the existence of positive externalities of consumption hence there is market failure at the free market equilibrium as there is an underconsumption of the merit good.

Question 37

Where is the socially optimum level of output for merit goods?

Answer 37

Where MSB = MSC.

Question 38

Why is a welfare loss present?

Answer 38

Because of the underconsumption.

Question 39

Why is government intervention needed?

Answer 39

So resource are more efficiently allocated with a greater level of output of merit goods.

Question 40

Why may governments use a subsidy to increase consumption of merit gooods?

Answer 40

A subsidy is a sum of money given tot he producer to reduce the costs of production to eoncoruhae higher levels of output or to reduce the price of consumption for consumers.

Question 41

How does the producer pass on some of the subsidy to the consumer?

Answer 41

In the form of lower prices, and keeps the remainder for themselves in the form of low production costs.

Question 42

What are the limitations of using subsidies?

Answer 42

It is difficult to set a precise subsidy that ensures MPC = MSC and MPB = MSB. The social return on the production and consumption of merit goods is difficult to measure. If the PED for the good is inelastic the lower price has little impact on the quantity demanded. There is always an opportunity cost in the provision of subsidies as the money could have been used on other government projects.

Question 43

How can legislation be used to deal with positive externalities?

Answer 43

Laws are used to encourage greater consumption of goods and services with positive externalities such as compulsory education for children, the requirement for children to be vaccinated against certain diseases.

Question 44

How can advertising be used to deal with positive externalities?

Answer 44

By influencing behaviour by informing and educating the public about the benefits of increased consumption of merit goods.

Question 45

What are the advantages go advertising?

Answer 45

Behaviour and consumption of individuals and firms can change there is a rise in the consumption of merit goods and a fall in the demand for demerit goods. Successful advertising may lead to culture changes in behaviour.

Question 46

What are the disadvantages of advertising?

Answer 46

Not all advertising is effective. It can take a long time to educate people and for the advertised message to be accepted and acted upon. There is an opportunity cost of government expenditure on advertising ie. the money might have been spent on something else deemed to be more beneficial to society.

Question 47

Why is direct provision of goods and services by the government a good thing?

Answer 47

Merit goods and public goods become accessible to everyone regardless of their income of social status.

Question 48

What are the limitations of direct provision of goods and services by the government?

Answer 48

Economic inefficiency - healthcare services might encourage consumption beyond the socially optimum level if people do not have to pay for healthcare they are more likely to overuse it. There is an opportunity cost of government provision as the money could have been spent on something else such as paying off government debt or possibly lowering tax rates. In the case of a shortage of supply due to excess demand it can be difficult to decide who should be able to take advantage of the free government service.

Question 49

What are public goods?

Answer 49

Goods and services that exert positive externalities with two key characteristics, non excludable and non rivalrous.

Question 50

What does non rivalrous mean?

Answer 50

A persons consumption of a public good doesn't not limit the benefits available to other people.

Question 51

What does non excludable mean?

Answer 51

Firms cannot exclude people form the benefits of consumption even if they do not pay.

Question 52

What are examples of public goods?

Answer 52

National defence, emergency services and street lighting.

Question 53

What are the characteristics of private goods?

Answer 53

Rivalrous, excludable and rejectable.

Question 54

What is the free rider problem?

Answer 54

Where those who do not pay cannot be excluded from benefiting from the provision of public goods. Free riders are people who take advantage of the goods or services provided by the government but have not contributed to government revenue through taxation.

Question 55

What is the issue with the free rider problem?

Answer 55

The market demand for a public good doesn't not actually exist. Its supply will be significantly below the socially optimum level if it exists at all.

Question 56

How is the free rider problem eradicated?

Answer 56

Direct provision of public goods as these improve well being in the economy since the MSB > MPB of production and consumption. Most public goods would not be available if it were not for government provision.

Question 57

What is the issue with direct government provision in this instance?

Answer 57

There is an opportunity cost involved in direct government provision. There is also potential government failure from intervening in markets as government do not necessarily know what is best for society.

Question 58

What are common access resources?

Answer 58

Refer to communal or public property they are rivalrous in nature but are non excludable. As these resources are used by the general public they suffer from overuse and therefore lack of sustainability.

Question 59

What are some negative externalities associated with common access resources?

Answer 59

Deforestation, pollution, overfishing and climate change.

Question 60

Why are common access resources open to overuse?

Answer 60

Since there is no effective pricing mechanism so depletion and degradation of the resources occurs because consumers do not pay for them. This is inefficient and poses a threat to the sustainability of the source.

Question 61

What is the tragedy of the commons?

Answer 61

The consequences of the abuse and inefficient use of common access resources where the users self interest leads to the destruction of these resources in the long run.

Question 62

What does the tragedy of the common present problems for sustainability?

Answer 62

It becomes difficult to maintain or preserve the resources for future generations.

Question 63

How is legislation used to increase sustainability?

Answer 63

Laws to protect fish and marine life, legislation to reduce CO2 emissions from vehicles.

Question 64

How is a carbon tax used to increase sustainability?

Answer 64

A per unit tax on greenhouse has emissions. The purpose is to create incentives for firms and households to reduce pollution in order to reduce their tax liability. Carbon taxes are set by assessing the pollution costs and the associated administrative costs of controlling the pollution. Establishing the correct tac level is key to the effectiveness of carbon taxes in responding to market failure. If the tax is too low then firms will simony continue to pollute whereas if the tax is too high the escalated costs negatively affect profits, employment and consumers.

Question 65

How is are cap and trade systems used to increase sustainability?

Answer 65

Government regulated emissions trading schemes using a market based approach. The regulator sets a limit on the total amount of emissions allowed in an industry and firms are issues emissions permits. Permits within a cap and trade system are feely traded allowing more efficient firms to sell their excess permits. This also creates an incentive for firms to develop clean technologies. Whilst cap and trade systems help to reduce carbon emissions they can also raise a significant amount of revenue for the government. It can be argues that the system is anti competitive and they can cause job losses due to higher costs of production.

Question 66

How is funding for clean technologies used to increase sustainability?

Answer 66

Provided by governments to create incentives for firms to adopt a sustainable approach. It includes subsidies for the adoption of renewable energy sources and investment funding to reduce emission from deforestation and negative impacts of forest degradation.

Question 67

What are the policies to reduce the threat to sustainability limited by?

Answer 67

The global lack of ownership of common access resources, the escalating global demand for scarce resources due to higher levels of economic activity and globalisation and thinned for international cooperating to deal with global issues threatening sustainability.

Question 68

What is asymmetric information?

Answer 68

Exists when one economic agent in an economic transaction has more information than the other in a certain market. the existence of asymmetric information between buyers and sellers in a market results in market failure and inefficiencies, consumer and producer surpluses are not maximised.

Question 69

How do governments deal with asymmetric information?

Answer 69

Legislation, regulation, provision of information.

Question 70

When does abuse of monopoly power occur?

Answer 70

Lack of competition means that profit maximising monopolists are likely to supply less than the social optimum and charge higher prices so there is productive and allocative inefficiency. This results in a welfare loss for society so the abuse of monopoly such as their ability to exploit consumer surplus by using price discrimination is a type of market failure.

Question 71

What are some examples of abuse of monopoly power?

Answer 71

Monopolists charging excessively high prices, collision (the agreement between firms with market power to set higher prices) and predatory pricing (setting low prices perhaps below the costs of production to force rival firms out of the industry).

Question 72

What are government responses to the abuse of monopoly power?

Answer 72

Legislation - it is illegal in most countries for monopolies to abuse their monopoly power such as charging excessively high prices or cutting prices below production costs to force out rivals. In extreme cases the government can break up a monopoly if it becomes too powerful. Regulation - rules are set by governments to control the operation of firms with monopoly power. Nationalisation - this occurs when the government takes control of an industry previously in the private sector in order to run it in the best interest of the public. Government control of certain industries prevents the potential exploitation of monopoly power. Trade liberalisation - this refers to the reduction or removal of barriers to the exchange of goods and services between countries. This creates greater competition and thus reduces the potential for firms to exploit their monopoly power.