5: Market failure (lack of public goods)

Question 1

Define a private good:

Answer 1

A private good has two characteristics: it must be rivalrous and excludable. Rivalrous means its consumption by one person reduces its availability for someone else, for example, your computer. Excludable means it is possible to exclude people from using the good, for example by charging a price for the good.

Question 2

Define a public good:

Answer 2

A public good has the two following characteristics: it must be non-rivalrous and non-excludable. Non-rivalrous means its consumption by one person does not reduce consumption by someone else. Non-excludable means it is not possible to exclude someone from using the good.

Question 3

Example of a public good?

Answer 3

A lighthouse as it is non-rivalrous and non-excludable.

Question 4

How do public goods indicate market failure?

Answer 4

Public goods illustrate the free rider problem, occurring when people can enjoy the use of a good without paying for it. The free rider problem arises from non-excludability: people cannot be excluded from using the good. This means firms do not produce these goods, and the market fails to allocate resources to their production.

Question 5

What are quasi-public goods? Examples?

Answer 5

Goods that do not fit neatly into the category of private goods or public goods. These goods are non rivalrous and excludable. For example, museums that charge an entrance fee and toll roads. They are excludable because pay is required.

Question 6

What are the implications of direct government provisions in the case of public goods?

Answer 6

The government must make choices on what public goods to produce and each choice has an opportunity cost in terms of other goods and services that are foregone. They must use cost-benefit analysis, and compare the benefit to society of a good to its costs.
However surveys are difficult as people who really want something are likely to exaggerate its value.

Question 7

What is a common access resource? Examples?

Answer 7

Resources that are not owned by anyone, do not have a price and are available for anyone to use without payment. Examples include clean air, lakes, rivers.

Question 8

Why are common access resources a source of market failure? Example?

Answer 8

The rivalry and non-excludability characteristics of common access resources pose serious threats to the environment. Producers and consumers are likely to use them abundantly and often overuse them because they have no price. Factories might use rivers for waste disposal, or the air, leading to an ‘overuse’ of the ozone layer. Or fish may be overfished.

Question 9

Define sustainability?

Answer 9

Sustainability refers to maintaining the ability of the environment and the economy to continue to produce and satisfy the wants and needs of future generations.

Question 10

What is sustainable resource?

Answer 10

Resources are used at a rate that allows them to reproduce themselves, so that they do not become degraded or depleted.

Question 11

What is pollution of affluence and what is pollution of poverty?

Answer 11

The threat to sustainability lies in the increased scale of economic activities around the world, which may be due to economic growth based on the use of fossil fuels, or may be due to the increasing numbers of very poor people who engage in environmentally destructive activities in an effort to survive.

Question 12

Why are government responses to threats to sustainability limited?

Answer 12

The problems of sustainability are often global in nature, rather than just regional or national, and the lack of ownership of common access resources, such as oceans, mean that effective responses require international cooperation.

Question 13

What is asymmetric information?

Examples?

Answer 13

Asymmetric information refers to situations where buyers and sellers do not have equal access to information, and usually results in an under-allocation of resources to the production of goods or services.

For example, in a free unregulated market, sellers of food could sell products that are unsafe for human consumption.

Question 14

Indicate possible government responses to asymmetric information:

Answer 14

1. Regulation - laws ensuring quality standards and safety features for goods such as goods, medications, private schools and construction.
2. Provision of information - governments can supply consumers directly with information, or force producers to provide information, such as crime rates in a neighbourhood.
3. Licensure - In the case of doctors, most countries have laws requiring doctors to be licensed.

Question 15

Evaluate possible government responses to asymmetric information:

Answer 15

1. Regulation - legislation and regulation are time consuming, which can slow economic activities. Medications for example can take around ten years before their safety is certified, and is a very costly process. This decreases incentive. Monitoring is also difficult,
2. Provision of information - The government has to collect information but it may not be accurate and complete. In addition the acquiring of information is difficult.
   In some professions it is impossible to eliminate all asymmetric information given that in some areas such as health and law, doctors and lawyers have specialised, technical information about their clients that the clients do not possess. They can selectively reveal information to demand more services than are necessary. This is called supplier induced demand.
3. Licensure may limit the supply of people in a profession as it becomes more difficult and time consuming. In addition it may raise the price of their services, meaning some may be unable to pay for a dentist for example.

Question 16

In what scenario of asymmetric information do the buyers have more information than the sellers?

Answer 16

Insurance for example as the buyer may know of preexisting conditions that are not in the forms.

Question 17

What is moral hazard? Example? How is this an example of asymmetric information?

Answer 17

When one takes risks but does not face the full costs of these risks. Buyers of car theft insurance may be less careful about protecting their car because they will be reimbursed if it happens.
In cases of insurance, buyers of the insurance have information about their future intentions that is not available to the sellers of insurance. This leads to under-allocation of resources by insurance companies as they are trying to protect themselves against higher costs due to risky behaviour of the buyers of insurance.

Question 18

Responses to moral hazards?

Answer 18

Insurance company may make the buyer of insurance pay part of the cost of damages, called ‘out of pocket payments’. This means the insurance buyer feels some consequence, leading to less risky behaviour. In the financial area, moral hazard is combatted with government regulation.

Question 19

Drawback of out of pocket payments as a response to moral hazard?

Answer 19

It relates to income as insurance companies offer a range of insurance policies and the lower the cost of the insurance, the higher the out of pocket payments. Low income earners are forced to buy the lower out of pocket payments. This means that they are more likely to change their behaviour than high income earners.

Question 20

What is adverse selection? How is this an example of market failure?

Answer 20

Adverse selection arises when buyers of insurance have more information about themselves than the sellers of insurance, most commonly in health insurance. This leads to an under-allocation of resources to health insurance services, since insurance companies reduce the supply of insurance to protect themselves against having to provide insurance coverage to very high risks. It also leads to high costs for insurance buyers.

Question 21

Responses to adverse selections?

Answer 21

Insurance companies usually protect themselves aggainst adverse selection by offering a range of insurance prices. The lower the cost of the insurance, the higher the out of pocket payments. Thus, people who have a low risk of getting sick can buy the lower cost of insurance.

Question 22

Drawback of out of pocket payments as a response to adverse selection?

Responses?

Problems with responses?

Answer 22

People with low incomes are forced to buy cheaper health insurance, no matter what the risk of getting sick is. In addition, health insurance companies often refuse to insure people above a certain age as the elderly are more likely to get sick. This means those that need health coverage most have little to no access to it.

This is why the government in some countries, such as the United Kingdom, has direct provision of health care services at low or zero prices, to an entire population financed by tax revenues. Or they could have social health insurance which covers the entire population–as is the case in Germany, or one which selectively covers only certain vulnerable groups of the population–as in the US.

A problem with this however is it is a burden on government revenue.

Question 23

What is the problem of safety in the workplace?

Responses?

Problems with responses?

Answer 23

Employers may have different views as to what constitutes an adequate amount of safety in the workplace than the employees. There is market failure due to asymmetric information in the labour market.

Governments can provide information to workers about safety conditions in various firms, or they may require employers to provide information to prospective workers about hazards and safety conditions, or set minimum safety requirements in the workplace. The latter is the most common.

It is difficult for the government to cover all possible safety and hazard eventualities. Labour unions often provide information to members but they only cover particular trades and professions in particular industries so it is limited.

Question 24

What is a monopoly?

Answer 24

A type of market structure where there is a single firm dominating the market for a product, where high barriers to entry ensure the monopoly position of single seller can be preserved.

Question 25

What is monopoly power?

Answer 25

The ability of a firm or a group of firms to control the price of the product that they sell. Monopoly power can be exercised by oligopolies too, where there are a few large sellers.

Question 26

Why is monopoly power considered to be undesirable?

Answer 26

It leads to a welfare loss, as social surplus is less that maximum. It also leads to allocative inefficiency, as marginal benefit is greater than marginal cost and therefore there is an under-allocation of resources to the good. There is productive inefficiency as production does not take place at the lowest possible cost. There is also a lower output and a higher price of the industry than the output and price of a more competitive market.

Question 27

Possible government responses to monopolies:

Answer 27

1. Legislation
2. Regulation
3. Nationalisation
4. Trade liberalisation

Question 28

Describe the government approach of legislation as a method of combatting monopoly:

Answer 28

The enforcement of anti monopoly laws. Legislation is often used to prevent collusion (agreement to fix prices) among oligopolistic firms and to encourage competition between them. They can also prevent mergers between firms that would result in too much monopoly power.

Question 29

Describe the government approach of regulation as a method of combatting monopoly:

Answer 29

Regulating natural monopolies, single firms that can produce enough to satisfy the entire market at a lower cost of production than two or more firms, often due to raw material or technology. It may not be in societies interest to break it up into two or more firms, so the government regulates it.

Question 30

Describe the government approach of nationalisation as a method of combatting monopoly:

Answer 30

The transfer from firm ownership toward government ownership. For example in the UK the government owns the Postal Service. The objective is to ensure that prices are lower and output is greater than would result from an unregulated monopoly. However, it is found that nationalised services are often more expensive than regulated services, for example electricity services were higher in the EU as compared to the US. For this reason, the UK is now privatising the postal service.

Question 31

Describe the government approach of trade liberalisation as a method of combatting monopoly:

Answer 31

The removal by the government of barriers to international trade, or the buying or selling of goods and services between different countries. Trade liberalisation increases imports and therefore increases competition faced by the domestic firm. Increasing competition reduces monopoly power.