Exam: Market Failure

Question 1

What is market failure?

Answer 1

Market failure refers to a situation in which the free market fails to allocate resources efficiently, resulting in a net loss of economic welfare

Question 2

When does the market fail according to economists?

Answer 2

When the market is not capable of producing the optimal or ‘best’ outcome for society, economists say that the market fails.

Question 3

When does market failure occur?

Answer 3

Market failure occurs when resources are not allocated efficiently, and the total surplus is not maximised.

Question 4

What are the four main types of market failure?

Answer 4

Market power, externalities, public goods and common property resources.

Question 5

When does allocative efficiency occur?

Answer 5

Efficient allocation of resources occurs when goods and services are distributed in a way that maximises total surplus meaning no one can be made better off without making someone else worse off

Question 6

How are decisions about production and consumption made in a free market?

Answer 6

By individuals and firms based on price signals and self-interest. However, markets do not always produce the most efficient outcomes

Question 7

What happens to resources during market failure?

Answer 7

Resources are overproduced or underproduced to certain activities meaning society is not getting the best use out of its limited resources.

The price mechanism does not reflect the true costs and benefits to society.

Question 8

What is market power?

Answer 8

When one firm (monopoly) or a few firms (oligopoly) control the market, they may restrict output and charge higher prices.

Question 9

How does market power create a deadweight loss?

Answer 9

This means producer surplus increases, but consumers are worse off because they pay more and receive less.

As a result, the total economic surplus decreases and there is therefore a deadweight loss

Question 10

Why is market power criticised for being inefficient?

Answer 10

Market power is a classic case against imperfect markets and why monopolies and oligopolies

Question 11

Provide an example of market power in Australia

Answer 11

An example of market power are Coles and Woolworths who are dominate grocery markets in Australia.

Question 12

What is an externality?

Answer 12

A cost or benefit that arises from production and falls on someone other than the producer.

Can also be a cost/benefit that arises from consumption and falls on someone other than the consumer.

Can occur in either production or consumption, as negative or positive.

Question 13

What is a negative externality?

Answer 13

A negative externality imposes an external cost on society that is not reflected in the price.

Question 14

Provide an example of an negative externality?

Answer 14

An example is a factory that emits pollution into the air.

The cost of pollution like people getting sick, or the air becoming dirty is not included in the price of the goods, so too much is produced, harming society.

Question 15

What is a positive externality?

Answer 15

A positive externality creates an external benefit for society that is not rewarded by the market

Question 16

Provide an example of a positive externality?

Answer 16

An example is when someone gets an education, they benefit (better job, higher income) but society also benefits (more skilled workers, lower crime, stronger economy).

However, the person pays the full cost (fees, time), but doesn’t get paid for all the benefits their education gives to society, so the person might decide not to study, even though it would be better for everyone if they did, leading to under-consumption.

Question 17

What is a public good?

Answer 17

Goods that are non-rivalrous and non-excludable meaning you can’t stop people from using them, and one person’s use doesn’t reduce its availability for others.

Question 18

What is a rivalry?

Answer 18

A rivalry is a situation that occurs when one person consuming a unit of good means no one else can consume it.

Question 19

What is excludability?

Answer 19

Excludability refers to a situation in which anyone who does not pay for a good cannot consume it.

Question 20

Provide an example of a public good?

Answer 20

An example is national defence or street lighting.

The market won’t supply these effectively because there’s no incentive to pay for them leading to underproduction.

Question 21

Why will the private market fail to provide public goods?

Answer 21

Because of the free rider problem. There is not inventive for people to pay for what they consume

Question 22

How can the government reduce market failure because of public goods?

Answer 22

The government needs to provide and fund public goods such as national defence and streetlights through taxation

Question 23

What are common resources?

Answer 23

Common resources are not excludable meaning they are free of charge to anyone.

Rival goods because one person’s use of the common resource reduces other people’s use.

Question 24

What do common resources suffer from?

Answer 24

The ‘Tragedy of the Commons’ which is the absence of incentive to prevent the overuse and depletion of a commonly owned resource.

Question 25

How are common resources affected according to the 'Tragedy of the Commons'?

Answer 25

This means that because these resources are accessible to everyone, they are often overused because individuals act in their own self-interest.

Question 26

How can the 'Tragedy of the Commons' be prevented?

Answer 26

They require the government to act as a protector and regulator, to manage and help control the use and overconsumption of these goods

Question 27

Provide an example of common resources?

Answer 27

An example is overfishing in oceans. No one owns the fish, so people catch as much as they can, depleting the resource.

Question 28

How is overfishing in Australia regulated?

Answer 28

Most states in Australia set a restricted fishing season, bag limits for recreational fishing, quotas, and licenses for commercial fishing.

Question 29

What is a monopoly and provide an example.

Answer 29

A market with just one firm. Synergy and Australia Post which are government regulated markets.

Question 30

What is an oligopoly and provide an example.

Answer 30

A market with few large dominant firms. Coles and Woolworths are dominate firms in the grocery market in Australia.

Question 31

How do fewer sellers in an imperfect market affect price?

Answer 31

With only a few sellers, each firm has greater control over price. These sellers can influence or set prices, often above marginal cost

Question 32

How do fewer sellers in an imperfect market affect product variety?

Answer 32

Fewer sellers typically mean less product variety, and consumers may not have access to close substitutes, limiting competition on both price and quantity, leading to higher prices and less variety

Question 33

Why do fewer sellers in an imperfect market create barriers to entry?

Answer 33

Markets with few sellers often have high barriers to entry which protects them from new competitors, allowing them to maintain market power.

Question 34

What are the barriers to entry in an imperfect market?

Answer 34

Cartel, collusion, collusive tendering, predatory pricing, resale price maintenance, exclusive dealing and merger.

Question 35

What is a cartel?

Answer 35

When firms agree to act or collude together instead of competing. This includes both price fixing and market sharing.

Question 36

What is collusion?

Answer 36

General term describing agreements between firms through either price or market sharking to reduce competition and increase profits.

Question 37

What is collusive tendering?

Answer 37

Firms agree to submit exorbitant tenders which ensure high profits and the sharing of work between collusive members.

Question 38

What is predatory pricing?

Answer 38

When a company with substantial market power sets its prices at a sufficiently low level with the purpose of eliminating or substantially damaging a competitor

Question 39

What is resale price maintainence?

Answer 39

The supplier sets the price at which a retailer must sell its products. The manufacturer may refuse to sell to any retailer which may resell their products at a discount.

Question 40

What is exclusive dealing?

Answer 40

When one person trading with another imposes some restrictions on the other’s freedom to choose with whom or where they deal

Question 41

What is a merger?

Answer 41

Two or more firms join together to form on larger firm – prohibited if it substantially reduces competition in the market

Question 42

How does product differentiation contradict the ideals of a perfectly competitive market?

Answer 42

Product differentiation violates the assumption of perfect competition that all products are identical (homogenous).

Question 43

How and why do markets differentiate their products?

Answer 43

Monopoly and oligopoly firms differentiate their products to stand out. This is done through branding, quality differences, features, customer service, packaging and location.

Question 44

What is the effect of product differentiation on the market?

Answer 44

This means firms offer non-identical products that are not perfect substitutes. Because products are different, firms can influence consumer preference giving them some control over price.

Question 45

What does it mean to have market power in an imperfect market?

Answer 45

In imperfect markets firms are said to have market or ‘monopoly’ power which means they can increase prices to increase profits.

Question 46

What is a price maker?

Answer 46

A price maker is a firm that has some control over the price it charges for its products. This means the firm does not have to accept the market price and it can raise or lower its price and still expect to sell some output. The ability to make pricing decisions reflects the firm’s power to influence the market.

Question 47

What is market power?

Answer 47

The ability of a firm to influence or set prices above competitive levels by restricting output

Question 48

How do imperfect markets emerge?

Answer 48

Imperfect markets emerge due to a lack of competition created by barriers to entry

Question 49

What are barriers to entry?

Answer 49

Barriers to entry are anything that restricts or blocks the entry of new firms into an industry

Question 50

Provide an example of a barrier to entry

Answer 50

Government-imposed barriers, ownership of a key resource, large infrastructure and capital.

Question 51

What are government imposed barriers?

Answer 51

Create legal monopolies meaning competition and entry are restricted by granting a patent or copyright to an individual or firm, which gives it exclusive rights to a produce a good or service. Can also be done by granting a firm a public franchise which makes it the exclusive legal provider of a good or service.

Question 52

What is ownership of key resources?

Answer 52

Owning or controlling a key resource

Question 53

Provide an example of a firm that owns/owned key resources?

Answer 53

OPEC and Oil: 80% of the world’s proven oil reserves are in OEPC member countries. De Beers and Diamonds: From the 1900s to the 2000s, De Beers controlled around 85% of the world’s diamond supply by buying all new diamond discoveries to keep control of supply.

Question 54

What is large infrastructure and capital?

Answer 54

These industries are natural monopolies. This is when a single firm can supply a good or service to an entire market at a lower cost than 2 or more firms. This is because infrastructure and capital machinery are so large that it's more efficient to have only one firm in the market. E.g. Electricity

Question 55

Explain how market power can reduce efficiency

Answer 55

These markets don't always produce the most efficient outcomes, and the allocation of goods and services isn't efficient. Resources are over/underproduced because of certain activities meaning society is not getting the best use out of its limited resources.

Question 56

Explain how market power causes deadweight loss?

Answer 56

The unregulated firms have restricted output which then increases prices. Increased prices lead to a rise in producer surplus while decreases consumer surplus, resulting in a deadweight loss.

Question 57

Describe how governments use regulation as a policy tool to influence market failure

Answer 57

Governments can use price regulation to reduce the market failure associated with monopoly firms. By reducing price from the unregulated price, output is increased, and total surplus is increased.

Question 58

Describe how governments use deregulation as a policy tool to influence market failure

Answer 58

Governments can reduce or remove government regulations on businesses and industries in a particular market, industry, or economy, aiming to increase competition and efficiency. Fewer regulations lead to more businesses entering the market, thus increasing competition.

Question 59

Describe how governments use legislation as a policy tool to influence market failure

Answer 59

An example of government legislation in Australia that attempts to prevent market power is the Competition and Consumer Act 2010 – administered by the Australian Competition and Consumer Commission (ACCC).

Question 60

What is the role of the ACCC?

Answer 60

The role of the ACCC is to protect, strengthen, and supplement the way competition works in Australian markets to improve market efficiency.

Question 61

What does the Competition and Consumer Act 2010 prevent?

Answer 61

It prevents monopoly practices and promotes fair competition. It prohibits firms from misusing market power, engaging in exclusive dealing, setting resale price maintenance, and making acquisitions that significantly reduce competition.

Question 62

What is the purpose of the CC Act 2010?

Answer 62

These provisions aim to promote fair competition and protect consumers.

Question 63

How is education a positive externality?

Answer 63

When people undertake education, they receive private benefits, and society gains an external benefit. This means the social (total) benefit will be greater than the private benefit.

Question 64

How is pollution a negative externality?

Answer 64

Pollution can be caused by a factory that emits pollution into the atmosphere. This imposes an external cost onto people living nearby meaning the social (total) cost will be greater than private cost.

Question 65

When do negative externalities occur?

Answer 65

This occurs when the social cost of production exceeds the private cost born by producers. The market overproducers the good because the full cost to society is not reflected in the market price

Question 66

How do negative externalities lead to market failure?

Answer 66

OP results in an inefficient allocation of resources, where more of the harmful goods are produced than is socially optimal. Because the market price doesn’t reflect the harm caused to society, resources are diverted away from more beneficial goods, leading to overall inefficiency

Question 67

How do negative externalities causes a deadweight loss?

Answer 67

Because of this, the market price is too low and too much of the good is produced, compared to what is best for society overall. This leads to market failure by causing the market to allocate resources inefficiently. As a result, society experiences a deadweight loss

Question 68

How does a positive externality lead to market failure?

Answer 68

Because the market fails to produce enough of a good or service. This happens because the social benefits exceed the private benefits as the market fails to account for the social benefits generated by the good or service

Question 69

How do positive externalities cause a deadweight loss?

Answer 69

This occurs when the social benefit exceeds the private benefits received by the consumer. The market underproduces these goods because individuals don't receive the full benefit of their consumption. This means that people don’t buy/use enough of a good/service because they only think about how it benefits them personally, not about how it also benefits other people or society - efficient allocation of resources

Question 70

Discuss why governments should intervene in markets where negative or positive externalities are present.

Answer 70

Governments should take action to reduce the production of goods causing negative externalities and increase the consumption of goods creating positive externalities. Government policy needs to ‘internalise’ the externality – force the market to recognise and include the external cost or benefit in the market price.

Question 71

How do governments respond to externalities?

Answer 71

Taxes and subsidies can be used to increase market efficiency and remove a deadweight loss.

Question 72

What are Pigouvian Taxes and Subsidies?

Answer 72

Named after the famous English economist Arthur Pigou because they eliminate a deadweight loss rather than create one

Question 73

How can governments internalise a negative externality?

Answer 73

To internalise a negative externality, the government can impose a tax on producers equal to the external cost that removes the deadweight loss.

Question 74

Provide a real-life example of how taxes are used on negative externalities?

Answer 74

A carbon tax addresses the negative externality of carbon emissions, global warming, air pollution and more. These negative spillover effects are not reflected in the market price of goods and services that generate carbon emissions as byproduct which leads to over-production.

Question 75

What are the benefits of using taxes to internalise a negative externality?

Answer 75

The government may use taxes to internalise the social cost of carbon emissions by making emitters pay for the environmental harm they cause encouraging them to adopt more sustainable practices.

Question 76

How can governments internalise a positive externality?

Answer 76

To internalise a positive externality, the government can pay a subsidy to consumers equal to the external benefit that removes the deadweight loss.

Question 77

Provide a real-life example of how subsidies are used on positive externalities?

Answer 77

Public transport has benefits that include reduced traffic congestion, lower pollution, and less reliance on fossil fuels. These positive spillover effects aren't reflected in the market price of using public transport which leads to under-consumption of this service.

Question 78

What are the benefits of using subsidies to internalise a positive externality?

Answer 78

The government may use subsidies to lower fares, improve infrastructure, or enhance service quality, making public transport more attractive to consumers and encourages greater usage, increasing the social benefits.

Question 79

Provide an example of a rival and non-rival good

Answer 79

- Rival Goods: A cup of coffee; a pizza - Non-Rival Goods: The air you breathe; a national park

Question 80

Provide an example of an excludable and non-excludable good

Answer 80

- Excludable Goods: Any store bought good - Non-Excludable Goods: The air you breath; footpath; national defence

Question 81

What is a private good?

Answer 81

Something which is rival in consumption and is excludable. - A private market can supply these goods in efficient quantities because they can be priced

Question 82

Provide an example of a private good

Answer 82

E.g. any store bought good: food, clothing, appliances, car, mobile phone etc.

Question 83

Provide an example of a public good

Answer 83

E.g. national defence, light house, road system, a firework display etc.

Question 84

What is a club good?

Answer 84

Something which is excludable but not rival. - Can be consumed by many people at the same time - A private market can supply these goods in efficient quantities because they can be priced.

Question 85

Provide an example of a club good

Answer 85

E.g. watching a movie in a cinema, going to a concert, gym membership, Netflix.

Question 86

What is the free rider effect?

Answer 86

The free rider effect is where individuals benefit from a public good or service without contribution to its cost or production.

Question 87

How does the free rider effect occur?

Answer 87

This occurs because there is no incentive for people to pay for what they consume. To reduce market failure, the government needs to provide and fund public goods

Question 88

What is the tragedy of the commons?

Answer 88

It describes a situation where individuals act in their own self-interests involving the absence of incentive to prevent overuse and depletion of a commonly owned resource.

Question 89

Why does the tragedy of the commons occur?

Answer 89

This occurs because each people have an incentive to maximise their own benefit without considering the long-term consequences for the shared resource.

Question 90

Identify a strategy to address failures involving public goods and common resources

Answer 90

Since public goods are non-excludable and non-rival, private markets may underproduce them due to the free rider problem. Governments can step in to supply these goods directly, ensuring their availability to all members of society.

Question 91

Identify a strategy to address failures involving public goods and common resources

Answer 91

For common resources, which are rivalrous but non-excludable, overuse can lead to depletion as depicted in the tragedy of the commons. Governments can implement regulations or set quotas to limit usage and promote sustainable consumption

Question 92

Identify a strategy to address failures involving public goods and common resources

Answer 92

Introducing pricing mechanisms like tradable permits or user fees can internalise the external costs associated with common resources. This approach encourages users to consider the social cost of their consumption, leading to more efficient and equitable resource use.