Market failure

Question 1

Price mechanism

Answer 1

How prices adjust to allocate scarce resources between competing uses in a market economy

Question 2

Functions of the price mechanism

Answer 2

• Signaling
• Rationing
• Incentive
• Allocative

Question 3

Market failure

Answer 3

When a market leads to a misallocation of resources (resources not allocated to the best interests of soceity)

Question 4

Complete market failure

Answer 4

A market is missing in it’s entirety

Question 5

Partial market failure

Answer 5

Where a market is not producing a good in the desired quantity or quality

Question 6

Types of market failures

Answer 6

• Externalities
• Public goods
• Information gaps
• Merit & demerit goods
• Monopoly power
• Inequalities in wealth and income

Question 7

Externalities

Answer 7

A cost or benefit an unrelated 3rd party receives from an economic transaction

Question 8

Public goods

Answer 8

Public goods are non-rival and non-excludable so the private sector won’t supply them

Question 9

Non-rival

Answer 9

One person’s use doesn’t reduce availability for others

Question 10

Non-excludable

Answer 10

People cannot be stopped from using it

Question 11

Free rider problem

Answer 11

Consumers can benefit from consuming the good without paying for it

Question 12

Information gaps

Answer 12

When consumers or producers lack complete information to make rational decisions

Question 13

Asymmetric information

Answer 13

When one side of a transaction has better knowledge than the other

Question 14

Merit goods

Answer 14

Goods that are under-consumed because consumers ignore or underestimate the benefits

Question 15

Demerit goods

Answer 15

Goods that are over-consumed because consumers ignore or underestimate harm

Question 16

Monopoly power

Answer 16

Firms with significant market power can restrict output and raise prices

Question 17

Inequality

Answer 17

• In free markets goods/services are distributed based on consumers ability to pay, making some essential goods unavailable to those on the lowest incomes
• This can lead to underconsumption of merit goods and overconsumption of demerit goods

Question 18

Government intervention

Answer 18

When the government intervenes into a market to correct market failures

Question 19

Types of government intervention

Answer 19

• Indirect taxes
• Subsidies
• Regulation
• State provision
• Price controls
• Tradable pollution permits
• Provision of information

Question 20

Indirect taxes

Answer 20

• A tax imposed on the production or sale of a good or service
• Used to increase private costs to reflect the full social cost, internalisaing negative externalities

Question 21

Evaluation of indirect taxes

Answer 21

• Can reduce consumption if demand is price elastic
• Regressive effect as it hits lower-income consumers harder
• May cause black markets if taxes are too high
• Generates government revenue for other measures

Question 22

Subsidies

Answer 22

A payment by the government to firms or consumers to lower costs, encouraging production or consumption of merit goods

Question 23

Evaluation of subsidies

Answer 23

• Helps internalise positive externalities
• Has a high opportunity cost
• Firms may become inefficient/keep the money as profits
• Can improve access to important goods and services

Question 24

Regulation

Answer 24

Rules and regulations from the government to change behaviors

Question 25

Evaluation of regulation

Answer 25

- Can directly correct market failures - Particularly effective when dealing with information failure - High administrative costs - Risks of regulatory capture

Question 26

State provision

Answer 26

The government directly provides goods and services for free/heavily discounted

Question 27

Evaluation of state provision

Answer 27

- Ensures socially optimal consumption for everyone (MSB = MSC) - Risk of government failure due to information gaps - Potential productive and dynamic inefficiencies due to the lack of competition

Question 28

Price controls

Answer 28

- Maximum price: legal upper limit a good/service can be sold for - Minimum price: legal lower limit a good/service can be sold for

Question 29

Evaluation of price controls

Answer 29

- Addresses allocative inefficiency caused by excessive market power - Can distort market signals - Risk of government failure due to difficulties in setting the correct level - Effectiveness depends on the PED of the good

Question 30

Tradable pollution permits

Answer 30

The government issues a limited number of pollution permits, restricting the allowed levels of pollution

Question 31

Evaluation of tradable pollution permits

Answer 31

- Incentivises firms to innovate and reduce emissions - Green firms can raise additional revenue by selling excess permits - Difficult to determine the correct number of permits to hand out (can stifle growth)

Question 32

Provision of information

Answer 32

The government provides information, encouraging better decisions without banning choices

Question 33

Evaluation of information provision

Answer 33

- Low cost whilst preserving consumer freedom - Can fix information gaps - May be ignored by consumers - Changes in behavior can be slow without financial incentives

Question 34

Government failure

Answer 34

When intervention in a market leads to a net welfare loss, instead of correcting the original market failure

Question 35

Causes of government failure

Answer 35

- Information failure - Administration/enforcement costs - Unintended consequences - Distortion of price signals - Political self-interest - Regulatory capture

Question 36

Information failure

Answer 36

- Governments often have to work with incomplete or inaccurate information - This may lead to the scale of intervention being incorrect

Question 37

Administration/enforcement costs

Answer 37

- The cost of researching, setting up and enforcing intervention can be extremely expensive - If this cost is too high it may have been better to simply do nothing

Question 38

Unintended consequences

Answer 38

- Firms and consumers act in irrational ways - This may lead to unexpected reactions to policies, resulting in new market failures emerging

Question 39

Distortion of price signals

Answer 39

Intervention can prevent markets from clearing naturally, leading to inefficiencies

Question 40

Political self-interest

Answer 40

- Politicians may pursue policies that are popular, not effective - This can lead to the further misallocation of resources

Question 41

Regulatory capture

Answer 41

Regulator may become biased towards the industries they are meant to regulate, leading to weak enforcement and failure to sufficiently protect consumers