Market Failure and State Intervention

Question 1

What is market failure?

Answer 1

Situation where the free market doesen’t allocate recources efficiently, leading to a loss of economic and socail welfare

Question 2

What is an externality?

Answer 2

• a cost or benefit that is caused by one party but financially incurred or received by another
• side effect coming from a transaction (negative and positive)

Question 3

Why is the existence of externalities a market failure?

Answer 3

• because they cause that resources are not used efficiently
• damages society or means that they don’t get the most benefit (MSC isn’t MSB)
• meaning that the costs for a society to produce a good/service are higher than the benefits gained through it

Question 4

What are postive externalities of consumption?

Answer 4

Goods and services which are consumed, are beneficial to those who consume them but also have benefits for third parties

• e.g. health care is beneficial for those who consume it as well as for society, who benefits now from a healthier workforce

Question 5

How can governments act to promote consumption of merit goods?

Answer 5

• by improving information about the advantages of the products through rating awareness campaigns (showing the people the benefits of consuming a merit good, problem could be that it is likely to be expensive)
• by legislation (government could make laws for example that citizens have vaccinations, but this must be free of charge; Problem could be that the people might see that as an infringement of their civil liberties)
• Subsidies

Question 6

What are positive externalities of production?

Answer 6

• the production of a good/service creates external benefits for third parties
• e.g. a company might decide to offer trading for their employees; when those employees change to another company, the new company benefits from their extra training

Question 7

How can governments act to promote positive externalities of production?

Answer 7

• providing subsidies
• direct provision

Question 8

What are negative externalities of consumption?

Answer 8

• goods/services that when being ‘consumed’ are having a negative effect on third parties
• e.g. if one person decides to smoke, people around him may suffer from “second-hand smoking”
• MSC (cost) is greater than MSB (benefit) for those units, causing a welfare loss to society and market failure

Question 9

What are demerit goods?

Answer 9

• products which are harmful to consumers, but people who consume them are either unaware of the possible harm or just ignore the risks
• create negative externalities when they are consumed

Question 10

How can the government act to reduce the consumption of demerit goods?

Answer 10

• indirect taxes (Pigouvan)
• legislation/regulation
• education
• consumer nudges

Question 11

What are negative externalities of production?

Answer 11

• Occur when the production of goods or services create external costs that are damaging third parties
• These relate mainly to environmental problems

Question 12

What are common pool resources?

Answer 12

• typically natural resources like forests, fishing grounds and pastures
• it is very difficult and probably expensive to forbid people using them

Question 13

How can international agreements reduce negative externalities of production and reduce the threats to common pool resources?

Answer 13

• focusing on climate change
• fishing resources
• waste management

Question 14

What can the government do to reduce or eliminate negative externalities of production?

Answer 14

• tradeable permits (set limits)
• carbon taxes (pay for the use of fossil fuels)
• legislation and regulation
• subsidies (to producers to reduce costs so that they may afford renewable energy sources)

Question 15

Why is a lack of public goods a market failure?

Answer 15

• Public goods have two characteristics, being non-excludable and non-rivalrous, so it is pointless for private individuals to provide the goods themselves
• Non-excludable shows that one person pays for something and a whole society benefits from it, because they cannot be excluded from using it
• Non-rivalrous means that one person’s use of a good doesn’t reduce the availability of the good for other members of society
• e.g. if one person benefits from a flood barrier, the other people benefit from it the same time

Question 16

What can governments do to reduce market failure?

Answer 16

1- providing public goods themselves
2- work in partnership with the privat sector