1.3 Market failure

• What is market failure?

  Failure to allocate resources efficiently
• Why does market failure occur?

  Price mechanism ignores all costs and benefits
• What are some reasons for market failure?

  Externalities, monopoly, information gaps
• What are externalities?

  Effects on third parties not involved in transactions
• What is a positive externality?


  Benefit to third parties from production or consumption
• What is a negative externality?


  Cost to third parties from production or consumption
• What is a private cost?


  Cost incurred by consumer or firm
• What is an external cost?


  Cost caused by externalities
• What is a social cost?


  Full cost borne by society
• What is an external benefit?


  Benefit to third parties from production or consumption
• What is a social benefit?


  Full benefit received by society
• Why does market failure occur in a free market?


  Price mechanism ignores external costs and benefits
• What is marginal private cost (MPC)?


  Cost of producing the last unit
• What is marginal social cost (MSC)?


  MPC plus external cost
• What does the difference between MPC and MSC curves represent?


  External cost of production
• What happens if MPC and MSC curves are parallel?


  External costs per unit are constant
• What happens if MPC and MSC curves diverge?


  External costs per unit increase with output
• What is marginal private benefit (MPB)?


  Benefit of consuming the last unit
• What is marginal social benefit (MSB)?


  MPB plus external benefit
• What does the difference between MPB and MSB curves represent?


  External benefits from production
• What happens if MPB and MSB curves are parallel?


  External benefits per unit are constant
• What happens if MPB and MSB curves diverge?


  External benefits per unit increase with output
• What is the equilibrium point in a free market?


  Where MPC equals MPB
• What is the socially optimum level of output?


  Where MSC equals MSB
• What is the result of overproduction in a free market?


  More produced at lower price than desirable
• What does the area between MSC and MSB represent?


  Welfare loss to society
• What is an example of overproduction?


  Chemical factory ignoring externalities
• What is the result of underconsumption in a free market?


  Less consumed at lower price than desirable
• What does the area between MSB and MSC represent?


  Potential welfare gain to society
• What are positive externalities of education?


  Better workforce productivity and reduced crime
• What are positive externalities of healthcare?


  Healthier workforce and increased productivity
• What are public goods?


  Consumed collectively and non-excludable
• What are the two main characteristics of public goods?


  Non-excludability and non-rivalry
• What are private goods?


  Excludable and exhibit rivalry
• What are pure public goods?


  Perfectly non-rival and non-excludable
• What are quasi public goods?


  Exhibit characteristics of public goods but not fully
• What leads to the free rider problem?


  Non-excludability of public goods
• What happens if everyone waits to see who pays for a public good?


  It won’t be provided
• Why are firms reluctant to supply public goods?


  Problems caused by free rider issue
• What is an example of a public good in the environment?


  Clean air