1.3 Market Failure

• What is market failure?

  Market failure occurs when the free market fails to allocate resources to the best interests of society.
• What happens to economic and social welfare during market failure?

  Economic and social welfare is not maximised where there is market failure.
• What are the types of market failure?

  • Externalities
  • Under-provision of public goods
  • Information gaps
• What is an externality?

  An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism.
• What are the two types of externalities?

  Externalities can be positive (external benefits) or negative (external costs).
• Why is it difficult to determine the monetary value of an externality?

  The extent to which the market fails involves a value judgement, making it hard to determine the monetary value of an externality.
• What are private costs?

  Private costs are the costs to economic agents involved directly in an economic transaction.
• What are examples of private costs for producers?

  Examples of private costs include rent, cost of machinery, labour, insurance, transport, and raw materials.
• How are social costs calculated?

  Social costs are calculated by adding private costs and external costs.
• How do external costs relate to marginal social costs (MSC) and marginal private costs (MPC)?

  External costs are shown by the vertical distance between MSC and MPC, indicating that MSC > MPC when external costs are present.
• What do consumers consider when evaluating private benefits?

  Consumers consider the price they are prepared to pay as a measure of private benefit.
• How are social benefits calculated?

  Social benefits are calculated by adding private benefits and external benefits.
• What is the social optimum position in terms of MSC and MSB?

  The social optimum position occurs where MSC equals MSB, indicating maximum welfare.
• What leads to deadweight welfare loss in the market?

  Deadweight welfare loss occurs when social costs exceed private benefits at the output level.
• What is an example of an external benefit of consumption?

  An example of an external benefit of consumption is the decline of diseases through vaccination programs.
• What are indirect taxes used for in relation to negative externalities?

  Indirect taxes are used to reduce the quantity of demerit goods consumed by increasing their price.
• How do subsidies affect the consumption of merit goods?

  Subsidies encourage the consumption of merit goods by including the full social benefit in the market price.
• What is the purpose of regulation in addressing negative externalities?

  Regulation is used to enforce less consumption of a good, such as setting a minimum school leaving age.
• What is the free-rider problem associated with public goods?

  The free-rider problem occurs when people who do not pay for a public good still receive benefits from it.
• Why are public goods underprovided in a free market?

  Public goods are underprovided because they are non-excludable and non-rival, leading to the free-rider problem.
• What are quasi-public goods?

  Quasi-public goods have characteristics of both public and private goods and are partially provided by the free market.
• What is symmetric information?

  Symmetric information means that consumers and producers have perfect market information to make their decisions.
• What is asymmetric information and how does it lead to market failure?

  Asymmetric information occurs when there is unequal knowledge between consumers and producers, leading to a misallocation of resources.
• What is the principal-agent problem?

  The principal-agent problem occurs when the agent makes decisions for the principal but acts in their own interests rather than those of the principal.
• How can information be made more widely available to reduce market failure?

  Information can be made more widely available through advertising or government intervention.
• What is moral hazard in the context of asymmetric information?

  Moral hazard occurs when a party with superior knowledge alters their behavior to benefit themselves at the expense of the party with inferior knowledge.
• What are the characteristics of public goods?

  • Non-excludable: One person's consumption does not prevent another's.
  • Non-rival: The benefit does not diminish with additional consumers.
• What are the strengths and weaknesses of government intervention in market failures?

  Strengths:

  • Can correct market failures
  • Can provide public goods
  • Can regulate negative externalities

  
  

  Weaknesses:

  • May lead to inefficiencies
  • Can create dependency
  • Risk of government failure