Unit 1: Market Failure

• What is market failure?

  Market failure is a situation where there is a less than optimal allocation of resources from the point of view of society.
• What are two examples of market failure?

  A lack of equity (inequality) and environmental degradation are examples of market failure.
• What does market failure lead to in terms of goods and services?

  Market failure leads to either an over-provision or under-provision of goods and services.
• What is allocative efficiency?

  Allocative efficiency occurs when resources are distributed in a way that maximizes societal welfare.
• What are some sources of market failure?

  Sources of market failure include externalities, under-provision of public goods, and information gaps in markets.
• What are externalities?

  Externalities occur when there is an external impact (cost or benefit) on a third party not involved in the economic transaction.
• What are the two types of externalities?

  Externalities can be positive or negative.
• What is a positive externality of consumption?

  A positive externality of consumption occurs when the external impact on society is positive, such as when electric vehicles are consumed and CO2 emissions fall.
• What is a negative externality of consumption?

  A negative externality of consumption occurs when the external impact on society is negative, such as when the consumption of alcohol increases anti-social behavior.
• What is a positive externality of production?

  A positive externality of production occurs when the external impact on society is positive, such as when managed pine forests produce timber and increase CO2 absorption.
• What is a negative externality of production?

  A negative externality of production occurs when the external impact on society is negative, such as when the production of electricity increases air pollution.
• How does the price mechanism in a free market relate to externalities?


  The price mechanism in a free market ignores externalities.
• What are public goods?

  Public goods are beneficial to society but would be under-provided by a free market.
• Why are public goods under-provided by a free market?

  Public goods are under-provided by a free market because there is less opportunity for sellers to make economic profits from providing these goods/services.
• Give examples of public goods.

  Examples of public goods include national defense, parks, libraries, and lighthouses.
• What are information gaps in free markets?

  Information gaps exist in nearly all free markets and distort market outcomes resulting in market failure.
• What is asymmetric information?

  Asymmetric information occurs when buyers and sellers have different levels of information, distorting market prices and quantities.
• How would knowledge of dangerous side effects affect the sale of goods/services?

  Goods/services with dangerous side effects would be sold in lower quantities if buyers were aware of these effects.
• How would awareness of extra benefits affect the sale of goods/services?

  Goods/services with extra benefits would be sold in higher quantities if buyers were aware of them.
• What are external costs?

  External costs occur when the social costs of an economic transaction are greater than the private costs.
• What is the formula for social costs?

  Social costs = Private cost + External cost.
• What are external benefits?


  External benefits occur when the social benefits of an economic transaction are greater than the private benefits.
• What is the formula for social benefits?

  Social benefits = Private benefit + External benefit.
• How do negative externalities of production affect the market?

  Negative externalities of production lead to over-provision of goods/services as only private costs are considered by producers.
• What would happen if external costs were considered in production?

  If external costs were considered, the quantity of goods/services provided would decrease and they would be sold at a higher price.
• What is marginal analysis in economics?

  Marginal analysis considers the cost or benefit of the next unit produced or consumed.
• What is the marginal private cost (MPC)?

  The marginal private cost (MPC) is the cost of the next unit produced or consumed.
• What is the marginal private benefit (MPB)?

  The marginal private benefit (MPB) is the benefit derived from the production or consumption of the next unit.
• What are positive externalities of consumption?

  Positive externalities of consumption are created during the consumption of a good/service, leading to under-consumption of these goods/services.
• What would happen if external benefits were considered in consumption?


  If external benefits were considered, the quantity of goods/services consumed would increase and they would be sold at a higher price.