2.4. Market Failure (not Market Power)

Consumer Surplus

Satisfaction gained by consumers when they buy a product for less than they were willing and able to pay for it.

Producer Surplus

Satisfaction gained by producers when they sell a product for more than they were willing and able to accept for it.

Social Surplus

The addition of consumer surplus, producer surplus and the surplus gained by all third parties.

Allocative Efficiency

Occurs when social surplus is maximised (MSC=MSB or MC=AR).

Choice architecture

The theory that decisions people make are heavily influenced by how the choices are presented.

How can "default choices" encourage more efficient decision-making?

Changing the default option (that consumers end up with if they don't choose) to the more socially desirable option.

How can "mandated choices" encourage more efficient decision-making?

Take away the default option so that consumers are mandated (forced) to actively choose. They now must think more carefully about the decision.

How can "restricted choices" encourage more efficient decision-making?

Reducing the number of options helps consumers to compute the information and make more informed choices.

Examples of cognitive biases (when consumers do not behave rationally like homo economicus)

1. Following rules of thumb, rather than maximising.

2. Anchoring preferences to the first thing they see.

3. Framing biases: people dislike losses more than they like gains.

4. Social conformity: behaving like everyone else.

5. Information availability: Only recalling recently learned information.

6. Bounded self-control: Biased towards short-term gains over long-term gains.

7. Bounded selfishness: Doing things for other people.

Free Market

A market with no government intervention, so market outcomes are determined by the free interaction of supply and demand.

Market Failure

Occurs when social surplus is not maximised in a free market (either too much or too little is produced from society's point of view).

Marginal Private Cost (MPC)

The cost to producers of producing an additional unit of a product.

Marginal Social Cost (MSC)

The cost to society when an additional unit of a product is produced.

Marginal Private Benefit (MPB)

The benefit to consumers from consuming an additional unit of a product.

Marginal Social Benefit (MSB)

The benefit to society when an additional unit of a product is consumed.

External Costs of Production

Costs to third parties when a product is produced.

External Benefits of Consumption

Benefits to third parties when a product is consumed.

Negative Externalities of Consumption

External costs to third parties that occur when a product is consumed.

If there is a negative externality of consumption, what is the correct inequality between the benefit curves or cost curves?

MSB is less than MPB

Demerit Good

A good that causes external costs when it is consumed (negative externalities of consumption).

Negative Externalities of Production

External costs to third parties that occur when a product is produced.

If there is a negative externality of production, what is the correct inequality between the benefit curves or cost curves?

MSC is greater than MPC

Cap and Trade Scheme

A scheme introduced by the government to reduce pollution, whereby there are a fixed number of tradeable pollution permits that firms can buy and sell from each other.

Positive Externalities of Consumption

External benefits to third parties that occur when a product is consumed.

If there is a positive externality of consumption, what is the correct inequality between the benefit curves or cost curves?

MSB is greater than MPB

Merit Good

A good that causes external benefits when it is consumed (positive externalities of consumption)

Positive Externalities of Production

External benefits to third parties that occur when a product is produced.

If there is a positive externality of production, what is the correct inequality between the benefit curves or cost curves?

MSC is less than MPC

Public Goods

Goods that are not provided in free markets, because they are non-excludable and non-rivalrous.

Non-Excludable

It is impossible to stop other people from consuming the good once it has been provided.

Non-Rivalrous

One person consuming the good does not stop someone else from also consuming the good.

Free Rider Problem

Occurs when nobody buys a public good because they can wait for someone else to provide it and use it for free.

Common Pool Resources

Resources that are non-excludable, but rivalrous, meaning they deplete over time.

Tragedy of the Commons

Occurs when self-interested firms deplete or spoil common pool resources, leading to a loss of social surplus.

Collective self-governance

Occurs when firms that use common pool resources are involved in making and adapting the rules regarding their use, preventing them from becoming depleted.

Sustainability

The ability of present generations to meet their needs without compromising the ability of future generations from meeting their own needs.

Linear Economy

An efficient economic system based on the Take, Make, Use, Dispose model.

Circular Economy

A sustainable economic system based on the Make, Use, Recycle model.

Carbon Taxes

A tax imposed on firms based on how much pollution they create.

Asymmetric Information

Occurs when one party in an economic transaction has more information than another party.

Adverse Selection

Occurs when one party in an economic transaction having more information than another party leads to certain (good quality) products being priced out of the market, even though they would increase social surplus.

Moral Hazard

Occurs when people have an incentive to take more risks when they know that someone else will pay for the negative consequences of that risk (e.g. an insurance company)

Private Signalling/Screening

When producers either provide information to consumers (through signals) or attempt to gain information about consumers (screen them) to overcome asymmetric information.