Studied by 7 people
What is market failure
It occurs when the market fails to allocate scarce resources efficiently
What are the three main types of market failure
Externalities, under-provision of public goods, and information gaps
What is an externality
A cost or benefit a third party receives from an economic transaction outside the market mechanism
What is a negative externality
A cost to a third party from a transaction
What is a positive externality
A benefit to a third party from a transaction
How do externalities lead to market failure
They cause over- or under-production of goods
What are the two key characteristics of public goods
They are non-rivalry and non-excludable
What does non-rivalry mean
One person's use of the good does not reduce its availability for others
What does non-excludable mean
People cannot be prevented from using the good
What is the free-rider problem
When people benefit from a public good without paying for it
Why does the free-rider problem lead to market failure
The private sector avoids providing public goods
What is an example of a public good
Streetlights
What is perfect information
When all economic agents have full knowledge to make rational decisions
What is an information gap
When economic agents lack sufficient knowledge to make rational decisions
How do information gaps lead to market failure
They cause a misallocation of resources as decisions fail to maximize welfare
What is asymmetric information
When one party has more knowledge than the other
How does asymmetric information cause market failure
It allows one party to exploit the other
What are examples of information gaps
Second-hand cars
What is an externality
A cost or benefit a third party receives from an economic transaction outside the market mechanism
What are the two types of externalities
Positive externalities and negative externalities
What are private costs
The costs to the individual or firm directly involved in an economic activity
What are private benefits
The benefits to the individual or firm directly involved in an economic activity
What are external costs
The costs to a third party not involved in an economic activity
What are external benefits
The benefits to a third party not involved in an economic activity
What are social costs
The total costs to society
What are social benefits
The total benefits to society
What are negative externalities
External costs that occur when social costs exceed private costs
Where does the market produce when there are negative externalities
At the point where marginal private cost (MPC) equals marginal private benefit (MPB)
Where should production occur to achieve the social optimum
Where marginal social cost (MSC) equals marginal social benefit (MSB)
What is the welfare loss in negative externalities
The shaded area between Q1 (market output) and Q2 (social optimum output)
What are examples of negative production externalities
Noise pollution from airplanes and industrial waste
What are positive externalities
External benefits that occur when social benefits exceed private benefits
Where does the market produce when there are positive externalities
At the point where marginal private cost (MPC) equals marginal private benefit (MPB)
What is the welfare loss in positive externalities
The shaded area between Q1 (market output) and Q2 (social optimum output)
What are examples of positive consumption externalities
Healthcare and education
What is a merit good
A good with external benefits where the benefit to society is greater than to the individual
What is a demerit good
A good with external costs where the cost to society is greater than to the individual
How are merit goods treated in the free market
They are underprovided
How are demerit goods treated in the free market
They are overprovided
What is the role of government in addressing externalities
To internalize external costs and benefits to move production closer to the social optimum
How do indirect taxes address negative externalities
By increasing the cost of goods with external costs
How do subsidies address positive externalities
By reducing the cost of goods with external benefits
What are tradable pollution permits
Permits allowing firms to produce a certain amount of pollution
How does government provision help with positive externalities
By directly providing goods with high social benefits
How does provision of information help with externalities
By reducing information gaps and enabling informed decisions about external costs and benefits
How does regulation address externalities
By limiting or banning harmful goods and activities
Why is it difficult to measure externalities
Because their value often depends on subjective judgments and is hard to monetize
How are information gaps related to externalities
People are often unaware of the full implications of their decisions
What is a public good
A good that is non-rivalry and non-excludable
What does non-rivalry mean
One person’s use of the good does not reduce its availability for others
What does non-excludable mean
People cannot be prevented from using the good
What is an example of a public good
Streetlights
Why are there few pure public goods
Because most goods have some level of rivalry or excludability
What is the free-rider problem
When people benefit from a public good without paying for it
Why does the free-rider problem lead to market failure
Because private firms cannot ensure profit
How is the free-rider problem addressed
Governments provide public goods and fund them through taxation
What are the two key characteristics of public goods
Non-rivalry and non-excludability
Why can private goods be excluded from public provision
Because private goods are both rival and excludable
Why doesn’t the private sector provide public goods
They cannot guarantee profit due to the non-excludability of public goods
How do governments typically provide public goods
Through taxation and public funding
What is a commonly cited example of a public good
National defense
How do streetlights exemplify public goods
They are non-rivalry and non-excludable
What is symmetric information
A situation where buyers and sellers have equal access to the same information
What is an information gap
A lack of sufficient information
What is asymmetric information
A situation where one party has more information than the other in a transaction
Who usually has superior knowledge in asymmetric information
Sellers typically have more information than buyers
How do information gaps cause market failure
They lead to a misallocation of resources as consumers and producers make suboptimal decisions
Why can asymmetric information lead to higher prices
Sellers exploit buyers’ lack of knowledge to charge more
What is an example of an information gap in healthcare
Patients may lack the knowledge to evaluate the necessity or effectiveness of medical treatments
How do information gaps affect pension schemes
Young people may not understand the long-term benefits of saving into pension schemes
What is an example of information gaps in financial services
Financial institutions may exploit consumers’ lack of understanding to sell unsuitable products (moral hazard)
How do information gaps relate to drugs
Users may not understand the long-term consequences of drug use
How does advertising contribute to information gaps
It often exaggerates benefits
How has technology impacted information gaps
Technology reduces information gaps by providing easier access to information
What is a key outcome of information gaps in markets
Consumer demand or producer supply may be too high or too low
Note 
Flashcard (45)