1.3 Market Failure

Flashcards covering the topic of market failure, externalities, public goods, and information gaps as described in the lecture notes.

Market failure

When the market fails to allocate scarce resources efficiently, causing a loss in social welfare.

Externality

A cost or benefit a third party receives from an economic transaction outside of the market mechanism.

Public goods

Goods that are non-rivalry and non-excludable, leading to under-provision by the private sector.

Free-rider problem

The problem that arises when individuals consume public goods without contributing to the cost of those goods

Homo economicus

The assumption that economic agents have perfect information to make rational decisions.

Private costs/benefits

Costs/benefits to the individual participating in the economic activity.

Social costs/benefits

Costs/benefits of the activity to society as a whole.

External costs/benefits are the difference between private costs/benefits and social costs/benefits.

Costs/benefits to a third party not involved in the economic activity.

Merit good

A good with external benefits, where the benefit to society is greater than the benefit to the individual.

Demerit good

A good with external costs, where the cost to society is greater than the cost to the individual.

Marginal cost/benefit

The extra cost/benefit of producing/consuming one extra unit of the good.

Negative production externalities

When social costs are greater than private costs.

MPB=MPC

Diagrammatically, the market equilibrium occurs where:

MSB=MSC

Diagrammatically, the social optimum position occurs where:

Positive consumption externalities

When social benefits are greater than social costs.

Indirect taxes and subsidies

Taxes on goods with negative externalities and subsidies on goods with positive externalities.

Tradable pollution permits

Permits that allow firms to produce up to a certain amount of pollution, which can be traded.

Public goods

Non-rivalry and non-excludability are characteristics of?

Non-rivalry

Says that one person’s use of the good doesn’t stop someone else from using it.

Non-excludable

Says that you cannot stop someone from accessing the good and someone cannot chose not to access the good.

Symmetric information

Buyers and sellers have potential access to the same information; this is perfect information.

Asymmetric information

One party has superior knowledge compared to another.

Imperfect Information

Leads to misallocation of resources such as over or under production because decisions are not based on accurate valuations.

Adverse Selection

A situation where asymmetric information leads to a concentration of undesirable or high-risk individuals in a particular market, such as health insurance.

Moral Hazard

Arises when one party has an incentive to alter their behaviour to take on more risk after a deal has been made, because the other party bears the costs of that risk.

Private Costs

The cost an individual or firm incurs directly from an economic activity or transaction

External Costs

The costs that affect parties external to a transaction, not reflected in the market price.

Social Costs

The total cost to society, including both private and external costs. (SC = PC + EC)

Private Benefits

The benefits an individual or firm enjoys directly from an economic activity or transaction.

External Benefits

The benefits that affect parties external to a transaction, not reflected in the market price.

Social Benefits

The total benefit to society, including both private and external benefits. (SB = PB + EB)