1.3 - market failure

What is market failure?

When the market fails to allocated resources efficiently, causing a loss in social welfare

What are the 3 types of market failure?

• Externalities

• Under-provision of public goods

• Information gaps

What is an externality?

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

What is under-provision of public goods?

Public goods are non-rivalrous and non-excludable so they are underprovided by the private sector due to the free-rider problem

What are information gaps?

Homo economicus is assumed to have perfect information to make rational decisions. Firms are assumed to have perfect information on their cost and revenue curves. Governments are assumed to know the full cost and benefits of each decision

What are private costs/benefits?

The costs/benefits to the individual participating in the economic

Which way does the cost curve go on an externalities diagram?

Up

Which way does the benefits curve go on an externalities diagram?

Down

Which curve shifts if the externality affects production?

Cost curve

Which curve shifts if the externality affects consumption?

Benefit curve

What are social costs/benefits?

The costs/benefits of the activity to society as a whole

What are external costs/benefits?

The costs/benefits to a third party not involved in the economic activity

What is a merit good?

A good with external benefits where the benefit to society is greater than the benefit to the individual (underprovided in free market)

What is a demerit good?

A good with external costs, where the cost to society is greater than the cost to the individual (overprovided in free market)

When do negative externalities of production occur?

MSC > MPC

When do positive externalities of consumption occur?

MSB > MPB

Why are sizes of externalities difficult to work out?

• Tend to be based on value judgements - difficult to monetise external costs

• Information gaps - unaware of consequences

What methods does the government use to intervene?

• Indirect taxes and subsidies - internalise externalities

• Tradable pollution permits - produce up to a certain amount of polluation

• Provision of the good - through taxation

• Provision of information - information gaps reduction

• Regulation - limit consumption

What are the characteristics of public goods?

• Non-rivalrous - one person using the good does not stop another from using it

• Non-excludable - cannot be stopped from accessing good, cannot choose not to access good

What is a free rider?

Someone who receives the benefits of a good without paying for it

Why does the private sector not supply public goods?

Cannot be sure they will make a profit

What is symmetric information?

When buyers and sellers have potential access to the same information

What is asymmetric information?

When one party has superior knowledge compared to another

Why does advertising lead to information gaps?

Designed to change attitudes of consumers to encourage them to buy the good

How do information gaps lead to market failure?

Misallocation of resources - people do not buy things that maximise their welfare