Market failure

What is market failure?

It occurs when markets are no longer allocatively efficient, and marginal social benefit does not equal marginal social cost.

What is an externality?

An externality occurs when the production or consumption of a good or service has an effect on a third party.

What are merit goods?

Goods that are beneficial to the individual and society as a whole, and are usually under-provided in a free market.

What are demerit goods?

Goods that have negative effects when consumed and cause negative externalities of consumption.

What is a negative production externality?

It occurs when the production of a good generates a negative effect on a third party or society.

Can you give an example of a negative production externality?

Mining rare earth metals, as it requires large land use, leading to deforestation.

What are possible government responses to negative production externalities?

Imposing carbon tax, tradable emission permits (Cap and Trade), legislation.

What is a positive production externality?

It occurs when the production of a good generates a positive effect on a third party or society.

Can you give an example of a positive production externality?

Bee-keeping, as bees pollinate agricultural plants benefiting farmers and consumers.

What are possible government responses to positive production externalities?

Subsidising firms, direct government provision.

What is a negative consumption externality?

It occurs when an individual's consumption of a good generates a negative effect on third parties.

Can you provide examples of negative consumption externalities?

Smoking cigarettes, drinking alcohol, and driving vehicles.

What are possible government responses to negative consumption externalities?

Banning or regulating, indirect taxes, minimum price controls, negative advertising.

What is a Pigovian tax?

An indirect tax used specifically to correct market failure from negative externalities.

What is a positive consumption externality?

It occurs when the consumption of a good generates a positive effect on a third party or society.

Can you give an example of a positive consumption externality?

Vaccination preventing illness not only for the individual but also for the community.

What are possible government responses to positive consumption externalities?

Subsidising firms, direct government provision, positive advertisement, legislation.

What problems might arise with subsidies for positive externalities?

It is difficult to estimate subsidy levels, and they have an opportunity cost.

What are problems associated with direct government provision?

High costs, opportunity costs, and lack of expertise compared to specialized firms.

What problems might arise from imposing indirect taxes for negative consumption externalities?

Addictive goods show price inelasticity, leading to minimal reduction in consumption.

What are the limitations of negative advertising as a solution?

High costs and uncertainty about how effective it is at reducing demand.

What issues arise from banning or regulating goods with negative consumption externalities?

Potential unemployment, reduced government revenue, and enforcement costs.

What is collective self-governance?

Voluntary actions by local communities to reduce negative externalities of consumption.

What are common pool resources?

Rivalrous but non-excludable resources, such as fish in the sea.

Why are common access resources a case of market failure?

The individual benefits exceed the private costs, leading to over-consumption.

What is allocative efficiency?

Producing the optimal combination of goods from a society's perspective; occurs at market equilibrium.

What is asymmetric information?

When one party in a transaction has more information than the other party.

What is moral hazard?

A situation where one participant takes on more risk because they will not face the consequences.

What is adverse selection?

A situation where one participant has more information before a transaction occurs.

What are the differences between adverse selection and moral hazard?

Adverse selection occurs before a transaction, while moral hazard occurs after.

What are the characteristics of public goods?

Public goods are both non-rivalrous and non-excludable.

How can a cap and trade system be described?

A government system where emission reduction targets are set, creating economic incentives for firms.

What are the strengths of legislation?

Legislation is effective when laws are specific and easy to enforce.

What are the strengths of direct government provision of public goods?

Improves social welfare, eliminates free-rider problems, and can achieve economies of scale.