Market failure flashcards

Market failure occurs when the price mechanism allocates resources inefficiently, leading to a loss of economic welfare. Students must understand the four main causes: externalities (positive and negative), public goods, common access resources, and information asymmetries. Each cause results in either overproduction or underproduction relative to the socially optimal output. The concept of marginal social cost and marginal social benefit is central, as is the idea of welfare loss (deadweight loss). Students should also be able to evaluate government responses such as taxes, subsidies, regulations, and the provision of public goods, considering both their effectiveness and potential government failure.

1. Card 1

   What is market failure?

   Market failure occurs when the free market allocates resources inefficiently, producing at an output where marginal social cost does not equal marginal social benefit.

2. Card 2

   What is an externality?

   An externality is a cost or benefit experienced by a third party not involved in the transaction, causing a divergence between private and social costs or benefits.

3. Card 3

   What is the difference between a negative production externality and a negative consumption externality?

   A negative production externality arises from the production process (e.g. factory pollution), while a negative consumption externality arises from consuming a good (e.g. passive smoking).

4. Card 4

   What is a welfare loss (deadweight loss) in the context of market failure?

   Welfare loss is the loss of net social benefit when output differs from the socially optimal level, shown as a triangle on a supply and demand diagram.

5. Card 5

   What are the two characteristics of a public good?

   A public good is both non-excludable (no one can be prevented from using it) and non-rival (one person's use does not reduce availability to others), e.g. national defence.

6. Card 6

   Why do public goods lead to market failure?

   The free-rider problem means consumers can benefit without paying, so private firms cannot profit and the good is underprovided or not provided at all by the market.

7. Card 7

   What is a common access resource?

   A common access resource is non-excludable but rival, meaning it is open to all yet can be depleted, leading to overuse and the tragedy of the commons.

8. Card 8

   What is information asymmetry and give one example?

   Information asymmetry occurs when one party in a transaction has more or better information than the other, e.g. a used-car seller knowing more about faults than the buyer.

9. Card 9

   How does a Pigouvian tax correct a negative externality?

   A Pigouvian tax equal to the marginal external cost shifts the supply curve left, raising price to the socially optimal level and reducing output to eliminate the welfare loss.

10. Card 10

    How does a subsidy correct a positive externality?

    A subsidy lowers the cost of production or consumption, shifting supply or demand right to increase output towards the socially optimal quantity, reducing underproduction.

11. Card 11

    What is the difference between marginal private cost and marginal social cost?

    Marginal private cost is the cost borne by the producer alone, while marginal social cost includes the external cost, so MSC = MPC + marginal external cost.

12. Card 12

    What is government failure in the context of correcting market failure?

    Government failure occurs when intervention to correct market failure creates new inefficiencies, such as setting a tax at the wrong level or causing unintended consequences.

• Students often confuse public goods with government-provided goods; a good is a public good because of its non-excludable and non-rival characteristics, not simply because the state supplies it.
• A common error is drawing the welfare loss triangle on the wrong side of the equilibrium; for a negative externality the triangle sits between the market output and the lower socially optimal output.
• Many students incorrectly state that a Pigouvian tax eliminates all market failure; in practice, measuring the exact external cost is very difficult, so the tax may be set at the wrong level.

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