Markets and Market Failure Quiz

Opportunity cost refers to the value of the next best alternative that is foregone when a decision is made. It is the cost of choosing one option over another.
Example: If a student decides to spend an hour studying economics rather than working a part-time job, the opportunity cost is the income they could have earned in that hour.

The law of demand states that, ceteris paribus (all other things being equal), as the price of a good or service falls, the quantity demanded increases, and vice versa. This inverse relationship between price and quantity demanded is typically represented by a downward-sloping demand curve.

The price mechanism refers to the system where the forces of supply and demand determine the prices of goods and services in a market economy. When demand increases, prices rise, signalling producers to supply more. Conversely, when demand falls, prices decrease, leading producers to supply less. This helps to allocate resources efficiently in response to changing market conditions.

Market equilibrium occurs when the quantity of a good or service demanded by consumers equals the quantity supplied by producers at a particular price. At this point, there is no tendency for the price to change, and the market clears.

One common cause of market failure is externalities. Externalities occur when the actions of individuals or firms have unintended side effects on third parties.
Example: Pollution from a factory is a negative externality because it harms the environment and people’s health without being reflected in the price of the good or service produced.

A positive externality occurs when the actions of individuals or firms benefit third parties.
Example: The provision of education creates a positive externality because it not only benefits the student but also society by fostering a more educated and productive workforce.

A negative externality occurs when the actions of individuals or firms impose costs on third parties.
Example: Air pollution from a factory is a negative externality because it harms the health of nearby residents.

Public goods are non-rivalrous and non-excludable, meaning that individuals can consume them without reducing their availability to others, and no one can be excluded from using them. As a result, firms have little incentive to produce these goods because they cannot charge consumers directly. This leads to under-provision of public goods in a free market, causing market failure.
Example: Street lighting is a public good.

Information failure occurs when consumers or producers lack the necessary information to make informed decisions, leading to inefficient market outcomes.
Example: In the case of used cars, sellers may have more information about the car’s condition than buyers, leading to adverse selection and the potential for market inefficiency.

Governments intervene in markets to correct market failures by implementing policies that aim to improve outcomes for society. These interventions can include:

• Imposing taxes or subsidies to correct negative or positive externalities.
• Providing public goods that the market will not supply.
• Regulating industries to prevent market abuses or monopolies.

Advantages:

• Can correct market failures (e.g., taxing negative externalities like pollution).
• Provides public goods that would not be produced by the private sector.
• Protects consumers and ensures fair competition.

Disadvantages:

• Government intervention can lead to inefficiency (e.g., excessive bureaucracy or misallocation of resources).
• It can distort market signals, leading to unintended consequences.
• There may be a lack of knowledge or political motives behind the interventions, leading to poor decision-making.

A merit good is a good that is deemed to have positive effects on individuals and society, but which may be under-consumed if left to the market. These goods often have positive externalities, and the government may intervene to ensure their provision.
Example: Healthcare is a merit good, as the government may intervene to provide universal access, ensuring that everyone receives necessary care, regardless of income, and to increase the overall health of the population.

A price floor is a minimum price set by the government above the market equilibrium price. It is usually implemented to ensure that producers receive a fair price for their goods or services.
Example: The minimum wage is a price floor that sets the lowest legal wage employers can pay workers, ensuring that workers receive a basic standard of living.

The tragedy of the commons occurs when individuals, acting in their own self-interest, overuse or deplete a common resource, leading to its eventual depletion. Because these resources are non-excludable, individuals do not bear the full cost of their actions, leading to market failure.
Example: Overfishing in international waters is a classic example, where the lack of regulation leads to the depletion of fish stocks.

A government subsidy is a financial assistance provided to encourage the production or consumption of a good that has positive externalities. By providing a subsidy, the government can reduce the price for consumers or increase the profitability for producers, thus encouraging more consumption or production of the good.
Example: A government might subsidise renewable energy production to encourage the use of cleaner energy sources, which have environmental benefits beyond the immediate market transaction.

Monopoly power refers to the ability of a single firm or a small group of firms to control a large share of the market, allowing them to set prices and output levels without competition. This leads to market failure because monopolies often produce less output at higher prices than would occur in a competitive market, reducing consumer welfare and economic efficiency.
Example: A monopoly in the electricity sector might charge consumers higher prices because there is no competition, leading to inefficiency and consumer exploitation.