The Problem of the Free Rider: Types of Goods and their -Be able to explain what is meant by ‘market failure’ in terms of the inefficient use of scarce

The Problem of the Free Rider: Types of The Problem of the Free Rider: Types of Goods and their Goods and their

The Problem of the Free Rider: Types of The Problem of the Free Rider: Types of Goods and their Goods and their

- Be able to explain what is Be able to explain what is meant by ‘market failure’ meant by ‘market failure’ in terms of the inefficient in terms of the inefficient use of scarce resources. use of scarce resources.

- Be able to define and Be able to define and explain different kinds of explain different kinds of market failure (ideally in market failure (ideally in terms of a misallocation terms of a misallocation of scarce resources). of scarce resources).

- Consider different Consider different scenarios and apply scenarios and apply economic concepts, terms economic concepts, terms and information and information appropriatelyappropriately

Learning objectiveLearning objective::

STARTER:STARTER: Why does the government help fund schools?

If the government didn’t fund schools what do you think would happen?

In what way does the school system in the UK relate to market failure?

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KEY TERMS1.Allocative efficiency2.Market Failure3.Perfect Information4.Asymmetrical information5.Moral Hazard6.Demerit goods7.Public goods

Key WordsWhat are merit

and demerit goods and why

are they an example of

market failure?

Market failure - when markets don’t allocate resources efficiently.

Perfect information – being in possession of information that completely eliminates uncertainty in a situation.

Asymmetric information - when the people on one side of an economic transaction know more than the other.

Moral hazard - when people’s behaviour is less careful than it could be, either because they believe that their

carelessness will not be found out, or because they are encouraged to behave carelessly.

EXAMINATIONA STYLE EXAMINATIONA STYLE QUESTIONSQUESTIONS

EXAMINATIONA STYLE EXAMINATIONA STYLE QUESTIONSQUESTIONS

To what extent To what extent do markets do markets

allocate allocate resources resources efficiently?efficiently?

EXAMINATION STYLE QUESTIONS

1. Market Failure

Explain why negative externalities arising from an increase in air transport are an example of market failure (4 marks)

Comment on why there is likely to be a market failure amongst consumers of processed red meat (6 marks)

“…the division between the ‘haves’, who own houses, and the ‘have-nots’, who do not, has been one of the most prominent market failures in the UK housing market” (Extract C, lines 10 –12).

In the light of this statement, evaluate the case for and the case against government intervention in the housing market in order to correct or to reduce market failures in such a market (18 marks)

What are Externalities?What are Externalities?What are What are

externalities and externalities and why are they an why are they an

example of example of market failure?market failure?

Costs to household Costs to household e.g. e.g.

Benefits to household Benefits to household e.ge.g

Benefits to energy producer Benefits to energy producer e.ge.g

Costs to energy Costs to energy producer e.g.producer e.g.

What are the external costs of producing energy with fossil fuels ?What are the external costs of producing energy with fossil fuels ?http://www.youtube.com/watch?v=MyW9yGV1Kqc http://www.youtube.com/watch?v=MyW9yGV1Kqc

Public GoodsPublic GoodsPublic GoodsPublic GoodsTo what extent To what extent

do markets do markets allocate allocate

resources resources efficiently?efficiently?

The Thames Barrier is an example of a good The Thames Barrier is an example of a good with public good properties. with public good properties.

Public goods – those goods that have non Public goods – those goods that have non excludable and non rival consumption.excludable and non rival consumption.

Non excludability: it is not possible to stop Non excludability: it is not possible to stop somebody consuming this good.somebody consuming this good.

Non rivallry: one person’s consumption does Non rivallry: one person’s consumption does not affect the consumption of another person.not affect the consumption of another person.

It is difficult to charge people for using public It is difficult to charge people for using public goods (free riders). This creates a goods (free riders). This creates a disincentive for firms to produce goods with disincentive for firms to produce goods with these properties. these properties.

The Thames Barrier is an example of a good The Thames Barrier is an example of a good with public good properties. with public good properties.

Public goods – those goods that have non Public goods – those goods that have non excludable and non rival consumption.excludable and non rival consumption.

Non excludability: it is not possible to stop Non excludability: it is not possible to stop somebody consuming this good.somebody consuming this good.

Non rivallry: one person’s consumption does Non rivallry: one person’s consumption does not affect the consumption of another person.not affect the consumption of another person.

It is difficult to charge people for using public It is difficult to charge people for using public goods (free riders). This creates a goods (free riders). This creates a disincentive for firms to produce goods with disincentive for firms to produce goods with these properties. these properties.

Why is Why is consumption of consumption of the barrier non the barrier non excludable and excludable and

non rival? non rival?

Why might the Why might the Thames Barrier Thames Barrier have free riders if it have free riders if it was left to the was left to the market mechanism market mechanism to provide this to provide this good?good?

Why would it be Why would it be difficult for a firm difficult for a firm to build the barrier to build the barrier and make a profit and make a profit from doing so?from doing so?

Why is Why is consumption of consumption of the barrier non the barrier non excludable and excludable and

non rival? non rival?

Why might the Why might the Thames Barrier Thames Barrier have free riders if it have free riders if it was left to the was left to the market mechanism market mechanism to provide this to provide this good?good?

Why would it be Why would it be difficult for a firm difficult for a firm to build the barrier to build the barrier and make a profit and make a profit from doing so?from doing so?

http://www.youtube.com/watch?v=OMp2f4Ll540

Public GoodsPublic GoodsPublic GoodsPublic GoodsTo what extent To what extent

do markets do markets allocate allocate

resources resources efficiently?efficiently?

Why does Why does the BBC the BBC have public have public good good properties?properties?

How does How does this explain this explain the licence the licence fee paid by fee paid by everybody everybody who owns a who owns a colour tv?colour tv?

Why does Why does the BBC the BBC have public have public good good properties?properties?

How does How does this explain this explain the licence the licence fee paid by fee paid by everybody everybody who owns a who owns a colour tv?colour tv?

Using supply and demand diagrams Using supply and demand diagrams to illustrate market failures?to illustrate market failures?

What are What are externalities and externalities and why are they an why are they an


Using supply and diagrams to Using supply and diagrams to illustrate market failures illustrate market failures


What are What are externalities externalities and why are and why are

they an they an example of example of

market failure?market failure?

Price Price per unitper unit

of of energyenergy

Price Price per unitper unit

of of energyenergy

Quantity of Quantity of EnergyEnergy

Quantity of Quantity of EnergyEnergy

DDDD

SSSS

PPPP

QQQQ

S1S1S1S1

P1P1P1P1

Q1Q1Q1Q1

In the diagram, the In the diagram, the amount of energy that amount of energy that would be consumed if would be consumed if private costs and private costs and benefits, alone, were benefits, alone, were taken into account is taken into account is equal to Q with price per equal to Q with price per unit of energy P.unit of energy P.

However, if the external However, if the external costs of energy costs of energy production were also production were also taken into account then taken into account then supply would shift from supply would shift from S to S1 . Higher costs S to S1 . Higher costs would mean that price would mean that price would increase to P1 per would increase to P1 per unit and less energy unit and less energy would be consumer would be consumer (Q1). (Q1).

The diagram also helps The diagram also helps to illustrate the market to illustrate the market failure created by the failure created by the existence of external existence of external costs. The external costs costs. The external costs mean that too much of mean that too much of our scarce resources are our scarce resources are allocated to energy allocated to energy production and , energy production and , energy is over consumed by Q is over consumed by Q – Q1, if left to market – Q1, if left to market forces alone. forces alone.

Positive Externalities?Positive Externalities?What are What are

externalities and externalities and why are they an why are they an


http://publicecon.wikispaces.com/Positive+Externalities+and+Educationhttp://publicecon.wikispaces.com/Positive+Externalities+and+Education

Besides the Besides the entertainment provided entertainment provided for all of us by University for all of us by University Challenge, what positive Challenge, what positive externalities are created externalities are created by people studying up to by people studying up to higher education?higher education?

Besides the Besides the entertainment provided entertainment provided for all of us by University for all of us by University Challenge, what positive Challenge, what positive externalities are created externalities are created by people studying up to by people studying up to higher education?higher education?






What are What are externalities externalities and why are and why are

they an they an example of example of


Price Price Price Price

Quantity Quantity EnergyEnergy

Quantity Quantity EnergyEnergy

DDDD

SSSS

PPPP

QQQQ

P1P1P1P1

Q1Q1Q1Q1

In the diagram, the In the diagram, the amount of that would amount of that would be consumed if private be consumed if private costs and benefits, costs and benefits, alone, were taken into alone, were taken into account is equal to Q account is equal to Q with price equal to P.with price equal to P.

However, if the external However, if the external benefits of were also benefits of were also taken into account then taken into account then demand would increase demand would increase from D to D1 . Higher from D to D1 . Higher demand would mean demand would mean that price would that price would increase to P1 but also increase to P1 but also that more would be that more would be consumed (Q1). consumed (Q1).

The diagram also helps The diagram also helps to illustrate the market to illustrate the market failure created by the failure created by the existence of external existence of external benefits. The external benefits. The external benefits mean that not benefits mean that not enough of our scarce enough of our scarce resources are allocated resources are allocated to and , is under to and , is under consumed by Q – Q1, if consumed by Q – Q1, if left to market forces left to market forces alone. alone. D1D1D1D1

CWCW Merit and Demerit goods Merit and Demerit goods Date:Date:………….…………. CWCW Merit and Demerit goods Merit and Demerit goods Date:Date:………….………….

What are merit What are merit and demerit and demerit

goods and why goods and why are they an are they an example of example of


Learn about merit Learn about merit and demerit and demerit goods. goods.

Learning Learning objectiveobjective::

STARTER:STARTER:

Why, if left to our Why, if left to our own devices, own devices, would we spend would we spend less on healthcare less on healthcare than we should?than we should?http://www.economicsonline.co.uk/Market_failures/http://www.economicsonline.co.uk/Market_failures/

Merit_goods.htmlMerit_goods.html









Price Price per unit per unit

of of healthcare healthcare


of of healthcare healthcare

Quantity of Quantity of healthcare healthcare

Quantity of Quantity of healthcare healthcare

DDDD

SSSS

PPPP

QQQQ

P1P1P1P1

Q1Q1Q1Q1

In the diagram, the In the diagram, the quantity of healthcare quantity of healthcare that would be consumed that would be consumed if we were left to our if we were left to our own devices would be own devices would be equal to Q with price equal to Q with price equal to P.equal to P.

However, if the full However, if the full benefits of healthcare benefits of healthcare were known then were known then demand would increase demand would increase from D to D1 . Higher from D to D1 . Higher demand would mean demand would mean that price would that price would increase to P1 but also increase to P1 but also that more would be that more would be consumed (Q1). consumed (Q1).

The diagram also helps The diagram also helps to illustrate the market to illustrate the market failure created by the failure created by the existence of merit existence of merit goods. Not enough of goods. Not enough of our scarce resources are our scarce resources are allocated to the allocated to the production of merits production of merits goods ; they are under goods ; they are under consumed by Q – Q1, if consumed by Q – Q1, if left to market forces left to market forces alone. alone.

D1D1D1D1










of of alcohol alcohol


of of alcohol alcohol

Quantity of Quantity of alcoholalcohol

Quantity of Quantity of alcoholalcohol

D1D1D1D1

SSSS

P1P1P1P1

Q1Q1Q1Q1

PPPP

QQQQ

Without perfect Without perfect knowledge of the knowledge of the benefits of alcohol benefits of alcohol consumption, we consumption, we consume a quantity consume a quantity equal to Q with price equal to Q with price equal to P.equal to P.

However, if the true However, if the true benefits of alcohol benefits of alcohol consumption were consumption were known then demand known then demand could fall from D to D1 . could fall from D to D1 . Lower demand would Lower demand would mean that less would be mean that less would be consumed and price consumed and price would fall until a new would fall until a new equilibrium is establised equilibrium is establised with price P1 and with price P1 and quantity Q1. quantity Q1.

The diagram also helps The diagram also helps to illustrate the market to illustrate the market failure created by the failure created by the existence of demerit existence of demerit goods. To many of our goods. To many of our scarce resources are scarce resources are allocated to the allocated to the production of demerits production of demerits goods ; they are over goods ; they are over consumed by Q – Q1, if consumed by Q – Q1, if left to market forces left to market forces alone. alone.

DDDD

CWCW Information Failure Information Failure Date:………….Date:…………. CWCW Information Failure Information Failure Date:………….Date:………….

What is What is information information

failure and why failure and why can it result in can it result in market failure?market failure?

Learn about Learn about information failure.information failure.

Learning Learning objectiveobjective::

STARTER:STARTER: What is a good What is a good price for these price for these products? Why is products? Why is not knowing what not knowing what a good price is, a a good price is, a problem? What problem? What other examples other examples can you think of, of can you think of, of situations where situations where you have a lack of you have a lack of information? information?

Information Failure and Market FailureInformation Failure and Market Failure

What is What is information information failure and failure and why can it why can it result in result in


What are the chances that, if you What are the chances that, if you smoke, you will be killed by a smoke, you will be killed by a smoking related illness?smoking related illness?

http://www.patient.co.uk/health/http://www.patient.co.uk/health/smoking-the-factssmoking-the-facts

How can this, and the other How can this, and the other examples of information failure lead examples of information failure lead to market failure?to market failure?

What don’t we have information about?What don’t we have information about?



There are known knowns. These are There are known knowns. These are things we know that we know. There are things we know that we know. There are known unknowns. That is to say, there known unknowns. That is to say, there are things that we know we don't know. are things that we know we don't know. But there are also unknown unknowns. But there are also unknown unknowns. There are things we don't know we don't There are things we don't know we don't know.know.

What don’t we have What don’t we have information about?information about?

All of the options All of the options available in the present.available in the present.

The true benefits and The true benefits and costs of the options costs of the options available. available.

The future.The future.








Price Price per per

packet packet OfOf

cigarettes cigarettes

Price Price per per

packet packet OfOf

cigarettes cigarettes

Quantity of Quantity of cigarettescigarettes

Quantity of Quantity of cigarettescigarettes

D1D1D1D1

SSSS

P1P1P1P1

Q1Q1Q1Q1

PPPP

QQQQ

Without perfect Without perfect knowledge of the costs knowledge of the costs of smoking , we of smoking , we consume a quantity consume a quantity equal to Q with price equal to Q with price equal to P.equal to P.

However, if the true However, if the true costs of smoking were costs of smoking were known then demand known then demand could fall from D to D1 . could fall from D to D1 . Lower demand would Lower demand would mean that less would be mean that less would be consumed and price consumed and price would fall until a new would fall until a new equilibrium is equilibrium is established with price established with price P1 and quantity Q1. P1 and quantity Q1.

The diagram also helps The diagram also helps to illustrate the market to illustrate the market failure created by the failure created by the existence of information existence of information failure. To many of our failure. To many of our scarce resources are scarce resources are allocated to the allocated to the production of demerits production of demerits goods ; they are over goods ; they are over consumed by Q – Q1, if consumed by Q – Q1, if left to market forces left to market forces alone. alone.

DDDD

Documents

The Problem of the Free Rider: Types of Goods and their -Be able to explain what is meant by ‘market failure’ in terms of the inefficient use of scarce