Study Notes
Market failure occurs when the free market fails to achieve allocative efficiency, leading to welfare loss. This can be caused by externalities, common pool resources, and other factors.
- Market Failure — occurs when resources are not allocated efficiently, leading to a loss of social welfare. Example: Overproduction of demerit goods like cigarettes.
- Externalities — costs or benefits affecting third parties not involved in the economic activity. Example: Pollution from factories affecting nearby residents.
- Common Pool Resources — resources that are rivalrous but non-excludable, leading to overuse and depletion. Example: Overfishing in international waters.
- Positive Externalities — benefits to third parties from consumption or production. Example: Vaccinations providing herd immunity.
- Negative Externalities — costs to third parties from consumption or production. Example: Smoking causing passive smoking effects.
- Merit Goods — goods that are under-consumed and under-produced, providing external benefits. Example: Education.
- Demerit Goods — goods that are over-consumed and over-produced, providing external costs. Example: Fast food.
Exam Tips
Key Definitions to Remember
- Market Failure
- Externalities
- Common Pool Resources
- Positive and Negative Externalities
- Merit and Demerit Goods
Common Confusions
- Confusing positive externalities with negative externalities
- Misunderstanding the difference between merit and demerit goods
Typical Exam Questions
- What causes market failure? Market failure is caused by inefficient resource allocation due to externalities, market power, and other factors.
- How do positive externalities affect market outcomes? Positive externalities lead to under-consumption or under-production, requiring government intervention.
- What is the tragedy of the commons? It describes the overuse and depletion of common pool resources due to their non-excludable and rivalrous nature.
What Examiners Usually Test
- Understanding of how externalities lead to market failure
- Ability to analyze diagrams showing marginal cost and benefit curves
- Explanation of the impact of common pool resources on market efficiency