Study Notes
Market failure occurs when the free market fails to achieve allocative efficiency, leading to welfare loss. It can be caused by externalities, merit and demerit goods, common pool resources, public goods, asymmetric information, and market power.
- Market Failure — occurs when resources are not allocated efficiently, leading to a loss of economic welfare. Example: Overproduction of demerit goods like cigarettes.
- Externalities — costs or benefits affecting third parties not involved in the economic transaction. 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, often with positive externalities. Example: Education.
- Demerit Goods — goods that are over-consumed and over-produced, often with negative externalities. Example: Fast food.
Exam Tips
Key Definitions to Remember
- Market Failure
- Externalities
- Common Pool Resources
- Merit Goods
- Demerit Goods
Common Confusions
- Confusing positive externalities with negative externalities.
- Misunderstanding the difference between merit and demerit goods.
Typical Exam Questions
- What is market failure? Market failure is when the free market fails to allocate resources efficiently, leading to a loss of economic welfare.
- How do positive externalities affect market outcomes? Positive externalities lead to under-consumption or under-production, as the full social benefits are not reflected in market transactions.
- What is the tragedy of the commons? It is 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.