Exam revision: Market Failure

Market failure occurs when:

• Government intervenes in the market

• There is a scarcity of goods

• The market does not allocate resources efficiently

• Consumers have limited purchasing power

Answer explanation

Market failure refers to a situation where the free market fails to efficiently allocate resources to their most valued uses. This can happen due to various reasons such as externalities, public goods, information asymmetry, and market power.

Which of the following is an example of an external cost?

• A decrease in the price of a product

• Pollution from a factory affecting nearby residents' health

• An increase in government regulations

• Increased competition between firms

Answer explanation

An external cost occurs when the production or consumption of a good or service imposes a cost on a third party not directly involved in the transaction. Pollution from a factory affecting nearby residents' health is an example of an external cost because the negative consequences are borne by people who are not directly involved in the production or consumption of the good.

Market failure can occur due to

• Perfect competition

• Government regulations

• Consumer preferences

• Monopolies

Answer explanation

Market failure can occur due to various reasons, including monopolies. A monopoly exists when a single firm has substantial control over a market, allowing it to influence prices and restrict competition. Monopolies can lead to reduced consumer welfare and inefficient allocation of resources.

Which of the following is an example of information asymmetry?

• A buyer and seller having equal knowledge about a product

• A used car salesperson not disclosing a car's history of accidents

• Consumers making rational decisions based on complete information

• Businesses conducting market research before launching a new product

Answer explanation

Information asymmetry occurs when one party in a transaction has more or better information than the other party. In this case, the used car salesperson possesses information about the car's history of accidents that the buyer may not be aware of, creating an imbalance of information.

Negative externalities can be best addressed by:

• Taxing the activity causing the externality

• Subsidising the activity causing the externality

• Removing government regulations

• Encouraging competition among firms

Answer explanation

Negative externalities are costs imposed on third parties by the production or consumption of a good. To address negative externalities, one effective approach is to impose taxes on the activity causing the externality. This tax can help internalise the costs and incentivise producers or consumers to take the external costs into account.