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 resources. -Be able to define and explain different kinds of market failure (ideally in terms of a misallocation of scarce resources). -Consider different scenarios and apply economic concepts, terms and information appropriately Learning objective: 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? llll KEY TERMS 1.Allocative efficiency 2.Market Failure 3.Perfect Information 4.Asymmetrical information 5.Moral Hazard 6.Demerit goods 7.Public goods

Key Words What 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 QUESTIONS To what extent do markets allocate resources 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 and why are they an example of market failure? Costs to household e.g. Benefits to household e.g Benefits to energy producer e.g Costs to energy producer e.g. What are the external costs of producing energy with fossil fuels ?

Public Goods To what extent do markets allocate resources efficiently? The Thames Barrier is an example of a good with public good properties. Public goods – those goods that have non excludable and non rival consumption. Non excludability: it is not possible to stop somebody consuming this good. Non rivallry: one person’s consumption does not affect the consumption of another person. It is difficult to charge people for using public goods (free riders). This creates a disincentive for firms to produce goods with these properties. The Thames Barrier is an example of a good with public good properties. Public goods – those goods that have non excludable and non rival consumption. Non excludability: it is not possible to stop somebody consuming this good. Non rivallry: one person’s consumption does not affect the consumption of another person. It is difficult to charge people for using public goods (free riders). This creates a disincentive for firms to produce goods with these properties. Why is consumption of the barrier non excludable and non rival? Why might the Thames Barrier have free riders if it was left to the market mechanism to provide this good? Why would it be difficult for a firm to build the barrier and make a profit from doing so? Why is consumption of the barrier non excludable and non rival? Why might the Thames Barrier have free riders if it was left to the market mechanism to provide this good? Why would it be difficult for a firm to build the barrier and make a profit from doing so?

Public Goods To what extent do markets allocate resources efficiently? Why does the BBC have public good properties? How does this explain the licence fee paid by everybody who owns a colour tv? Why does the BBC have public good properties? How does this explain the licence fee paid by everybody who owns a colour tv?

Using supply and demand diagrams to illustrate market failures? What are externalities and why are they an example of market failure? Using supply and diagrams to illustrate market failures What are externalities and why are they an example of market failure? Price per unit of ofenergyPrice per unit of ofenergy Quantity of Energy Energy DD SS PP QQ S1S1 P1P1 Q1Q1 In the diagram, the amount of energy that would be consumed if private costs and benefits, alone, were taken into account is equal to Q with price per unit of energy P. However, if the external costs of energy production were also taken into account then supply would shift from S to S1. Higher costs would mean that price would increase to P1 per unit and less energy would be consumer (Q1). The diagram also helps to illustrate the market failure created by the existence of external costs. The external costs mean that too much of our scarce resources are allocated to energy production and, energy is over consumed by Q – Q1, if left to market forces alone.

Positive Externalities? What are externalities and why are they an example of market failure? Besides the entertainment provided for all of us by University Challenge, what positive externalities are created by people studying up to higher education?

Using supply and demand diagrams to illustrate market failures? What are externalities and why are they an example of market failure? Using supply and diagrams to illustrate market failures What are externalities and why are they an example of market failure? PricePrice QuantityEnergyQuantityEnergy DD SS PP QQ P1P1 Q1Q1 In the diagram, the amount of that would be consumed if private costs and benefits, alone, were taken into account is equal to Q with price equal to P. However, if the external benefits of were also taken into account then demand would increase from D to D1. Higher demand would mean that price would increase to P1 but also that more would be consumed (Q1). The diagram also helps to illustrate the market failure created by the existence of external benefits. The external benefits mean that not enough of our scarce resources are allocated to and, is under consumed by Q – Q1, if left to market forces alone. D1D1

CW Merit and Demerit goods Date:…………. CW Merit and Demerit goods Date:…………. What are merit and demerit goods and why are they an example of market failure? Learn about merit and demerit goods. Learning objective: STARTER: Why, if left to our own devices, would we spend less on healthcare than we should? goods.html goods.html

Using supply and demand diagrams to illustrate market failures? What are externalities and why are they an example of market failure? Using supply and diagrams to illustrate market failures What are merit and demerit goods and why are they an example of market failure? Price per unit ofhealthcarePrice ofhealthcare Quantity of healthcare healthcare DD SS PP QQ P1P1 Q1Q1 In the diagram, the quantity of healthcare that would be consumed if we were left to our own devices would be equal to Q with price equal to P. However, if the full benefits of healthcare were known then demand would increase from D to D1. Higher demand would mean that price would increase to P1 but also that more would be consumed (Q1). The diagram also helps to illustrate the market failure created by the existence of merit goods. Not enough of our scarce resources are allocated to the production of merits goods ; they are under consumed by Q – Q1, if left to market forces alone. D1D1

Using supply and demand diagrams to illustrate market failures? What are externalities and why are they an example of market failure? Using supply and diagrams to illustrate market failures What are merit and demerit goods and why are they an example of market failure? Price per unit ofalcoholPrice ofalcohol Quantity of alcohol alcohol D1D1 SS P1P1 Q1Q1 PP QQ Without perfect knowledge of the benefits of alcohol consumption, we consume a quantity equal to Q with price equal to P. However, if the true benefits of alcohol consumption were known then demand could fall from D to D1. Lower demand would mean that less would be consumed and price would fall until a new equilibrium is establised with price P1 and quantity Q1. The diagram also helps to illustrate the market failure created by the existence of demerit goods. To many of our scarce resources are allocated to the production of demerits goods ; they are over consumed by Q – Q1, if left to market forces alone. DD

CW Information Failure Date:…………. CW Information Failure Date:…………. What is information failure and why can it result in market failure? Learn about information failure. Learning objective: STARTER: What is a good price for these products? Why is not knowing what a good price is, a problem? What other examples can you think of, of situations where you have a lack of information?

Information Failure and Market Failure What is information failure and why can it result in market failure? What are the chances that, if you smoke, you will be killed by a smoking related illness? king-the-facts king-the-facts How can this, and the other examples of information failure lead to market failure?

What don’t we have information about? What is information failure and why can it result in market failure? There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know. What don’t we have information about? All of the options available in the present. The true benefits and costs of the options available. The future.

Using supply and demand diagrams to illustrate market failures? What are externalities and why are they an example of market failure? Using supply and diagrams to illustrate market failures What is information failure and why can it result in market failure? PriceperpacketOfcigarettes PriceperpacketOfcigarettes Quantity of cigarettes cigarettes D1D1 SS P1P1 Q1Q1 PP QQ Without perfect knowledge of the costs of smoking, we consume a quantity equal to Q with price equal to P. However, if the true costs of smoking were known then demand could fall from D to D1. Lower demand would mean that less would be consumed and price would fall until a new equilibrium is established with price P1 and quantity Q1. The diagram also helps to illustrate the market failure created by the existence of information failure. To many of our scarce resources are allocated to the production of demerits goods ; they are over consumed by Q – Q1, if left to market forces alone. DD