Chapter 16 Notes
Questions pg. 404
1) A) The “formal defence” of free markets is that if all markets were perfectly competitive, then prices would equal marginal
cost for all products and the economy would be allocatively efficient.
B) The “informal defense” of free markets is based on three central arguments:
Automatic coordination of the actions of decentralized decision makers (speed and flexibility to market changes)
Pursuit of profits provides a stimulus for innovation and economic growth
Permits decentralization of economic power (freedom)
C) A situation in which the free market, in the absence of government intervention, fails to achieve allocative efficiency is
called market failure.
D) The four main market failures that justify some government intervention are:
Market power: firms with power will charge a price higher than marginal cost
Externalities: social and private marginal costs are not equal. Negative externality = too much output, positive externality =
too little input.
Excludable and Rivalrous Goods: Public Goods will be underprovided, common-property resources will be overused
Information asymmetries: moral hazard and adverse selection (lemons)
2) A) The marginal cost faced by the private decision-makers is known as private costs. The marginal cost faced by private
decision makers plus the cost imposed by third parties is known as social cost. If there is a divergence between these two marginal
costs then we can say that externalities are present.
B) An economic outcome is allocatively efficient when marginal social costs and marginal social benefit are equal.
C) Suppose a potato chip plant is operating beside a residential neighbourhood and produces noise and an unpleasant odour.
We can say that there is a negative externality because the marginal social private cost of producing potato chips is higher than the
private cost of producing potato chips. As a result, the free market is producing too many potato chips.
D) Suppose an apple orchard is operating beside a residential neighbourhood and provides beautiful blossoms and a pleasant
fragrance. We can say that there is a positive externality because the marginal social cost of apples is less than the marginal private
cost of apples. As a result, the free market is producing too little apples.
3) A) A good service that is rivalrous and excludable (restaurant meal, sofa) is known as a private good and is most efficiently
provided by the market.