Question

1.)

Assume you see that two macroeconomic variables are correlated with each other. But you want to know if there’s an underlying or causal relationship between the two variables. Would you use an empirical or theoretical investigation? Explain why.

2.)

Identify six disadvantages of markets (i.e. cases of market failures).

Answer 1

Answer 1 - One would use a theoretical investigation. This is because empirical investigation can be useful in describing a macroeconomic phenomenon, but may not be adequate in explaining them. Empirical investigation can identify that the two macroeconomic variables are correlated, but cannot clarify if there’s a causal relation or underlying relation between the two. So, a theoretical investigation should be used because it can more closely examine complex relationships between the two macroeconomic variables and explain the phenomena.

Answer 2 -

Market failure is an economic situation described by inefficient allocation of goods and services. This happens when price mechanism fails to consider all the costs and benefits associated with the provision and consumption of a good. As a result, the market produces a good that is not socially optimal – it will be under or over produced. The structure of market systems is such that it leads to market failure. This is because in the real world, the presence of externalities (Positive and negative externalities), lack of public goods (not provided in free market), monopoly power (higher prices restricting output) and environmental concerns make it logically possible for all markets to be perfect.

• Positive and negative externalities : The effect on a third-party due to production or consumption of a good is known as externality. A positive externality is the benefit enjoyed by third party due to an economic transaction. (For example – Though public education benefits the students and schools, but an educated population has positive effects on the entire society). A negative externality can be described as a negative spill over or a cost imposed on third party from the production or consumption of a good or service. (For example - Passive smoking can deteriorate the health of the people, who are not directly engaged in smoking).
• Lack of public goods: Public goods are such goods where the total cost of production does not increase with the number of consumers. For example – National defense or police. Since they are non-rival and non-excludable, they can be under-produced because one can wait for someone else to provide it and then use it without incurring a cost. This problem of benefiting from goods and services without paying for it is known as the free rider problem.
• Underproduction of merit goods: A merit good is a private good that society assumes is under consumed. For example – education and healthcare. The society underestimates the benefit of the merit good, often with positive externalities.
• Overprovision of demerit goods: A demerit good is a private good which has negative externalities that society assumes is over consumed. For example – addictive goods which are harmful to health like alcohol and cigarettes. The society underestimates the costs of the demerit good.
• Abuse of monopoly power: Inefficient producers restrict output to maximize profit. Large firms can exploit suppliers by reducing their prices and consumers by charging higher prices to maximize profits, even in presence of competition.
• The nature of the exchange - Some markets fail depending on the nature of the economic exchange. Markets may have agency problems, informational asymmetry or significant transaction costs, which may result in economic inefficiency. This means that it may not be in the interest of one party to provide enough information. Examples are adverse selection and moral hazard. Most commonly, information asymmetries are studied in the context of principal–agent problems, where there are two agents with different objectives and information asymmetries.