Question

Question 3 an example of a market failure where the government intervention can be justified and a) Provide explain which of the four reasons makes it a market failure. b) Calculate the GDP using only those numbers that may be relevant from the following numbers Consumption S60B S10B $15B S10B S10B S6B S8B Government purchases Private Sec Savings Imports Exports e) Explain why Real GDP is more relevant for comparing the trends in GDP than a Nominal GDP?

Answer 1

a) Market failure refers to failure of competitive market to allocate resources efficiently or distribute goods efficiently. In the case of market failure, pareto optimality conditions are not satisfied. Causes of market failure:

a) Externalities: These can be defined as an impact of production and consumption of products affecting the third party. Externalities can be either positive or negative.

b) Public good: These are the goods that are characterised by non-excludability and non-rivalry. By non-excludability, it means that a good that benefits an individual can be used by others too to derive the same benefits. Non-rivalry implies that the enjoyment of using a product does not reduce the satisfaction of those who have been using it from a certain time. Example: Defense

c) Information asymmetry: It deals with the study of decisions in transactions, wherein one party has access to more or better information than others. Due to information asymmetry, the following two problems occur:

(i) Adverse selection: This implies taking the advantage of asymmetric information before transaction. For example, a person may be more eager to purchase life insurance due to health problems than, someone who is healthy.

(ii) Moral hazards: This implies taking the advantage of asymmetric information after transaction. For example, if someone has car insurance he may commit theft by getting his car stolen to reap the benefits of the insurance.

b) GDP = Consumption + Investment + Government spending + Exports - Imports

GDP = 60B + 10B + 10B + 8B - 6B

GDP = $ 82B

c) Real GDP is adjusted for inflation while nominal GDP does not. Nominal GDP only shows value in money terms and does not take into account inflation while Real GDP takes into account the inflation rate which makes it more relevant as compared to Nominal GDP.