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Market Failure and the Role of Government

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Market Failure and the Role of Government

What happens when you have a factory polluting the air? Who bears the consequences of air pollution? Should the government step in? What is the government's role in this scenario? This is what market failures are all about, and this article will help you learn all about it.

Meaning of market failure

Market failure can be defined as a situation where there is an inefficient distribution of goods and services in the free market. Typically, this means the socially optimal output is not reached. A distortion can arise between the interests of different actors in the free market. The mismatch of the interests happens when there is a violation of the basic principles a free market.

According to free-market assumptions, all individuals are rational actors motivated by self-interest, and they respond to incentives. For the free market to operate, there also needs to be a system of clearly defined property rights. Finally, we need prices to accurately reflect the true social cost of production--all of the economic costs, even if those costs fall on individuals who are not participating in this market. If any of these factors are missing, there will likely be a market failure of some sort.

A market failure occurs when an assumption about free markets is violated. If there is a common resource that no one has private ownership of, then the market for using or consuming the resource will involve a market failure. Similarly, if there is a positive or negative externality, then market prices do not accurately reflect the true social cost of consumption or production, and there is a market failure.

Whenever the activities in a free market occur in such a way that there is a disequilibrium in goods demanded and supplied, then we can say that there is a market failure. The market fails to reach the socially optimal equilibrium outcome. Another way to say this is that the allocation of resources is inefficient. Governments often step in to take corrective action when there is a market failure, and the type of intervention depends on the type of market failure.

Causes and Types of market Failures

Market failures can take many forms. They generally arise from one of several sources:

  • positive or negative externalities
  • lack of information, also called asymmetric information
  • concentrated market power
  • public goods

Market Failure and the Role of Government: Externalities

An externality is a cost or benefit associated with a particular economic transaction that is incurred or benefited by an agent not directly involved in the transaction. It is important to know that an externality can be positive or negative.

One example of a negative externality is pollution. There are many companies that produce certain goods, and during the production process, they pollute the air or water. The good is sold in the market to interested buyers at a price that accounts for only the company's costs of production. Any pollution caused in the production process is unaccounted for in the pricing of the goods. However, the pollution affects the whole community living in the region, and such an externality causes a market failure.

How do governments deal with externalities such as pollution? Well, the first thing to recognize is that pollution has both a benefit and a cost and therefore should not be completely zero at the socially optimal outcome. The benefit of the pollution is the ability to manufacture the goods without spending more money, and the cost of the pollution is the well-being of the people affected.

By ceasing the company's production process altogether, all of the consumers who were enjoying the good would lose the benefit of their enjoyment, which could be larger than the negative effects of the pollution. Instead, the efficient level of pollution is the level where the true marginal cost of the production process, including any externalities, equals the true marginal benefit to society of consuming the good. When the marginal cost and marginal benefit of an externality are equal, a socially optimal point is reached.

Figure 1 shows a fictional market for the pollution itself. The "demand for pollution" is the marginal social benefit of the next consumer who gets to enjoy the good. The "supply of pollution" is the marginal social cost of the next individual harmed by the pollution. The socially optimal outcome is where the marginal cost of pollution and marginal benefit equal each other. At that point the quantity of pollution should be Q* at a price of P*.

market failure role of government dealing with externalities studysmarterFigure 1. Dealing with externalities, StudySmarter Original

If the market clears in a way that the socially optimal pollution is produced, then the markets are efficient and hence there is no market failure. This is, however, not the case in many instances in the real world. In many instances, the costs of pollution are incurred by society because companies do not have the incentive to prevent pollution.

If left unregulated, pollution is produced beyond the socially optimal point. This is because preventing pollution is costly, and the company does not receive direct economic benefits. Pollution is an example of an external cost.

An external cost is any negative externality created by a firm's operations and imposed on other people without compensation.

Market Failure and the Role of Government: Lack of Information (Information Asymmetry)

Another assumption that is important to ensure that free markets are efficient is that all agents have perfect information. If buyers and sellers have accurate information about the good they are buying and its quality and characteristics, then prices accurately reflect production costs, and markets clear efficiently.

However, instead there may be information asymmetry. That means one side of the market--typically the sellers--have more accurate information than the other side of the market--typically the buyers. Since sellers only earn revenue when they make a sale, their incentive is to share only the information that will help them to sell the product. In the presence of information asymmetry, a market may never reach the socially optimal equilibrium price and quantity; hence market failure occurs.

When you buy a used car from your neighbor who wants to sell her car, your neighbor has much more detailed information about exactly how well that car has been operating and how well she has taken care of it. You and your neighbor have asymmetric, or different, information about the car. If you don't trust your neighbor to be honest with you about the shape the car is in, you probably won't want to buy it. This is an example of a market failure.

You can see a lack of information, or asymmetric information, present in many industries in the real world, including financial markets. To fix the problem of asymmetric information, governments usually require companies to share key information about their products or business operations. This is especially true in the stock market, where every publicly traded company is required by law to disclose its financial situation.

Market Failure and the Role of Government: Concentrated Market Powers

A free market is one in which no single entity has control over the market. This means that the forces of demand and supply are allowed to shift and determine the market price. The self-regulating aspect of competitive markets fails, however, if a single entity can control one side of the market, either the demand or supply.

Such power is possible in a monopoly market. A monopoly occurs when a single firm is the sole producer of the good. The monopoly firm can adjust production to maximize its own profits without considering the general welfare of the society. Having monopoly power is considered an artificial control of production. It hinders the market forces of demand and supply, which leads to market failure.

Market Failure and the Role of Government: Public Goods

To understand how public goods cause a market failure, we first need to understand the concept of a public good. There are two characteristics of goods used to classify goods. They are:

  • Excludability--A good is excludable if the supplier can prevent those who do not pay for it from consuming it
  • Rival in consumption--With a rival good, each unit can only be consumed by one person

Milk is sold in any number of grocery stores. This is because milk is excludable and rival. Each store can provide a gallon container of milk only to the people who are willing to purchase it, and once the gallon is consumed, it is no longer consumable by anyone else.

The construction of new roads is provided by the government. Roads can be very useful for getting to the grocery store! However, they can be used by the whole population, regardless of who paid the taxes that paid for the construction of the road. That's because they are nonexcludable. In addition, roads are nonrival because using the road still leaves it available for others to use after you.

Public goods are both nonexcludable and nonrival in consumption. These two properties create the free-rider problem. A public good is socially beneficial, and in the absence of intervention, the free market will underprovide any public good. This is called the free-rider problem. Private companies cannot operate efficiently to provide public goods due to a lack of incentives, since everyone can consume the good together once it has been produced. This is a market failure.

That's what leads to government interventions for the provision of public goods.

Government Interventions in Market Failure

Market failure occurs when the market outcome is inefficient, and therefore, the government may step in to correct the market. Under certain assumptions, free markets are able to self-regulate through competition, in the absence of government intervention. When there is not enough competition in the market,

One broad approach the government uses is ensuring competition in the market. The government promotes competition by preventing anticompetitive market structures such as monopoly and oligopoly. Monopiles are only allowed when it is a natural monopoly. Even with natural monopolies, the government has oversight to ensure the production of goods is carried out efficiently. Therefore, the government promotes competition by preventing unnatural monopolies and ensuring natural monopolies are not manipulating the demand and supply process.

The government promotes competition by establishing legal frameworks and policies that prevent the formation of monopolies and other anticompetitive market structures. One policy used is the antitrust policy. The first antitrust act in America is the Sherman antitrust act. The Sherman antitrust act is the three major federal antitrust law. The act was passed in 1890. The Sherman antitrust prevents the artificial restraining of interstate trade and monopolizes interstate trade and commerce.

The other two antitrust acts are the Clayton antitrust act and the federal trade commission act. The department of justice has an antitrust division that oversees antitrust laws. The goals of the antitrust laws are to protect competition, ensure lower prices, and promote the development of new products.

The Clayton antitrust act was implemented to clarify the Sherman antitrust act since the Sherman act was not clear on specific practices. Clayton made it illegal to make price discrimination, anticompetitive practices, anticompetitive mergers and acquisition, and interlocking directorates.

The federal trade act was passed in 1914 and was intended to create a federal trade act (FTC) and make it illegal to use unfair methods of competition in interstate trade.

Types of Government Interventions in the Market

There are several different ways that a government can intervene in a market when there is a market failure. Regulation and price mechanisms typically do not bring about the socially optimal outcome, but taxes, subsidies, and government provision of public goods have the potential to correct market failures and create socially optimal outcomes. In addition, the U.S. government interventions often aim to simply bolster the competitive environment. Each of these types of government interventions into markets are discussed below.

Market Failure and the Role of Government: Regulation

One option the government has is outright regulation of an industry or behavior. The government can create standards that businesses must follow, or enact bans on certain goods. If the government simply made pollution illegal, then companies would have to find a way to manufacture their goods without causing pollution. The outcome would be zero pollution, but fewer goods and higher prices due to higher production costs.

Market Failure and the Role of Government: Price Mechanisms

The government may use price mechanisms like price ceilings or price floors to correct what it sees as a market failure. Rent control is an example of a price ceiling.

Market Failure and the Role of Government: Taxes

The government can levy a tax to correct a market failure. For example, in the case of pollution, the government can tax the goods whose manufacture causes pollution. This can lead to the socially optimal level of pollution being attained. In the absence of the tax, market forces do not account for pollution since it is a negative externality not incurred by the company. Therefore, the government can enforce a pollution tax that the consumer incurs, and this can bring about the socially optimal quantity.

Market Failure and the Role of Government: Subsidies

In the case of a positive externality, the government could impose a subsidy to correct a market failure. The government subsidizes a lot of farming operations to ensure that they can weather temporary downturns and continue to provide food for people to eat. A subsidy works just like a tax to bring the market to the socially optimal outcome.

Market Failure and the Role of Government: Provision of Public Goods

Some goods that are associated with market failures are also essential to people. These include electricity, water and sanitation, transport, and other public amenities. Private firms do not have enough incentives to provide public goods because they are nonexcludable and nonrival. The government steps in to cover the cost of such goods and services by producing them itself, since there are essential.

Market Failure and the Role of Government: Promoting Competition

The U.S. government tries to take a minimalist approach to market interventions by promoting competition in hopes that the market forces will then provide self regulation. The best way to promote competition is break up any monopolies and oligopolies. The government's mechanism is through enforcement of anti-trust laws.

Examples of Market Failures

Some common example markets failure include pollution, education, healthcare, water supply, cigarette smoking, alcohol consumption, defense, and policing. Most of the market failures are associated with negative impacts, but some market failures have positive benefits. Education is an example of a positive externality. Although the government spends tax revenue on public education, the improvement in human capital benefits the whole society.

Market Failure and the Role of the Government - Key Takeaways

  • Market failure can be defined as a situation where there is an inefficient distribution of goods and services in the free market.
  • When activities in the free market occur in such a way that there is a disequilibrium in goods demanded and supplied, there is an inefficient allocation of resources--market failure.
  • Market failure can be caused by externalities, lack of information, concentrated market control, or public goods.
  • When the marginal cost and marginal benefit of an externality are equal, the market has reached a socially optimal quantity of it.
  • When the market outcome is inefficient, the government may step with corrective measures.
  • Under certain assumptions, free markets can self-regulate through competition in the absence of government intervention.
  • Government intervention can take the form of regulation, taxes or subsidies, providing a public good, or promoting a competitive market environment by enforcing anti-trust laws.
  • Some common examples of market failure include pollution, education, healthcare, water supply, cigarette smoking, alcohol consumption, defense, and policing.

Frequently Asked Questions about Market Failure and the Role of Government

Market failure can be defined as a situation where there is an inefficient distribution of goods and services in the free market. 

When activities in the free market occur in such a way that there is a disequilibrium in goods demanded and supplied, then we can say that there is a markets failure, and the allocation of resources occurs in an inefficient way.

Common interventions can include (1) regulations and standards, (2) taxes and subsidies, (3) promoting competition through enforcing antitrust laws, and (4) providing public goods.

Market failure types include externalities, lack of information, concentrated market control, and the public good.

Yes it can, if the government chooses the wrong policy to address a market failure, or levies a tax that is not the optimal size, then the outcome might still be market failure. Sometimes government intervention is not even warranted and actually causes a market failure in an otherwise efficient market.

Final Market Failure and the Role of Government Quiz

Question

What is market failure?

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Answer

Market failure can be defined as a situation where there is an inefficient distribution of goods and services in the free market. This occurs due to a violation of one of the assumptions about markets--perfect information, competitive environment, true social costs.

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Question

What happens to the allocation of resources when there is a market failure?

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Answer

When activities in the free market occur in such a way that there is a disequilibrium in goods demanded and supplied, then we can say that there is a markets failure, and the allocation of resources occurs in an inefficient way.

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Question

What are the types of market failure?

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Answer

Market failure types include externalities, lack of information, market control, and the public good.

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Question

What are externalities?

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Answer

An externality is a cost or benefit associated with a particular economic transaction that is incurred or benefited by an agent not involved in the transaction. It is important to know that an externality can be positive or negative.

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Question

What's an example of externalities?

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Answer

A good example is a pollution.

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Question

How do governments deal with externalities such as pollution? 

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Well, in such a case, pollution should not be completely zero as it will come with the ceasing of the company's production process, and it will cause more costs to the economy. In this case, the pollution should be at levels where the marginal cost and marginal benefit coming from the solution is equal.

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Question

When is a socially optimal point reached in an economy?

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When the marginal cost and marginal benefit of an externality are equal, a socially optimal point is reached in the economy.

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Question

What happens when the market reaches the socially optimal point?

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If the market clears in a way that the socially optimal pollution is produced, then the markets are efficient and hence no market failures. This is, however, not the case in many instances in the real world. In many instances, pollution turns out to be an external cost incurred by society if left unregulated.

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Question

Explain lack of information as a cause of market failure?

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Answer

Free markets are efficient because all agents are assumed to have perfect information. If buyers and sellers have the correct information in the market, then prices reflected are considered to be accurate, and the markets clear efficiently.

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Question

Explain how concentrated market powers cause externalities? 

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Answer

Free markets are possible because there is no single entity that has control over the market. This means that forces of demand and supply control prices. The self-regulating aspect of markets fails if a single entity can control either the demand or supply. This is possible in monopoly markets.

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Question

What is an example of a concentrated market power?

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Answer

Monopoly.

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Question

What's one of the main interventions of government in the market?

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One broad approach the government uses is ensuring competition in the market. The government promotes competition by preventing anticompetitive market structures such as monopoly and oligopoly.

Show question

Question

Why governments have to step in when there's a market failure?

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Answer

Because in the case of market failure, the market is incapable of regulating itself.

Show question

Question

How does the government promote competition?

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Answer

The government promotes competition by establishing legal frameworks and policies that prevent the formation of monopolies and other anticompetitive market. structures.

Show question

Question

What are three types of government intervention in the market?

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Answer

Regulation and Standards, 

Taxes and Subsidies

Provision of Public Goods


Show question

Question

Explain taxes and subsidies as a government intervention in market failures.

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The government can also use taxes and subsidies to intervene in market failures. For example the case of pollution, the government can tax goods associated with pollution such that the socially optimal pollution is attained. The market forces do not accommodate pollution since it is a negative externality. Therefore, the government has to enforce a pollution tax that the product user incurs. 

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Question

Explain provision of public goods as a government intervention in the market failure.

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Answer

The government might also use provision of public goods to prevent market failures. Some goods are associated with market failures, yet they are essential to people. These include electricity, water and sanitation, transport, and other public amenities. Private firms do not have enough incentives to provide such goods and services. 

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Question

Mention some examples of market failure.

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Answer

Some common example markets failure include pollution, education, healthcare, water supply, cigarette smoking, alcohol consumption, defense, and policing

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Question

What is the link of the Gini coefficient with the Lorenz curve?

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You can calculate the Gini coefficient from the Lorenz curve. Gini coefficient measures how far the Lorenz curve is from the line of equality.


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What is the Lorenz curve?

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Lorenz Curve is a graphical representation of the distribution of income or wealth within an economy.


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Why is the Lorenz curve important?

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The Lorenz curve is an important inequality metric since it allows economists to measure income and wealth inequality in an economy and compare across countries or regions. 


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The further the Lorenz curve is to the line of equality the higher the income or wealth inequality in an economy. 

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True

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What is the other name of the 45° straight line in the Lorenz curve?

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The line of equality

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The 35° straight line in the Lorenz curve shows perfect equality in income where everyone in the economy receives the same income. 

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False

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What does it mean when the Lorenz curve moves closer to the 45° straight line?

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It means that income or wealth inequality decreases in an economy.


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When comparing two Lorenz curves, if two Lorenz curves intersect, we cannot compare the inequality level across both.

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True

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Which one is not a limitation of the Lorenz Curve?

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The Lorenz curve ignores the life cycle effect.

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What is measured on the x-axis of a Lorenz curve?

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The x-axis on a Lorenz curve shows the percentage of the total population.

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What is measured on the y-axis of a Lorenz curve?

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The y-axis on a Lorenz curve shows the percentage of total income or wealth.

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Why do economists use the Lorenz curve?

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Answer

to show the population growth rate

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Assume that country A has a Gini coefficient of 0.8, and Country B has a Gini coefficient of 0.4. Which of the countries has more equally distributed income?

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Counrty A

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A high Gini coefficient means income or wealth is distributed unequally.

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True

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The larger the gap between the Lorenz curve and the perfect equality line, the bigger the amount of income equality.

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True

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What is the Gini coefficient?

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Gini coefficient is an index that measures income distribution across a population.


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What does it mean that the Gini coefficient is 1?

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If the Gini is 1, it means perfect inequality

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What does it mean that the Gini coefficient is 0?

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If the Gini is 0, it means perfect equality

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A Gini coefficient closer to 0 means that there is less income inequality in the society

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True

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If the Gini coefficient is 1, it means every individual receives the same amount of income.

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True

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Gini coefficient measures how far the Lorenz curve is from the 45° line of equality.

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True

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What does a lower Gini coefficient illustrate? 


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The lower Gini coefficient illustrates more equally distributed income or wealth across populations in the economy. 


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If the Lorenz curve goes further from the 45° line of equality, how does the Gini coefficient change? 

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The Gini coefficient rises closer to 1.

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If the Lorenz curve is closer to the 45° line of equality, the Gini coefficient would be close to 0.

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True

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Which one is not a limitation of the Gini coefficient? 

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Answer

Through the conversion of the Lorenz curve to a number, we might lose some important information.

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US's Gini coefficient is around 0.4 and 0.45, which is higher than Europe and less than Africa on average.

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True

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Assume Country A's Gini coefficient is 0.9 and Country B's coefficient is 0.3. Which country has a more equal distribution of income?

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Country A

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Question

What does it mean for a good to be excludable?

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Excludable means that access to the good can be restricted

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What does it mean for a good to be nonexcludable?

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Nonexcludable means that access to the good cannot be restricted

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What does it mean for a good to rivalrous?

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Rivalrous means that availability of the good is limited. One person using the good can reduce the availability for others.

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What does it mean for a good to be nonrivalrous?

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Nonrivalrous means that availability of the good is not limited. One person using the good does not reduce the availability for others.

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What is a public good?

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A public good is a good that is nonexcludable and nonrivalrous

Show question

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