1.3 Market Failure Flashcards
What is market failure?
Market failure is when the price mechanism causes an inefficient allocation of resources, leading to a net welfare loss.
What is an externality?
A cost or benefit which is external to an exhange.
What are external costs and benefits?
Give an example of each.
An external cost is a negative third party effect outside a market transaction. For example, pollution is an external cost of production in a chemical firm.
An external benefit is a positive third party effect outside of a market transaction. For example, the recycling of waste materials such as glass or paper in production.
What are private costs and benefits?
Private costs are costs (of production) paid by firms that are internal to a market transaction, and are therefore taken into account by the price mechanism.
Private benefits are benefits (from consuming a good/service) to consumers that are internal to a market transaction, and are therefore taken into account by the price mechanism.
What are social costs and benefits?
Social costs are the sum of private costs and external costs - aka the overall cost for society for production of a good.
Social benefits are the sum of private benefits and external benefits - aka the overall benefit (utility) for society from consuming a good
What is MSB, MSC, MPC and MPB?
- MSB = marignal social benefit, it is the benefit gained by society from consuming one additional good
- MSC = marginal social cost, it is the cost to society from producing one additional good
- MPC = marginal private cost, it is the additonal cost paid by producers for producing one additional good
- MPB = marginal private benefit, the benefit/utility derived by the consumer from producing one additonal good
What is the difference between free market equilibrium (QFE) and socially optimal equilibirum (QSO)
At free market equilibrium, MPB = MPC and externalities are not taken into account.
At socially optimum equilibirum, MSC = MSB and therefore external costs and benefits are taken into account. This means that there is no welfare loss or market failure.
Explain negative production externalities [6]
- The producer does not take society into account and therefore ignores external costs
- That means that MSC > MPC
- This means that they produce at an amount that is not socially optimal
- Instead they overproduce at the free market amount
- There is therefore an overallocation of resources, which is market failure. [QFE > QSO]
- This creates welfare loss.
Explain positive consumption externalities [6]
- The consumer does not take society into account and therefore ignores external benefits
- That means that MSB > MPB
- This means that they consume at an amount that is not socially optimal
- Instead they underconsume at the free market amount
- There is therefore an underallocationof resources, which ismarket failure. QSO > QFE
- This creates welfare loss.
What is an example of a negative production externality and a positive production externality?
- Negative - increased production of biofuels that kill rain forests and increase food prices
- Positive - Wind turbines and tidal power to create energy
What is an example of a negative consumption externality and a positive consumption externality?
- Negative - Excessive alcohol intake leading to vandalism
- Positive - Consumption of vaccinations, which reduce spread and so protect others from diseases.
What are three policies to correct the market failure of a negative production externality? What might prevent them from being effective?
- Indirect taxes - but causes welfare loss
- Regulation, legislation - but needs to be enforced
- Minimum prices - causes disequilibrium
What are three policies to correct the market failure of a positive consumption externality? What might prevent them from being effective?
- Subsidies - must be targeted correctly, waste?
- Direct provision - expensive, government inefficiency
- Information campaigns - must be targeted effectively
What is a public good?
A good that is non-rivalrous and non-excludable
aka one person’s consumption of it does not affect anothers, and you cannot stop individuals from consuming it
What is the problem called in the free market with regard to public goods? Explain this problem.
The “free-rider” problem:
- The market fails as it is not possible for firms to withold the product from those who do not pay for it
- A rational consumer will wait for someone else to pay and provide the good instead of paying for it, meaning everyone is waiting and it is not provided
- This leads to a missing market for the good.
