Chapter 5: Market failure and negative externalities Flashcards Preview

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Flashcards in Chapter 5: Market failure and negative externalities Deck (60):

What is market failure?

When market forces fail to deliver the best level of output for society, which leads to a loss of welfare.


When is market failure said to exist?

When the price mechanism fails to deliver the optimal and most efficient allocation of resources such that the best level of output for society is reached.


What is the price mechanism?

The demand and supply model.


How can a government intervene to try and correct market failure?

Information, taxing, subsidising or legislating.


What might happen as a result of government intervention?

The outcome may be a deepening of the market failure, a new failure may arise or the intervention strategy is just ineffective.


When does government failure exist?

When government intervention leads to a less efficient allocation of resources.


What is public choice theory?

It assumes that individuals seek to maximise satisfaction and firms seek to maximise profits.


Why do economists question whether politicians' motives are consistent with the pursuit of policies to correct market failure?

Politicians attempt to maximise their own self-interest through maximising votes.


What are negative externalities/external costs?

They are the third-party or spill-over effects arising from the production and/or consumption of goods and services.


When do negative externalities exist?

When the social costs of an economic action are greater than the private costs.


What is the formula for social costs?

Private costs + external costs = social costs


What needs to happen in order for the optimal level of production to occur where all costs and benefits are taken into account?

The market should produce at the output and price level where the marginal social cost is equal to the marginal social benefit.


What is a demerit good?

A good that is valued more by the individual than society so the marginal private benefits are higher than the marginal social benefits.


Give an example of negative externalities from consumption.

The consumption of too much alcohol may impose spill-over costs on society such as drink-driving, violence, days off work and domestic abuse.


What are the axis labelled on an externalities graph?

Costs and benefits are along the y axis and quantity is on the x axis.


What are the demand curves on an externalities graph labelled?

Marginal social benefit and marginal private benefit.


What are the supply curves on an externalities graph labelled?

Marginal social cost and marginal private cost.


Which area on a graph for a demerit good represents the net welfare loss?

It is a triangle. Its largest side is the distance between the benefits curves.


What does the MPB curve represent on a graph for a demerit good?

An individual's satisfaction from the consumption of the demerit good.


When can a complete ban be justified?

When the social marginal cost of consumption is always higher than the social marginal benefit i.e. the two curves do not intersect.


What does the combined area of consumer and producer surplus indicate?

The welfare from the production and consumption of a product.


What happens in the region of consumer and producer surplus?

The marginal benefit is higher than the marginal cost.


What would happen if the producer of a product were to take into account all the external costs and what represents this?

Their costs of production would be higher and this is represented by the marginal social cost curve.


What does the vertical distance between the two supply curves that reflect costs show?

The size of the negative externality.


What is a net welfare loss?

An area of negative welfare for society.


What area is net welfare loss represented by on a diagram where the marginal social cost is higher than the marginal private cost?

It is a triangle and its largest side is the distance between the marginal social cost and the marginal social benefit.


What is the market failure with demerit goods?

The free market will overproduce demerit goods.


What is the point of government intervention when negative externalities exist?

The government tries to make firms internalise their costs.


How are taxes a method of government intervention?

If the government were to introduce a tax equal to the negative externality then this would shift the firm's marginal private cost curve to the left.


What are the results of imposing a tax onto a product?

There is a fall in the production and consumption of the product but also there is a reduction in the size of the net welfare loss.


What is 'shifting the burden of the tax'?

When the supplier may be able to pass on some or all of the tax onto the consumer through a higher price.


What does shifting the burden of the tax depend on?

It depends on the price elasticity of demand and supply.


What is the problem with using taxes as a method of intervention?

It is often difficult for governments to estimate optimal levels of tax as it is difficult to place monetary values on negative externalities.


What is the effect of taxes raising the price of a good or service?

This reduces consumer surplus, it may have an adverse effect on low income groups and it reduces the international competitiveness of a good or service if the producer markets their goods abroad.


What is the problem with environmental taxes?

They require the agreement of a number of countries which can be extremely difficult.


How is legislation a method of government intervention?

The government can pass laws to correct or prevent negative externalities.


What is an example of legislation that has been passed in order to reduce the size of a negative externality?

Drink driving is against the law.


When is a policy likely to be more effective?

When the policy has the force of the law rather than being a voluntary agreement.


What is the effectiveness of a policy dependent on?

How effective the enforcement of the policy is and the size of any penalties.


Why do the costs of enforcement need to be considered?

There could be an opportunity cost associated with this.


What is the time lag associated with legislation?

It takes time to introduce new laws and there may be a time lag before legislation is passed.


What is the problem with legislation being imposed in one country only?

It may be ineffective - there may need to be a global agreement to prevent firms from evading regulation.


What impact does legislation have on revenue unlike taxation?

It will not raise revenue.


What are property rights?

Legal rights of ownership.


When does legislation tend to work best in terms of property rights?

When property rights are clearly defined.


When do negative externalities tend to occur in terms of property rights?

When there are ill-defined or non-existent property rights.


Give examples of things that are polluted as a result of no one owning these assets.

Air, the atmosphere and oceans.


Why is it the case that a privately owned river is less likely to be polluted than a public river?

The private owner would have a clear incentive to sue anyone who polluted their river and claim compensation too.


What is the solution to negative externalities in terms of property rights?

Allocating ownership of the product that is experiencing the negative externalities as this would produce an efficient outcome.


What is the problem with legally protecting the rights of the owners of environmental resources?

This carries a cost and may be difficult.


What does the EU Emissions Trading scheme do?

It incentivises the reduction of CO2 emissions in a cost-effective and efficient manner.


How does the EU scheme operate?

Through the trade of CO2 emissions allowances, one allowance represents one tonne of CO2.


What is the effect of setting a cap on emissions?

It creates the scarcity required in the market.


What happens to those firms who have released more CO2 than they have allowances for?

They are heavily fined.


What is the aim of carbon trading?

Policy can help to internalise environmental costs of firms' production and encourage lower emissions to tackle climate change.


What happens in a cap and trade system?

The number of available permits would gradually decline.


What is the effect of the number of permits reducing?

The supply curve shifts inwards (which is a vertical line) causing the price to increase - this encourages investment into cleaner technologies.


What is the problem with the EU Emissions trading scheme?

The recession reduced industrial demand for the permits and the EU gave away too many allowances in the first place.


What is the result of giving out too many allowances?

There is massive overcapacity in the carbon market which has led to a sharp decrease in the price of permits.


What is the problem with the scheme targeting production rather than consumption?

It has resulted in the closure of industrial plants in the EU and firms have instead moved them to Asia which has affected the competitiveness of the EU. Consumption has been increasing which means that there is more pollution.