Chapter 7 Flashcards
Define equity and explain how this applies to economics.
A fair distribution of resources. The free market fails to lead to a fair distribution of resources if it results in some people living in great affluence while others live in dire poverty.
Define social efficiency.
Production and consumption at the point where marginal social benefits equal marginal social costs. Thus: MSB > MSC = produce more; MSC > MSB = produce less; MSB = MSC = keep production at its current level.
Social efficiency is an example of “allocative efficiency” i.e., the best allocation of resources between alternative uses.
Define the general equilibrium.
Markets are in a constant state of flux; changes in demand and supply cause markets to adjust to a new equilibrium. Thus, it is useful to look at the overall equilibrium to which markets are heading: the general equilibrium.
What makes an economy where all markets are perfectly competitive and there are no externalities socially efficient when there is a state of general equilibrium?
In the absence of externalities, benefits from consumption are confined to consumers. I.e., as members of society their benefit is the whole social benefit. P = MU = MSB. Likewise, the costs of production are confined to the producers: there are no costs imposed on other members of society P = MC = MSC.
What are externalities and how do they contribute to market failure?
Externalities are the side effects, or “third-party” effects, of production or consumption. i.e., the actions of producers or consumers that affect people other than themselves. They can be positive or negative. If other people are affected beneficially, there are said to be external benefits (vs external costs).
Thus, the full cost to society (the social cost) of the production of any good or service is the private cost faced by firms plus an externalities of production (positive or negative). Likewise, the full benefit to society (the social benefit) from the consumption of any good is the private benefit enjoyed by consumers plus any externalities of consumption (positive or negative). There are 4 main types of externality.
Define the external costs of production (MSC > MC)
Most common and important form of externality. E.g., when waste is dumped into a river, the community bears costs additional to those borne by the firm. The marginal social cost (MSC) of chemical production exceeds the marginal private cost (MC). The MSC curve is above the MC curve. This problem occurs in a free-market economy because no one has legal ownership of air/rivers, and no-one cause prevent or charge for their use. Thus control must be left to the government.
Define the external benefits of production (MSC < MC)
If a timber company plants new woodlands, there is a benefit not only to the company itself but also to the world. Thus the marginal social cost of providing timber is less than the marginal private cost to the company. The MSC curve is below the MC curve.
Define the external costs of consumption (MSB < MB)
When people use their cars, other people suffer from the exhaust fumes, congestion, noise, etc. These negative externalities make the marginal social benefit of using cars less than the marginal private benefit for the motorist. Thus, the MSB curve is below the MB curve. When there are negative externalities in consumption, the actual level of consumption is too great from society’s point of view.
Define the external benefits of consumption (MSB > MB)
When people travel by train, etc other people benefit by there being less congestion/accidents/exhaust. Thus, the marginal social benefit of rail travel is greater than the marginal private benefit to the rail passenger. There are external benefits from rail travel. The MSB curve is above the private MB curve.
To summarise: whenever there are external benefits, there will be too little produced or consumed. Whenever there are external costs, there will be too much produced or consumed. The market will not equate MSB and MSC.
What are public goods and how do they contribute to market failure?
A category of goods where the positive externalities are so great that the free market would not produce them at all (e.g., street light and public services such as police).
What 2 characteristics do public goods have?
- Non-rivalry. Where the consumption of a good or service by one person will not prevent others from enjoying it. This makes them socially desirable, but privately unprofitable (e.g., footpath; no single individual would pay to have this built along their street as the private benefit is too small relative to the cost).
- Non-excludability. Where it is not possible to provide a good or service to one person without it thereby being available to others to enjoy. Others would get the benefits for free and have no incentive to pay themselves. This is known as the free-rider problem (where it is not possible to exclude other people from consuming a good that someone has bought).
How does monopoly power contribute to market failure?
Whenever markets are imperfect the market will fail to equate MSB and MC even if there are no externalities. A monopoly will produce less than the socially efficient output.
What is deadweight loss under monopoly?
Consumer and producer surplus. Consumer surplus is the excess of consumers’ total benefit (or utility) from consuming a good over their total expenditure on it. Producer surplus is another name for profit. Monopoly profits are larger than profits under perfect competition. Consumer surplus, however, will be much smaller. The net loss of total surplus is known as the deadweight welfare loss of monopoly.
How does ignorance and poor decision making contribute to market failure?
There is often a great deal of ignorance and uncertainty from consumers and producers. Some goods are only purchased a few times in a lifetime. Consumers may not be aware of quality until after they purchase these goods. Advertising can contribute to ignorance by misleading people.
Firms are often ignorant of ways to be more efficient, prices, costs, etc. Thus, the government may feel the need to protect people from poor economic decisions on their own behalf. It may feel people will consume too many harmful things (taxes to discourage smoking). It may feel that people consume too little of things that are good for them (i.e., merit goods). Thus, it may subsidise these or provide them for free (e.g., healthcare).
How can people lose from poor decision made by others acting on their behalf?
Principal-agent problem. Inherent danger for the principal: there is asymmetric information. The agent knows more about the situation than the principal. The agent may not act in the principal’s best interests and may get away with it because of the principal’s imperfect knowledge.
