Market failure 1 - externalities

Question 1

What is an externality

Answer 1

When the trading of a product affects third parties

Question 2

Why are externalities bad

Answer 2

Only costs and benefits to the firm and consumer are taken into account so extra costs and benefits decreases allocative efficiency

Question 3

Describe the difference between negative externalities in production and consumption

Answer 3

• Negative externalities in production are caused by firms during production of goods and services
• Negative externalities in consumption are caused by households during the consumption of goods and services

Question 4

How is a negative externality in production shown on a diagram

Answer 4

Shift in of supply
- Supply is the private cost so the shifted in curve is the social cost

Question 5

What is the formula for marginal social cost

Answer 5

Marginal social cost = marginal private cost + external costs

Question 6

What is the formula that represents allocative efficiency

Answer 6

When Marginal social costs = marginal social benefits

(this takes into account all costs and benefits)

Question 7

How can externalities be solved on a diagram

Answer 7

Movement along the curve to the social optimum point, which is allocatively efficient

Question 8

What is deadweight loss

Answer 8

The difference in quantity demanded/supplied between the private and social optimum causing it not to be allocatively efficient

Question 9

Explain the tragedy of the commons

Answer 9

• Negative externalities caused by overconsumption
• If everyone makes rational individual decisions, everyone will be worse off in the long run

Question 10

What are the challenges of government intervention to correct market failure

Answer 10

• Difficult to assess the scale
• How best to intervene

If they get any these wrong, government failure occurs

Question 11

What are 2 good examples of a negative externality that requires government intervention

Answer 11

Global warming
Traffic congestion

Question 12

What are the 3 way that the government can tackle negative externalities

Answer 12

• Education
• Regulation
• Use of the price mechanism

Question 13

How does education prevent negative externalities

Answer 13

It raises awareness and prompts individuals and firms to change their behaviour

Question 14

What is 2 examples of regulation that has reduced negative externalities

Answer 14

Ban of smoking in public places from 2007
Rules about recycling

Question 15

Explain how the price mechanism can be used to reduce negative externalities

Answer 15

• Indirect tax shifts the supply curve to the left
• This reduces consumption and production, so closer to the social optimum
• turns negative externality into private costs to firm

e.g. london congestion charge

Question 16

What are the drawbacks of using education to prevent negative externalities

Answer 16

• Cost to tax payer
• people may not respond

Question 17

What are the drawbacks of using regulation to prevent negative externalities

Answer 17

-Works on firms much better than households because there are far less firms than households
- it is difficult to assess the appropriate levels of consumption for lots of different people

Question 18

What are the drawbacks of using the price mechanisms to prevent negative externalities

Answer 18

• Have to assess the price and cross elasticity of demand effectively
• Tax is regressive so an increase in price of a product affects poorer people more

Question 19

What are 3 government policies that could be used to prevent positive externalities

Answer 19

• Advertising to increase consumption
• Making goods/services compulsory
• Subsidy to reduce market price and encourage consumption