market failure Flashcards
(33 cards)
What is market failure
When the price mechanism leads to a misallocation of resources
What are the three types of market failure
- Externalities
- Under provision of public goods
- Information gaps
What is an externality
unintended side effects that affect third parties who are not part of the transaction.
What is a negative consumption externality
when the consumption of a good or service imposes external costs on third parties who are not involved in the transaction
What is a negative production externality
when the production of a good or service imposes external costs on third parties who are not part of the transaction
3 examples of consumption externalities
- Second hand smoking
- Alcohol consumption: excessive drinking leads to public health issues/ accidents
- Noise pollution
3 examples of production externalities
- Air pollution: affects the health of residents
- Water pollution: harm to marine life
- Deforestation: loss of diversity
What are private costs
Costs that a producer or consumer directly pays when making or consuming a good or service.
What are external costs
Costs imposed on third parties who are not part of the transaction or activity.
What are social costs
Total costs to society from producing or consuming a good or service: external costs + private costs
What are private benefits
Benefits received by those directly involved in a transaction
What are external benefits
Benefits received by third parties who are not part of the transaction
What are social benefits
Total benefits to society from the consumption or production of a good or service: private benefits + external benefits
Impact of negative externalities in consumption
Consumers focus on personal satisfaction to maximise utility →
Overconsumption: negative effects (e.g. health, environment) not reflected in price →
Misallocation of resources: harmful goods overproduced to meet excess demand →
Third-party effects: others suffer (e.g. passive smoking, NHS strain) →
Market failure: social cost > private cost
Impact of negative externalities in production
Producers focus on profit and ignore wider social costs →
Overproduction: harmful side effects (e.g. pollution) not included in production costs →
Misallocation of resources: too many resources used to produce damaging goods →
Third-party effects: others suffer (e.g. poor air quality, health issues) without benefiting →
Market failure: social cost > private cost
Impact of positive externalities in consumption
Consumers focus on personal benefit, ignoring wider social gains →
Underconsumption: full benefits (e.g. education, vaccines) not reflected in private value →
Misallocation of resources: too few resources used to produce socially beneficial goods →
Third-party benefits: others gain (e.g. educated workforce, herd immunity) without paying →
Market failure: social benefit > private benefit
Impact of positive externalities in production
Producers focus on private profit, ignoring wider social benefits →
Underproduction: full value (e.g. from research, training) not reflected in private returns →
Misallocation of resources: not enough resources used to produce beneficial goods →
Third-party benefits: others benefit (e.g. innovation spreads, skilled workers) without paying →
Market failure: social benefit > private benefit
How can the government correct externalitiees
- Taxes
- Subsidies
- Regulation
- Tradeable pollution permits
- Minimum/ maximum price
How does taxes correct externalities
Increases costs -> production becomes more expensive and private costs increase -> reduces incentives for producers to supply more of the good or service -> ensures market is working at the socially efficient equilibrium -> internalises negative externality as producers require higher prices to makeup for tax
How does subsidies correct externalities
Subsidies = reduces the cost of production or consumption -> increases the incentive to supply more of the good or service -> subsidy reduces the price of the good for consumers increasing demand -> : The subsidy helps the market reach the social optimum, where the quantity produced and consumed is higher -> reduces welfare loss
What is a public good
Public goods = non-excludable and non-rivalrous, meaning that no one can be excluded from their benefits, and consumption by one does not reduce availability to others.
What is a private good
Private goods = rivalry and excludability, consumption by one individual reduces the availability of the good for others and Producers or sellers can prevent individuals from consuming the good if they do not pay for
What is the free rider problem
When individuals can benefit from a public good without having to pay for it
Why should the government provide public goods
- State provision helps to prevent under production and under consumption increasing social welfare
- Providing public goods helps affordability as private firms rely on profit-making,
