Market Failure- Externalities

Question 1

What is market failure

Answer 1

Market failure is when there is a misallocation of resources causing a loss in social welfare loss.

Question 2

What are externalities

Answer 2

An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism.

Question 3

What is the under provision of public goods?

Answer 3

As public goods are non rivalrous and non excludable this means they are under provided due to the free rider problem. This means no revenue is generated leading to the good being under provided .

Question 4

What are information gaps?

Answer 4

When either the buyer or seller does not have access to the information needed for them to make a fully informed decision.

Question 5

What is a private cost/ private benefit?

Answer 5

Private costs are costs to the individual participating in the economic activity.

Private benefits are benefits to the individual participating in the economic activity.

Question 6

What are social costs/ benefits?

Answer 6

Social costs/ benefits are the costs/ benefits of the activity as a whole.

Social benefits= private benefits + external benefits

Social costs= private costs + external costs

Question 7

What are external costs/ benefits

Answer 7

External costs/ benefits are the costs/ benefits to a third party not involved in the economic transaction.

Question 8

What is a merit good?

Answer 8

A merit good is a good with external benefits, where the benefit to society is greater than benefit to the individual.

Question 9

What are production externalities?

Answer 9

When the social costs of production differ from the private costs of production

Question 10

What are negative externalities of production

Answer 10

Occur when social costs are greater than private costs in production. An example is when a factor pumps sewage into a river at no cost to itself.

Question 11

What are positive externalities of production?

Answer 11

Occur when a third party benefits from the production of a good or service. For example, if building a bus station can provide shelter for the homeless when it is raining. Therefore in this example the production of the bus station has provided a benefit for the third party ( shelter for homeless).

Question 12

What are positive externalities of consumption?

Answer 12

Occur when social benefits are greater than private benefits in consumption. An example is if a student consumes education the private benefit to the student would be a good job, however the social benefit of this to the rest of society would be that the student may pay a higher tax revenue to the government. Therefore, the positive externality of consuming education would be higher tax revenue for the government.

Question 13

What are negative externalities of consumption?

Answer 13

Occurs when social benefits are less than private benefits in consumption. For example, with a passive smoking, a person who smokes in their home harms the health of others in the home

Question 14

What does a positive externality in consumption diagram look like?

Answer 14

Question 15

What does a positive externality in production diagram look like?

Answer 15

Question 16

Why can positive externalities generate market failure and how can we overcome this?

Answer 16

Positive externalities create market failure because there is an UNDER PRODUCTION and UNDER CONSUMPTION. One method in which this type of market failure can be overcome is by increasing production and consumption of goods and services which generate positive externalities. One way to do this could be do to subsidise goods that generate positive externalities.

Question 17

What does the diagram of subsidising good that generate positive externalities look like?

Answer 17

Question 18

What does the diagram of negative externalities in consumption look like?

Answer 18

Question 19

What does the diagram of negative externalities in production look like?

Answer 19

Question 20

What can taxes on negative externalities do?

Answer 20

Taxes are intended to make consumers and producers pay the FULL social cost of the good. This can reduce the over consumption therefore creating a more socially efficient outcome. If a good generates negative externalities such as someone smoking this can create passive smoking. Without any tax, there will be an over consumption of cigarettes as people will ignore the social cost.

Question 21

What does the diagram of putting a tax on a good that generates negative externalities look like?

Answer 21

Question 22

Chain of analysis for negative externalities from production

Answer 22

Marginal social cost exceeds marginal private cost.

If market output supplied is higher than the social optimum then there is a market failure and a deadweight loss of social welfare.

Question 23

Model answer

Answer 23