Micro 9 - Introduction to Market Failure and Externalitites

Question 1

What are the 3 causes of market failure?

Answer 1

• Externalities
• Under-provision of public goods
• Information gaps

Question 2

When does market failure occur?

Answer 2

A market fails when the price mechanism (the forces of supply and demand) fails to allocate scarce resources efficiently and society suffers as a result

Question 3

How commonly does market failure occur?

Answer 3

Market failure is a common problem and governments often intervene to try and prevent it

Question 4

What are externalities?

Answer 4

Externalities are the effects that producing or consuming a good or service has on people who aren’t involved in the making, buying, selling and consumption of the good or service. These people are called third parties

Question 5

Who do externalities affect?

Answer 5

Third Parties

Question 6

What are the two types of externalities?

Answer 6

Positive or negative

Question 7

What are positive externalities?

Answer 7

Positive externalities are the external benefits to a third party

Question 8

What are negative externalities?

Answer 8

Negative externalities are the external costs to a third party

Question 9

What two things can externalities occur in?

Answer 9

Production or consumption

Question 10

Give an example of a negative externality in production

Answer 10

A negative externality of producing steel could be the pollution that harms the local environment

Question 11

Give an example of a positive externality in consumption

Answer 11

A positive externality of someone training to become a doctor could be the benefit to society that this brings

Question 12

How do externalities cause market failure?

Answer 12

Market failure occurs because externalities are ignored

Question 13

Define the term private cost

Answer 13

A private cost is the cost of doing something to either a consumer or a firm

Question 14

Define the term external cost

Answer 14

External costs are the costs imposed on a third party as a result of the decisions made by others to produce or consume a product

Question 15

How do you calculate social cost?

Answer 15

• Adding the private cost to the external cost gives the social cost
• Social cost = Private cost + External cost

Question 16

Define the term private benefit

Answer 16

A private benefit is the benefit gained by a consumer or a firm by doing something

Question 17

Define the term external benefit

Answer 17

External benefits are the benefits that are experienced by third parties as a result of decisions made by others to consume or produce a product

Question 18

How do you calculate social benefit?

Answer 18

• Adding the private benefit to the external benefit gives the social benefit
• Social benefit = Private benefit + External benefit

Question 19

Define the term social benefit

Answer 19

The social benefit is the full benefit received by society from a good or service

Question 20

Define the term social cost

Answer 20

The social cost is the full cost borne by society of a good or service

Question 21

Why does market failure occur in the free market?

Answer 21

Market failure occurs because in a free market the price mechanism will only take into account the private costs and benefits but not the external costs and benefits

Question 22

Do negative externalities occur in production or consumption?

Answer 22

Production

Question 23

What do negative externalities occur in?

Answer 23

Production

Question 24

What is the marginal private cost?

Answer 24

The marginal private cost (MPC) is the cost of producing the last unit of a good

Question 25

How do you calculate the marginal social cost?

Answer 25

Marginal social cost = Marginal private cost + External cost

Question 26

On a diagram what is the difference between the MPC and MSC curves?

Answer 26

The difference between the MPC and MSC curves is the external cost of production which is the negative externalities

Question 27

What does it mean if the MPC and MSC curves are parallel?

Answer 27

The external costs per unit produced are constant

Question 28

What does it mean if the MPC and MSC curves diverge?

Answer 28

The external costs per unit increase with output

Question 29

Give an example of why the MPC and MSC curves might diverge

Answer 29

The curves might diverge due to pollution - the external costs per unit created pollution can increase as the output increases

Question 30

Do positive externalities occur in production or consumption?

Answer 30

Consumption

Question 31

What do positive externalities occur in?

Answer 31

Consumption

Question 32

What is the Marginal private benefit?

Answer 32

The marginal private benefit is the benefit to someone of consuming the last unit of a good

Question 33

How do you calculate marginal social benefit?

Answer 33

Marginal social benefit = Marginal private benefit + External benefit

Question 34

What is the difference between the MPB and MSB curves?

Answer 34

The difference between the MPB and MSB curves are the external benefits which are the positive externalities

Question 35

What does it mean if the MPB and MSB curves are parallel?

Answer 35

The external benefits per unit are constant

Question 36

What does it mean if the MPB and MSB curves diverge?

Answer 36

The external benefits per unit increase with output

Question 37

Give an example of why the MPB and MSB curves diverge

Answer 37

An example of when the curves might diverge is vaccination - the more people that are vaccinated the greater the protection for unvaccinated people

Question 38

What is the general relationship between the equilibrium point and the socially optimal point?

Answer 38

The equilibrium point may be different to the socially optimal point

Question 39

When does equilibrium occur in the free market?

Answer 39

When supply equals demand

Question 40

On a diagram can the MPC curve be seen as a supply curve or a demand curve?

Answer 40

Supply curve

Question 41

On a diagram can the MPB curve be seen as a supply curve or a demand curve?

Answer 41

Demand curve

Question 42

On a diagram does the MPB curve slope upwards or downwards?

Answer 42

Downwards

Question 43

On a diagram does the MPC curve slope upwards or downwards?

Answer 43

Upwards

Question 44

On a diagram where does the free market equilibrium occur and why?

Answer 44

The FM equilibrium occurs when MPC = MPB as in a free market consumers only consider their private costs and private benefits and ignore any social costs and benefits

Question 45

On a diagram where does the socially optimal level of output occur and why?

Answer 45

Where MSC = MSB because this includes the external costs and benefits to society

Question 46

What will the socially optimal level of output give society in terms of externalities?

Answer 46

The socially optimal level of output and price will give society the maximum benefit of any positive externalities and still cover up the cost of any negative externalities

Question 47

What is caused by ignoring negative production externalities?

Answer 47

Overproduction

Question 48

What causes overproduction?

Answer 48

Ignoring negative production externalities

Question 49

On a negative production externality diagram why does MPB = MSB

Answer 49

As there are no positive externalities

Question 50

Why does ignoring negative externalities in production lead to overproduction and under-pricing of a good?

Answer 50

In the free market only private costs are considered so the level of output would be higher than the social optimum. This would cause overproduction and under-pricing of a good as more is produced and sold at a lower price than is desirable for society.

Question 51

What is the relationship between the marginal social cost and marginal social benefit for a good produced between the FM equilibrium and the social optimum?

Answer 51

For each unit of a good produced between the FM equilibrium and the social optimum the marginal social cost is greater than the marginal social benefit

Question 52

What is the area of the triangle between the marginal social cost and marginal social benefit equal to on a negative externality diagram?

Answer 52

Welfare loss

Question 53

Define the term welfare loss

Answer 53

The welfare loss is the loss to society caused by ignoring externalities

Question 54

What does the welfare loss/gain triangle always point to?

Answer 54

The social optimum

Question 55

What does ignoring positive consumption externalities lead to?

Answer 55

Underconsumption

Question 56

What causes underconsumption?

Answer 56

Ignoring positive consumption externalities

Question 57

On a positive consumption externality diagram why is MPC = MSC?

Answer 57

As there are no negative externalities

Question 58

Why does ignoring positive consumption externalities lead to underconsumption and under-pricing of a good?

Answer 58

In a free market only private benefits are considered which causes underconsumption and under-pricing of a good - less is consumed and sold at a lower price than is desirable for society.

Question 59

What is the relationship between the marginal social benefit and marginal social cost for a good produced between the FM equilibrium and the social optimum?

Answer 59

For each unit of this good consumed between the FM equilibrium and the social optimum the marginal social benefit is greater than the marginal social cost

Question 60

What is the area of the triangle between the marginal social benefit and marginal social cost equal to?

Answer 60

Welfare gain

Question 61

Define the term welfare gain

Answer 61

The welfare gain is the gain to society lost by ignoring externalities

Question 62

What are some examples of services with positive consumption externalities?

Answer 62

- Education - Healthcare

Question 63

What is the relationship between education and healthcare and the free market?

Answer 63

In the free market both of these services are under-consumed and the potential welfare gain to society is lost

Question 64

Draw a diagram showing a negative externality in prodcution

Answer 64

*See page 76*

Question 65

Draw a diagram showing a positive externality in consumption

Answer 65

*See page 76*