MICRO - LS17 - Market Failure & Externalities

Question 1

Market failure

Answer 1

It’s where too much or too little of a good is produced and/or consumed compared with the socially optimal level of output, or when the price mechanism leads to an inefficient allocation of resources

Question 2

Externalities

Answer 2

• The consumption and production of some goods/services provides costs or benefits to economic agents that were not involved in the transaction (i.e. not the seller or buyer).
  E.g. the negative health effects of second-hand smoking fall on people that did not sell or buy the product.

Question 3

Public goods

Answer 3

Some goods/services would be underprovided if provision was left entirely to the private sector
e.g. health care.

Question 4

Information gaps

Answer 4

Some markets have information problems, for consumers and or producers, which results in under of over consumption of the product
e.g. many individuals are unaware of the full benefits a private pension can provide.

Question 5

External costs

Answer 5

Negative externalities
A cost to a third party that’s not involved in the making, buying/selling and consumption of a specific good/service

Question 6

External benefit

Answer 6

Positive externalities
A benefit to a third party that’s not involved in the making, buying/selling and consumption of a specific good/service

Question 7

Policies to address negative externalities

Answer 7

• indirect tax - shifts MPC to MSC
• pollution permit trading schemes
• ‘nudge’ policies - use behavioural methods to encourage less pollution
• legislation/regulation
• banning/restricting output

Question 8

Policies to address positive externalities

Answer 8

• legislation/regulations
• government provision free at the point of use - ‘blunt’ intervention - providing free (e.g. NHS) can result in market quantity above social optimum output - best used when externality is very large
• subsidy - shifts the MPB to MSB
• ‘nudge’ policies - behavioural methods to encourage consumption

Question 9

Evaluation of gov policies to reduce/eliminate externalities

Answer 9

• size of externality
• extent to which externality can be measured
• whether there are unintended consequences
• whether there is government failure
• opportunity cost of policy - can be expensive
• how policy affects distribution of income - are there winners & losers