1.3 Flashcards
what is meant by market failure
when the free market leads to an inefficient allocation of resources
what is meant by an externality and give an example
the effect on the third party who is not involved with the transaction. e.g. smoking has a negative effect on those around the smokers, the externality is the others inhaling the smoke.
define negative externalities
a negative effect/cost on the third party not involved with the transaction
define positive externalities
a positive effect/benefit on the third party not involved with the transaction
define private costs
the cost to the consumer or producer only
give three examples of private costs in the production of a pencil
the cost of wood
the cost of graphite
the cost of the eraser at the end of the pencil
these are private costs to the producer of the pencil.
define external costs
costs to a third party
give two examples of external costs in the production of a pencil
- the cost to the environment as trees are cut down for wood
- the emission of CO2 from factories, has external costs on environment
define external benefits
benefits to a third party not involved with the transaction
define social costs
the private + external cost
define social benefits
private + external benefit
draw a diagram showing positive externalities in CONSUMPTION
- costs/benefits y axis
- quantity x axis
- two skewed lines going downwards (AD) - top one MSB (marginal social benefit) and bottom one MPB (marginal private benefit)
- one line going up (AS) - MSC (marginal social cost)
- equilibrium (A) at Q1 P1 (MPB) + line going up to MSB (C)
- Q2 P2 at MSB (B) - outward shift from Q1
- welfare loss triangle (>) (CBA)
draw a diagram showing negative externalities in CONSUMPTION
- 2 skewed AS lines, bottom one MSB and top one MPB
- AD line, MSC = MPC
- Equilbrium (C) Q1 P1 with line going up to MPB from MSC (B)
- inward shift to Q2 P2 (A)
- welfare loss (
draw a diagram showing positive externalities in PRODUCTION
- two skewed AD lines, top one MPC and bottom one MSC
- one AS curve MPB = MSB
- (free market) equilibrium Q1P1 at MPC (A)
- outward shift Q2P2 (socially optimum eq) to MSC (B) with line continued to MPC (B)
- welfare loss triangle (
draw a diagram showing negative externalities in PRODUCTION
- two skewed AS lines, top one MSC bottom one MPC
- one AD line MSB
- (free market) equilbrium Q1P1 MPC (A), line continued up to MSC (C)
- inward shift Q1P2 (socially optimium equilibrium) to MSC (B)
- welfare loss triangle (BCA)
on all diagrams make sure you label free market and socially optimum equilbrium
free market equilbrium - Q1P1
socially optimum equilbrium - p2q2
define and give examples of a merit good
a good which has positive externalities in consumption, such as education, vaccination
define and give examples of a demerit good
a good which has negative externalities in consumption, such as cigarrettes
define private goods
goods that are provided by the free market
in what way are externalities a case of market failure?
externalities means that the socially optimum market equilbrium is different to the free market equilbrium. this means that some goods are over/under produced and consumed leading to an market failure
what are missing markets
markets for goods which are not provided by the free market because they are not profitable to provide because of the free rider problem
define and give examples of public goods
goods that are non-excludable and non-diminishable such as street lamps
what is the difference between a merit and a public good
a merit good has positive externalities in consumption, but a public good is non-excludable and non-diminishable. merit goods are underconsumed and underprovided by the market mechanism, whereas public goods are not provided at all
what is meant by asymmetric information
where a party in a transaction has more or superior infomration compared to another
give three examples of markets with asymmetric information
- second hand car sales
- housing market
- life insurance
in what way does information gaps give rise to market failure?
they restrict the ability of consumers and producers to make rational choices, which may lead to an inefficient allocation of resources
how does asymmetric information give rise to adverse selection?
adverse selection is a situation in which sellers have more information than buyers have, or vice versa, about some aspect of product quality. Adverse selection occurs when asymmetric information is exploited.
adverse selection is also a situation in which a person at risk is more likely to take out insurance
how does asymmetric information give rise to moral hazard?
moral hazard is a situation in which a person who has taken out insurance is prone to taking more risk. this is a second type of information gap.
