1.3.1 and 1.3.2 Market Failure and Externalities

Question 1

define market failure

Answer 1

when the market forces of supply and demand do not result in an efficient allocation of resources.

Question 2

why does market failure arise

Answer 2

because the price mechanism does not take into account all the costs and/or benefits in the production and consumption of the product

Question 3

define externalities

Answer 3

costs or benefits that are not directly part of a transaction between producers and consumers

Question 4

why are externalities a form of market failure

Answer 4

market forces will not result in an efficient allocation of resources. since some of the effects will be felt by third parties, they may not be aligned with the best interests of society

Question 5

define a negative externality

Answer 5

harmful effect of an economic activity on third parties aka external cost

Question 6

define a positive externality

Answer 6

beneficial effect of an economic activity on third parties, aka external benefit

Question 7

where can externalities occur

Answer 7

• production stage of an economic activity
• consumption stage of an economic activity

Question 8

what are the three types of cost

Answer 8

• private cost
• external cost
• social cost

Question 9

define private costs

Answer 9

costs to the individual participating in the economic activity

Question 10

give examples of producer’s private costs

Answer 10

raw materials, energy costs

Question 11

what are consumer’s private costs

Answer 11

usually the price paid for the good

Question 12

what represents private costs

Answer 12

the supply curve

Question 13

what are external costs

Answer 13

costs to the third party - negative spillover effects from the production or consumption which the market fails to take into account

Question 14

give an example of an external cost of production

Answer 14

depleting a natural resource

Question 15

what are social costs

Answer 15

costs to society as a whole

Question 16

what is the formula for social costs

Answer 16

private costs + external costs

Question 17

what is a private benefit

Answer 17

benefit to the individual participating in the economic activity

Question 18

what represents private benefits

Answer 18

demand curve

Question 19

what are the private benefits for producers and consumers

Answer 19

producers - revenue from producing the good
consumers - utility from consuming the good

Question 20

what are external benefits

Answer 20

benefits to the third party who is not involved in the economic activity

Question 21

give an example of an external benefit of production

Answer 21

employment created by a firm

Question 22

what are social benefits

Answer 22

benefits to society as a whole

Question 23

what is the formula for social benefits

Answer 23

social benefits = private benefits + external benefits

Question 24

what are merit goods

Answer 24

• a good with external benefits, where the benefit to society is greater than the benefit to the individual
• tend to be underprovided in the free market

Question 25

give examples of merit goods

Answer 25

• education
• healthcare
• libraries

Question 26

what are demerit goods

Answer 26

• goods with external costs where the cost to society is greater than the cost to the individual
• tend to be over-provided by the free market

Question 27

give examples of demerit goods

Answer 27

• alcohol
• junk food
• drugs

Question 28

give three issues with externalities

Answer 28

• it is difficult to work out the size of the externality as it tends to be placed on value judgements, since it is difficult to monetise external costs
• many externalities are involved with information gaps, as people are unaware of the implications of their decisions
• many externalities are on a time lag therefore impacts not felt initially