1.5.1 Market failure and externalities

Question 1

Private costs

Answer 1

Cost of the individual taking the economic action

Question 2

Private benefits

Answer 2

a benefit for an individual as a result of an economic action they have taken

Question 3

External costs

Answer 3

Cost of someone elses economic action borne by a third party

Question 4

External benefits

Answer 4

A benefit for a third party as a result of an economic action taken by someone else

Question 5

externalities

Answer 5

Positive or negative effects on third parties

Question 6

Social costs

Answer 6

Total sum of private and external costs for a particular economic action

Question 7

Social benefits

Answer 7

Total sum of the private and external benefits for a particular economic action

Question 8

Positive externalities

Answer 8

External benefits experienced by third parties but paid for by someone else

Question 9

Negative externalities

Answer 9

External costs that have a detrimental effect on the lives of people who neither bought or sold the product

Question 10

Allocation of resources

Answer 10

Refers to the way resources are used and distributed within the economic system

Question 11

Market failure

(why does it occur)

Answer 11

Occurs whenever social costs exceed social benefits → negative externalities.
- Resources are not being allocated efficiently enough because consumers do not pay for the external costs associated with the G/S they consume but someone else

Question 12

Under consumption

Answer 12

Socially desirable products are too expensive for everyone to cover the costs themselves (healthcare, education etc)

Question 13

Over consumption

Answer 13

• social costs exceed private costs (petrol and diesel) → if external costs and private costs are experienced by the consumer, the private costs = social costs and demand would go down
• if consumer has to deal with the cost of buying it and the third party effects, then they will not want it

Question 14

a public good

Answer 14

A public good is not provided by businesses in a free market because they would not be able to charge people effectively to use them
- Non rival: if one person consumes a good, another is not stopped from using that same good
- Non-excludable: once a good is provided it is impossible to stop another person from using the same good even if they haven’t paid
- This causes the ‘free-rider effect’

Question 15

a merit good

Answer 15

• A merit good is one we tend to under-consume/under-produce because we don’t realise how good it is for us, as some sort of information breakdown exists
• The government often provides merit goods so that we dont have to pay for them, because they are more aware of the benefits we bring than we are

Question 16

why is education a merit good

Answer 16

• At the time school is not fully appreciated, or people leave school at 16, forfeiting higher education
• This is because people want to earn a living as they do not like education, or it is a necessity (women and girls)

It is good because:
- A better education brings more skilled workers
- Society becomes better as a more educated society is more cohesive and tolerant → people care more about their health, diet and complete less crime

Question 17

why is healthcare a merit good

Answer 17

• People cannot always access education do no having enoug time and their lifestyle
• They also do not have the money for treatment if it not free (america)

It is good because:

• Gov: everyone needs to access healthcare to be healthy and contribute to society → raises GPD and living standards
• The health of the person increases herd immunity → people do not miss work and affect the economy

Question 18

demerit goods

(how does the government try to reduce consumption of them)

Answer 18

• Demerit goods are goods that we tend to overconsume/overproduce because we dont realise how bad it is for us, as a sort of information breakdown exists.
• The government discourages consumption of them through taxes, bans and advertising campaigns, because they are more aware of the disadvantages than we are

Question 19

why is alcohol a demerit good

Answer 19

• Individual and society is affected
• Violent crime, domestic abuse, family breakdown
• Increased health costs on the tax payer

it is limited
- Age limits
- Taxes
- Licenced premises
- Alcohol regulation
- education

Question 20

why is nicotine a demerit good

Answer 20

• Health issues, passive smoking
• People dont consider the long term effect

it is limited
- Cannot smoke on school premises
- Have to smoke in an 50% open shelter
- Heavily taxed
- Packets are most unnatractive colour to young people to deter

vaping
- vaping → government did not regulate and made it attractive to young people (flavours): - -GOVERNMENT FAILURE
- Merit: for people who smoke cigarettes and are attempting to stop
- People who dont smoke nicotine has a negative health impact

Question 21

tragedy of the commons

(what kind of good is it)

Answer 21

• If there is a common resource available to all, it becomes overused and useless
• This is an example of a rival good, as its use means it is not available to others
• Individual behaviour has a negative impact on others to the extent we would all be better off if - that behaviour was curtailed, but individuals are better off continuing with what they are doing for themselves
• Eg road space, exploitation of NR resources, fishing and beach uses

Question 22

positive externalities

Answer 22

Positive externalities are acceptable.
- These occur when there is some gain in satisfaction for a third party, who is neither the buyer nor the seller of the product.
- The aim is to increase social benefit as merit goods - which cause these benefits - are under-consumed

Social benefit > private benefit = positive externalities

The difference between the MPB and MSB = external benefit

Supply has been extended → more is being produced/consumed which is good as it is a merit good

Question 23

negative externalities

Answer 23

However, negative externalities are regarded as being undesirable but that does not mean there is a case for banning the product that causes it.

Social cost > private cost = negative externalities

When externalities occur, there is a misallocation of resources as the wrong group of consumers are paying for the cost. This causes market failure. This means the government needs to intervene and provide policies to help with this.

D = MPD (marginal private benefit) → slopes downards showing diminishing marginal utility (more used less valued)
S = MPC (marginal private cost)
MSC = marginal social cost

Therefore the cost between MPC and MSC = external cost

Question 24

how to internalise external costs

(measuring externalities problems)

Answer 24

• at the FREE MARKET EQUILIBRIUM, the external cost is NOT included in the consumers private cost, and results in negative externalities (spillover on third parties)
• At the SOCIALLY OPTIMAL EQUILIBRIUM, the external cost IS included in the consumers private cost
• Here, the price of the good has increased to a socially optimal level, so the quantity demanded has decreased to one too, causing demand to contract until an SOE is reached, where less people are using the demerit good
• The externality is now INTERNALISED, so the right group of people are paying for the cost

Private costs and benefits are usually qualitative (expenses) and are easier to measure, but external costs and benefits are usually qualitative and harder to quantify as a whole (pollution, social problems)

Question 25

strengths of the market economy

Answer 25

• Free markets do work mostly: the profit signalling mechanism leads to an efficient allocation of resources
  –> Demand and supply work together to create an equilibrium price and quantity
• These market forces respond to changes in the conditions of DS, adjusting output accordingly and adapting to the needs of customers
• Competition is good because it drives down costs and increases efficiency → drives down prices and spurs businesses to make better and more innovative products to attract sales
• The allocation of resources reflects both consumer choices and production costs

Question 26

weaknesses of the market economy

Answer 26

When the free market is left alone it can fail in a number of ways:

Negative externalities create the spillover effect (pollution)
- Not reflected in the products price as if the price was charged an equal amount to to the full social cost of the product, demand for the product would be lower
- There is an over-production and over-consumption

Some desirable products like education and healthcare may be unobtainable for those low incomes (unless provided by the state)
- Such products will be underproduced and under-consumed
- This is market failure as it cuts out potential benefits to society as a whole.

Some firms acquire market power → markets will become less competitive, and prices will then be higher than necessary
- Price mechanism no longer ensures efficiency and this reduces living standards for all

Market forces do not guarrantee a reasonable standard of living for all and are likely to lead to inequality

Question 27

government intervention

Answer 27

In order to address such issues, governments can intervene, creating various legal and procedural frameworks that reduce market failure

The government can play a part in redesigning the market to allow it to perform better eg tax
tax eg petrol tax to increase the costs of motoring as a deterrent, and a tax on alcohol
Individual tax

• Governments may try to stop firms from doing something → may encourage firms to find ways to circumvent the rules
• Government intervention can increase costs to firms of doing something → might make a particular behaviour more expensive using taxes
• Government intervention can make firms want to change their behaviour → tries to change the rules of the market and try to influence business behaviour

Question 28

exam q for merit/demerit goods and market failure

Answer 28

For merit good (vice versa for demerit good)
- underconsumed/produced
- Information breakdown
- Gov encourages as they know its benefits for us
- Causes positive externalities
- Talk about the private benefits + spillover benefits on third parties (NAME THEM eg the tax payer)
- Think about ECONOMIC benefits (boosts/hinders the economy (work etc))

Market failure
- Overconsumption and over production of a demerit good
- Cause negative externalities, causing a spillover cost on third parties (name them)
- Name the private cost and the external cost

Question 29

how to carry out a cost benefit analysis

Answer 29

• identify all private and external costs + private and external benefits
• find all the values for them
• find the social costs and social benefits (totals for both)
• compare social costs with social benefits
• if cost exceed benefits then do not go ahead, otherwise do go ahead

Question 30

things to consider when doing a cost benefit analysis (however/but point)

Answer 30

• it is an estimation as assigning monetary values to external costs and benefits is hard (qualitative)
• CBA are very costly and hard to undertake themselves (survey’s/analysis etc)
• changing circumstances –> high interest and inflation rates, exchange rates etc
• estimation of budgets are often wrong as usage and costs of material is hard to predict well into the future
• actual costs can rise above planned costs due to moral hazard –> it is paid for by the gov, so no profit is made so no one is trying to keep costs down, so they inflate
• moral hazard –> the gov is only going to try and save projects that took alot of investment, not small ones
• politicians make the final decision and their main concern may not be economic costs but political advantageous actoins