2.8 + 2.9 Market Failure Flashcards
What is a market failure?
A situation in which the allocation of goods and services is not efficient.
True or False: Externalities can lead to market failure.
True
Define externality.
A consequence of an economic activity that affects other parties who did not choose to be involved in that activity.
What are positive externalities?
Benefits experienced by third parties as a result of an economic transaction.
What are negative externalities?
Costs suffered by third parties as a result of an economic transaction.
Fill in the blank: An example of a negative externality is _____ pollution.
air
What is a common pool resource?
A resource that is available to all but is limited in supply, leading to potential overuse.
True or False: Common pool resources are non-excludable and rivalrous.
True
What is the tragedy of the commons?
A situation in which individuals acting in their own self-interest deplete a shared resource.
Which of the following is an example of a common pool resource? A) Public park B) Ocean fish stocks C) Public library D) National defense
B) Ocean fish stocks
What is the Coase theorem?
The proposition that if property rights are well-defined and transaction costs are low, parties can negotiate solutions to externalities.
Fill in the blank: Government intervention to correct externalities typically involves _____ or subsidies.
taxes
What is an example of a positive externality?
Education, as it benefits society beyond the individual receiving it.
True or False: The presence of externalities always leads to government intervention.
False
What is an external cost?
A cost incurred by a third party due to an economic transaction.
What is an external benefit?
A benefit received by a third party due to an economic transaction.
Fill in the blank: The market outcome is efficient when _____ are accounted for.
externalities
What is meant by ‘internalizing the externality’?
Incorporating external costs or benefits into the decision-making process of the parties involved.
True or False: All externalities can be easily quantified.
False
What role do taxes play in addressing negative externalities?
They increase the cost of the harmful activity, potentially reducing its occurrence.
What is a public good?
A good that is non-excludable and non-rivalrous, meaning individuals cannot be effectively excluded from use and one person’s use does not reduce availability to others.
Fill in the blank: Overfishing is a classic example of the _____ of the commons.
tragedy
What is a possible solution to the tragedy of the commons?
Implementing regulations or creating property rights to manage resource use.
True or False: Common pool resources can be managed sustainably.
True
What is an example of a policy to mitigate negative externalities?
Carbon taxes or cap-and-trade systems.
What is the significance of transaction costs in the Coase theorem?
High transaction costs can impede negotiations to resolve externalities.
Examples of market failure include:
When a production process causes pollution, such as in the air or water
When people consume goods that are harmful for them and the rest of society, such as cigarettes and illegal drugs
When the current generation exploits or depletes resources so that they won’t be available to future generations
In other words, when the marginal social benefit (MSB) equals the marginal social cost (MSC),
this is the socially optimal output.
situation where the market has achieved the optimal social welfare
externality
When these benefits or costs are passed on to those who are not involved in producing or consuming that particular good
how can externalities be created
can result either from the consumption or production of goods and services, and they create a gap or difference between the MPC and the MSC, or between the MPB and the MSB
In other words, an externality occurs when
free market leads to an outcome where MPB is equal to MPC but MSB is not equal to MSC and the outcome for the society is allocative inefficiency
Merit goods
private goods that will be under-produced by the market as consumers do not appreciate the benefits to themselves and society of their consumption
merit goods are _____ by the market. why?
under-provided
because firms are profit driven and will only produce goods and service
Demerit goods
are private goods that will be over-consumed and therefore over-provided by the market
why are demerit goods overconsumed and overprovided
consumers do not appreciate the costs to themselves and society of their consumption
negative externality of production
When the production process of a good or service generates a negative effect on a third party or on society as a whole
what is the situation in a negative externality? why?
the marginal social cost of production (MSC) is greater than the private cost of production (MPC)
as firms do not take these extra costs into consideration when deciding how much to supply at each price level.
benefits of carbon taxes
Carbon taxes on polluting firms are much easier to apply than other measures, such as tradable emission permits.
Tax revenues from carbon tax will be collected, and can be invested in promoting innovation and new technologies, such as renewable sources of producing energy.
problems with carbon taxing
It is often difficult to measure the pollution created and put a value on it to establish the amount of the tax.
It is also difficult to identify which firms are polluting and to what extent each firm is responsible for the pollution.
Taxes make firms pay for the pollution they create but do not actually stop the pollution from taking place.
problems with legislation
The ban or restriction may lead to unemployment in the corresponding industry, as jobs would be lost if firms are closed or the market reduced.
Banning a firm would create non-consumption of the good that was being produced, which might be a good necessary or desirable to consumers.
The cost of setting and then enforcing the policy standards may be very difficult to implement, and/or have a greater cost than the pollution itself.
beneftis of Tradable emission permits
It encourages firms to seek lower-cost methods of reducing emissions, such as better energy efficiency, which will lower their overall production costs.
It helps achieve the environmental objective of reduced emissions at lower costs.
The price of permits is determined by the free market, which allows greater flexibility to firms, because in a period of recession the price will fall due to falling output and in periods of economic boom the price will rise. This flexibility will allow firms to benefit from reducing emissions.
It provides a way for international cooperation to tackle the global challenge of emissions.
problems with Tradable emission permits
To start with, it is difficult to set an acceptable level of pollution.
It is also difficult to measure a firm’s pollution production in order to establish the amount of permits per firm.
Firms pay for the pollution they create but it does not lead to a reduction in pollution once the allowed limit has been set.
positive externality of production
when the production process of a good or service generates a positive effect on a third party or on society as a whole
when happens when positive externality of production
the marginal social cost of production (MSC) is smaller than the marginal private cost of production (MPC)
What is a positive externality of production?
When the production process of a good or service generates a positive effect on third parties or society as a whole.
Give examples of positive externalities of production.
Private firms investing in research and development.
Employee training provided by firms.
Bee-keeping benefiting agriculture through pollination.
Building flood defenses.
Why does positive externality of production lead to market failure?
The market under-allocates resources to the good because the marginal social cost (MSC) is lower than the marginal private cost (MPC), leading to less production than the socially optimal level (Q2 < Q*).
What does the demand curve represent in a market with a positive externality of production?
The demand curve represents both marginal private benefits (MPB) and marginal social benefits (MSB), meaning MPB = MSB.
What is the welfare loss due to positive externalities of production?
It is the potential welfare gain that society misses out on because production is below the socially optimal level (Q). Represented by the yellow triangle between Q2 and Q in a graph.
What are two government responses to positive externalities of production?
Subsidies to firms: Reduces firms’ production costs, increasing output closer to the socially optimal level.
Direct government provision: Government funds or directly provides goods/services with positive externalities.
what are the advantages of subsidies for addressing positive externalities of production?
Encourages firms to produce more goods with external benefits.
Reduces unrealized potential welfare gain.
What are the disadvantages of subsidies?
Difficulty in determining the appropriate level of subsidy.
Uses government funds, which have an opportunity cost (e.g., could be spent on healthcare).
What are the advantages of direct government provision?
Governments can ensure goods/services with positive externalities are available.
Reduces the externality by lowering firms’ production costs.
What are the disadvantages of direct government provision?
High cost for the government, creating opportunity costs.
Governments may lack the expertise of specialized firms.
May discourage private firms from investing in the same areas.
How does a subsidy affect the market for a good with positive externalities of production?
it shifts the supply curve from MPC to MPC + subsidy, reducing the externality and increasing production closer to Q*.
Why are resources under-allocated to goods with positive externalities of production?
Because the private cost of production (MPC) is higher than the total cost to society (MSC), leading to lower output than socially optimal.
What is the socially optimal level of production?
the point where marginal social cost (MSC) equals marginal social benefit (MSB), at Q*.
What is the relationship between MSC, MPC, and the externality in positive externalities of production?
MSC is smaller than MPC for every output level, and the vertical difference between MSC and MPC represents the externality.
diagram for negative consumption externality
What are externalities of consumption?
Externalities of consumption occur when the consumption of a good or service generates an effect (positive or negative) on third parties who are not part of the consumption decision
What are negative externalities of consumption?
Negative externalities of consumption happen when an individual’s consumption negatively affects third parties. Examples include second-hand smoke from cigarettes, air pollution from cars, and noise pollution from loud music.
What is the relationship between MSB and MPB in negative externalities of consumption?
In negative externalities of consumption, the marginal social benefit (MSB) is less than the marginal private benefit (MPB) because of the harm caused to third parties.
What is the socially optimal quantity of consumption for a good with negative externalities?
The socially optimal quantity (Q*) occurs where the marginal social cost (MSC) curve intersects the marginal social benefit (MSB) curve.
Why do negative externalities of consumption lead to market failure?
The market fails because the quantity consumed (Q1) is greater than the socially optimal quantity (Q), leading to overconsumption and inefficient resource allocation. The welfare loss is shown by a triangle between Q1 and Q.
What are the possible government responses to negative externalities of consumption?
Ban or regulate the good (e.g., restricting smoking areas or limiting car use).
Impose an indirect (Pigouvian) tax to increase the cost of consumption.
Fund negative advertising to reduce demand.
What are the challenges of banning or regulating a good?
Negative impact on industries, shareholders, and employment.
Reduced government tax revenue.
Perceived as restricting individual freedoms, leading to public dissatisfaction.
High enforcement costs.
What is a Pigouvian tax, and how does it work?
A Pigouvian tax is an indirect tax designed to internalize the external costs of a good. It shifts the supply curve upward, increasing price and reducing quantity consumed closer to the socially optimal level (Q*).
What are the problems with imposing taxes on goods with negative externalities?
Demand for addictive goods (e.g., cigarettes) is price inelastic, so consumption may not decrease significantly.
High taxes might encourage black markets.
Taxes make consumers pay for the external cost but do not eliminate the negative effect.
How does negative advertising help address negative externalities?
Negative advertising raises awareness of the risks associated with consuming harmful goods, reducing demand. This shifts the demand curve closer to the MSB curve, minimizing welfare loss.
What are the limitations of negative advertising?
High costs, creating an opportunity cost for the government.
Limited effectiveness in certain demographics (e.g., reducing teenage smoking).
Results may vary depending on the type of good and target audience.
How can you distinguish between negative externalities of production and consumption in a diagram?
Production externalities: MSC ≠ MPC (supply-side).
Consumption externalities: MSB ≠ MPB (demand-side)
What happens to welfare loss in negative externalities of consumption if no government action is taken?
The welfare loss remains as the quantity consumed exceeds the socially optimal level, with society bearing costs greater than the benefits from overconsumed units.
Why might governments prefer taxes or advertising over banning goods?
Taxes generate revenue that can mitigate the externality’s effects.
Advertising avoids directly restricting freedoms and can complement other measures.
Bans can provoke public backlash and disrupt industries.
positive externality of consumption graph
subsidy in positive externality of consumption graph
