2.8 Market Failure

Question 1

What is market failure ?

Answer 1

market failure occurs when the market fails to deliver an efficient allocation of resources; the price mechanism fails to maximise social welfare

Question 2

What are the possible reasons for market failure ?

Answer 2

1) negative externalities
2) positive externalities
3) demerit-goods
4) merit goods
5) information failure
6) public goods
7) monopoly power

Question 3

What is an externality ?

Answer 3

An externality is a harmful effect imposed on, or beneficial effect enjoyed by, any 3rd party outside the economic transaction for which no compensation is paid

Question 4

What are negative externalities ?

Answer 4

• negative externalities are harmful effects imposed on 3rd parties outside the economic transaction for which no compensation is paid
• the market over-allocates resources if, at the market determined output, MSC > MSB

Question 5

What are positive externalities ?

Answer 5

positive externalities are beneficial effects for 3rd parties outside the economic transaction for which no payment is made
- the market under-allocates resources if, at the market determined output MSB > MSC

Question 6

what is marginal external costs (MEC) ?

Answer 6

the additional costs to 3rd parties of producing an additional unit of output

Question 7

what is marginal external benefit (MEB) ?

Answer 7

the additional benefit for 3rd parties from the consumption of an additional unit of output

Question 8

why does optimal output occur when MSB=MSC ?

Answer 8

the social optimum output Q* maximises social welfare because total benefits to society outweigh the total costs to society by the maximum possible, where MSC=MSB

Question 9

what happens when there is an under allocation of resources ?

Answer 9

if MSB>MSC, at the market determined output, there is a welfare loss, since an additional unit of output will increase benefits to society more than the costs to society, increasing social welfare

Question 10

what happens when there is an over allocation of resources ?

Answer 10

if MSB<MSC, at the market determined output, there is a welfare loss, since an additional unit of output will increase costs to society more than the benefits to society, decreasing social welfare

Question 11

what does negative production externality look like on a graph ?

Answer 11

Chain of reasoning:
the marginal private costs are less than marginal social costs, MPC<MSC, the market over-allocates resources since Q1 > Q* since the MSC>MSB at the market determined output, meaning there is a deadweight loss of social welfare FGH and social welfare is not maximised

Question 12

what does negative consumption externality look like on a graph ?

Answer 12

chain of reasoning:
the marginal private benefit of consumers is greater than the marginal social benefit MPB>MSB, the market over-allocates resources to the market **Q1 > Q* **, this is because at Q1 MSB<MSC, this means there is a deadweight loss of social welfare FGH and social welfare is not maximised

Question 13

what does positive production externality look like on a graph ?

Answer 13

chain of reasoning:
the marginal social costs are less than the marginal private costs, MSC<MPC, the market under-allocates resources since Q1 < Q* , since the MSC<MSB at the market determined output, this means there is a deadweight loss of social welfare KJL, social welfare is not maximised

Question 14

what does positive consumption externality look like on a graph ?

Answer 14

chain of reasoning:

the marginal social benefit of the G/S is greater than the marginal private benefit, MSB>MPB, the market under-allocates resources since **Q1 < Q* **, since at the market determined output MSB>MSC, this means there is a deadweight loss of social welfare KJL, social weflare is not maximised