2.8 Market Failure and Externalities

Question 1

What is market failure?

Answer 1

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

Question 2

What are the reasons that markets could fail?

Answer 2

Negative externalities
Positive externalities
Information failure - de-merit goods
- merit goods
- asymmetric information
Public goods
(Immobility of factors, monopoly power, inequality)

Question 3

What is an externality?

Answer 3

A cost imposed on, or a benefit received by any third party outside an economic transaction for which no compensation is paid. It is a ‘spill-over’ effect.

Question 4

What are third parties?

Answer 4

Any economic agents not directly involved in the economic transaction that are affected (cost or benefit) by the economic activity

Question 5

What are negative externalities?

Answer 5

Harmful effect imposed on third parties outside the economic transaction for which no compensation is paid

The market over-allocates resources if at the market determined output the MSC > MSB

Question 6

What are positive externalities?

Answer 6

Beneficial effect for third 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 7

What are marginal external costs (MEC)?

Answer 7

The additional cost to third parties of producing an additional unit of output

Question 8

What makes up MSC?

Answer 8

MSC = MPC + MEC

Question 9

What is marginal external benefit (MEB)?

Answer 9

The additional benefit for third parties from the consumption of an additional unit of a good/service

Question 10

What makes up MSB?

Answer 10

MSB = MPB + MEB