3.8 Limitations of Markets

Question 1

What is the definition of an externality?

Answer 1

An externality is a cost or benefit to a third party outside the economic activity being considered

Question 2

what is the definition of a negative externality?

Answer 2

A negative externality is a cost imposed on a third party as a result of an economic activity

Question 3

what is the definition of a positive externality?

Answer 3

A positive externality is a benefit enjoyed by a third party as a result of an economic activity

Question 4

What is a consumption externality?

Answer 4

A consumption externality is when a consumer doesn’t take into account the external costs or benefits to third parties of their consumption decision

Question 5

What is a production externality?

Answer 5

A production externality arises when a producer does not take into account the external costs and benefits to third parties of their production decision

Question 6

What do markets need to be fully competitive…

Answer 6

…all consumers and producers need to have perfect, costless and complete infomation

Question 7

What is an example of information failure?

Answer 7

• information failure could occur when a consumer underestimates the risks of consuming a good that is harmful to them

Question 8

What are 3 reasons why information failure may occur?

Answer 8

1. The information is too complicated
2. The information is not avalaible
3. The consumer may be resistant to the information (e.g because they are addicted to the good)

Question 9

What is the definition of a demerit good?

Answer 9

Demerit goods are goods that would be overproduced and over-consumed in a free market due to the associated information failure and may result in negative externalities
(e.g fast food, sugary drinks, gambling)

Question 10

What is the definition of a merit good?

Answer 10

• A merit good is a good that would be underproduced and under-consumed in a free market due to associated information failure and may result in positive externalities
  (e.g education, healthcare, fitness activities)

Question 11

What does the price mechanism do to a demerit good?

Answer 11

The price mechanism allocates more resources to production and consumption of demerit goods than is socially acceptable

Question 12

What does the price mechanism do to a merit good?

Answer 12

The price mechanism allocates less resources to production and consumption of merit goods than is socially acceptable

Question 13

What 5 government policies can be used to correct positive and negative externalities?

Answer 13

1. Indirect Taxes
2. Subsidies
3. State Provision
4. Legislation and Regulation
5. Information Provision

Question 14

How do indirect taxes help fix negative externalities?

Answer 14

• An increase in indirect taxes on a demerit good or service will lead to an increase in price, so there will be a contraction in demand
• taxes on factors of production may mean a shift in supply to the left
• used especially on cars, where consumers pay a VED depending on the CO2 emissions of the car

Question 15

What are 3 evaluation points for the use of indirect taxes to try and fix negative externalities?

Answer 15

1. The extent to which the imposition of a tax will reduce the quantity bought and sold of a good depends on the size of the tax and the PED of the good or service - a price inelastic good will not be as affected (also can be applied to addictions)
2. Since indirect taxes are regressive they will take more % income from those with lower income, so the government may increase income inequality while reducing negative externalities - high indirect taxes may also lead to smuggling and more spent on policing
3. They may lead to reductions in negative externalities or increases in tax revenue is the demand is price inelastic

Question 16

How do subsidies help boost positive externalities?

Answer 16

• they may be used to encourage the production and consumption of goods with positive externalities (??also discouraging goods with negative externalities?)

Question 17

What are 2 evaluation points for the use of subsidies to boost positive externalities?

Answer 17

1. Subsidies will be more effective is the demand for the good is price elastic, because changes in price will be met with larger changes in quantity, larger subsidies will obviously also be more effective
2. Opportunity costs of subsidies may also be high, as there are many other areas that may require government spending, but they help those on lower income to afford products with positive externalities

Question 18

How can State Provision be used to boost positive externalities?

Answer 18

• the state directly provides the good or service with the positive externality (e.g education and healthcare), which benefits the whole society
• this is a type of good that would be underproduced and under consumed in the free market

Question 19

What are 2 evaluation points to the use of State Provision for supplying goods with positive externalities?

Answer 19

1. If the government provides services at 0 charge (perfectly inelastic supply), there is likely to be excess demand, so some peoples needs are still not being met
2. Opportunity cost to the taxpayer who ultimately funds this and the government is liekly to face pressure to increase provision of different merit goods to different population groups

Question 20

How can the government use legislation and regulation to reduce or eliminate negative externalities?

Answer 20

• could introduce laws that ban a market altogether, or restrict demand or advertising etc., created stricter health codes
• regulations tend to increase cost of productions for firms, shifting supply to the left

Question 21

what are 2 evaluation points for the use of laws and regulations to eliminate positive externalities?

Answer 21

1. banning a product is effective, but will also require effective policing of the law to make sure it is upheld
2. the effectiveness of the law depends on the amount of illegal activities occurring and the resources available for policing, which has an opportunity cost

Question 22

How can you use information provision to boost positive externalities and reduce negative externalities?

Answer 22

The government can try and reduce consumption of demerit goods by educating the public about their negative externalities and boost merit goods by educating and providing information to the public about their positive externalities

Question 23

What are 2 evaluation points for the use of information provision to boost positive externalities and reduce negative externalities?

Answer 23

• extent to which it will be effective depends on the responsiveness of consumers, for addictive goods such as smoking consumers may ignore the warnings
• cheaper to educate the public rather than police them, opportunity cost to government funds however