3.8 Limitations of Markets

Question 1

What is an externality?

Answer 1

The impact (costs or benefits) of an economic transaction on a third party.

Question 2

Externalities are/aren’t taken into account in market demand and supply? Why is this?

Answer 2

Aren’t, because a third party is not involved in the production or consumption of a good/service (the demand and supply).

Question 3

What is a positive externality? Give an example.

Answer 3

The benefit of an economic transaction for a third party. Eg: people begin to cycle more, so there is less congestion on roads for car owners.

Question 4

What is a negative externality? Give an example.

Answer 4

The cost of an economic transaction for a third party. Eg: people smoking creates air pollution for passers by, which can harm their health.

Question 5

What are five government policies used to correct negative and positive externalities?

Answer 5

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

Question 6

Taxation only affects…

Answer 6

Supply.

Question 7

How does taxation correct negative externalities?

Answer 7

Indirect taxes increase the costs of production for a firm so supply decreases. This causes the equilibrium price to rise and demand to fall. This reduces the quantity of products sold so there are fewer negative externalities.

Question 8

How does taxation correct positive externalities?

Answer 8

The government can lower taxes on goods with positive externalities, such as bikes, to encourage supply and thus increase demand.

Question 9

Why can taxation be ineffective in reducing negative externalities for products?

Answer 9

If demand is inelastic, then consumers will be unresponsive to the price change as inelastic goods are usually addictive. Eg: cigarettes.

Question 10

What are two benefits of using taxation to correct externalities?

Answer 10

1. Reduction in negative externalities and increase in positives.
2. Tax revenue rises so the government can spend more on improving the economy.

Question 11

What are two costs of using taxation to correct externalities?

Answer 11

1. If tax is regressive, it takes a greater proportion of a low income which could increase inequalities.
2. Enforcing taxation could lead to products being sold on the black market, so the government doesn’t receive any tax revenue.

Question 12

How do subsidies correct positive externalities?

Answer 12

Subsidies encourage production as they reduce costs for a firm. Therefore, supply shifts to the right, making the equilibrium price fall and demand rise. Consequently, more products with positive externalities are sold.

Question 13

What factor do subsidies depend on when correcting externalities?

Answer 13

A susbidy would have a greater effect on elastic demand.

Question 14

What are two benefits of using subsidies to correct externalities?

Answer 14

1. Encourages production and consumption of goods with positive externalities.
2. More jobs are created in subsidised markets.

Question 15

What are two costs of using subsidies to correct externalities?

Answer 15

1. If the government pays for subsidies, the opportunity cost would be money spent elsewhere. Eg: healthcare.
2. Government may raise taxation to pay for the subsidy.

Question 16

How does state provision correct negative externalities?

Answer 16

Some goods and services may not be supplied if the profit is too low. Therefore, the government intervenes to supply goods and services (NHS) directly to consumers to reduce negative externalities.

Question 17

What is an issue with state provision?

Answer 17

If the government doesn’t provide enough supply, there can be excess demand leading to shortages in staff at a hospital for example.

Question 18

What are two benefits of using state provision to correct externalities?

Answer 18

1. Improved standard of living as low-income consumers have access to essential services.
2. Can be a multiplier effect from state provision.

Question 19

What are two costs of using state provision to correct externalities?

Answer 19

1. If the government pays for state provision, the opportunity cost would be money spent elsewhere.
2. Government may raise taxation to pay for the provision.

Question 20

How does legislation and regulation correct negative externalities?

Answer 20

Legislation can get rid of a market entirely (such as banning drugs) to reduce negative externalities. Regulation works by using fines and restrictions to minimise negative effects.

Question 21

What is one benefit of using legislation and regulation to correct externalities?

Answer 21

1. They can pinpoint specific postive or negative externalities.

Question 22

What are two benefits of using legislation and regulation to correct externalities?

Answer 22

1. People may resort to using black markets which are expensive to police.
2. Government will have to monitor regulations which is also expensive.

Question 23

How does information provision correct positive externalities?

Answer 23

It can encourage consumers to buy goods and services by showing how this product can help them. This increases demand and postive externalities.

Question 24

How does information provision correct negative externalities?

Answer 24

It can discourage consumption by giving consumers facts about how products are harmful. This decreases the quantity demanded and negative externalities associated with the good/service.

Question 25

Why can information provision be ineffective sometimes?

Answer 25

• Consumers may be unresponsive to information
• Information could be difficult to deliver

Question 26

What is one benefit of using information provision to correct externalities?

Answer 26

1. It costs less than other policies to correct positive and negative externalities.

Question 27

What is one cost of using information provision to correct externalities?

Answer 27

1. Opportunity cost of producing and delivering this information could be spending money elsewhere.