#5 Market Failure

Question 1

What are the characteristics of common pool resources?

(2 + examples)

Answer 1

Rivalrous: Consumption by one person reduces the availability for others. Example: Fish stocks.

Non-Excludable: It is not possible to prevent others from using the resource. Example: Clean air, oceans.

Question 2

What is the tragedy of the commons?

Answer 2

The overuse and depletion of common pool resources due to their rivalrous and non-excludable nature. Example: Overfishing reduces fish stocks for others and harms ecosystems.

Question 3

What is the difference between sustainable and unsustainable production?

Answer 3

Sustainable Production: Uses resources at a rate that allows replenishment (e.g., regulated fishing).
Unsustainable Production: Depletes resources faster than they can replenish, leading to degradation (e.g., overfishing).

Question 4

What is the maximum sustainable yield of a resource?

Answer 4

The highest rate of use that does not harm the resource’s capacity to regenerate. Beyond this point, overuse leads to degradation and reduced yields.

Question 5

What is the distinction between renewable and non-renewable resources?

Answer 5

Renewable Resources: Can replenish naturally if managed sustainably (e.g., forests, water).
Non-Renewable Resources: Finite and cannot replenish (e.g., fossil fuels, minerals).

Question 6

Why are non-renewable resources associated with unsustainability?

Answer 6

Non-renewable resources like fossil fuels cannot replenish naturally once depleted.
Mismanagement leads to permanent depletion and harmful externalities like greenhouse gas emissions.

Question 7

What is market failure?

Answer 7

Market failure refers to the inability of free markets to allocate resources efficiently, leading to overproduction or underproduction of goods/services from society’s perspective.

Question 8

What is allocative efficiency?

Answer 8

Allocative efficiency is achieved when MB = MC, or when social surplus is maximized, reflecting the optimal allocation of resources.

Question 9

What are externalities?

Answer 9

Externalities are costs or benefits from production/consumption affecting third parties who are not part of the action, leading to market failure.

Question 10

What are marginal private benefits (MPB) and marginal private costs (MPC)?

Answer 10

MPB: Benefits to consumers from consuming one more unit of a good.
MPC: Costs to producers for producing one more unit of a good.

Question 11

What are marginal social benefits (MSB) and marginal social costs (MSC)?

Answer 11

MSB: Benefits to society from consuming one more unit of a good.
MSC: Costs to society from producing one more unit of a good.

Question 12

When does allocative efficiency fail due to externalities?

Answer 12

Allocative efficiency fails when MPC ≠ MSC or MPB ≠ MSB, causing a divergence between private and social costs or benefits.

Question 13

What are negative production externalities, and how do they arise?

Answer 13

Negative production externalities occur when production imposes external costs on third parties. These costs are not reflected in the private cost of production and include environmental pollution, depletion of resources, and harm to ecosystems.

Question 14

How is a negative production externality illustrated on a graph?

Answer 14

Question 15

How to locate welfare cost on the graph

Answer 15

1. Always lies between Qm and Qopt
2. The base of the triangle gives the difference between MSB and MSC at Qm
3. Triangle points towards Q opt

Question 16

What is a Pigouvian tax, and how does it address negative production externalities?

Answer 16

A Pigouvian tax is a tax equal to the external cost of production (e.g., pollution). It shifts MPC → MSC, reducing output to Qopt, the socially optimal level.

Question 17

Explain the Pigouvian tax graph.

Answer 17

Without tax: Overproduction at Qm (MPC = D).
With tax: Output reduces to Qopt (MSC = D).
Welfare loss is eliminated as output reaches Qopt.

Question 18

What are carbon taxes, and how do they work?

Answer 18

Carbon taxes are levied on emissions, encouraging firms to reduce pollution by switching to cleaner technologies. This reduces the external cost and shifts MPC → MSC, reducing overproduction.

Question 19

What are tradable permits, and how do they function to reduce negative externalities?

Answer 19

Governments issue a limited number of permits allowing firms to emit a specific amount of pollutants. Firms can trade permits, incentivizing low-cost pollution reduction.

Question 20

What graph represents tradable permits?

Answer 20

Question 21

What are the advantages of using market-based policies like taxes and tradable permits?

Answer 21

Internalizes the externality, aligning private costs with social costs.
Incentivizes firms to innovate and reduce pollution.
Reduces pollution at lower overall societal cost.

Question 22

What are the limitations of market-based policies?

Answer 22

Difficulty in measuring external costs accurately.
Carbon taxes are often set too low for significant impact.
Tradable permits require detailed monitoring and can lead to favoritism or unfair allocation.

Question 23

How can government regulation address negative production externalities?

Answer 23

Governments can set restrictions or mandates such as emission limits, quotas, and requirements for cleaner technologies.

Question 24

How does government regulation affect production with externalities?

Answer 24

Question 25

What are the pros and cons of government regulations for negative externalities?

Answer 25

Advantages:
Simple to implement.
Clear reduction targets.
Disadvantages:
Can increase costs for firms.
May lack flexibility and efficiency compared to market-based policies.

Question 26

Define the following terms:

Marginal Private Cost (MPC)
Marginal Social Cost (MSC)
Welfare Loss

Answer 26

MPC: Cost to producers for producing one more unit of a good.
MSC: Total cost to society, including external costs.
Welfare Loss: Reduction in societal welfare due to misallocation of resources.

Question 27

define Collective Self-Governance

Answer 27

Refers to resource users managing common pool resources (e.g., fisheries, forests) sustainably without top-down government control.

Requires communication and cooperation among users.
Solutions are community-driven and tailored to local settings.

Question 28

2 advantages and 2 disadvantages of collective self governance

Answer 28

Advantages:

Avoids the “tragedy of the commons” by encouraging cooperation.
Reduces reliance on government intervention.

Disadvantages:

Requires strong communication and agreement between users.
Difficult to implement globally (e.g., for oceans or climate change).

Question 29

What are negative consumption externalities? + ex

Answer 29

External costs created by consumers when consuming goods that cause harm to others, e.g., smoking in public or fossil fuel consumption.

Question 30

What happens to social welfare in the presence of negative consumption externalities?

Answer 30

The market equilibrium quantity (Qm) exceeds the socially optimal quantity (Qopt), leading to overproduction and welfare loss.

Question 31

purge

Question 32

What policy tools can correct negative consumption externalities?

Answer 32

Market-based policies: Pigouvian taxes, tradable permits.
Legislation and regulation: Smoking bans, age restrictions.
Education and awareness campaigns.
Nudges (HL only): Incentives like bike lanes.

Question 33

Indirect Taxes - how do they work

Answer 33

Taxes are imposed on goods causing negative externalities (e.g., petrol, cigarettes).
Shifts MPC upward to MPC + tax, reducing overconsumption and improving allocative efficiency (Qm → Qopt).

Question 34

Identify advantages and disadvantages of using Pigouvian taxes (2+3)

Answer 34

Advantages:
Internalizes the externality, increasing production costs and reducing consumption.
Tax revenue can fund education or awareness programs to further mitigate externalities.

Disadvantages:

Ineffective if demand is inelastic (e.g., cigarettes, petrol): consumption remains high despite higher prices.
Difficult to measure external costs accurately, leading to challenges in setting the tax.
Politically sensitive: high taxes may disproportionately affect low-income groups.

Question 35

What are tradable permits, and what are their challenges
(1+2+3)

Answer 35

A cap-and-trade system where firms are allocated permits to pollute; permits can be traded in a market.
Effectiveness:
Provides a clear pollution cap.
Firms with low emissions can profit by selling permits, encouraging cleaner production.

Challenges:
Requires accurate measurement of emissions and enforcement of limits.
High administrative costs.
Risk of favoritism when allocating permits.

Question 36

What role does government legislation play in reducing negative consumption externalities?

Answer 36

Legislation sets legal limits (e.g., smoking bans, mandatory warning labels) to prevent externalities, reducing Qm to Qopt

Question 37

govt regulation examples

Answer 37

Smoking bans in public spaces.
Restricting vehicle entry into cities to reduce pollution.
Limits on pollutant emissions by industries.

Question 38

govt regulation advantages and disadvantages

Answer 38

Advantages:

Direct and enforceable; ensures compliance to reduce externalities immediately.
Effective in reducing harm from visible externalities (e.g., second-hand smoke, vehicle emissions).

Disadvantages:

High monitoring and enforcement costs.
Can stifle innovation or create unintended economic hardships for businesses.

Question 39

What are the advantages and disadvantages of education and awareness campaigns?

Answer 39

Advantages: Influences consumer behavior without heavy enforcement.
Disadvantages: Effectiveness depends on public receptivity; may take a long time for visible results.

Question 40

carbon tax - definition
effectiveness
challenges

(1+2+2)

Answer 40

What are carbon taxes?
Tax based on the carbon content of fossil fuels to reduce greenhouse gas emissions.

Effectiveness:
Encourages cleaner energy use and discourages high-carbon options.
Can fund renewable energy initiatives.

Challenges:
Hard to set an effective tax rate (too low = ineffective; too high = politically challenging).
Regressive impact: higher energy costs may disproportionately affect lower-income households.

Question 41

nudges definition + example

Answer 41

Definition:
Behavioral economic policies influencing consumer choices without direct regulation or taxation.
Example: Warning labels on cigarette packs or graphic images showing health risks.

Question 42

nudges advantages and disadvantages (2+2)

Answer 42

Advantages:
Cost-effective and less invasive than taxes or regulations.
Encourages voluntary behavior change, shifting MPB toward MSB (reducing external costs).
Disadvantages:
Impact varies across demographic groups and may not be sufficient for large-scale externality correction.
Long-term effectiveness is uncertain.

Question 43

when r govt regulations useful & what limitations do they have

Answer 43

When are they effective?

In addressing severe and immediate externalities where market-based solutions (like taxes) are infeasible.
Where behavior needs strict deterrence (e.g., bans on harmful substances).

Limitations:

Cannot address every type of externality (e.g., fuel consumption may require taxes, not just regulations).
Limited success without strong monitoring and compliance mechanisms.

Question 44

how to evaluate policy effectiveness (3 key considerations)

Answer 44

Key Considerations:

Is the policy cost-effective?
Does it target the root cause of the externality (e.g., reducing emissions vs. treating effects)?
Can it be scaled or adapted across demographics?