7) Externalities Flashcards
What is market failure?
a situation in which the free market mechanism does not lead to an optimal allocation of resources, e.g. where there is a divergence between marginal social benefit and marginal social cost.
What is marginal social cost??
The cost to society of producing/ consuming one extra unit of a good
What is marginal social benefit??
The additional benefit that society gains from the production or consumption of a good
What is marginal private cost and marginal private benefit??
Marginal private cost is the cost to an individual/ firm of producing/ consuming an extra good
Marginal private benefit is the additional gain to an individual of producing/ consuming an extra good
How can costs and benefits that aren’t included in the price mechanism still lead to market failure??
an overconsumption of goods in which the marginal social cost is not paid for (society are worse off from the actions of an individual
an underconsumption of a good in which the marginal social benefits are not considered (additional consumption would benefit all of society eg healthcare)
Because allocative efficiency and economic efficiency is not achieved, society is worse off than it could be
What does divergence between social and private costs and benefits mean??
A divergence occurs between social and private costs when an individual pays for the costs of their actions without paying for the full cost of their actions to society.
A divergence occurs between social and private benefits when an individual consumes at a level lower than a level that would benefit all of society because they only consider the benefits to themselves.
How are subsidies useful at correcting market failure and under what elasticity are they most beneficial?
Subsidies decrease the costs of production for firms, and lower the price, causing an extension of demand. This increased demand means more people are consuming the merit good that has been subsidised by the government, so MPB has shifted towards a more socially optimum level of MSB. When PeD is relatively elastic, subsidies work best, as a small decrease in price leads to a larger increase in demand
What are the disadvantages of subsidies as a means of correcting market failure??
- High opportunity cost for the government, especially of PED is inelastic
- depends on competition, lower competition means less incentive from firms to pass Lower prices onto consumers
Why does subsidy compare favourably and unfavourably to a tax??
Favourably- better to subsidise consumption of merit goods rather than tax de merit goods.
Tax can pay for the subsidy, so more effective when used together
Unfavourable- taxes raise revenue whilst subsidies have an opportunity cost because they’re a form of government spending
Define an externality
a cost or a benefit that is external to a market transaction, and is thus not reflected in market prices
Define private cost
a cost incurred by an individual (firm or consumer) as part of its production or other economic activities
Define external cost
external cost- a cost that is associated with an individual’s (a firm or household’s) production or other economic activities, which is borne by a third party
Common examples of negative externalities of consumption
obesity air pollution waste addiction crime
What is deemed the socially optimum level of consumption or production on a diagram??
when marginal social benefit= marginal social cost
Additional consumption does not make society any better or worse off
How are negative externalities of consumption shown on a diagram???
supply line = MSC =MPC (assumption)
Demand lines = MPB to the right of the MSB line, because the external benefit is negative. The consumption needs to be reduced to that MPB = MSB at the optimum level of consumption. There is currently overconsumption of the good and there is a triangle of welfare loss present.
