7.4 Private costs and benefits, externalities and social costs and benefits

Question 1

What is market failure?

Answer 1

This is when the price mechanism leads to an inefficient allocation of resources and a deadweight loss of economic welfare

Question 2

What are some of the reasons for market failure?

Answer 2

Negative externalities and Positive externalities
Public goods - free rider problem and profit-motivated firms
Merit goods and De-merit goods - information failure
Information failures
Monopolies - one dominant seller and high barriers to entry
Immobility of factor inputs - suppliers can’t produce extra output or workers are immobile
Income inequality

Question 3

What is an externality?

Answer 3

It is the cost or benefit a 3rd party receives from an economic transaction outside of the market mechanism. In other words, it is the spill-over effect of the production or consumption of a good or service.

Question 4

What is the under provision of public goods?

Answer 4

Public goods are non-excludable and non-rivalrous and they are underprovided in the free market because of the free rider problem

Question 5

What are information gaps?

Answer 5

It is assumed that consumers and producers have perfect info when making economic decisions. However, this is rarely the case and imperfect info leads to a misallocation of resources.

Question 6

What are monoploies?

Answer 6

Since consumers have very little choice where to buy goods and services offered by monopolies, they are often overcharged. This leads to the underconsumption of the good or service and thus there is a misallocation of resources, since consumers needs and wants aren’t fully met

Question 7

What is inequalities in the distribution of income and wealth?

Answer 7

There is an unequitable distribution of income and wealth. Income refers to a flow of money, while wealth refers to a stock of assets. This can lead to negative externalities and social unrest

Question 8

What is complete and partial market failure?

Answer 8

Complete market failure occurs when there is a missing market. The market doesn’t supply the products at all. Partial market failure occurs when the market produces a good, but it is the wrong quantity or the wrong price. Resources are misallocated where there is a partial market

Question 9

What are positive externalities?

Answer 9

They create external benefits. These are caused by merit goods. They are underprovided in the free market.
MSB>MSC

Question 10

What are negative externalities?

Answer 10

They create external costs. They are caused by demerit goods. They are usually overprovided
MSC>MSB

Question 11

What are private costs?

Answer 11

Those costs that are incurred by an individual who produces a good or service.
This determines how much the producer will supply

Question 12

What is marginal private cost? MPC

Answer 12

It is the cost to a firm of producing one extra unit

Question 13

What is a social cost?

Answer 13

The total costs of a particular action.
This is calculated by the private cost + external costs

Question 14

What is the marginal social cost?

Answer 14

It is the extra cost on society derived per extra unit consumed.
It can be seen that MSC and MPC diverge from each other.
MSC = MPC + MexternalC

Question 15

What is a private benefit?

Answer 15

benefits that go to individuals who produce or consume a particular good.
Could also be a firms revenue from selling a good

Question 16

What is a social benefit?

Answer 16

These are private benefits + external benefits

Question 17

What is a marginal social benefit?

Answer 17

It is the extra benefit on society derived per extra unit consumed
MSB = MPB + MexternalB

Question 18

What are examples of negative production externalities?

MSC > MPC

Answer 18

• Industrial pollution of the water and air
• Climate change from greenhouse gases
• Resource depletion
• Deforestation
• Resource degradation

Question 19

What would be some negative production externalities solutions?

Answer 19

COMMAND
* limit the emission of pollutants by setting a maximum level of pollutants permitted
* limit the quantity of output produced by the firm
* require polluting firms to install technologies reducing emissions
MARKET
* A tax per unit of output that directly corrects the overallocation of resources to the good.
* A tax on emissions creates incentives for the firm to buy fewer polluting resources and to switch to less polluting technologies (alternative energy sources); a contemporary example is carbon taxes.
* Tradable permits (“cap and trade”) puts a limit (“cap”) on the number of permits but allows firms to trade permits with each other, creating a market for permits.

Question 20

What are some Negative production externalities analysis points?

Answer 20

Firms are ignoring full social cost because of self-interest. They are only looking at private cost and that is why they produce at p1 q1 which is the private optimum instead of the social optimum. The result of this is the overproduction of the good. The price is too low at P1 as it is only accounting for the private costs and not the external costs. That makes the whole problem worse as it encourages overconsumption of the good and then you see a misallocation of resources which gives you a welfare loss

Question 21

What are examples of negative consumption externalities?

MSB < MPB

Answer 21

Demerit goods like alcohol, cigarettes, gambling, unhealthy foods, and certain drugs.
Pollution from individual behaviours such as automobile travel or littering.
Excessive sugary drinks / fast food

Question 22

What would be some negative consumption externalities solutions?

Answer 22

Indirect taxes
Help and schemes to quit
Provide more info and education

Question 23

What are some Negative consumption externalities analysis points?

Answer 23

The market will allocate at the private optimum at p1 q1 but society would like resources allocated at MSB = MSC the social optimum. Too much is being produced which leads to an overconsumption. If there is allocative inefficiency there will be a welfare loss.

Consumers are ignoring the social benefits of their actions, only considering private benefits due to their self-interest. The end result is allocating resources at the wrong place which leads to overconsumption and production of these goods. As a result, there is a misallocation of resources which leads to allocative inefficiency and a welfare loss to society

Question 24

What are examples of Positive Production Externality?

MSC < MPC

Answer 24

• Education of workers by a firm useful outside of the firm such as first aid, CPR, literacy, and numeracy.
• Research and Development (“R&D”) done by firms - other firms can copy

Question 25

What would be some positive production externalities solutions?

Answer 25

Direct government provision can provide these directly by having government agencies do research and development, create medicines, worker training, etc.
Or with subsidies government can fund the private sector to provide more of the things listed above.

Question 26

Positive production externalities analysis

Answer 26

producers or firms only consider private costs not full social costs, and ignore external benefits. Occurs due to self-interest. That means resources are allocated at the private optimum of p1 q1 not the social optimum. This leads to an underproduction and consumption of these goods. The end result is a misallocation of resources, allocative inefficiencies and a welfare loss

Question 27

What are examples of positive consumption externalities?

MSB > MPB

Answer 27

Merit goods
Healthcare
Education
Exercise
Healthy eating
Use of renewable resources or otherwise lowering ecological footprint

Question 28

What would be some positive consumption externalities solutions?

Answer 28

Legislation such as compulsory education for young people.
Advertising to illustrate the benefits of the good like vaccination, milk or vitamins.
Direct government provision of goods like education or healthcare.
Subsidies to producers of goods which has the same overall effect as the direct government provision (perhaps better because of the profit motive of private firms).

Question 29

Positive consumption externalities analysis

Answer 29

Consumers are ignoring full social benefits. Only considering private benefits out of self-interest. As a result market allocates at the private optimum which means there is an underproduction and consumption compared to the social optimum. This allocates in a misallocation of resources, allocative inefficiency and welfare loss.

Question 30

When would you see external costs of production?

Answer 30

This occurs when a good is being used or produced, such as pollution
They are shown by the vertical distance between MSC and MPC
With negative externalities, MSC>MPC. At the free market equilibrium there is an excess of social costs at the output between Q1 and QE.
Where social costs>private benefits, there is a deadweight welfare loss.

Question 31

When would you see external benefits of production?

Answer 31

It could be the decline of diseases and the healthier lives of consumers through vaccination programs.
They are underprovided and consumed in a free market where MSB>MPB, leading to market failure
WELFARE gain would be the triangle on left