Chapter 5: Market failure and negative externalities

Question 1

What is market failure?

Answer 1

When market forces fail to deliver the best level of output for society, which leads to a loss of welfare.

Question 2

When is market failure said to exist?

Answer 2

When the price mechanism fails to deliver the optimal and most efficient allocation of resources such that the best level of output for society is reached.

Question 3

What is the price mechanism?

Answer 3

The demand and supply model.

Question 4

How can a government intervene to try and correct market failure?

Answer 4

Information, taxing, subsidising or legislating.

Question 5

What might happen as a result of government intervention?

Answer 5

The outcome may be a deepening of the market failure, a new failure may arise or the intervention strategy is just ineffective.

Question 6

When does government failure exist?

Answer 6

When government intervention leads to a less efficient allocation of resources.

Question 7

What is public choice theory?

Answer 7

It assumes that individuals seek to maximise satisfaction and firms seek to maximise profits.

Question 8

Why do economists question whether politicians’ motives are consistent with the pursuit of policies to correct market failure?

Answer 8

Politicians attempt to maximise their own self-interest through maximising votes.

Question 9

What are negative externalities/external costs?

Answer 9

They are the third-party or spill-over effects arising from the production and/or consumption of goods and services.

Question 10

When do negative externalities exist?

Answer 10

When the social costs of an economic action are greater than the private costs.

Question 11

What is the formula for social costs?

Answer 11

Private costs + external costs = social costs

Question 12

What needs to happen in order for the optimal level of production to occur where all costs and benefits are taken into account?

Answer 12

The market should produce at the output and price level where the marginal social cost is equal to the marginal social benefit.

Question 13

What is a demerit good?

Answer 13

A good that is valued more by the individual than society so the marginal private benefits are higher than the marginal social benefits.

Question 14

Give an example of negative externalities from consumption.

Answer 14

The consumption of too much alcohol may impose spill-over costs on society such as drink-driving, violence, days off work and domestic abuse.

Question 15

What are the axis labelled on an externalities graph?

Answer 15

Costs and benefits are along the y axis and quantity is on the x axis.

Question 16

What are the demand curves on an externalities graph labelled?

Answer 16

Marginal social benefit and marginal private benefit.

Question 17

What are the supply curves on an externalities graph labelled?

Answer 17

Marginal social cost and marginal private cost.

Question 18

Which area on a graph for a demerit good represents the net welfare loss?

Answer 18

It is a triangle. Its largest side is the distance between the benefits curves.

Question 19

What does the MPB curve represent on a graph for a demerit good?

Answer 19

An individual’s satisfaction from the consumption of the demerit good.

Question 20

When can a complete ban be justified?

Answer 20

When the social marginal cost of consumption is always higher than the social marginal benefit i.e. the two curves do not intersect.

Question 21

What does the combined area of consumer and producer surplus indicate?

Answer 21

The welfare from the production and consumption of a product.

Question 22

What happens in the region of consumer and producer surplus?

Answer 22

The marginal benefit is higher than the marginal cost.

Question 23

What would happen if the producer of a product were to take into account all the external costs and what represents this?

Answer 23

Their costs of production would be higher and this is represented by the marginal social cost curve.

Question 24

What does the vertical distance between the two supply curves that reflect costs show?

Answer 24

The size of the negative externality.

Question 25

What is a net welfare loss?

Answer 25

An area of negative welfare for society.

Question 26

What area is net welfare loss represented by on a diagram where the marginal social cost is higher than the marginal private cost?

Answer 26

It is a triangle and its largest side is the distance between the marginal social cost and the marginal social benefit.

Question 27

What is the market failure with demerit goods?

Answer 27

The free market will overproduce demerit goods.

Question 28

What is the point of government intervention when negative externalities exist?

Answer 28

The government tries to make firms internalise their costs.

Question 29

How are taxes a method of government intervention?

Answer 29

If the government were to introduce a tax equal to the negative externality then this would shift the firm’s marginal private cost curve to the left.

Question 30

What are the results of imposing a tax onto a product?

Answer 30

There is a fall in the production and consumption of the product but also there is a reduction in the size of the net welfare loss.

Question 31

What is ‘shifting the burden of the tax’?

Answer 31

When the supplier may be able to pass on some or all of the tax onto the consumer through a higher price.

Question 32

What does shifting the burden of the tax depend on?

Answer 32

It depends on the price elasticity of demand and supply.

Question 33

What is the problem with using taxes as a method of intervention?

Answer 33

It is often difficult for governments to estimate optimal levels of tax as it is difficult to place monetary values on negative externalities.

Question 34

What is the effect of taxes raising the price of a good or service?

Answer 34

This reduces consumer surplus, it may have an adverse effect on low income groups and it reduces the international competitiveness of a good or service if the producer markets their goods abroad.

Question 35

What is the problem with environmental taxes?

Answer 35

They require the agreement of a number of countries which can be extremely difficult.

Question 36

How is legislation a method of government intervention?

Answer 36

The government can pass laws to correct or prevent negative externalities.

Question 37

What is an example of legislation that has been passed in order to reduce the size of a negative externality?

Answer 37

Drink driving is against the law.

Question 38

When is a policy likely to be more effective?

Answer 38

When the policy has the force of the law rather than being a voluntary agreement.

Question 39

What is the effectiveness of a policy dependent on?

Answer 39

How effective the enforcement of the policy is and the size of any penalties.

Question 40

Why do the costs of enforcement need to be considered?

Answer 40

There could be an opportunity cost associated with this.

Question 41

What is the time lag associated with legislation?

Answer 41

It takes time to introduce new laws and there may be a time lag before legislation is passed.

Question 42

What is the problem with legislation being imposed in one country only?

Answer 42

It may be ineffective - there may need to be a global agreement to prevent firms from evading regulation.

Question 43

What impact does legislation have on revenue unlike taxation?

Answer 43

It will not raise revenue.

Question 44

What are property rights?

Answer 44

Legal rights of ownership.

Question 45

When does legislation tend to work best in terms of property rights?

Answer 45

When property rights are clearly defined.

Question 46

When do negative externalities tend to occur in terms of property rights?

Answer 46

When there are ill-defined or non-existent property rights.

Question 47

Give examples of things that are polluted as a result of no one owning these assets.

Answer 47

Air, the atmosphere and oceans.

Question 48

Why is it the case that a privately owned river is less likely to be polluted than a public river?

Answer 48

The private owner would have a clear incentive to sue anyone who polluted their river and claim compensation too.

Question 49

What is the solution to negative externalities in terms of property rights?

Answer 49

Allocating ownership of the product that is experiencing the negative externalities as this would produce an efficient outcome.

Question 50

What is the problem with legally protecting the rights of the owners of environmental resources?

Answer 50

This carries a cost and may be difficult.

Question 51

What does the EU Emissions Trading scheme do?

Answer 51

It incentivises the reduction of CO2 emissions in a cost-effective and efficient manner.

Question 52

How does the EU scheme operate?

Answer 52

Through the trade of CO2 emissions allowances, one allowance represents one tonne of CO2.

Question 53

What is the effect of setting a cap on emissions?

Answer 53

It creates the scarcity required in the market.

Question 54

What happens to those firms who have released more CO2 than they have allowances for?

Answer 54

They are heavily fined.

Question 55

What is the aim of carbon trading?

Answer 55

Policy can help to internalise environmental costs of firms’ production and encourage lower emissions to tackle climate change.

Question 56

What happens in a cap and trade system?

Answer 56

The number of available permits would gradually decline.

Question 57

What is the effect of the number of permits reducing?

Answer 57

The supply curve shifts inwards (which is a vertical line) causing the price to increase - this encourages investment into cleaner technologies.

Question 58

What is the problem with the EU Emissions trading scheme?

Answer 58

The recession reduced industrial demand for the permits and the EU gave away too many allowances in the first place.

Question 59

What is the result of giving out too many allowances?

Answer 59

There is massive overcapacity in the carbon market which has led to a sharp decrease in the price of permits.

Question 60

What is the problem with the scheme targeting production rather than consumption?

Answer 60

It has resulted in the closure of industrial plants in the EU and firms have instead moved them to Asia which has affected the competitiveness of the EU. Consumption has been increasing which means that there is more pollution.