Chapter 8: Market failure and externalities Flashcards
Define market failure
A situation in which the free market equilibrium does not lead to a socially optimal allocation of resources, such that too much or too little of a good is being produced and/or consumed
Define marginal social benefit (MSB)
The additional benefit that society gains from consuming an extra unit of a good
Define marginal social cost (MSC)
The cost to society of producing an extra unit of a good
When does market failure occur?
When markets work in a way to produce a bad outcome for society as a whole
What would be an ideal outcome for society?
Where the marginal benefit that society receives from consuming each good or service matches the marginal cost of producing it
When does an externality exist?
Where the economic agents do not pay all of the costs of their actions or do not take account of the benefits that may be received by third parties from their activities
Describe public goods
Due to their characteristics, they cannot be provided by a purely free market
Give an example of a public good
Street lights
Why may education in some developing countries be seen as a merit good?
If parents do not fully perceive the benefits that their children could gain from it
Why do free markets not always lead to the best possible allocation of resources?
There may be market failure, causing the market equilibrium to diverge from the socially optimum position
When will the economy not reach allocative efficiency?
When there are costs or benefits that are external to the price mechanism
When can markets operate effectively?
When participants in the market have full information about market conditions
Define merit goods
Goods that the government believes are undervalued by consumers and as a result, will be under-consumed in a free market
Define demerit goods
Goods that the government believes are overvalued by consumers and as a result, will be overconsumed in a free market
When may markets fail?
When firms are able to utilize market power to disadvantage consumers
Define externality
A cost or a benefit that is external to a market transaction, is therefore not reflected in market prices, and may affect third parties not involved in the transaction
Why will an externality lead to a form of market failure?
Because if the cost or benefit is not reflected in market prices, it cannot be taken into consideration by all parties to a transaction
Define private costs
Costs incurred by an individual (firm or consumer) as part of its production or other economic activities
Define external costs
Costs associated with an individual’s (a firm or household’s) production or other economic activities, which are borne by a third party and are not reflected in market prices
Define social costs
The sum of private and external costs
Define social benefits
The sum of private benefits and external benefits
Define private benefits
The benefits received by an individual ( a firm or consumer) as part of its economic activity
Define external benefits
The benefits received by society ( a firm or a household) that accrues to a third party (firm or household) not engaged in that economic activity, and which are not reflected in market prices
Define production externality
An externality that affects the production side of a market which may be either positive or negative
Draw a negative production externality diagram
Figure 8.1
Describe the costs of negative production
Private costs are lower than the social costs
Define welfare loss
The social loss incurred when the market equilibrium diverges from the social optimum (where MSB = MSC) often referred to as the deadweight welfare loss
Define consumption externality
An externality that affects the consumption side of a market, which may be either positive or negative
Draw a positive consumption externality diagram
Figure 8.2
What’s MPB?
Demand represents consumers’ willingness and ability to purchase a good or service
What’s MSB?
Where a society receives more or less benefit from the consumption of a good or service
What’s MPC?
Supply represents a firms’ willingness and ability to supply a good or service
What’s MSC?
Where society incurs more or less cost from the production of a good or service
Draw a positive production externality diagram
Figure 8.3
Draw a negative consumption externality diagram
Figure 8.4
When can markets operate effectively?
If all relevant costs and benefits are taken into account in decision making
Why are some costs and benefits neglected?
Costs and benefits are external to the market mechanism causing a distortion in resource allocation
Give 3 examples of externalities and the environment
- Global warming
- Health
- Education
Why are environmental issues especially prone to externality effects?
As market prices do not always incorporate environmental issues, especially where property rights are not assigned
Why do externalities arise in areas of healthcare provision and education?
Because individuals do not always perceive the full social benefits that arise
