Chapter 8: Market failure and externalities

Question 1

Define market failure

Answer 1

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

Question 2

Define marginal social benefit (MSB)

Answer 2

The additional benefit that society gains from consuming an extra unit of a good

Question 3

Define marginal social cost (MSC)

Answer 3

The cost to society of producing an extra unit of a good

Question 4

When does market failure occur?

Answer 4

When markets work in a way to produce a bad outcome for society as a whole

Question 5

What would be an ideal outcome for society?

Answer 5

Where the marginal benefit that society receives from consuming each good or service matches the marginal cost of producing it

Question 6

When does an externality exist?

Answer 6

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

Question 7

Describe public goods

Answer 7

Due to their characteristics, they cannot be provided by a purely free market

Question 8

Give an example of a public good

Answer 8

Street lights

Question 9

Why may education in some developing countries be seen as a merit good?

Answer 9

If parents do not fully perceive the benefits that their children could gain from it

Question 10

Why do free markets not always lead to the best possible allocation of resources?

Answer 10

There may be market failure, causing the market equilibrium to diverge from the socially optimum position

Question 11

When will the economy not reach allocative efficiency?

Answer 11

When there are costs or benefits that are external to the price mechanism

Question 12

When can markets operate effectively?

Answer 12

When participants in the market have full information about market conditions

Question 13

Define merit goods

Answer 13

Goods that the government believes are undervalued by consumers and as a result, will be under-consumed in a free market

Question 14

Define demerit goods

Answer 14

Goods that the government believes are overvalued by consumers and as a result, will be overconsumed in a free market

Question 15

When may markets fail?

Answer 15

When firms are able to utilize market power to disadvantage consumers

Question 16

Define externality

Answer 16

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

Question 17

Why will an externality lead to a form of market failure?

Answer 17

Because if the cost or benefit is not reflected in market prices, it cannot be taken into consideration by all parties to a transaction

Question 18

Define private costs

Answer 18

Costs incurred by an individual (firm or consumer) as part of its production or other economic activities

Question 19

Define external costs

Answer 19

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

Question 20

Define social costs

Answer 20

The sum of private and external costs

Question 21

Define social benefits

Answer 21

The sum of private benefits and external benefits

Question 22

Define private benefits

Answer 22

The benefits received by an individual ( a firm or consumer) as part of its economic activity

Question 23

Define external benefits

Answer 23

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

Question 24

Define production externality

Answer 24

An externality that affects the production side of a market which may be either positive or negative

Question 25

Draw a negative production externality diagram

Answer 25

Figure 8.1

Question 26

Describe the costs of negative production

Answer 26

Private costs are lower than the social costs

Question 27

Define welfare loss

Answer 27

The social loss incurred when the market equilibrium diverges from the social optimum (where MSB = MSC) often referred to as the deadweight welfare loss

Question 28

Define consumption externality

Answer 28

An externality that affects the consumption side of a market, which may be either positive or negative

Question 29

Draw a positive consumption externality diagram

Answer 29

Figure 8.2

Question 30

What’s MPB?

Answer 30

Demand represents consumers’ willingness and ability to purchase a good or service

Question 31

What’s MSB?

Answer 31

Where a society receives more or less benefit from the consumption of a good or service

Question 32

What’s MPC?

Answer 32

Supply represents a firms’ willingness and ability to supply a good or service

Question 33

What’s MSC?

Answer 33

Where society incurs more or less cost from the production of a good or service

Question 34

Draw a positive production externality diagram

Answer 34

Figure 8.3

Question 35

Draw a negative consumption externality diagram

Answer 35

Figure 8.4

Question 36

When can markets operate effectively?

Answer 36

If all relevant costs and benefits are taken into account in decision making

Question 37

Why are some costs and benefits neglected?

Answer 37

Costs and benefits are external to the market mechanism causing a distortion in resource allocation

Question 38

Give 3 examples of externalities and the environment

Answer 38

1. Global warming
2. Health
3. Education

Question 39

Why are environmental issues especially prone to externality effects?

Answer 39

As market prices do not always incorporate environmental issues, especially where property rights are not assigned

Question 40

Why do externalities arise in areas of healthcare provision and education?

Answer 40

Because individuals do not always perceive the full social benefits that arise