Chapter 8 - Market failure and externalities Flashcards
What is 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
What is marginal social benefit (MSB)?
The additional benefit that society gains from consuming an extra unit of a good.
What is marginal social cost (MSC)?
The cost to society of producing an extra unit of a good
In terms of externalities, what would be an ideal outcome for society?
It would be where the marginal benefit that society receives from consuming each good or service matches the marginal cost of producing it.
How would market failure affect the market?
Free markets do 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 there are costs or benefits that are external to the price mechanism, the economy will not reach allocative efficiency.
Markets can operate effectively only when participants in the market have full information about market conditions.
Merit (/Demerit) goods are goods that the government believes are undervalued (/overvalued) by consumers and as a result will be underconsumed (/overconsumed) in a free market.
Public goods have characteristics that prevent markets from supplying the appropriate quantity.
Markets may fail when firms are able to utilise market power to
disadvantage consumers.
What is an 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
What are private costs?
Costs incurred by an individual (firm or consumer) as part of their production or other economic activities
What are 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
What are social costs?
The sum of private and external costs
What are social benefits?
The sum of private benefits and external benefits
What are private benefits?
The benefits received by an individual (a firm or consumer) as part of their economic activity
What are external benefits?
The benefits received by society (a firm or household) that accrues to a third party (firm or household) not engaged in that economic activity, and which are not reflected in market prices
What is a production externality?
An externality that affects the production side of a market, which may be either positive or negative.
On an externality diagram, where is the social optimum position?
It is where MSC = MSB. When it is not at this point, market failure occurs
What is 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
What is an consumption externality?
An externality that affects the consumption side of a market, which may be either positive or negative.
Resources will not be optimally allocated if they are present.
How does externalities affect global warming?
Scientists argue that the problem is caused mainly by pollution created by transport and industry, especially in the richer countries of the world. However, poorer countries suffer the consequences as well.
It is an example of a negative production externality, in which the nations causing most of the damage face only part of the costs caused by their lifestyles and production processes. The inevitable result in an unregulated market is that too much pollution is produced.
In December 2015, 196 countries adopted the Paris Agreement, a new framework designed as a coordinated effort to tackle climate change. This seemed to be a major step forward in tackling the issue, but the agreement suffered a setback in 2017, when President Trump announced that the USA would withdraw as soon as it was legal to do so. Trump argued that the deal reached had been unfair to the USA, and threatened to cost US$3 trillion in lost GDP and 6.5 million jobs.
How does externalities affect healthcare?
Consider the case of vaccination against a disease such as measles. Suppose an individual is considering whether or not to be vaccinated. Being vaccinated reduces the probability of that individual contracting the disease, so there are palpable potential benefits to that individual. However, these benefits must be balanced against the costs. There may be a direct charge for the vaccine, some individuals may have a phobia against needles, or they may be concerned about possible side effects. Individuals will opt to be vaccinated only if the marginal expected benefit to them is at least as large as the marginal cost.
From society’s point of view, however, there are potential benefits that individuals will not take into account. After all, if they do contract measles, there is a chance of their passing it on to others. Indeed, if lots of people decide not to be vaccinated, there is the possibility of a widespread epidemic, which would be costly and damaging to many.
The social benefits to society of having people vaccinated against measles exceed the private benefits that will be perceived by individuals, so marginal social benefits exceed marginal private benefits.
Private individuals will choose to balance marginal private benefit against marginal private cost at Q1, whereas society would prefer more people to be vaccinated at Q*. This parallels the discussion of a positive consumption externality.
How does externalities affect education?
When deciding to study, there were probably a number of factors that influenced the decision. Perhaps it was to intend to demand even more education in the future, by going on to study at university. Part of the decision process probably takes into account the fact that education improves future earnings potential.
Expected lifetime earnings depend in part upon the level of qualifications. Research has shown that, on average, graduates earn more during their lifetimes than non graduates. This is partly because there is productivity effect: by becoming educated, they cultivate a range of skills that in later life will make them more productive, and this helps to explain why they can expect higher lifetime earnings than someone who chooses not to demand education. There is also a signalling effect, as having a degree signals to potential employers that they have the ability to cope with university study and have gained a range of skills.
What does society get out of this? Evidence suggests that, not only does education improve productivity, but a group of educated workers cooperating with each other become even more productive. This is an externality effect, as it depends upon interaction between educated workers (who are the third party) - but each individual perceives only the individual benefit, and not the benefits of cooperation.
In other words, when deciding to undertake education, it is done on the basis of the expected private benefits that is hoped to gained from education. However, they do not take into account the external benefits through cooperation that society will reap. So here is another example of a positive consumption externality.
