Externalities

Question 1

Market failure

Answer 1

When the free market mechanism does not lead to an optimal allocation of resources

Question 2

What is a free market?

Answer 2

Equivalent to the private sector
- no government intervention

Question 3

What is a demand curve equivalent to in a free market?

Answer 3

The marginal private benefit
- the MPB is downwards sloping because of the law of diminishing marginal utility
- with every extra output you consume, the utility decreases

Question 4

What is a supply curve equivalent to in a free market?

Answer 4

The marginal private cost
- the MPC is upwards sloping because as you supply an additional cost is incurred for every additional unit supplied

Question 5

Where does the free market operate?

Answer 5

MPB = MPC

Question 6

Externalities

Answer 6

Externality occurs when those not involved in particular decisions (third parties) are affected by the action of others

Question 7

Marginal social cost

Answer 7

MPC + external costs

Question 8

Marginal social benefit

Answer 8

MPB + external benefits

Question 9

Socially optimum

Answer 9

MSC = MSB
- takes into account externalities

Question 10

Why does the market fail when there is externalities of consumption?

Answer 10

Individuals only think about themselves and their own benefit when deciding to consume the product
- ignoring the cost to third parties leading to overconsumption

Question 11

Negative externalities of consumption
(Overconsumption)

Answer 11

The market operates at the free market equilibrium as firms care about their private costs and households only care about utility maximization so negative externalities are not taken into account
- the socially optimum is below the free market equilibrium as there is negative externalities taken into account
- at Qm, mpb > msb
- allocative inefficiency as firms are allocating too many scarce resources to the production of something that doesn’t benefit society

Question 12

Positive externalities of consumption
(Underconsumption)

Answer 12

The market operates at the free market equilibrium as firms care about their private costs and households only care about utility maximization so negative externalities are not taken into account
- the socially optimum is above the free market equilibrium as there is positive externalities taken into account
- at Qm, msb > mpb
- allocative inefficiency as firms are allocating too few scarce resources to the production of something that doesn’t benefit society

Question 13

Why does the market fail when there is externalities of production?

Answer 13

Firms only think about profit and their own benefits when deciding to produce the product
- ignoring the cost to third parties leading to over production

Question 14

Negative externalities of production
(Overproduction)

Answer 14

The market operates at the free market equilibrium as firms care about their private costs and households only care about utility maximization so negative externalities are not taken into account
- the socially optimum is below the free market equilibrium as there is negative externalities taken into account
- at Qm, msc > mpc
- allocative inefficiency as firms are allocating too many scarce resources to the production of something that doesn’t benefit society

Question 15

Positive externalities of production
(Underproduction)

Answer 15

The market operates at the free market equilibrium as firms care about their private costs and households only care about utility maximization so negative externalities are not taken into account
- the socially optimum is below the free market equilibrium as there is negative externalities taken into account
- at Qm, mpc > msc
- allocative inefficiency as firms are allocating too few scarce resources to the production of something that doesn’t benefit society

Question 16

Model Answer (For overproduction)

Answer 16

1. If left to the free market, the market will operate at MPC = MSC as firms care about their private costs and households only care about utility maximization so externalities are not taken into account
2. This causes the market to fail because there overproduction as third party impacts are not taken into account
3. This causes a divergence between the two curves as MSC > MPC
4. Therefore, the market fails as firms operate at Q1 but socially optimum is at Qstar
5. Allocative efficiency as firms are allocation too many resources