LS17- Market Failure and Externalities

Question 1

What is a market failure?

Answer 1

When too much or too little of a good is produced or consumed, compared to the socially optimal level of output, and when the price mechanism leads to inefficient allocation of resources.

Question 2

External cost

Answer 2

A cost to a third party that is not involved in the making, buying/selling and consumption of a specific good/service.
- negative externalities

Question 3

External benefit

Answer 3

A benefit to a third party that is not involved in the making, buying/selling and consumption of a specific good/service.
- positive externalities

Question 4

Negative externality in production explained

Answer 4

• in a free market, producers only consider their private costs of production
• they ignore the social cost of their actions (the external costs) due to self interest
• so resources are allocated at the private equilibrium of p1 and q1 in the market and NOT the social optimum of p2 and q2
• overproduction and overconsumption in the market as q1 is greater than q2
• price is too low at p1 rather than p2 not reflecting the full social cost of production, incentivising more consumption and thus more production, worsening the problem
• end result is a misallocation of resources , allocative inefficiency -> generates a welfare loss with society bearing more cost than benefit with units beyond q2 being produced

Question 5

Where is the private equilibrium when there is a negative externality in production?

Answer 5

At the point where MSB=MPB meets MPC
- at this point, producers ignore the full social costs of their actions (the negative externality in the form of costs to third parties) due to self interest

Question 6

Where is the social optimum equilibrium when there is a negative externality in production?

Answer 6

At the point where MSB=MPB meets MSC

Question 7

Where is the private equilibrium when there is a positive externality in consumption?

Answer 7

At the point where MSC=MPC=S meets MPB
- in a free market, individual consumers only consider their private benefits in consumption, they ignore the full social benefits of their actions due to self interest
- consequently, resources are allocated at the private equilibrium and not the social optimum
- there is an underproduction and underconsumption in the market as Q1 is less than Q2 (social optimum)
- end result is a misallocation of resources, allocative inefficiency where too few resources are allocated to this market than is socially desirable generating a welfare loss to society

Question 8

Where is the social optimum equilibrium when there is a positive externality in consumption?

Answer 8

At the point where MSC=MPC=S meets MSB