Market failure 1 - externalities Flashcards
What is an externality
When the trading of a product affects third parties
Why are externalities bad
Only costs and benefits to the firm and consumer are taken into account so extra costs and benefits decreases allocative efficiency
Describe the difference between negative externalities in production and consumption
- Negative externalities in production are caused by firms during production of goods and services
- Negative externalities in consumption are caused by households during the consumption of goods and services
How is a negative externality in production shown on a diagram
Shift in of supply
- Supply is the private cost so the shifted in curve is the social cost
What is the formula for marginal social cost
Marginal social cost = marginal private cost + external costs
What is the formula that represents allocative efficiency
When Marginal social costs = marginal social benefits
(this takes into account all costs and benefits)
How can externalities be solved on a diagram
Movement along the curve to the social optimum point, which is allocatively efficient
What is deadweight loss
The difference in quantity demanded/supplied between the private and social optimum causing it not to be allocatively efficient
Explain the tragedy of the commons
- Negative externalities caused by overconsumption
- If everyone makes rational individual decisions, everyone will be worse off in the long run
What are the challenges of government intervention to correct market failure
- Difficult to assess the scale
- How best to intervene
If they get any these wrong, government failure occurs
What are 2 good examples of a negative externality that requires government intervention
Global warming
Traffic congestion
What are the 3 way that the government can tackle negative externalities
- Education
- Regulation
- Use of the price mechanism
How does education prevent negative externalities
It raises awareness and prompts individuals and firms to change their behaviour
What is 2 examples of regulation that has reduced negative externalities
Ban of smoking in public places from 2007
Rules about recycling
Explain how the price mechanism can be used to reduce negative externalities
- Indirect tax shifts the supply curve to the left
- This reduces consumption and production, so closer to the social optimum
- turns negative externality into private costs to firm
e.g. london congestion charge
What are the drawbacks of using education to prevent negative externalities
- Cost to tax payer
- people may not respond
What are the drawbacks of using regulation to prevent negative externalities
-Works on firms much better than households because there are far less firms than households
- it is difficult to assess the appropriate levels of consumption for lots of different people
What are the drawbacks of using the price mechanisms to prevent negative externalities
- Have to assess the price and cross elasticity of demand effectively
- Tax is regressive so an increase in price of a product affects poorer people more
What are 3 government policies that could be used to prevent positive externalities
- Advertising to increase consumption
- Making goods/services compulsory
- Subsidy to reduce market price and encourage consumption
