Market failure 1.3 Flashcards
What is an externality?
-An externality is the cost or benefit a third part receives from an economic transaction outside the market mechanism.
-It is the spillover effect of the production or consumption of a good or service.
-This leads to the over or under-production of goods, meaning resources aren’t allocated efficiently.
Public goods are non-rivalry and non-excludable, this means that…
they are underprovided by the private sector due to the free-rider problem.
What are private costs/benefits?
Private costs/benefits are costs/benefits to the individual participating in the economic activity. The demand curve represents private benefits and the supply curve represents private costs.
What are social costs/benefits?
Social costs/benefits are the costs/benefits to a third part not involved in the economic activity. They are the difference between the private costs/benefits and the social costs/benefits.
What is a merit good?
A merit good is a good with external benefits, where the benefit is society to greater than the benefit to the individual. Merit goods tend to be underprovided by the free market.
What is a demerit good?
A demerit good is a good with external costs, where the cost to society is greater than the cost to the individual. They tend to be over-provided by the free market.
What the marginal cost/benefit?
The extra cost/benefit of producing/consuming one extra unit of the good. For example, the MPB is the extra satisfaction gained by the individual from consuming one more of a good and the MSB is the extra gain to society from the consumption of one more good.
The MPC is the is the extra cost to the individual from producing one more of the good. The MSC is the extra cost to society from the production of one more good.
Using a diagram explain negative externalities of production.
Negative externalities of production occur when social costs are greater than the private costs.
The market left to operate freely will ignore the external costs involved in producing the good.
It will produce where MPB = MPC, the market equilibrium, at QeP1. At Qe, The costs to society are higher than the benefits resulting in the loss of welfare equal to the shaded area (WYX).
The external costs at Qe is equal to the line WX. The economy should produce where MSB = MSC, the social optimum position at Q1P1.
The difference between the MSC and the MPC increases as output grow, because external cost increase as output increases.
Using a diagram, explain positive externalities of consumption.
Positive externalities of consumption occur where the social benefits are greater than the social costs.
In the diagram, the market left to its own devices will produce where MPB = MPC, it will not consider the benefits to society so will produce at QePe.
If the market considers all the benefits, it would produce where the MSB = MSC at Q2P2. The failure of the market to consider the external benefits has led to a misallocation of resources and so there is a underproduction of Q2-Qe. This leads to a welfare loss of the shaded area.
The line MZ represents the social benefit.
The difference between the marginal private benefit and the marginal social benefit grows since external benefits grow the more people that undertake the activity (e.g. the external benefit of vaccinations grow the more people that have the vaccination.
Why is it difficult to work out the size of the externality?
It is difficult to work out the size of the externality as it tends to be placed on value judgements, since it is difficult to monetise external costs.
Public goods are non-rivarly, what does this mean?
Consumption of the good or service does not reduce the quality and availability of the good or service for others.
Public goods are non-excludable, what does this mean?
This means that you cannot stop someone accessing the good and someone cannot choose not to access to the good.
Explain the free rider problem.
Free rider problem says that public goods will be under-provided by the free market, leading to market failure. The reason they will be under-provided is because no one will agree to pay for it as they will argue that they will not directly benefit from it. As a result, the government provides public goods directly in return for paying a tax.
Why does most advertising lead to information gaps?
What reduces information gaps?
Most advertising leads to information gaps as it is designed to change the attitudes of consumers to encourage them to buy the good. It could cause them to think the benefits are greater than they actually are.
Increases in technology mean information gaps are on the decline can get access to more information.
Why do information gaps lead to market failure?
Information gaps lead to market failure as there is a misallocation of resources because people do not buy things to maximise their welfare. It means that consumer demand for a good or producer supply of a good may be too high or too low, and thus the price and quantity are not at the social optimum positions.
