Market Failure Flashcards
Define Market Failure
When the free market fails to allocate resources at the social optimal level
MSB does not equal MSC
What are the consequences of Market Failure
- Externalities are present
- Loss of Social Welfare
- Underprovision of Merit goods and Overproduction of Demerit Goods
- Monopoly Power
- Lack of Public Goods
- Tragedy of the Commons
What are the reasons for Market Failure
- Self Interest of Economic Agents
- Monopoly Power
- Information Failure
- Factor Immobility
What is a Negative Externality
Negative Spillover Effects to third parties as a result of actions of economic agents such as consumers or producers
Give an Example of a Negative Production Externality
Dumping of waste in a river - local residents suffer
Give an Example of a Negative Consumption Externality
Alcohol - Strain on healthcare services, Loss of Productivity due to intoxication
Safety due to Intoxicated Behaviour
What is the Condition for a Negative Production Externality and a Negative Consumption Externality
NE in Production = MPC > MSC
NE in Consumption = MPB > MSB
Why do economic agents operate at their Private Optimum Rather than their Social Optimum?
As a result of self interest
What is the Market outcome of a NPE?
The good is overproduced and underpriced [i.e allocative efficiency is lost]
What does the externality reflect in the price and supply?
- The MPC is lower than the MSC, which does not reflect the externality.
- The firm only accounts for their private cost rather than the social cost
- Society bears a higher cost than the producer
Why is there a welfare loss in a Negative Production Externality?
Wasted resources and inefficiency which create a gap between the social costs and social benefits - leading to society being worse off as a result.
What is the Market Outcome for NCE?
The good is overconsumed and underpriced
What does the externality reflect in demand and supply?
- The MPB is greater than the MSB as consumers do not consider harm to others
- Too many resources are allocated in this market which extends supply
Why is there a welfare loss in a Negative Consumption Externality?
As the consumer does not choose the quantity where MSB = MSC, the extra consumption creates harmful spillover effects to societal welfare, leaving them worse off than if the right amount was consumed.
What is a Positive Externality?
Benefits to third parties as a result of an economic agents actions, being consumers or producers
Give an example of a Positive Production Externality and a Positive Consumption Externality
PE in Production: In work training - Firms can poach workers and pay higher wages whilst avoiding the extensive training costs as these workers have already benefitted from other firms training schemes
PE in Consumption: Education - workers are more productive and skilled which creates better scope for employment leading to higher incomes and increased tax revenue for the government which can be used for public spending
What is the condition for a Positive Production Externality and a Positive Consumption Externality
PE in Production: MPC > MSC
PE in Consumption: MSB > MPB
What is the Market Outcome of PCE?
The good is underconsumed and underprovided
What does the externality reflect in demand and supply?
- MSB is greater than MPB - society gains more than the individual
- Too little resources are allocated to this market
Why is there a welfare loss in a Positive Consumption Externality?
Due to the missing consumption, societal gains are not maximised.
What is the Market Outcome of a Positive Production Externality?
The good is underproduced and underprovided
What does the PPE reflect in terms of demand and supply?
MSC is lower than the MPC, society benefits more than what the firm accounts for
Why is there a welfare loss in a Positive Production Externality?
Due to the missing production, society does not maximise total well being, missing out on external benefits
What policies can be used to correct Negative Production Externalities?
- Pigouvian Taxes / Specific / Ad Valorem Taxes
- Tradeable Pollution Permits
- Regulations
- Property Rights
What policies can be used to correct Negative Consumption Externalities?
- Specific Indirect Taxation
- Regulation
- Information Provision
What policies can be used to correct Positive Consumption Externalities?
- Subsidies
- Information Provision
- State Provision
- Nudges / Frames
What policies can be used to correct Positive Production Externalities?
- Subsidies
- State Provision
- Tax deductions
