Market failure and externalities

Question 1

Define externality.

Answer 1

cost or benefit external to a market transaction and so not reflected in market price, which may affect third parties not involved in the transaction

Question 2

Define market failure.

Answer 2

situation in which free market equilibrium does not lead to socially optimal allocation of resources, so too much or too little of a good or service is being produced and/or consumed

Question 3

Name three possible causes of market failure.

Answer 3

• externalities
• information gaps
• public goods

Question 4

Define consumption externality.

Answer 4

an externality that affects consumption side of market (either positively or negatively)

Question 5

Define production externality.

Answer 5

an externality that affects production side of market (either positively or negatively)

Question 6

Define private cost.

Answer 6

cost incurred by an individual (firm or consumer) as part of its production or other economic activities

Question 7

Define private benefit.

Answer 7

the benefit from an individual (firm or consumer) economic activity that accruse to that individual

Question 8

Define external cost.

Answer 8

a cost associated with an individual’s (firm or household) production or other economic activities which is borne by a third party and not reflected in market prices

Question 9

Define external benefit.

Answer 9

benefit that society reeives over and above those that accur to the individual (firm or household) engaged in an economic activity

Question 10

What is the formula for social cost?

Answer 10

social cost = private cost + external cost

Question 11

What is the formula for social benefit?

Answer 11

social benefit = private benefit + external benefit

Question 12

Define marginal social cost.

Answer 12

cost to society of producing an extra unit of a good

Question 13

Is the emission of toxic fumes by a factory a negative or positive consumption or production externality?

Answer 13

negative production externality

Question 14

Is putting Christmas lights outside your house a negative or positive consumption or production externality (assuming that everyone like Christmas lights)?

Answer 14

positive consumption externality

Question 15

Does the presence of a negative production externality cause overproduction or underconsumption?

Answer 15

overproduction

Question 16

Does the presence of a positive consumption externality cause overproduction or underconsumption?

Answer 16

underconsumption

Question 17

Give two examples of international negative production externality.

Answer 17

• global warming from using fossil fuels to produce energy
• polluted rivers from dumping waste from production into water

Question 18

How does the London congestion charge work to reduce externalities?

Answer 18

marginal private cost increases, so it moves towards marginal social cost, reducing car travel so others benefit from less congestion

Question 19

What sort of externality do vaccinations create?

Answer 19

positive consumption externality (as protects others as well as yourself)

Question 20

What sort of externality does education create?

Answer 20

positive consumption externality, as society benefits from more productive workforce