Market Failure - Positive and negative externalities

Question 1

What are the 4 functions of prices?

Answer 1

• Signalling function
• Incentive function
• Rationing function
• Allocative function

Question 2

What is the signalling function?

Answer 2

This is when prices provide information to buyers + sellers.

Question 3

What is the incentive function?

Answer 3

Prices create incentives for people to alter their economic behaviour eg. A higher market price of good/service creates incentive to produce more.

Question 4

What is the rationing function?

Answer 4

Rising prices ration demand for a product.

Question 5

What is the allocative function?

Answer 5

It directs resources between markets away from markets exhibiting excess supply into markets with excess demand.

Question 6

What is a free market economy?

Answer 6

It’s a system in which the prices of goods/services are determined by supply and demand.

Question 7

What are the advantages of a free market economy?

Answer 7

• Efficient allocation of resources
• Competitive prices for consumer
• Dynamic efficiency (when competition drives innovation and invention increasing profits

Question 8

What are the disadvantages of a free market economy?

Answer 8

• Some members of society are unable to work
• Demerit goods (goods that are bad for us) may be over produced
• Due to a profit motive, firms may cut costs and exploit labour

Question 9

What is a command economy?

Answer 9

It’s where the government has a central plan to control the production and prices of the economy.

Question 10

What are the advantages of a command economy?

Answer 10

• Low level of inequality
• Resources are allocated efficiently

Question 11

What are the disadvantages of a command economy?

Answer 11

• Bureaucratic costs
• Problems in fixing prices of goods and services
• Low productivity and weak incentives

Question 12

What are merit goods?

Answer 12

They’re goods/services which tend to be underconsumed or underprovided in the market system hence making them cheap or free.

Question 13

What are demerit goods?

Answer 13

It’s a good/service which tends to be over-consumed or over-provided in the market system whose consumption is considered unhealthy or degrading due to the negative effects on the consumers.

Question 14

What is a negative externality?

Answer 14

Cost of an economic transaction incurred on a 3rd party not directly involved in that transaction.

Question 15

What is a positive externality?

Answer 15

Benefit of an economic transaction enjoyed by a 3rd party not directly involved in that transaction.

Question 16

What are private costs?

Answer 16

Costs of production felt only by the producer of a good or service and excluding costs incurred on 3rd parties.

Question 17

What are private benefits?

Answer 17

Benefits felt only by the consumer of a good or service and not those felt by 3rd parties.

Question 18

What are social costs?

Answer 18

Costs of production and consumption of a good or service felt by the private producer and the costs felt by the 3rd parties not involved in the transaction.

Question 19

What are social benefits?

Answer 19

Benefits felt by the consumer of a good or service and the benefits felt by 3rd parties.

Question 20

What is information failure?

Answer 20

Where, in a free market, consumers or producers don’t have sufficient info to make a rational choice and so the market doesn’t produce where MC=MB.

Question 21

What is asymmetric information?

Answer 21

This occurs where information isn’t equally shared between 2 parties.
I.e. relying on someone else, trusting them to fix only what’s necessary.

Question 22

Negative externalities in production diagram explanation

Answer 22

When there are negative externalities in production, the producer incurs external costs on 3rd parties.
So each additional unit produced incurs a greater cost on society than on the firm, therefore the marginal social cost of each successive unit (MSC) is higher than the marginal private cost of each unit (MPC=S).
The distance between the 2 is the external cost of each successive unit.
If the firm could be charged for the external costs, then they would have a supply curve at MSC and output would be Q* and price P*.
However, the market price is set by private costs and benefits so the market equilibrium output Qm is higher than is socially optimal.
For every unit produced where MSC is greater than MSB, there is an increasing welfare loss to society, illustrated by the triangle to the right of MSB=MSC.

Question 23

Positive externalities in production diagram explanation

Answer 23

When there are positive externalities in production, the producer brings benefits to 3rd parties for which they aren’t rewarded.
So each additional unit produced incurs a greater cost on the firm than on society, therefore the marginal social cost of each successive unit (MSC) is lower than the marginal private cost of each unit (MPC=S).
The distance between the 2 is the external benefits of each successive unit.
If the firm could be rewarded for the external benefits, then they would have a supply curve at MSC and output would be Q* and price P*.
However, the market price is set by private costs and benefits so the market equilibrium output Qm is lower than is socially optimal.
For every unit not yet produced where MSB is still higher than MSC, there is a welfare loss to society, or potential welfar gain, illustrated by the triangle to the left of MSB=MSC.

Question 24

Negative externalities in consumption diagram explanation

Answer 24

When there are negative externalities in consumption, the consumption of the good brings costs to 3rd parties for which they aren’t being compensated. So each additional unit consumed brings less benefit to society than it does to the individual, therefore the marginal social benefit of each successive unit (MSB) is lower than than the marginal private benefit of each unit (MPB=D).
The distance between the 2 is the external cost of each successive unit consumed.
If the consumer could be charged for the external costs, then they would have a demand curve at MSB and output would be Q* and price P*.
However, the market price is set by private costs and benefits and the the market equilibrium output Qm is higher than is socially optimal.
For every unit consumed where MSC is above MSB, there is a welfare loss to society, illustrated by the triangle to the right of MSB=MSC, which is the socially optimal level of consumption.

Question 25

Positive externalities in consumption diagram explanation

Answer 25

When there are positive externalities in consumption, the consumer brings benefits to 3rd parties for which they are not rewarded.
So each additional unit consumed brings more benefit to society than it does to the individual, therefore the marginal social benefit of each successive unit (MSB) is higher than the marginal private benefit of each unit (MPB=D).
The distance between the 2 is the external benefit of each successive unit.
If the consumer could be rewarded for the external benefits, then they would have a demand curve at MSB and the output would be Q* and price P*.
However, the market price is set by private costs and benefits and so the market equilibrium output Qm and price Pm are lower than is socially optimal.
For every unit not yet produced where MSB is still higher than MSC, there is a welfare loss to society, or potential welfare gain, illustrated by the triangle to the left of MSB=MSC.