Micro 10 - Market Failure, Positive and Negative Externalities

Question 1

Q. Explain with an appropriate diagram why a competitive market that is operating where price is equal to MC could be said to be allocatively efficient. (9 marks).

Answer 1

1. MC = AR or MC = price - allocatively efficient.
2. Assumed competitive industries will operate at AE as if a firm charges more than MC = AR and reduce supply, other firms will undercut them + take their customers.
3. Define MC and AR. If assume consumers are rational, price of next unit informs utility of the next unit. So the sale of the next unit will increase total utility within the economy by whatever price the next consumer is willing to pay for it.
4. When MCMC). So the next unit sold will increase welfare by a greater value than it will increase TC = brings more utility than disutility. Every unit between Q1 and Q* brings more utility than disutility - DWL1 - potential welfare gain.
5. Once we pass MC = AR then one more unit will sell for a lower price than it will increase costs by. DWL2.
6. Therefore, a free market economy will operate where MC = AR which is where marginal disutility = marginal utility and so is AE. This is marked at QP on the diagram.

Question 2

Market Failure - definition

Answer 2

> When the free market fails to allocate resources efficiently, leading to a net welfare loss for society.
Over/under consumed or over/under produced.

Question 3

Externalities - definition

Answer 3

> Costs or benefits of an economic transaction felt by 3rd parties not directly involved in the transaction.

Question 4

Negative externalities - definition

Answer 4

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

Question 5

Private Costs - definition

Answer 5

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

Question 6

Positive externalities - definition

Answer 6

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

Question 7

Social costs - definition

Answer 7

> 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 8

Private benefits - definition

Answer 8

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

Question 9

Social benefits - definition

Answer 9

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

Question 10

Merit goods - definition

Answer 10

> One which tends to be unerconsumed or underprovided in the market system.

Question 11

Demerit goods - definition

Answer 11

> One which tends to be over-consumed or over-provided in the market system.

Question 12

Extra

Answer 12

> Whether something should be considered a merit or demerit good is a subjective matter based on a value judgement.
Label a good twice in essays: pos/neg externalities and merit or demerit.
Use information failure as a source of evaluation in essays.

Question 13

Information failure - definition

Answer 13

> 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 14

Asymmetric information - definition

Answer 14

> 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.
Also known as imperfect information.

Question 15

Negative Externalities in Production diagram explanaition.

Answer 15

> 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 16

Positive externalities in production diagram explanation

Answer 16

> 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 17

Negative externalities in consumption diagram explanation

Answer 17

> 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 18

Positive externalities in consumption diagram explanation

Answer 18

> 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.

Question 19

Q. Explain how it could be argued that the MMR vaccine is a merit good.

Answer 19

>Merit good.
>Market failure.
>Positive externalities.
>Info failure.
>Protects those who can't have vaccine.