Micro 9 - Introduction to Market Failure and Externalitites Flashcards
What are the 3 causes of market failure?
- Externalities
- Under-provision of public goods
- Information gaps
When does market failure occur?
A market fails when the price mechanism (the forces of supply and demand) fails to allocate scarce resources efficiently and society suffers as a result
How commonly does market failure occur?
Market failure is a common problem and governments often intervene to try and prevent it
What are externalities?
Externalities are the effects that producing or consuming a good or service has on people who aren’t involved in the making, buying, selling and consumption of the good or service. These people are called third parties
Who do externalities affect?
Third Parties
What are the two types of externalities?
Positive or negative
What are positive externalities?
Positive externalities are the external benefits to a third party
What are negative externalities?
Negative externalities are the external costs to a third party
What two things can externalities occur in?
Production or consumption
Give an example of a negative externality in production
A negative externality of producing steel could be the pollution that harms the local environment
Give an example of a positive externality in consumption
A positive externality of someone training to become a doctor could be the benefit to society that this brings
How do externalities cause market failure?
Market failure occurs because externalities are ignored
Define the term private cost
A private cost is the cost of doing something to either a consumer or a firm
Define the term external cost
External costs are the costs imposed on a third party as a result of the decisions made by others to produce or consume a product
How do you calculate social cost?
- Adding the private cost to the external cost gives the social cost
- Social cost = Private cost + External cost
Define the term private benefit
A private benefit is the benefit gained by a consumer or a firm by doing something
Define the term external benefit
External benefits are the benefits that are experienced by third parties as a result of decisions made by others to consume or produce a product
How do you calculate social benefit?
- Adding the private benefit to the external benefit gives the social benefit
- Social benefit = Private benefit + External benefit
Define the term social benefit
The social benefit is the full benefit received by society from a good or service
Define the term social cost
The social cost is the full cost borne by society of a good or service
Why does market failure occur in the free market?
Market failure occurs because in a free market the price mechanism will only take into account the private costs and benefits but not the external costs and benefits
Do negative externalities occur in production or consumption?
Production
What do negative externalities occur in?
Production
What is the marginal private cost?
The marginal private cost (MPC) is the cost of producing the last unit of a good
How do you calculate the marginal social cost?
Marginal social cost = Marginal private cost + External cost
On a diagram what is the difference between the MPC and MSC curves?
The difference between the MPC and MSC curves is the external cost of production which is the negative externalities
What does it mean if the MPC and MSC curves are parallel?
The external costs per unit produced are constant
What does it mean if the MPC and MSC curves diverge?
The external costs per unit increase with output
Give an example of why the MPC and MSC curves might diverge
The curves might diverge due to pollution - the external costs per unit created pollution can increase as the output increases
Do positive externalities occur in production or consumption?
Consumption
What do positive externalities occur in?
Consumption
What is the Marginal private benefit?
The marginal private benefit is the benefit to someone of consuming the last unit of a good
How do you calculate marginal social benefit?
Marginal social benefit = Marginal private benefit + External benefit
What is the difference between the MPB and MSB curves?
The difference between the MPB and MSB curves are the external benefits which are the positive externalities
What does it mean if the MPB and MSB curves are parallel?
The external benefits per unit are constant
What does it mean if the MPB and MSB curves diverge?
The external benefits per unit increase with output
Give an example of why the MPB and MSB curves diverge
An example of when the curves might diverge is vaccination - the more people that are vaccinated the greater the protection for unvaccinated people
What is the general relationship between the equilibrium point and the socially optimal point?
The equilibrium point may be different to the socially optimal point
When does equilibrium occur in the free market?
When supply equals demand
On a diagram can the MPC curve be seen as a supply curve or a demand curve?
Supply curve
On a diagram can the MPB curve be seen as a supply curve or a demand curve?
Demand curve
On a diagram does the MPB curve slope upwards or downwards?
Downwards
On a diagram does the MPC curve slope upwards or downwards?
Upwards
On a diagram where does the free market equilibrium occur and why?
The FM equilibrium occurs when MPC = MPB as in a free market consumers only consider their private costs and private benefits and ignore any social costs and benefits
On a diagram where does the socially optimal level of output occur and why?
Where MSC = MSB because this includes the external costs and benefits to society
What will the socially optimal level of output give society in terms of externalities?
The socially optimal level of output and price will give society the maximum benefit of any positive externalities and still cover up the cost of any negative externalities
What is caused by ignoring negative production externalities?
Overproduction
What causes overproduction?
Ignoring negative production externalities
On a negative production externality diagram why does MPB = MSB
As there are no positive externalities
Why does ignoring negative externalities in production lead to overproduction and under-pricing of a good?
In the free market only private costs are considered so the level of output would be higher than the social optimum.
This would cause overproduction and under-pricing of a good as more is produced and sold at a lower price than is desirable for society.
What is the relationship between the marginal social cost and marginal social benefit for a good produced between the FM equilibrium and the social optimum?
For each unit of a good produced between the FM equilibrium and the social optimum the marginal social cost is greater than the marginal social benefit
What is the area of the triangle between the marginal social cost and marginal social benefit equal to on a negative externality diagram?
Welfare loss
Define the term welfare loss
The welfare loss is the loss to society caused by ignoring externalities
What does the welfare loss/gain triangle always point to?
The social optimum
What does ignoring positive consumption externalities lead to?
Underconsumption
What causes underconsumption?
Ignoring positive consumption externalities
On a positive consumption externality diagram why is MPC = MSC?
As there are no negative externalities
Why does ignoring positive consumption externalities lead to underconsumption and under-pricing of a good?
In a free market only private benefits are considered which causes underconsumption and under-pricing of a good - less is consumed and sold at a lower price than is desirable for society.
What is the relationship between the marginal social benefit and marginal social cost for a good produced between the FM equilibrium and the social optimum?
For each unit of this good consumed between the FM equilibrium and the social optimum the marginal social benefit is greater than the marginal social cost
What is the area of the triangle between the marginal social benefit and marginal social cost equal to?
Welfare gain
Define the term welfare gain
The welfare gain is the gain to society lost by ignoring externalities
What are some examples of services with positive consumption externalities?
- Education
- Healthcare
What is the relationship between education and healthcare and the free market?
In the free market both of these services are under-consumed and the potential welfare gain to society is lost
Draw a diagram showing a negative externality in prodcution
See page 76
Draw a diagram showing a positive externality in consumption
See page 76
