Micro exam essay revision (Positive externalities& market failure)

Question 1

Define market failure

Answer 1

Market failure occurs when allocative efficiency is not achieved.

Question 2

Define positive externalities

Answer 2

Where the marginal social benefit of an activity exceeds the marginal private benefit of an activity is a positive externality of consumption

Question 3

market based solution other than subsidies to achieve allocative efficiency when positive externalities occur

Answer 3

advertisement and education so that people know the true costs or benefits of their action

Question 4

non market based solution to achieve allocative efficiency when positive externalities occur

When is that used?

Answer 4

Provision of a good or service

Normally reserved for goods where the externality is so big that a stronger approach is needed.

Question 5

Define merit goods

Answer 5

Have more private benefit than the consumer realises and so will be under consumed and also exhibit positive externalities

Question 5

Name disadvantages of regulation to solve market failure

Answer 5

• cost and problems of enforcement
• how to set appropriate standards: government failure
• policy may not raise revenue
• Non-market based solution: may lead to a black market

Question 7

Name disadvantages of subsidies to solve market failure

Answer 7

• difficult to know the MSB/ externality of an activity.
• thus difficult to set the size of the subsidy
• if too little or too much is consumed, market failure is replaced by government failure
• the externality may change over time and so the subsidy would need to be changed
• opportunity cost as the government could have used the resources somewhere else e.g. education, problem of having to pay interest on loans

Question 8

Advantages of using tax to solve market failure

Answer 8

+ market-based solution: still lets the market operate
+ raise revenue for the government or allows the person affected to be compensated
+ easy to impose

Question 9

Disadvantages of using indirect taxes to solve market failure

Answer 9

• hard to know size of the externality
• hard to set the right level of tax
• government failure if right level is not achieved
• if set too high it can lead to tax evasion
• externality changes over time so tax would have to be changed
• might tax the wrong people who don’t produce the externality or such a big one

Question 10

How can you judge the success of subsidies?

Answer 10

Depends on:

• How well the subsidy can be paid to producers
• if supply is inelastic, subsidy has to be very big which government might not be able to afford