Microeconomics - L12 Market Failures (Negative Externalities)

Question 1

What is a market failure?

Answer 1

A situation where competitive markets are unable to allocate resources efficiently.

Question 2

When does an externality result?

Answer 2

When the well-being of a third party not involved in a transaction (or activity) is affected.

Question 3

A postitive externality occurs when…

Answer 3

A third party receives a benefit from the production or consumption of a good or service.

Question 4

A negative externality occurs when…

Answer 4

A social cost is imposed on a third party not involved in the transaction, from the production or consumption of a product.

Question 5

Briefly outline three examples of positive externalities.

Answer 5

1. Education = the more education a person receives, the greater the social benefit to all as a result of the economic value the person’s education brings to the community.
2. Choosing a healthy lifestyle will potentially lead to less need for medical care = less pressure on health system
3. Recycling = less waste/rubbish in the environment
4. Giving up smoking = less passive smoking/less need for health system
5. Vaccination = keeps the individual and other safe through reducing spread of illness

Question 6

Briefly outline three examples of negative externalities.

Answer 6

1. Pollution resulting from the production process. Eg. Air, noise or water pollution impacts people other than the business who produce the product or the purchasers that consume the product.
2. Smoking cigarettes can place strain on the public health system, thereby impacting the tax payer who was not involved in either the production or consumption of the cigarettes.
3. Alcohol production and consumption can result in anti social behaviour including crime as well as domestic violence and increased pressure on the public health system. The production and consumption of alcohol can have negative impacts on people who were not involved in producing or consuming it.

Question 7

Negative externalities lead to an inefficent allocation of resources due to an over allocation / under allocation of resources toward their production or consumption?

Answer 7

Over-allocation.
Producers are motivated by profit and will produce goods and services that are most likely to return a profit. This can include producing goods and services that impose a cost on third parties that were not involved in the production or consumption of the good or service.

Question 8

Provide two examples of ways that the government can intervene to correct an over-allocation of resources to negative externalities.

Answer 8

1. Advertising to influence tastes and preferences and make people aware of negative consequences. Eg. gambling, smoking etc.
2. Introducing regulations. Eg. banning smoking in enclosed public places in 2007.
3. Indirect taxes. Eg. indirect taxes on cigarettes makes them more expensive for businesses to produce. The cost is then passed on to the consumer to discourage them from smoking.
4. Subsidies. Eg. The government can provide subsidies to businesses and households to discourage the burning of fossil fuels and encourage use of solar power.