THEME 1 - Topic 6 - Market Failure and Externalities

Question 1

Define market failure

Answer 1

It exists any and every time that a free market fails to lead to the optimum allocation of scarce resources.

Question 2

Define productive efficiency

Answer 2

Occurs when an economy’s resources are fully and efficiently employed, situated on the PPF, producing the maximum possible output, and the firm is producing at the lowest average cost.

Question 3

Define allocative efficiency

Answer 3

Is achieved when the product mix reflects consumer’s tastes and so resources are allocated in the right proportions to producing the different goods/services, which is know as consumer sovereignty, and occurs when the price of good is equal to the marginal cost.

Question 4

Define an externality

Answer 4

Is a cost or a benefit that is said to arise if a third party is affected by the decisions and actions of others, and is not taken into account by decision-makers, thus is not reflected in the market price.

Question 5

Define a third party

Answer 5

People who are not directly involved in decision-making and whose costs/benefits are ignored.

Question 6

Define consumption externality

Answer 6

Is an externality that affects the consumption side of a market, which may be either positive or negative.

Question 7

Define productional externality

Answer 7

Is an externality that affects the production side of a market, which may be either positive or negative.

Question 8

Define private cost

Answer 8

Is the cost of an activity to the decision-maker as a result of its production or consumption.

Question 9

Define private benefit

Answer 9

Is the benefit of an activity to the decision-maker as a result of its production or consumption.

Question 10

Define external cost

Answer 10

Is the cost associated with the production or consumption of an individual firm or consumer which is borne by the third party and not taken into account by the decision-maker and is not reflected in the market price.

Question 11

Define external benefit

Answer 11

Is the benefit associated with the production or consumption of an individual firm or consumer which is borne by the third party and not taken into account by the decision-maker and so is not reflected in the market price.

Question 12

Define social cost

Answer 12

Is the total cost of a particular action, and so is equal to the private cost plus external cost (not quantifiable).

Question 13

Define social benefit

Answer 13

Is the total benefit of a particular action, and so is equal to the private benefit plus external benefit (not quantifiable).

Question 14

Define negative externality

Answer 14

If the social cost is greater than the private cost. External costs impact on the third party, and are not taken into account by the decision-maker, thus are not reflected in the market price.

Question 15

Define positive externality

Answer 15

If the social benefit is greater than the private benefit. External benefits impact on the third party, and are not taken into account by the decision-maker, thus are not reflected in the market price.

Question 16

Name 5 examples of negative production externalities

Answer 16

Deforestation
Illegal dumping of waste
Traffic congestion
Carbon emissions
Water pollution

Question 17

What’s the first paragraph of describing a negative production externality?

Answer 17

The free market equilibrium occurs at point c, where the PMC curve intersects the PMB curve, corresponding with an output of q0 and a price p0.

Question 18

What’s the second paragraph of describing a negative production externality?

Answer 18

The socially optimum equilibrium occurs at point A, where the SMC curve intersects the SMB curve, corresponding with an output of q1 and a price p1.

Question 19

What’s the third paragraph of describing a negative production externality?

Answer 19

The producer only considers the private costs of their actions. They ignore the external costs of their actions. Therefore, they do not taken into account the full social costs of their actions.

Question 20

What’s the fourth paragraph of describing a negative production externality?

Answer 20

Subsequently, the producer prices to low at p0. This generates too higher level of demand at q0. There is an overproduction equal to q0-q1. Too many scarce resources are devoted to the production of this good. There is allocative inefficiency and the market has failed as demonstrated by the welfare loss triangle ABC.

Question 21

What’s the fifth paragraph of describing a negative production externality?

Answer 21

Had the producer charged a price p1. Where p1=SMC, this would cause a contraction in demand to q1, the socially optimum output level. There would no longer be allocative inefficiency or market failure.

Question 22

Define a negative production externality

Answer 22

When the social costs are greater than the private costs as a results of the production of a good/service. External costs affect the third party, and whose affects are ignored by decision-makers, and are not reflected in the market price. Resulting in the overproduction and overconsumption or a good/service

Question 23

What is the first paragraph of describing a positive consumption externality?

Answer 23

The free market equilibrium occurs at point D, when the PMC curve intersects the PMB curve, corresponding with an output level q0, and price level p0.

Question 24

What is the second paragraph of describing a positive consumption externality?

Answer 24

The socially optimum equilibrium occurs at Point E, where the SMC curve intersects the SMB curve, corresponding with an output level q1, and a price level p1.

Question 25

What is the third paragraph of describing a positive consumption externality?

Answer 25

The consumer only takes into account the private benefits of their actions, they ignore the external benefits of their actions, therefore they do not take into account the full social benefits of their actions.

Question 26

What is the fourth paragraph of describing a positive consumption externality?

Answer 26

Subsequently, the consumer registers too low a level of demand at q0. There is an underconsumption equal to q1-q0. Too few scarce resources are devoted to the production of this good. There is allocative inefficiency and the market has failed, as demonstrated by the welfare gain triangle DEF.

Question 27

What is the fifth paragraph of describing a positive consumption externality?

Answer 27

Had the consumer taken into account the full social benefits of their actions, they would have registered a higher level of demand, q1, and there would no longer be allocative inefficiency or market failure.

Question 28

Define a positive consumption externality

Answer 28

When the social benefits are greater than the private benefits. External benefits are generated which are not taken into account by the consumer, thus do not reflect the market price.