THEME 1 - Topic 6 - Market Failure and Externalities Flashcards
Define market failure
It exists any and every time that a free market fails to lead to the optimum allocation of scarce resources.
Define productive efficiency
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.
Define allocative efficiency
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.
Define an externality
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.
Define a third party
People who are not directly involved in decision-making and whose costs/benefits are ignored.
Define consumption externality
Is an externality that affects the consumption side of a market, which may be either positive or negative.
Define productional externality
Is an externality that affects the production side of a market, which may be either positive or negative.
Define private cost
Is the cost of an activity to the decision-maker as a result of its production or consumption.
Define private benefit
Is the benefit of an activity to the decision-maker as a result of its production or consumption.
Define external cost
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.
Define external benefit
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.
Define social cost
Is the total cost of a particular action, and so is equal to the private cost plus external cost (not quantifiable).
Define social benefit
Is the total benefit of a particular action, and so is equal to the private benefit plus external benefit (not quantifiable).
Define negative externality
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.
Define positive externality
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.
Name 5 examples of negative production externalities
Deforestation
Illegal dumping of waste
Traffic congestion
Carbon emissions
Water pollution
What’s the first paragraph of describing a negative production externality?
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.
What’s the second paragraph of describing a negative production externality?
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.
What’s the third paragraph of describing a negative production externality?
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.
What’s the fourth paragraph of describing a negative production externality?
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.
What’s the fifth paragraph of describing a negative production externality?
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.
Define a negative production externality
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
What is the first paragraph of describing a positive consumption externality?
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.
What is the second paragraph of describing a positive consumption externality?
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.
What is the third paragraph of describing a positive consumption externality?
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.
What is the fourth paragraph of describing a positive consumption externality?
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.
What is the fifth paragraph of describing a positive consumption externality?
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.
Define a positive consumption externality
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.
