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.