Unit 2.8: Market Failure

Question 1

Market Failure

Answer 1

The failure of the free market to allocate resources efficiently to what is deemed socially desireable

Question 2

Externalities

Answer 2

The spillover benefits or costs imposed on third parties through consumption or production

Question 3

Positive externalities

Answer 3

External benefits imposed to third parties through economic activities

Due to external benefits imposed to a third party, the MSG of a merit good is larger than the MPB: MSB>MPB

Question 4

Positive externalities of consumption

Answer 4

The external benefits imposed to third parties through economic activities

Question 5

Government intervention correcting positive externalities

Answer 5

Markets associated with positive externalities of consumption or production suffer from an under-allocation of resources leading to market failure.

Question 6

Legislation and regulation

Answer 6

Laws enforced by the government to ensure certain behaviour from consumers and producers.

Question 7

Advantages and disadvantages of legislation and regulation in correcting positive externalities

Answer 7

Advantages:
1. Effective in reducing externalities from a command-and-control approach

Disadvantages:
1. Monitoring and enforcing costs incurred by the government

2.People may choose to break the rules if penalties are not significant

3. Political pushback

Question 8

Education-awareness creation

Answer 8

Governments may educate the public about the benefits of merit goods through ads, campaign, and schools to encourage consumption

The government may also discourage the consumption of demerit goods through education and awareness campaigns so that the public is more aware of the negative effects of the good.

Question 9

Advantages and disadvantages of education-awareness creation in correcting positive externalities

Answer 9

Advantages
1. Effective campaigns may change consumer behaviour for the long term

Limitations
1. Education campaigns only encourage people to change behaviour; effectiveness may vary

2. Requires time for the message to be accepted and behaviour to change

3.Opportunity cost of government spending

Question 10

Direct provision

Answer 10

Governments may directly provide goods and services in the public sector associated with positive externalities such as education, healthcare, and infrastructure.

Question 11

Disadvantages of direct provision in correcting positive externalities

Answer 11

Opportunity cost – Direct provision requires government spending, which always involves foregone benefits of alternative uses.

Economic inefficiency – Goods and services may be provided free of charge or at a very low cost, potentially resulting in overconsumption such use of A&E (accident and emergency) services for common illnesses.

Inequality – If the goods provided are in shortage, the government may need to prioritize certain groups e.g., healthcare services for the elderly.

Question 12

Advantages and disadvantages of subsidies in correcting positive externalities

Answer 12

Advantages:
1. Incentivizes production and consumption.

2. Reduces the price of the good, increasing its affordability to lower income groups.

Disadvantages:
1. Imperfect market information – difficult to accurately calculate the level of subsidy and externalities in order to achieve the socially-optimum output.

2. Effectiveness is dependent on PED – larger subsidies required for price inelastic products.
3. Opportunity cost – Subsidies require government spending, which always involves foregone benefits of alternative uses.

Question 13

Negative externalities of consumption

Answer 13

The negative spillover costs (negative benefits) generated to third parties by consumers during consumption activities.

Question 14

Negative externalities of production

Answer 14

The negative spillover costs generated to third parties by producers during production activities.

Question 15

Government intervention correcting negative externalities

Answer 15

Markets associated with negative externalities of consumption or production suffer from an over-allocation of resources leading to market failure.

Question 16

Advantages and disadvantages of indirect taxes in correcting negative externalities

Answer 16

Advantages
1. The price increase discourages consumption.

2. The higher cost discourages production.
3. Tax revenue is generated for the government.

Disadvantages
1. Regressive – low-income groups pay a higher portion of their income for the tax.

2. Relatively ineffective for goods with inelastic PED
3. Imperfect market information means the size of the tax is unlikely equal to the external cost.
4. Emergence of parallel markets – smuggling activities for demerit goods.

Question 17

Advantages of legislation and regulation in correcting negative externalities

Answer 17

Advantages:
1. Effective in reducing externalities from a command-and-control approach

Disadvantages:
1. Monitoring and enforcing costs incurred by the government

2. Political pushback
3. People may choose to break the rules if penalties are not high enough.

Question 18

Collective self-governance

Answer 18

The voluntary communal actions that combat negative externalities.

Successful campaigns may change social norms and cultural behaviours.

Question 19

Carbon emissions

Answer 19

The release of carbon into the atmosphere and is one of the most common and significant negative externalities which occur from economic activity.

Question 20

Carbon taxes

Answer 20

Imposed on producers for carbon emissions from production activities with the aim of minimising environmental pollution.

Question 21

Advantages and disadvantages of carbon taxes in correcting negative externalities

Answer 21

Advantages
1. Long term benefits – create incentives for firms to use cleaner technologies in production

2. Internalize externality – producers and consumers pay for the environmental costs
3. Tax revenue generated
4. Easily implemented

Carbon taxes - disadvantages
1. Regressive – low-income groups pay a higher portion of their income for the tax

2. Ineffective for products with inelastic PED
3. Imperfect market information – difficult to accurately calculate the level of externalities and carbon tax in order to achieve the socially-optimum output.